The Powerful Force Driving Bank Consolidation


margins-8-16-19.pngA decades-old trend that has helped drive consolidation in the banking industry can be summarized in a single chart.

In 1995, the industry’s net interest margin, or NIM, was 4.25%, according to the Federal Reserve Bank of St. Louis. (NIM reflects the difference between a bank’s cost of funds and what it earns on its assets, primarily loans.) Twenty years later, the margin dropped to a historic low of 2.98%, before gradually recovering to 3.30% last year.

NIM-chart.png

The vast majority of banks in this county are spread lenders, making most of their money off the difference between what they pay for deposits and what they charge for loans. When this spread narrows, as it has since the mid-1990s, it pinches their profitability.

The decision by the Federal Reserve’s Federal Open Market Committee to reduce the target range for the federal funds rate by 25 basis points in August will likely exacerbate this by reducing the rates that banks can charge on loans.

“For most banks, net interest income [accounts for] the majority of their revenue,” says Allen Tischler, senior vice president at Moody’s Investor Service. “A reduction in [it] obviously undermines their ability to generate incremental earnings.”

There have been two recessions since the mid-1990s: a brief one in 2001 and the Great Recession in 2007 to 2009. The Federal Reserve cut interest rates in both instances. (Over time, lower rates depress margins, although banks may initially benefit if their deposit costs drop faster that their loan pricing.)

Inflation has also remained low since the mid-1990s — particularly since 2012, when it never rose above 2.4%. This is why the Fed has been able to keep rates so low.

Other factors contributing to the sustained decline in NIMs include intermittent periods of intense competition and rate cutting between banks, as well as the emergence of fintech lenders. Changes over time in a bank’s the mix of loans and securities, and among different loan categories, can impact NIMs, too.

The Dodd-Frank Act has exacerbated the downward trend in NIMs by requiring large banks to carry a higher share of low-yielding liquid assets on their balance sheets, which depresses their margins. This is why large banks have contributed disproportionally to the industry’s declining average margin – though, these institutions can more easily offset the compression because upwards of half their net revenue comes from fees.

Community banks haven’t experienced as much compression because they allocate a larger portion of their balance sheets to loans and do most of their lending in less-competitive markets. But smaller institutions are also less equipped to combat the compression, since fees make up only 11% of the net operating revenue at banks with less than $1 billion in assets, according to the Office of the Comptroller of the Currency.

The industry’s profitability has nevertheless held up, in part, because of improvements to operating efficiency, particularly at large banks. The corporate tax cut that went into effect in 2018 plays into this as well.

“If you recall how banking was done in 1995 versus today … there’s just [greater] efficiency across the board, when you think about what computer technology in particular has done in all service industries, not just banking,” says Norm Williams, deputy comptroller for economic and policy analysis at the OCC.

The Fed’s latest rate cut, combined with concerns about additional cuts if the escalating trade war with China weakens the U.S. economy, raises the specter that the industry’s margin could nosedive yet again.

Tischler at Moody’s believes that sustained margin pressure has been a factor in the industry’s consolidation since the mid-1990s. “That downward trend does undermine its profitability, and is part of the reason why the industry has consolidated as much as it has,” he says.

If the industry’s margin takes another plunge, it could drive further consolidation. “The industry has been consolidating for decades … and there’s no reason why that won’t continue,” says Tischler. “This just adds to the pressure.”

There were 11,971 U.S. banks and thrifts in 1995. Today there are 5,362. Given the direction of NIMs, it seems like we may still have too many.

Exclusive: How This Growing Community Bank Focuses on Risk


risk-5-16-19.pngManaging risk and satisfying examiners can be difficult for any bank. It’s particularly hard for community banks that want to manage their limited resources wisely.

One bank that balances these challenges well is Bryn Mawr Bank Corp., a $4.6 billion asset based in Bryn Mawr, Pennsylvania, on the outskirts of Philadelphia.

