Growing the Bank

If the purpose of a publicly owned company is to provide a satisfactory return to its shareholdersu00e2u20ac”and if the report card for management and the board of directors is the company’s stock priceu00e2u20ac”then wouldn’t it be great if you could isolate the one key factor that helps shareholder value grow the most? In a consolidating industry that seems to place great importance on both scale and diversification, you might think that size or an unusually high percentage of fee income would be fertile drivers. Or perhaps, in a business that has become highly competitive and increasingly commoditized, being a low-cost producer with an efficiency ratio significantly below 50% are the magic beans that makes a bank stock shoot up.

In fact, none of those factors have a high, positive correlation with growth in shareholder valueu00e2u20ac”and one of them actually has a small negative correlation. Instead, the “secret” turns out to something banks often take for granted for yearsu00e2u20ac”deposits. Based on proprietary research that it has performed over the last few years, New York-based First Manhattan Consulting Group says the variable most responsible for driving a bank’s stock price is organic growthu00e2u20ac”particularly the growth of consumer and small business deposits.

“New analysis of total return to shareholders over time for regional banks shows empirically the importance of same-store deposit growth in the retail-oriented branches,” says FMCG President Jim McCormick. “This is perhaps not surprising, since it is a metric that is analogous to the ‘same-store’ metric that is an obsession in retailing. The fact that we found a surprisingly large difference in the organic growth rates of individual banks heightened the importance.”

In a recent analysis of a large number of regional banks that it performed for Bank Director, FMCG identified a group of 12 regional banks that have an established track record for delivering superior organic growth, including strong deposit generation. All 12 banks also have above-average investor returns for the industry. First Manhattan used two measures to single them out. The first one is revenue-per-share (RPS), which is the sum of net interest and noninterest income minus loan-loss provisions and certain forms of nonrecurring income, divided by average common shares outstanding. FMCG describes this as a proxy for what it deems “organic revenue growth.” The second gauge is a variation of a performance yardstick that has been a staple of the retailing industry for yearsu00e2u20ac”same-store sales growthu00e2u20ac”although what FMCG actually measured was same-store deposit growth (SSDG). The firm measured RPS and SSDG over a three-year period, from 2002 through 2005.

The 12 banks were then divided into two groups depending on their performance level. Those with double-digit annual growth in RPS and same-store deposit growth that generally exceeded 8% annually were placed in the gold category. These banks were:

Commerce Bancorp, Cherry Hill, New Jersey; assets $36 billion

Glacier Bancorp, Kalispell, Montana; assets $3.7 billion

PrivateBancorp, Chicago, Illinois; assets $3.5 billion

Synovus Financial Corp., Columbus, Georgia; assets $27.6 billion

Wachovia Corp., Charlotte, North Carolina; assets $538 billion

Wintrust Financial Corp., Lake Forrest, Illinois; assets $8.1 billion

A second group of banks that has strong revenue-per-share growth and SSDG of 5% to 8% annually included:

Cathay General Bancorp, Los Angeles, California; assets $6.3 billion

City National Corp., Beverly Hills, California; assets $14.5 billion

Cullen/Frost Bankers, San Antonio, Texas; assets $11.7 billion

Mercantile Bankshares, Baltimore, Maryland; assets $16 billion

Texas Regional Bankshares, McAllen, Texas; assets $6.5 billion

Wells Fargo & Co., San Francisco, California; assets $482 billion

FMCG used each bank’s reported financial statements to do the revenue-per-share calculations. The same-store deposit growth analysis was performed using annual deposit data provided by the Federal Deposit Insurance Corp. All insured institutions are required to report their deposit totals by branch to the FDIC every June, and this data is publicly available. However, the firm goes through the data carefully to exclude branches that received international deposits or large sums of commercial deposits if they have been designated as “headquarter locations.” It also drops branches that have been recently consolidated. And it eliminates any deposit growth that is a result of an acquisition, since SSDG is a measurement of organic, rather than acquired, growth.

The gist of FMCG’s theory is that organic growthu00e2u20ac”or what it calls RPSu00e2u20ac”drives total shareholder return (which is the annual appreciation in a company’s stock price plus dividends), and that same-store deposit growth is the primary driver of RPS.

Adding it all up

To understand the theory more fully, it helps to work back to the beginning. For those banks with strong organic growth (as opposed to those banks that have grown primarily through acquisition) FMCG’s research shows a strong statistical correlation between their returns on equity (ROE) and ratios of market-value-to-book price. The correlation analysis produces an r2 of 67%, which means that two-thirds of the variation in market-to-book ratios from one bank to another is explained by their respective ROEs. Put another way, ROE drives book value. (Book value is defined as assets minus liabilities and intangible assets. It tells you what a company is worth in accounting terms.)

FMCG’s research also shows that for banks with strong organic growth, total shareholder return is heavily driven by earnings-per-share growth. There the r2 is nearly 50%. Double up and add ROE to the calculation and the r2 jumps up to 60%. In other words, shareholder returns are driven primarily by the combination of ROE and EPS growth.

