Crossing the $10 billion asset threshold has a big impact on a growing bank, due to enhanced regulations mandated by the Dodd-Frank Act. In March, Bank Director President & CEO Al Dominick sat down with Dallas Wells of PrecisionLender for “The Purposeful Banker” podcast, to explain the implications of crossing the $10 billion mark, and what banks should do to prepare for it.
Implications of Being a $10 Billion Asset Bank
M&A and Scale
Infrastructure and Talent
Dallas Wells: Welcome to another episode of “The Purposeful Banker,” a podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today’s best bankers. I’m Dallas Wells, and thank you for joining us.
Today, we’re talking about the $10 billion asset threshold and why it has become so critically important for banks. To help us with this conversation, I’m joined by one of the industry’s foremost experts on bank strategy, Al Dominick. Al is the president and CEO at Bank Director and has lots of commentary out there about how banks are handling this exact issue. Al, welcome and thank you so much for taking the time to do this.
Al Dominick: Yeah, my pleasure. Great to be a part of this.
Dallas Wells: Al, for anyone who might not be familiar, tell us a little bit about yourself and what you all do at Bank Director…
For a complete transcript of this “The Purposeful Banker” podcast, please view here.
Why are there so many people attending Bank Director’s 2016 Acquire or Be Acquired Conference this year, which at over 900 people is the largest number of attendees in the 22 years that we have been holding this event? Clearly the participants are interested in learning about the mechanics of bank M&A and the trends that are driving the market. But something seems to be different. I sense that more boards and their management teams are seriously considering M&A as a growth plan than perhaps ever before.
The heightened level of interest could certainly be explained by the continued margin pressure that banks have been operating under for the last several years. The Federal Reserve increased interest rates in December by 25 basis points–the first rate hike since 2006. But Fed Chairman Janet Yellen has said that a tightening of monetary policy will occur gradually over a protracted period of time, so any significant rate relief for the industry will be a long time in coming.
Other factors that are frequently credited with driving M&A activity include the escalation in regulatory compliance costs – which have skyrocketed since the financial crisis – and management succession issues where older bank CEOs would like to retire but have no capable successor available. But these challenges have been present for years, and there’s no logical reason why they would be more pressing in 2016 than, say, 2013.
What I think is different is a growing consensus that size and scale are becoming material differentiators between those banks that can look forward to a profitable future as an independent entity and those that will struggle to survive in an industry that continues to consolidate at a very rapid rate.
In a presentation this morning, Tom Michaud, the president and CEO at Keefe, Bruyette & Woods, showed a table that neatly framed the challenge that small banks have today in terms of their financial performance. Michaud had broken the industry into seven asset categories from largest to smallest. Banks with $500 million in assets or less had the lowest ratio of pre-tax, pre-provision revenue as a percentage of risk weighted assets – at 1.41 percent – of any category. Not only that, but the profitability of the next four asset classes grew increasingly larger, culminating in banks $5 billion to $10 billion in size, which had a ratio of 2.27 percent. Profitably then declined for banks in the $10 billion to $50 billion and $50 billion plus categories. Banks in the $5 billion to $10 billion are often described as occupying a sweet spot where they are large enough to enjoy economies of scale but still small enough that they are not regulated directly by the Consumer Financial Protection Bureau or are subject to restrictions on their card interchange fees under the Durbin Amendment.
Size allows you to spread technology and compliance costs over a wider base, which can yield valuable efficiency gains. It makes it easier for banks to raise capital, which can be used to exploit growth opportunities in existing businesses or to invest in new business lines. And larger banks also have an easier time attracting talent, which is the raw material of any successful company.
There will always be exceptions to the rule, and some smaller banks will be able to outperform their peers thanks to the blessings of a strong market and highly capable management. But I believe that many banks under $1 billion is assets are beginning to see that only by growing larger will they be able to survive in an industry becoming increasingly more concentrated every year. And for banks in slow growth markets, that will require an acquisition.
Achieving economies of scale is one of the key strategic reasons behind a bank merger. The thinking is that a larger institution can spread costs such as investments and regulatory burdens across a larger customer and revenue base. Plus, for banks with $10 billion and more in assets, a merger offsets the lower interchange revenue from the Durbin Amendment and higher regulatory requirements.
Data from the Cornerstone Performance Report shows that the necessary improvements to productivity often fall short of the economies of scale that make a merged bank more competitive. In the report, Cornerstone compares “assets per employee” for banks of two broad asset size ranges.
Assets per employee
Return on average assets
A median performer in the $5 billion to $10 billion group needs to achieve a 24 percent productivity improvement to become a 75th percentile performer and a 27 percent productivity increase to be a median performer once it breaks the $10 billion barrier. However, most merger cost savings usually target 20 to 30 percent of expenses—with 50 to 60 percent of those savings being people-related. In other words, a bank’s cost-save targets may enable it to achieve 75th percentile productivity temporarily but it will revert back to the “average” as the bank grows. Clearly, banks do not pursue mergers to sustain mediocrity. A bank that is a median performer today in the $10 billion to $20 billion asset category would need to improve by 63 percent to achieve and sustain high productivity performance.
So, how can banks turbo-charge their merger efforts to achieve high-performer economies of scale and productivity improvements? Here are five ways:
Ensure that the bank is performing an integration and not just a conversion. The terms “integration” and “conversion” are often used interchangeably. However, they are very different. Integration includes conversion (i.e., getting all customers and employees on common technology platforms) and a rigorous evaluation and streamlining of the bank’s operating processes and organization. Conversions do contribute to productivity saves and scale but not to the extent that integration does. In the race to convert their core, Internet banking and other systems, many banks will not perform any significant redesign. Serial acquirers often fall into this trap as they want to convert quickly and move on to the next deal. Nine times out of 10, the serial acquirer’s processes are geared to a much smaller institution and eventually break down, requiring the bank to stop and truly integrate.