Bank Director Vice President of Research Emily McCormick recently interviewed Chief Risk Officer Patrick Killeen about the bank’s approach to risk for a feature story in our second quarter 2019 issue. That story, titled “Banks Regain Sovereignty Over Risk Practices,” dives into the results of Bank Director’s 2019 Risk Survey. (You can read that story here.)

In the transcript of the interview—available exclusively to members of our Bank Services program—Killeen goes into detail about how his bank approaches stress testing, cybersecurity and credit risk, and explains how the executive team and board have strengthened the organization for future growth.

He discusses:

  • The top risks facing his community bank
  • Hiring the right talent to balance risk and growth
  • Balancing board and management responsibilities in lending
  • Conducting stress tests as a community bank
  • Managing cyber risk
  • Responding to Bank Secrecy Act and anti-money laundering guidance

The interview has been edited for brevity, clarity and flow.

download.png Download transcript for the full exclusive interview

Avoid the Risk of Complacency


growth-5-10-19.pngBank directors have a golden opportunity to position their banks for future growth and prepare them for change—if they can resist the lull of complacency, according to speakers at the opening day of Bank Director’s 2019 Bank Board Training Forum on May 9.

The current economic environment remains benign, as regulators have paused interest rate increases and credit quality remains pristine, says Joseph Fenech, managing principal and head of research at Hovde Group. Further, he argues that banks today are better equipped to withstand a future economic downturn.

But speakers throughout the day say the risk is that board members may feel lulled by their banks’ current performance and miss their chance to position these institutions for future growth.

“We’re going through the good years in banking. I would argue your biggest competitor is complacency,” says Don MacDonald, chief marketing officer at MX Technologies. He adds that bank boards needs to be asking hard questions about the future despite today’s positive operating environment.

Banks are grappling with the rapid pace of change and technology, shifting customer demographics and skills gaps at the executive and board levels. Speakers during the conference provided a variety of ways that directors can address these concerns with an eye toward future growth.

One way is to redefine how community banks think about their products and their markets, according to Ron Shevlin, director of research at Cornerstone Advisors. Shevlin says many community banks face competition from firms outside of their geographic marketplace. In response, some community banks are moving away from a geographic community and toward affinity, or common bond, groups. These firms have identified products or loans they excel at and have expanded their reach to those affinity customers. He also advises banks to examine how their products stack up to competing products. He uses the example of checking accounts, pointing out that large banks and financial technology firms sometimes offer rewards or personal financial management advice for these accounts.

“Everyone talks about customer experience, but fixing the customer experience of an obsolete product is a complete waste of money,” he says.

Another challenge for boards is the makeup of the board itself. Directors need to have a skill set that is relevant to the challenges and opportunities a bank faces. Today, directors are concerned about how the bank will respond to technology, increase the diversity of their boards and remain relevant to the next generation of bank customers, says J. Scott Petty, managing partner of financial services at Chartwell Partners, an executive search firm.

He challenges directors to consider the skills and experiences they will need in a few years, as well as how confident they are that they have the right board and leadership to run the bank.

“Change doesn’t happen overnight. It has to be planned for,” he says. “Board composition should reflect the goals of the financial institution.”

Banks can resist complacency with their culture, according to Robert Hill, Jr., CEO of South State Corp. Hill says there is never a point in time when “you’ve got it made and your bank is cruising.” Various headwinds come and go, but the overarching theme behind the bank’s challenges is that pace of change, need for customer engagement and competition are all increasing.

In response, Hill says the bank is very selective about who they hire, and looks for passion, values and engagement as well as specific skills. South State prioritizes soundness, profitability and growth—in that order—and wraps its cultural fabric around and throughout the company. A large part of that is accomplished through leadership, and the accountability that goes with it.

“If the culture is not strong and foundation is not strong, it will be much harder for a company to evolve,” he says.

Building a Stronger Bank



Following an acquisition or merger, many banks struggle to build and strengthen their brand. The branch channel is an important part of the franchise for most institutions, so determining which locations to keep, and which to close, is a key strategic decision post-merger. In this video, Anthony Burnett of Level 5 explains how to approach these decisions. He also shares how banks can position themselves for future growth by evaluating opportunities and staffing, and developing a long-term growth plan for the back office.