It makes perfect sense that earnings growth (as measured by EPS) and the effective use of equity capital (measured as ROE) would drive a company’s stock price. But what drives ROE and EPS? For the banks with strong organic growth, it turns out to be the growth in consumer and small business deposits. Other variables that FMCG testedu00e2u20ac”including size and efficiency ratio, had only small, positive correlations. And a third variableu00e2u20ac”an increase in fees as a percentage of revenuesu00e2u20ac”actually had a small, negative correlation.

Cause and effect

So why does deposit growth have such a significant impact on a company’s stock price? “Number-one, it lowers a bank’s risk,” says Ted Francavilla, a senior associate at FMCG who performed the data analysis for Bank Director. “Have you ever heard of a bank that lost money because of its deposits?” Core deposits, which include checking and savings accounts, time deposits, and money-market accounts, are a cheap source of funding. As a result, banks with a high percentage of core funding don’t have to take as much risk in their loan portfolio to generate a strong return. “You don’t have to grow as fast and you don’t have to chase the more risky loans,” Francavilla says.

Another advantage of strong deposit growth is that it’s easy on the balance sheet. “You don’t need to add to equity [capital] as you grow deposits,” he says. “As you grow loans, you need to raise more equity to support that.” A “less measurable but still important” advantage of having a high percentage of checking accounts, Francavilla adds, is that checking tends to be the hub account in most retail banking relationships. Industry studies have shown that banks have more success cross-selling additional products to their checking account customers than any other financial products. “The customer views the checking account as the core of the [banking] relationship,” Francavilla says. “[Banks] get better deposits and a much larger role with checking customers than with mortgages or certificates of deposit.”

Industry experts also believe that deposits are universally valuable regardless of the environment. “In most rate environments, [deposit growth] pays exponentially,” says Gary Townsend, a bank stock analyst at Friedman, Billings, Ramsey & Co. in Arlington, Virginia. “For the bank that can gain transaction accounts, that means it’s taking share from some other bank that would just as soon hold on to it. I would argue that it is inherently important to grow deposits.”

Drilling down: Secrets of success

The 12 banks that FMCG identified in its survey as having strong same-store deposit growth provide an interesting contrast in size, business model, and location. Commerceu00e2u20ac”which has long been a proponent of using SSDG to gauge its performanceu00e2u20ac”is a mass-market retailer that emphasizes service quality and has expanded aggressively from the Greater New York marketplace south to the Washington, D.C. area. While they hail from diverse sections of the country, four of the institutionsu00e2u20ac”Glacier, Synovus, Wintrust, and Mercantileu00e2u20ac”are essentially networks of community banks that have retained their own names and operate with a great deal of autonomy.

Cathay General is a commercial bank that focuses on the Asian community in Southern California and has representative offices in Hong Kong, Shanghai, and Taipei. City National provides private banking services and also has developed close ties with the movie and entertainment industry in Los Angeles. PrivateBancorp provides private banking services to affluent customers in the Chicago area. Cullen/Frost and Texas Regional are highly regarded regional banks in an attractive Texas market, while Wachovia and Wells Fargo are two of the country’s largest banks.

For all their diversity, most of these burgeoning banks appear to have several things in common. “Focus,” says Francavilla. “They’re not trying to be all things to all people.” The exceptions are Wachovia, Wells Fargo, and Commerce, which do service a variety of customer types. The lesson, says Francavilla, is to “pick a business or segment and be really good at it. Don’t spread yourself too thin.”

A second trait that most of the banks shared was a strong community orientation. This strategy was especially evident with Glacier, Synovus, Wintrust, and Mercantile, which operate in their local markets as separately branded community banks. And finally, all these banks do an excellent job of providing first-rate customer service. Commerce can even be said to have elevated service to an art form, and Wachovia has improved its service in recent years as well.

Focus, focus, focus

A bank that clearly has a highly focused business model is PrivateBancorp. The bank operates through subsidiaries in Chicago, St. Louis, and Bloomfield Hill, Michigan, and offers its customers a variety of loan and deposit products, as well as wealth management services. According to Chairman and Chief Executive Officer Ralph B. Mandell, PrivateBancorp’s target market of households with yearly income exceeding $150,000 is the fastest-growing demographic segment in the United States. “It’s also a highly fragmented marketu00e2u20ac”no one owns it,” he says.

Steve Alexopoulos, a securities analyst with Sandler O’Neill & Partners in New York, says PrivateBancorp survives in the same market as investment management powerhouse Northern Trust Corp. by going after a market niche well below the $500 million in assets and above that Northern Trust serves. Instead, PrivateBancorp targets customers with assets from $1 million to $100 million and provides them with first-class service. “At Northern Trust, that’s coach class,” says Alexopoulos.

