Helping Customers When They Need It Most

Orvin Kimbrough intimately understands the struggles shared by low-to-moderate income consumers. Raised in low-income communities and the foster care system, he also worked at the United Way of Greater St. Louis for over a decade before joining $2.1 billion Midwest BankCentre as CEO in January 2019. “[Poverty costs] more for working people,” he says. “It’s not just the financial cost; it’s the psychological cost of signing over … the one family asset you have to the pawn shop.”

His experiences led him to challenge his team to develop a payday loan alternative that wouldn’t trap people in a never-ending debt cycle. The interest rate ranges from 18.99% to 24.99%, based on the term, amount borrowed (from $100 to $1,000) and the applicant’s credit score. Rates for a payday loan, by comparison, range in the triple digits.

The application process isn’t overly high-tech, as applicants can apply online or over the phone. The St. Louis-based bank examines the customer’s credit score and income in making the loan decision; those with a credit score below 620 must enroll in a financial education class provided by the bank.

Industry research consistently finds that many Americans don’t have money saved for an emergency — a health crisis or home repair, for example. When these small personal crises occur, cash-strapped consumers have limited options. Few banks offer small-dollar loans, dissuaded by profitability and regulatory constraints following the 2008-09 financial crisis.

If the current recession deepens, more consumers could be looking for payday loan alternatives. Regulators recently encouraged financial institutions to offer these products, issuing interagency small-dollar lending principles in May that emphasize consumers’ ability to repay. 

Everybody needs to belong to a financial institution if you’re going to be financially healthy and achieve your financial aspirations,” says Ben Morales, CEO of QCash Financial, a lending platform that helps financial institutions automate the underwriting process for small-dollar loans.

QCash connects to a bank’s core systems to automate the lending process, using data-driven models to efficiently deliver small-dollar loans. The whole process takes “six clicks and 60 seconds, and nobody has to touch it,” Morales says. QCash uses the bank’s customer data to predict ability to repay and incorporates numerous factors — including cash-flow data — into the predictive models it developed with data scientists. It doesn’t pull credit reports.

Credit bureau data doesn’t provide a full picture of the customer, says Kelly Thompson Cochran, deputy director of FinRegLab and a former regulator with the Consumer Financial Protection Bureau. Roughly a fifth of U.S. consumers lack credit history data, she says, which focuses on certain types of credit and expenses. The data is also a lagging indicator since it’s focused on the customer’s financial history.

In contrast, cash flow data can provide tremendous value to the underwriting process. “A transaction account is giving you both a sense of inflows and outflows, and the full spectrum of the kind of recurring expenses that a consumer has,” says Cochran.

U.S. Bancorp blends cash flow data with the applicant’s credit score to underwrite its “Simple Loan” — the only small-dollar loan offered by a major U.S. bank. The entire process occurs through the bank’s online or mobile channels, and takes just seven minutes, according to Mike Shepard, U.S. Bank’s senior vice president, consumer lending product and risk strategy. Applicants need to have a checking account with the bank for at least three months, with recurring deposits, so the bank can establish a relationship and understand the customer’s spending behavior.

“We know that our customers, at any point in time, could be facing short-term, cash-flow liquidity challenges,” says Shepard. U.S. Bank wanted to create a product that was simple to understand, with a clear pricing structure and guidelines. Customers can borrow in $100 increments, from $100 to $1,000, and pay a $6 fee for every $100 borrowed. U.S. Bank lowered the fee in March to better assist customers impacted by the pandemic; prior to that the fee ranged from $12 to $15.

Since the loan is a digital product, it’s convenient for the customer and efficient for the bank.

Ultimately, the Simple Loan places U.S. Bank at the center of its customers’ financial lives, says Shepard. By offering a responsible, transparent solution, customers “have a greater perception of U.S. Bank as a result of the fact that we were able to help them out in that time of need.”

The Illusive Hunt for Revenue

Fintel.pngThe operating environment for banks is becoming increasingly inhospitable. Rising credit costs and falling interest rates threaten to squeeze profitability in a vice grip unless banks find new revenue sources.

This is why Bank Director’s second annual Experience FinXTech event and awards, hosted virtually at the beginning of May, highlighted fintech companies that are helping banks grow their top lines.

The event brought together bankers and technologists for demonstrations and conversations about the present and future of banking.

As a part of the event, Bank Director crowned fintech winners in seven categories, including Best Solution for Customer Experience, Best Solution for Loan Growth and Best Solution for Revenue Growth.