  • Strategies that Strengthen Your Bank’s Brand
  • Making Decisions About Branch Redundancies
  • Addressing the Back Office
  • Positioning the Bank for Future Growth

Should 1,900 Banks Restructure After Tax Reform?


strategy-2-18-19.pngOne of the big story lines of 2018 was tax reform, which should put more money in the pockets of consumers and businesses to grow, hire, and borrow more from banks.

Shareholders of Subchapter-S banks may ask whether the benefits of Sub-S status are as meaningful in the new tax environment. Roughly 35 percent of the 5,400 banks in the U.S. are Subchapter-S corporations, and given the changes brought by the Tax Cuts and Jobs Act, some choices made under the prior tax regime should be revisited.

Prior to tax reform, the benefits of Sub-S status were apparent given the double taxation of C-Corp earnings with its corporate tax rate of 35 percent, plus the individual dividend tax rate of 20 percent. That’s compared to the S-Corp, which only carried the individual income tax rate up to 39.5 percent.

Tax reform lowered the C-Corp tax rate to 21 percent, lowered the maximum individual rate to 37 percent, and created a potential 20 percent deduction of S-Corp pass-through earnings, all of which make the choice much more complicated.

Add complexities about how to calculate the 20 percent pass-through deduction on S-Corp earnings, the 3.8 percent net investment income tax on C-Corp dividends and some S-Corp pass-through earnings, and it becomes more challenging to decide which is best.

Here are some broad concepts to consider:

  • S-Corp shareholders are taxed on the corporation’s earnings at the individual’s tax rate. If the corporation does not pay dividends to shareholders, the individual tax is being paid before the individual receives the actual distribution. 
  • The individual tax on S-Corp earnings may be mitigated by the 20 percent pass-through deduction allowed by the IRS, but not all the rules have been written yet. 
  • A C-Corp will pay the 21 percent corporate tax, but individual tax liability is deferred until shareholders are paid dividends. The longer the deferral, the more likely a C-Corp structure could be more tax efficient.

The impact of growth, acquisitions, distributions, and capitalization requirements are interrelated and critical in determining which entity makes the most sense.

If a bank is growing quickly and distributing a large percentage of its earnings, its retained earnings may not be sufficient to maintain required capital levels and may require outside capital, especially if the bank is considering growth through acquisition. Because an S-Corp is limited in the type and number of shareholders, its access to outside capital may also be limited, often to investments by management, board, friends, family and community members.

A bank with little or no growth may be able to fully distribute its earnings and still maintain required capital levels. Depending on the impact of Internal Revenue Code Section 199A, state taxes, the 3.8 percent net investment income tax and other factors, Subchapter S status may be more tax efficient.

Section 199A permits the deduction of up to 20 percent of qualifying trade or business income and can be critical to determining whether Subchapter-S makes sense. For shareholders with income below certain thresholds, the deduction is not controversial and can have a big impact.

For shareholders with income above the thresholds, the deduction could be limited or eliminated if the business income includes specified service trade or business income, which includes investment management fees and may include trust and fiduciary fees and other non-interest income items.

S-Corp structures can be terminated at any time. If your bank is a C-Corp and considering a Subchapter S election for the 2019 calendar tax year, the election is due on or before March 15, 2019.

Given the level of complexity and amount of change brought about by the new tax legislation, it is clear that that decisions made under the old rules should be revisited.

Exclusive: An Interview with Brian Moynihan


bank-of-america-2-14-19.pngBank Director’s writers and editors talk with the best bankers in the United States to inform the stories we publish on BankDirector.com and in Bank Director magazine. But these conversations often go deeper and extend beyond the subject matter of those stories, leaving a lot of immensely valuable information on the cutting room floor, so to speak.

With this in mind, we are making available—exclusively to our members—the unabridged transcripts of these conversations. It is our belief that the insights found within them can help bankers gain knowledge and improve their own institutions.