PrivateBancorp had a $2.6 billion loan portfolio at the close of the fourth quarter of 2005, about 62% of which were related to commercial real estate. All of those loans were made to customers that the bank was also providing other products tou00e2u20ac”including deposit services. “Wealthy people tend to keep more deposits,” says Mandell. “Everyone’s idea of what to keep in cash reserves varies. For some people, it’s $25,000. For some it’s $20 million. We have both.” Thirty-five percent of the $2.2 billion in core deposits as of year-end 2005 were in money-market accounts.

Mandell also credits his team of managing directorsu00e2u20ac”the people who work directly with customersu00e2u20ac”with providing the very best in service. Indeed, private banking customers expect nothing less. “Our clients have high expectations and we meet or exceed them,” says Mandell. “Many of the companies we compete against don’t do that. It’s all about service. We are a client-driven company. We are not a product-driven company.”

Reaching out for customers

It may seem unlikely given that it’s the fourth-largest bank in the country, but Wachovia owes much of its deposit growth success to a significant improvement in customer service. There was a time when one of Wachovia’s predecessor banksu00e2u20ac”First Union Corp.u00e2u20ac”had a less-than-favorable customer service reputation in its branch operation, thanks to a disastrous merger integration in the mid-1990s. But Wachovia has since learned how to acquire and integrate banks while avoiding the kind of service black eyes that drive away customers. Sandler O’Neill securities analyst Kevin Fitzsimmons says that Wachovia’s last two dealsu00e2u20ac”the 2001 merger of First Union with the old Wachovia, and Wachovia’s 2004 acquisition of SouthTrust Corp.u00e2u20ac”proceeded much more smoothly than in years past. “They’ve provided a model for how to do a big bank deal,” he says.

Just as importantly, Wachovia’s senior management teamu00e2u20ac”led by Chairman and CEO Kenneth Thompsonu00e2u20ac”have focused its attention on service quality with laudable results. Thompson chairs a monthly meeting on service quality that is attended by the bank’s major business line heads as well as its senior technology executives. It has also contracted with The Gallup Organization to perform an ongoing customer service survey that focuses on its retail operation. “This is one way that we make sure we get accurate information down to the front lines, where the customer feels it,” says Gwynne Whitley, Wachovia’s head of corporate customer service excellence.

These initiatives are paying big dividends in the form of greater customer retention. Betty Cowell, Wachovia’s director of deposit and access services, says the bank’s retention rate is 45% better than most of its peers. “That’s 45% that we don’t have to replace,” she says. Even though she has responsibility for designing the bank’s retail deposit products, Cowell says pricing is not nearly as important as service. Pointing to Wachovia’s success at penetrating the small business market, Cowell says, “What small business customers are driven by most is convenience and service. Customers don’t bring up price as the reason why they selected you.”

Know your market

If all politics is local, the same could be said for banking. At first glance, Mercantile Bankshares’ operating strategy of maintaining separate and high autonomous banking affiliates would seem inefficient. But Mercantile understands the great advantage that community banks have in the local marketplace, and it has chosen to copy that advantage by competing as a local bank in the 11 communities it serves in Maryland, Virginia, and Delaware. It is a booming marketplace that has seen tremendous population growth in recent years and has long attracted the attention of some of the country’s biggest banks, including Wachovia, Bank of America Corp., PNC Financial Corp., and Commerce.

While Mercantile is the largest bank holding company in Maryland, it still manages to operate as a local bank in each of the communities it serves. Each Mercantile affiliate bank has its own president, chief financial officer, and board of directors, and operates under its own name. Although there are some centralized functions, the affiliate presidents are responsible for their own credit quality and profitability, and in many respects the affiliates operate the same as before they were acquired.

“It creates a very entrepreneurial environment,” says Peter Floeckher, Mercantile’s executive vice president for affiliate banking. “That model is about execution,” adds Alexopoulos. “If you give people in the region the authority, they will beat the big banks.”

Traditionally, Mercantile’s affiliate banks have emphasized commercial banking much more than they have the consumeru00e2u20ac”evidence that even corporate and small business customers can provide strong deposit flows for those banks that focus on developing deposit relationships. Floeckher believes an important part of Mercantile’s success has been the emphasis it places on developing close personal relationships with the business owners who bank there. “Our customers in the small business area know their lenders, the head of the lending unit, their branch manager and the president of the affiliate bank,” says Floeckher. “There are four points of contact for the customer.”

Because most of its affiliates have deep roots in commercial banking, Mercantile has not been as effective raising deposits on the retail side of the business. According to Floeckher, this is something the bank is working on now to improve, in part by developing a new consumer banking strategy that will be standardized across all 11 affiliates. “We’ve never thought of ourselves as a retail bank,” says Floeckher. “We really haven’t gone after the retail side of the market.” And if Mercantile can be as successful there as they have been in commercial banking, its deposit growth could skyrocket. “I would say we have a lot more room for growth,” says Floeckher.