Fintel Connect won the final category: Best Solution for Revenue Growth.

The Canada-based company amplifies a bank’s marketing campaigns by leveraging an affiliate network of publishers and social influencers, as we explain on our FinXTech Connect platform, which profiles hundreds of tried-and-true technology companies serving the banking industry.

A selling point is that, instead of paying for clicks or impressions, customers of Fintel Connect only pay once a lead converts into an actual customer.

Canada’s EQ Bank has been working with Fintel Connect for years, using it to manage media affiliates — bloggers, interest rate aggregators, etc. EQ attributes the service with boosting customer acquisition “fairly substantially,” with between 5% and 10% of EQ’s new customers now coming through it.

Nest Egg was a runner-up in the category of Best Solution for Revenue Growth. The Philadelphia-based company enables banks to offer high-quality, fully digital investment services in order to increase customer affinity.

OceanFirst Financial Corp., a $10.5 billion bank based in Red Bank, New Jersey, liked Nest Egg so much that it invested in the company.

OceanFirst has recommended Nest Egg’s semi-automated money management tool to retail clients for about a year, with assets under management growing from $0 to $43 million over that time. The service is already cash flow positive for OceanFirst.

The last finalist for this category was Flybits, a fintech company based in Toronto.

Mastercard has been working with Flybits for a year now. They’re still in the early stages of implementing its product, which helps provide contextualized offers to end users of their cards for the purpose of driving usage.

The trajectory has been a positive one for Mastercard, leaving the company optimistic that working with Flybits will help their clients — mainly banks — increase card usage and associated fee income.

One reason Mastercard chose to work with Flybits is because of the way it deals with data. All data is tokenized, with Flybits only selectively accessing the data it needs. There are any number of ways for banks to grow revenue. These are three of the best, according to experienced panel of judges convened to choose the winners at Bank Director’s 2020 Experience FinXTech.

How One Bank CEO is Navigating the Covid-19 Pandemic

Like most of his peers throughout the banking industry, Dennis Shaffer, the CEO at Sandusky, Ohio-based Civista Bancshares, is confronting challenges unlike anything he has faced in his long career.

The Covid-19 pandemic is ravaging the U.S. economy, leading to the highest levels of unemployment since the Great Depression and a likely recession of unknown depth and duration. That is forcing CEOs like Shaffer to make decisions about sustainability and workforce deployment that were unimaginable six months ago.

The $2.5 billion bank serves a three-state area that spans big chunks of Ohio as well as southeastern Indiana and northern Kentucky. Civista’s profitability has already been impacted by the pandemic: Net income in the first quarter was down nearly 18%, to $7.8 million year over year.

But Shaffer says the bank’s mortgage loan originations are at record levels and several construction projects that it financed prior to the pandemic are still going forward. The bank processed 2,141 loans under the SBA’s Paycheck Protection Program, totaling $262 million. Shaffer estimates that over 300 of those loans were to new and very grateful customers that could lead to expanded business relationships in the future.

Civista has also reached out to borrowers that have been hard hit by the downturn and offered them 90-day loan modifications. In the first quarter, the bank modified 66 loans totaling $39.9 million, according to its first quarter earnings report. These were primarily deferral of principal and/or interest payments. Since March 31, it has received requests to modify an additional 727 loans totaling $410 million.

“The bank’s doing fine,” he says. “Our main emphasis has been keeping our customers and employees healthy and also continue to do business as normal as possible for our customers.”

The biggest challenge that Shaffer and other bank CEOs face today is economic uncertainty. If he knew how deep and long the recession will be, Shaffer could better estimate the impact that will have on Civista’s balance sheet.

This is my 35th year in banking and I’ve never seen anything like this,” he says. “We’ve gone through recessions where a business goes from making $1 to maybe 70 cents. Well here, they’ve gone from $1 to some of these businesses making nothing.”

Shaffer faced up to that challenge by taking a hard look at the bank’s capital structure and factoring in nightmarish projections.

He started with evaluating whether Civista had enough capital to sustain losses that could be at “historical levels.” During the last recession, the bank sustained $54 million in losses over a four-year period. In his analysis, Shaffer decided to double that — and compress four years to two. He also assumed the bank would continue paying its dividend and wouldn’t lay off employees.