For the cover story in the fourth quarter 2018 issue of Bank Director magazine, Executive Editor John Maxfield interviewed Brian Moynihan, CEO of Bank of America Corp., at the bank’s New York City offices.

While the story focused on how Moynihan, who has led Bank of America since 2010, transformed the bank’s culture and performance, the conversation also delved into his views on growth, risk management and other topics of interest to bank leaders.

In this lengthy interview, which has been lightly edited for clarity and brevity, Moynihan shares:

  • The sources of his philosophy on banking
  • The principles that inform Bank of America’s revamped growth philosophy
  • How history informs his view of the future
  • Lessons learned from the financial crisis
  • How Bank of America deepens relationships with existing customers
  • Why operating leverage helps the bank better manage risk

Larry De Rita, Bank of America’s senior vice president of corporate communications, is also quoted in the transcript.

download.png Download transcript for the full exclusive interview

Fuel for More M&A in 2019



How will economic factors like today’s strong stock market and rising interest rates, along with the banking industry’s demand for core deposits, impact profitability and growth in 2019? Dory Wiley of Commerce Street Capital predicts we’ll see more deals. Find out why in this video.

  • M&A Drivers in 2019
  • What to Know About Valuations
  • Powering Future Growth
  • Headwinds Facing the Industry

How History’s Playbook Can Help You Grow Today


leadership-1-30-19.pngOne might assume that many attendees at Bank Director’s Acquire or Be Acquired Conference in Arizona left town with an M&A game plan focused solely on their next acquisition, but a legendary banker suggested a different strategy.

John B. McCoy, the former chairman and chief executive officer of Banc One Corp., recommended during a presentation on the final day of the conference that bankers consider a strategy his father used that ended up revolutionizing banking.

This year’s conference, which celebrated its 25th anniversary, was held at the JW Marriott Phoenix Desert Ridge resort in Phoenix.

McCoy’s advice is a page taken directly from the playbook of his father, John G. McCoy, who founded Bank One and turned it into a regional powerhouse before it was eventually acquired by JPMorgan Chase & Co. in 2004.

“One of the things he did, which I suggest for all of you, is he set aside that first year 4 percent of the profits, (which) went to (research and development) to do new things, not fix old problems,” McCoy said.

The advice is especially prescient today because the banking industry is being pressured to keep pace with an evolving digital economy and changing customer preferences for how they bank, especially in the retail sector.

Bank One spent that money building an exceptional retail franchise. It was the first bank to place ATMs in every branch, add drive-thru lanes at its branches, offer a Bank of America credit card and essentially invent the country’s first debit card.

“That set us off,” McCoy said. “One took us to the next.”

That investment strategy played an important role in its growth: Bank One’s assets grew from $140 million in 1958—when it was the smallest of three banks in Columbus, Ohio—to more than $8 billion 25 years later, eventually becoming the sixth-largest bank in the country.

Early in its history, Bank One pursued an ambitious M&A strategy where it bought dozens of small banks—first in Ohio and later in surrounding states—using a concept that it called the “Uncommon Partnership,” where it would leave the management team of the acquired bank in place while centralizing many of its back office functions to save money. In fact, McCoy said they would only acquire a bank if the CEO agreed to stay in place.

Bank One also limited the risks of its acquisition program by never buying a bank that was more than 20 percent of its own asset size.

An announcement on Monday that Detroit-based Chemical Financial Corp. was acquiring Minneapolis-based TCF Financial in a $3.6 billion deal, creating the country’s 27th largest bank with $45 billion in assets, also generated a lot of talk during the conference. Chemical and TCF billed the transaction as a merger of equals even though Chemical’s shareholders will own 54 percent of the merged company.

While some some conference presenters suggested that mergers of equals could occur with more frequency given the recent declines in bank valuations, which has made it more difficult for acquirers to pay a big takeover premium, others were more skeptical.

Tom Brown, founder and CEO of the hedge fund Second Curve Capital, which invests exclusively in banks and other financial companies, doubted that those deals will become regular. For one thing, there are significant social issues to resolve, like which CEO will end up running the company, how many directors from the two banks will constitute the new board and what will the new company’s name be. (In the TCF/Chemical deal, the new company’s headquarters will be in Chemical’s hometown of Detroit, but it will take the TCF name.)