Ensure that metrics related to scale benefits (both bank-wide and in key functions) are included in any merger reporting. Management and board reporting typically include progress based on achieving milestones, which usually just measures conversion priority. Tracking benefits such as productivity improvements is as important as integration costs and cost-saves. Managing conversion risk is a critical responsibility for the board and management, but so is managing the strategic risks of not being competitive because the bank is less productive than its competitors.
Engage and empower younger managers in the integration process. Banks that pursue true integration often fall short of full success due to an inability to change. Senior managers 1) feel comfortable with what they do and are reluctant to change, and 2) want to change but don’t know how (i.e., don’t know what they don’t know). This occurs most often when a transaction or series of transactions increases the bank’s assets by 30 to 50 percent in a short period of time—when real change is required. Fresh perspectives in the form of newer and younger managers who are free of a “we’ve always done it that way” mindset can help drive new ways to do business that better leverage technology and/or streamline processes.
Discourage “Phase 2.” Banks sometimes approach productivity savings by planning a Phase 2 after conversion to optimize processes, better leverage technology, and so forth. Phase 2 almost never happens, especially with serial acquirers because other priorities or opportunities arise, causing banks to leave money on the table. If the bank insists on a Phase 2, ensure the initiative is continually monitored and measured as part of ongoing merger reporting.
Integrate to what the bank will look like in the future—not just what it will look like after a transaction. Determine the performance levels (and metrics) for a much larger institution and plan the integration efforts to achieve them.
Many U.S. retailers and banks have not made changes to accommodate new EMV standards (named after the organizations that developed it, Europay, Mastercard and Visa in the 1990s), despite an October 1 deadline that shifts liability from banks to merchants. The banks that fail to do so not only risk increased exposure to fraud, but could lose out on potential revenue and market share.
EMV technology uses encrypted microchip data on a customer’s credit or debit card. The card numbers and cards are much harder to counterfeit or steal than magnetic stripe cards. The card number isn’t transmitted on a point-of-sale system (POS), as a new code is generated for each transaction. Also, an EMV-enabled POS system recognizes cards that are supposed to have the encrypted chip data, even if a counterfeiter has stolen a card number and created a magnetic stripe card, says Deborah Baxley, principal at Capgemini Financial Services.
Magnetic stripe cards are still used by about 59 percent of U.S. consumers, according to a survey by ACI Worldwide, an electronic payments company headquartered in Naples, Florida. Boston-based Aite Group, a research and advisory firm, estimates that as many as 60 percent of POS systems will not be ready for EMV by the end of the year. Gas stations have until October 1, 2017, to comply.
But for most retailers, after October 1 of this year, the liability for card fraud shifted. Previously, banks were liable for any in-store fraud. But now, any retailer breached that hasn’t updated its POS system to accept EMV is on the hook to make the bank whole—as long as the bank has migrated its card portfolio to EMV. If both bank and retailer are on the same playing field, the liability shifts back to the bank. Retailers with an inadequate focus on cybersecurity will now pay the piper.
What about banks that missed the October 1 deadline? “If you don’t have a plan, and you’re not informed enough to know what you should do, then you’re probably lagging,” says Bob Legters, senior vice president, payment products at FIS. Many banks are making decisions on who gets the new EMV cards first, and typically prioritize lost, stolen and expiring cards.
Despite the much-ballyhooed shift in liability, most banks haven’t migrated all their customers to chip cards. Aite Group estimates that 70 percent of credit cards, and 40 percent of debit cards, will be replaced with chip cards by the end of the year. Debit cards have been more difficult to replace, due to merchant routing restrictions under the Durbin Amendment of the Dodd-Frank Act that mandated that retailers have a choice of at least two unaffiliated networks to authenticate a transaction made with a debit card. Until this year, EMV did not comply with that requirement, says Baxley.
Chip cards aren’t the magic bullet that will finally kill credit card fraud. Fraud is expected to shift online, where the retailer still bears the liability. More troublesome, crooks could target banks and merchants that haven’t yet shifted to safer standards, putting a target on the backs of community banks and mom-and-pop shops. Banks that issue their EMV cards sooner rather than later will have a competitive advantage, says Legters. “If you [the customer] have a chip card and a nonchip card in your wallet, [and] you perceive the chip card to be more secure, you’re going to tend to lean that direction with your spending,” he says.
The subtle shift to mobile wallets such as Apple Pay and the newer Samsung Pay is also working in consumers’ favor, as these wallets employ the EMV framework. As mobile wallet adoption increases, merchants have another reason to shift to EMV-enabled POS systems, as most are set up to accept these forms of payment.
Of course, new technology means that the average American needs to learn a new way to pay. Once banks have issued EMV cards, “the biggest thing they need to do is worry about communication, because from a customer perspective, all of the sudden you’re using a card that works a little bit differently,” says Gil Mermelstein, managing director in the banking practice at West Monroe Partners.
Most consumers that have received chip cards don’t really know why, according to the ACI survey. Sixty-seven percent have not received any information from their financial institution to explain why this card is safer.
Banks don’t have to replace every card in their portfolio this month, or even this year. But delaying implementation will only harm the bank in the long run due to a higher risk of fraud—and the reputational damage that comes along with it.
“I believe [issuers] need to wrap it up, and try to issue quickly. They are exposed to greater targeting of fraud from fraudsters that will migrate from more secure bank cards to ones that are less so,” says Mermelstein.