After they factored in all those assumptions, “we were still above 8% on a Tier 1 [capital] basis, so we feel pretty good about that,” he says. The mandated regulatory minimum is 6%, which would give the bank the capacity to absorb even more losses, although Shaffer hopes to avoid falling that low. That analysis gave Shaffer confidence that Civista could take a hard punch in the recession and still carry on. It also answered the question of whether the bank need to raise additional capital.

“We felt we didn’t need to,” he says. “We think we’re really strongly capitalized. I think our stress testing has proved that.”

Shaffer believes the loan modifications and Paycheck Protection loans have bought many of Civista’s customers valuable time, but he won’t know yet for a couple of months how many of those businesses will sustain themselves through the pandemic. “Sales [won’t be] 100%, but are they going to be 90% or are they going to be 50%?” he says.

Another challenge Shaffer has encountered is running the bank with a distributed workforce. Seventy percent of Civista’s employees are working from home, most of them since early March. (Shaffer comes to the office every day because he feels he needs to be visible to the employees working there.) While he had some apprehensions at first, he’s pleased with the bank’s productivity.

Still, Shaffer has to decide when to bring most of those people back into the office. Ohio has already begun to reopen its economy, but he intends to normalize the bank’s operations more gradually. Civista’s branch lobbies have been closed since March ­— just the drive-through lanes are readily accessible — and Shaffer plans to maintain the status quo through May and perhaps extend it through June.

He also doesn’t see an immediate need to repatriate the majority of Civista’s office employees. “We’ll phase that in and probably do that gradually,” Shaffer says. As other businesses with more pressing needs bring their people back, the bank can afford to wait.

“I just think it benefits the greater community because it eliminates more people coming back into the workforce,” he says. “We can do our part there.”

Why This Crisis Is Different

The USS Economy is steaming into dangerous waters and the country’s banks are trapped aboard with the rest of the passengers.

A public health policy of social distancing and lockdowns in response to the COVID-19 virus is creating a devastating impact on the U.S. economy, which in recent years has been driven by consumer spending and a historically low unemployment rate. According to the Bureau of Labor Statistics, the U.S. labor market added 273,000 jobs in February, while private sector wages grew 3%. Moody’s Investors Service also says that the U.S. economy grew 2.3% last year, with personal consumption expenditures contributing 77% of that growth.

That is changing very quickly. Brace yourself for the virus economy.

Wall Street firms are forecasting that the U.S. economy will contract sharply in the second quarter — with Goldman Sachs Group expecting a 24% decline in gross domestic product for the quarter.

“The sudden stop in U.S. economic activity in response to the virus is unprecedented, and the early data points over the last week strengthened our confidence that a dramatic slowdown is indeed already underway,” Goldman’s chief economist Jan Hatzius wrote in a March 20 research note.

My memory stretches back to the thrift crisis in the late 1980s, and there are others that have occurred since then. They’ve all been different, but they generally had one thing in common: They could be traced back to particular asset classes — commercial real estate, subprime mortgages or technology companies that were grossly overfunded, resulting in dangerous asset bubbles. When the bubbles burst, banks paid the price.

What’s different this time around is the nature of the underlying crisis.

The root cause of this crisis isn’t an asset bubble, but a public health emergency that is wreaking havoc on the entire U.S. economy. Enforced governmental policies like social distancing and sheltering in place have been especially hard on small businesses that employ 47.5% of the nation’s private workforce, according to the U.S. Small Business Administration. It puts a lot of people out of work when those restaurants, bars, hardware stores and barber shops are forced to close. Economists expect the U.S. unemployment rate to soar well into double digits from its current rate of just 3.5%.   

Bank profitability will be under pressure for the remainder of the year. It began two weeks ago when the Federal Reserve Board began cutting interest rates practically to zero, which will put net interest margins in a vice grip. One bank CEO I spoke to recently told me that every 25-basis-point drop in interest rates clips 4 basis points off his bank’s margin — so the Fed’s 150 basis point rate cut reduced his margin by 20 basis points. Worse yet, he expects the low-rate environment to persist for the foreseeable future.

Making matters worse, banks can expect that loan losses will rise over time — perhaps precipitously, if we have a long and deep recession. Many banks are prepared to work with their cash-strapped borrowers on loan modifications to get them through the crisis; federal bank regulators have said lenders will not be forced to automatically categorize all COVID-19 related loan modifications as troubled debt restructurings, or TDRs.

Unfortunately, a prolonged recession is likely to outpace most banks’ abilities to temporarily forego principal and interest payments on their troubled loans. A sharp rise in loan losses will reduce bank profitability even more.