“They’re just really tough to do,” Brown said during the conference’s closing session. “Someone who has been a CEO is not going to take a different role. And, while they all make great sense to me as an investor, the amount of work before the deal could even be agreed upon is just too challenging.”

Several speakers at the conference also said that smaller banks will need to gain scale to compete in a consolidating industry. Conventional wisdom says that scale helps improve efficiency, reduces costs and boosts profitability–but the urge to grow bigger purely for the scale must be tempered, Brown said.

“I talk to all sorts of CEO’s who are $250 billion assets and they still think they don’t have scale,” Brown said. “Let’s just stop using the get bigger to get scale idea because I haven’t seen that work yet.”

The Three M&A Virtues of M&T


merger-1-4-19.pngM&T Bank Corp.—the $117 billion asset bank holding company headquartered in Buffalo, New York—is well-known for its disciplined approach to M&A, a strategy that has served the big regional bank well through the 18 whole-bank acquisitions it has made since 1987.

Its most recent deal, which closed in November 2015, was also its biggest—the purchase of Hudson City Bancorp, a Paramus, New Jersey-based regional thrift that expanded M&T’s reach in New Jersey, Connecticut and parts of New York City, adding $37 billion in assets and $18 billion in deposits.

The well-priced deal led to M&T’s first-place tie with Phoenix, Arizona-based Western Alliance Bancorp. for the Best M&A Strategy in Bank Director’s 2019 RankingBanking study.

Given M&T’s three decades of successful deals, Bank Director interviewed M&T Chief Financial Officer Darren King to explore the bank’s philosophy around M&A. He says three values drive its M&A strategy.

The first—and perhaps most important value—is patience. Put simply, if a deal doesn’t align with M&T’s strategy, it won’t happen.

“We’ve never been a bank that’s been interested in growth just for growth’s sake,” says King. M&T is laser-focused on getting a return on the dollars invested, whether that’s for an acquisition, an investment in technology or any other investment made to grow and improve the business.

“Our job is to provide our shareholders with a better-than-average return on their investment,” says King. That focus on returns—rather than chasing growth—yields the discipline the bank needs to execute on its strategy.

Part of that patience means the bank will wait for the right partner—one that is committed to the long-term success of the deal. This is the second value that drives dealmaking at M&T.

“One of the places that helps you earn that return [on investment] is the price that you pay,” says King. Committed partners tend to hold to a more long-term view on that point. “Our hope is that anyone who is a willing partner—which is precondition for us for the combination—would like to be paid in our stock, and therefore the price [paid] isn’t necessarily a reflection of the value that would be created for both [entities’] shareholders by putting the two organizations together.” A lower price in a successful transaction will have a positive impact on M&T’s stock—which benefits the seller as a stockholder.

Having so-called skin in the game by taking stock in the transaction also represents a commitment from the seller that the acquired bank’s management team will stay on board to ensure the future success of the merged entity—and raise the value of the stock.

“They don’t want someone to sell their bank to M&T, and go away and retire,” says Brian Klock, a managing director at Keefe, Bruyette and Woods, who covers M&T. “They want to have those local managers and executives that will make a difference and be the M&T leader in that market, so they want those executives to stay around. If they take M&T stock and don’t take as big a price, that’s a commitment from the bank that’s selling to them.”

The final value for M&T is its consideration for the size and location of the target.

“We’re cautious not to go too big, because then it increases the risk,” says King. Integrating a large deal can get out of hand if a bank bites off more than it can chew. But a deal can’t be too small either, he says, because some of the risks related to integration and conversion aren’t scalable. “If you’re going to take on that risk, it needs to be worth the trip,” King says.

M&T also prefers in-market deals or locations in contiguous markets, where its brand is well known.

Outsiders may see M&T as a bank focused on price, but that’s not the case, says King. “If you look at our history, people would describe us as focused on price, and we buy troubled assets,” he says.

Economic downturns tend to yield troubled franchises with strong long-term potential. Having the discipline to focus on long-term returns—not just price—puts M&T in a position to take advantage of opportunities in the marketplace. M&T scooped up four banks—totaling more than $10 billion in assets—from late 2007 through August 2009. It gained another $10.8 billion through its acquisition of Wilmington Trust in May 2011.

It’s often said the best deal is the one you don’t make. By making deals that adhere to three key M&A virtues—patience, focusing on in-market targets that are the right size, and finding a committed partner—M&T’s disciplined approach has served it well.

What Bankers Should Know About Conversational AI in 2019


omnichannel-12-21-18.pngWe’ve come a long way since filmgoers watched nervously as the computer “Hal” struck out on his own with the bland yet threatening response, “I’m sorry Dave, I’m afraid I can’t do that,” in Stanley Kubrick’s “2001: A Space Odyssey.”

Today, humans are comfortable interacting with machines. Twenty-five percent of customer service and support operations will integrate virtual customer assistant (VCA) or chatbot technology by 2020, up from less than 2 percent in 2017, according to Gartner, Inc. And in some cases, consumers seem to prefer machines to humans. Therapy bots like Woebot are successful in part because users don’t experience the fear of judgment that may exist speaking with another human.

The technology that enables machine-to-human interactions is known as conversational AI. It powers virtual assistants across apps, websites, messaging and smart speakers. In 2018, we saw virtual assistants take off in banking – finding their way into the apps and websites of the world’s largest banks. Pilots turned into production, and virtual assistants started engaging with real consumers at scale.

This technology is a growth engine for banks by servicing customers more efficiently, engaging customers to boost brand loyalty and acquiring customers to increase their lifetime value. But all conversational AI solutions are not the same.

Here are three key trends for banks implementing conversational AI in 2019.

Think omnichannel, not multichannel
Consumers’ expectations for banking are evolving from siloed multichannel experiences to deeply personalized omnichannel experiences. They expect the experience with their bank to be consistent and informed, no matter which channel they interact on, and they expect to move smoothly between channels. Banks implementing conversational AI should support “channel traveling” and never lose sight of who the customer is – not just their unique ID, but their preferences, history and more.

Make sure your solution supports sophisticated customer journeys and hand-offs between channels. Your customer should be able to start a conversation with your virtual assistant on Amazon Alexa, and the virtual assistant should be smart enough to follow up with more related details in the mobile app. The virtual assistant knows the optimal interaction model for each channel and generates the right response for the channel of choice.

Conversations that explain “why”
By now, consumers are accustomed to automated assistants that respond to them. A virtual assistant that answers questions has become table stakes. In 2019 and beyond, we’ll see consumers gravitate toward services that can give them answers to questions and explain their finances. People will come to expect answers to “why” in addition to “what.”

For example, customers will want to know their balance, but also why it is lower than expected. Or, they may ask if they can afford a vacation now, and if they could still afford it in six months. They’ll want to know their FICO score, and why it is lower than last year.

Banking customers already know chatbots can give their balance and move their money. In 2019, their expectation will be that conversational AI will do more to help manage their money with context and insights.

The era of available data is here
After years of waiting for banking data to be available, the future is finally here. Inspired by regulations such as PSD2, or the Payment Services Directive, in the European Union, large banks around the world are adopting open banking standards and launching modern developer portals that enable a new world of banking services. This is good for conversational AI, because its real value comes from personalized, actionable experiences—experiences that require data and services. With financial institutions such as Wells Fargo, Citi, Mastercard and Standard Chartered streamlining access to APIs, building meaningful conversational experiences and integrating them with the banks’ other services will be much easier and faster.

In 2018, we’ve seen conversational AI is here to stay, and in 2019, we need to make virtual assistants do more than respond to FAQs and complete simple tasks. Banks implementing conversational AI should remember consumer expectations are growing every year. To meet those expectations, leverage the abundance of available data via APIs to create omnichannel customer journeys that can understand your customers and explain the context to them.