There is another way in which this crisis is different from previous crises that I have witnessed. The industry is much stronger this time around, with roughly twice the capital it had just 12 years ago at the onset of the subprime mortgage crisis.

Think of that as first responder capital.

During the subprime mortgage crisis, the federal government injected over $400 billion into the banking industry through the Troubled Asset Relief Program. The government eventually made a profit on its investment, but the program was unpopular with the public and many members of Congress. The full extent of this banking crisis remains to be seen, but hopefully this time the industry can finance its own recovery.

The Keystone Trait of Prudent and Profitable Banking

The more you study banking, the more you realize that succeeding in the industry boils down to a handful of factors, the most important of which is efficiency.

This seems obvious, but it’s worth exploring exactly why efficiency is so critical.

A bank, at its core, is a highly leveraged fund, with the typical bank borrowing $10 for every $1 worth of capital. This makes banks profitable. However, it also means that banks, by design, are incredibly fragile institutions, using three times as much debt as the typical company.

Warren Buffett wrote about this in his 1990 letter to shareholders:

The banking business is no favorite of ours. When assets are twenty times equity — a common ratio in this industry — mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks.

The primary source of mistakes in banking, Buffett noted, is what he refers to as the institutional imperative, “the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.”

Buffett was writing about a commercial real estate crisis in the early 1990s that was laying waste to the banking industry. As competition for commercial loans heated up, banks cut rates and eased terms in order to win business. When real estate prices crashed, banks paid the price for doing so.

It was during that time, for instance, that Security Pacific Corp., one of the great California banking dynasties, sold itself to BankAmerica Corp. to stave off insolvency.

These pressures — the fear of missing out, if you will — have not gone away. They factored into the financial crisis, causing lenders to move down the credit ladder in order to make subprime loans. And the word on the street is that these same pressures are causing some banks to cut rates and ease lending terms today.

The key is to insulate yourself from these pressures.

Part of this is psychological — understanding how emotions, particularly fear and greed, play into decision making. And part of it is practical — operating so efficiently that it eliminates the temptation to boost profitability by easing credit standards.

The direct role of efficiency in a bank’s operations is obvious: The less revenue a bank spends on expenses, the more that’s left over to fall to the bottom line.

But the indirect role of efficiency is even more important: A bank that operates efficiently can relinquish some of its margin to attract the highest-quality credits. It also eliminates the need to stretch on credit quality in order to earn one’s cost of capital — a return on equity of between 10% and 12%.

“Being a low-cost provider gives one a tremendous strategic advantage,” Jerry Grundhofer, the former chairman and CEO of U.S. Bancorp, once told Bank Director’s Jack Milligan. “It allows you to deal with challenges, be competitive on the asset and liability sides of the balance sheet and take care of customers.”

Indeed, it’s no coincidence that the most efficient banks when it comes to operations also tend to be the most prudent when it comes to risk management.

But not all efficiency is created equal. In banking, efficiency is expressed as a ratio of expenses to revenue. The key is to have the right mix of the two.

The temptation is to drive efficiency through cost control. The problem with doing so, however, is that a bank can only lower its costs so far before it begins to cannibalize its business.

The same isn’t true of revenue, which tends to be twice as large as expenses. Consequently, the most efficient banks through time generally are those with the highest revenue to assets, not the highest expenses to assets.

The archetype for a high-performing bank isn’t just one that operates efficiently, but one that drives its efficiency through revenue, the denominator in the efficiency ratio.

How Consolidation Changed Banking in Five Charts

Over the past 35 years, few secular trends have reshaped the U.S. banking industry more than consolidation. From over 18,000 banks in the mid-1980s, 5,300 remain today.

Consolidation has created some very large U.S. banks, including four that top $1 trillion in assets. The country’s largest bank, JPMorgan Chase & Co., has $2.7 trillion in assets.

Historically, very large banks have been less profitable on performance metrics like return on average assets (ROAA) and return on average tangible common equity (ROTCE) than smaller banks. The standard theory is that banks benefit from economies of scale as they grow until they reach a certain size, at which point diseconomies of scale begin to drag down their performance.

This might be changing, according to interesting data offered Keefe, Bruyette & Woods CEO Thomas Michaud in the opening presentation at Bank Director’s 2020 Acquire or Be Acquired conference. The rising profitability of large publicly traded banks and one of the underlying factors can be seen in five charts from Michaud’s presentation.

Profitability is High

Profitability
Banking has been highly profitable since the early 1990s — except, of course, for that big dip starting in 2006 when earnings nosedived during the financial crisis. The industry’s profitability reached a post-crisis high in the third quarter of 2018 when its ROAA hit 1.41%. Keep in mind, however, this chart looks at the entire industry and averages all 5,300 banks.

Banking 2016

Sweet Spot of Profitability
Banking is also highly differentiated by asset size: many very small institutions at the bottom of the stack,  four behemoths at the top. Michaud’s “sweet spot” in banking refers to a specific asset category that allows banks to maximize their profitability relative to other size categories. They have enough scale to be efficient but are still manageable enterprises. In 2016, this sweet spot was in the $5 billion to $10 billion asset category, where the banks’ pre-tax, pre-provision income was 2.32% of risk weighted assets.

Banking 2019

Sweet Spot Shifts
It’s a different story three years later. In 2019, the category of banks with $50 billion in assets and above captured the profitability sweet spot, with pre-tax, pre-provision income of 2.43% of risk weighted assets. What’s especially interesting about this shift is that, by my count, there are just 31 U.S. domiciled banks in this size category. (I excluded the U.S. subsidiaries of foreign banks, but included The Goldman Sachs Group and Morgan Stanley.) Of course, these 31 banks control an overwhelming percentage of the industry’s assets and deposits, so they wield disproportionate power to their actual numbers. But what I find most interesting is that as a group, the biggest banks are now the most profitable.

Big Banks

Big Bank Profitability
Even the behemoths have stepped up their game. You can see from the chart that KBW expects five of the six big banks — Bank of America Corp., JPMorgan, Wells Fargo & Co., Morgan Stanley and Goldman Sachs — to post ROTCEs of 12% or better for 2019. And some, like JPMorgan and Bank of America, are expected to perform significantly better. KBW expects this trend to continue through 2021, for the most part. What’s behind this improved performance? Buying back stock is one explanation. For example, between 2017 and 2021, KBW expects Bank of America to have repurchased 27.6% of its outstanding stock at 2017 levels. But there is more to the story than that.

bank share

Taking Market Share
The 20 largest U.S. banks have aggressively grown their national deposit market share – a trend that seems to be accelerating. Beginning during the financial crisis in 2008, the top 20 began gaining market share at a faster rate than the rest of the industry. The differential continues to widen through at least the third quarter of last year. But the financial crisis ended over a decade ago, so a flight to safety can no longer explain this trend. Something else is clearly going on.

Consumers across the board are increasingly doing their banking through digital channels. Digital banking requires a significant investment in technology, and this is where the biggest banks have a clear advantage. Digital has essentially aggregated local deposit markets into a single national deposit market, and the largest banks’ ability to tap this market through technology gives them a significant competitive advantage that is beginning to drive their profitability.

Having too much scale was once a disadvantage in terms of performance — that may no longer be the case. Banking increasingly is becoming a technology-driven business and the ability to fund ambitious innovation programs is quickly becoming table stakes.

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.

A Common Trait Shared by Elite Bankers


investment-8-2-19.pngIf you talk to enough executives at top-performing banks, one thing you may notice is that not all of them see themselves as bankers. Many of them identify instead as investors who run banks.

It’s a subtle nuance. But it’s an important one that may help explain the extraordinary success of their institutions.

This came up in a conversation I had last week with the president and chief operating officer of a $2.6 billion asset bank based in New England. (I’d share the bank’s name, but they prefer to keep a low profile.)

His bank is among the most profitable in the country and is a regular fixture atop industry rankings, including our latest Bank Performance Scorecard.

Its profitability and earnings growth are consistently at the top of its peer group each year. More importantly, its total shareholder return (dividends plus share price appreciation) ranks in the top 3% of all publicly traded banks since the current leadership team gained control in 1993.

The distinction between investors and bankers seems to lay in how they prioritize operations and capital allocation.

For many bankers, capital allocation plays a supporting role to operations. It’s a pressure release valve that purges a bank’s balance sheet of the excess capital generated by operations. As capital builds up on the balance sheet, it impairs return on equity, which can foster the illusion that a bank isn’t earning its cost of capital.

To investors, the relationship between operating a bank and allocating its capital is inverted: The operations are the source of capital, while the efficient allocation of that capital is the ultimate objective.

Bankers who identify as investors also tend to be agnostic about banking. If a different industry offered better returns on their capital, they’d go elsewhere. They’ve gravitated to banking only because it’s a peculiarly profitable endeavor. In no other industry are businesses leveraged by a factor of 10 to 1 and financed with government-insured funds.

There are plenty of other bankers that fall into this categorization. The recently retired chairman of Citigroup, Michael O’Neill, is one of them. He said this when I interviewed him recently for a profile to be published in the upcoming issue of Bank Director magazine.

O’Neill’s time as chairman and CEO of Bank of Hawaii bears this out. A major objective of his, after refocusing its geographic footprint, was reducing the bank’s outstanding share count.

Bank of Hawaii had 80 million shares outstanding when O’Neill became CEO in 2000. When he left 4 years later, that had declined by 38% to only 55 million outstanding shares. This helped the bank’s stock price more than triple over the same stretch.

Another example is the Turner family, which has run Great Southern Bancorp for almost half a century. Since going public in 1991, Great Southern has repurchased nearly 40% of its original outstanding share count. A $2 million investment during the initial public offering would have been worth $140 million last year.

The Turners never said this when I talked with them last year, but it seems safe to infer that they view banking in a similar way. They’re not trying to build a banking empire for the sake of running a big bank. Instead, they’re focused on creating superior long-term value.

This philosophical approach coupled with meaningful skin in the game insulates a bank’s executives from external pressures to chase short-term growth and profitability at the expense of long-term solvency and performance.

“Having a big investment in the company … gives you credibility with institutional investors,” Great Southern CEO Joe Turner told me last year. “When we tell them we’re thinking long term, they believe us. We never meet with an investor that our family doesn’t own at least twice as much stock in the bank as they do.”

M&T Bank Corp. offers yet another textbook example of this. Of the largest 100 banks operating in 1983, when its current leadership team took over, only 23 remain today. Among those, M&T ranks first when it comes to stock price growth

I once asked its chairman and CEO René Jones what has enabled the bank to create so much value. One of the main reasons, he told me, was that they could gather 60% of the voting interests in the bank around the coffee table in his predecessor’s office.

And the bank in New England that I mentioned at the top of this article is the same way. The family that runs it, along with its directors, collectively hold 40% of the bank’s stock.

The moral of the story is that it’s tempting to think that capital allocation should play second fiddle to a bank’s operations. But many of the country’s best bankers see things the other way around.

Getting a Return on Relationship Profitability


profitability-7-8-19.pngHow profitable are your bank’s commercial relationships?

That may seem like a strange question, given that banks are in the relationship business. But relationship profitability is a complex issue that many banks struggle to master. A bank’s ability to accurately measure the profitability of its relationships may determine whether it’s a market leader or a stagnant institution just trying to survive. In my experience, the market leaders use the right profitability metrics, measure it at the right time and distribute that information to the right people.

Should Your Bank Use ROE or ROA? Yes.
Many banks use return on assets, or ROA, to measure their portfolio’s overall profitability. It’s a great way to compare a bank’s performance relative to others, but it can disguise credit issues hidden within the portfolio. To address that concern, the best-performing banks combine an ROA review with a more precise discussion on return on equity, or ROE. While ROA gives executives a view from above, ROE helps banks understand the value, and risk, associated with each deal.

ROA and ROE both begin with the same numerator: net income. But the denominator for ROA is the average balance; ROE considers the equity, or capital that is employed by the loan.

If your bank applies an average equity position to every booked loan, then this approach may not be for you. But banks that strive to apply a true risk-based approach that allocates more capital for riskier deals and less capital for stronger credits should consider how they could use this approach to help them calculate relationship profitability.

Take a $500,000 interest-only loan that will generate $5,000 of net income. The ROA on this deal will be 1 percent [$5,000 of net income divided by the $500,000 average balance]. The interest-only repayment helps simplify the outstanding balance discussion and replicates the same principles in amortizing deals.

You can assume there is a personal guarantee that can be added. It’s not enough to change the risk rating of the deal, but that additional coverage is always desirable. The addition of the guarantee does not reduce the outstanding balance, so the ROA calculation remains unchanged. The math says there is no value that comes from adding the additional protection.

That changes when a bank uses ROE.

Let’s say a bank initially allocated $50,000 of capital to support this deal, generating a 10 percent ROE [$5,000 of net income divided by the $50,000 capital].

The new guarantee changes the potential loss given default. A $1,000 reduction in the capital required to support this deal, because of the guarantee, increases ROE 20 basis points, to 10.20 percent [$5,000 of net income divided by the $49,000 of capital]. The additional guarantee reduced risk and improved returns on equity.

The ROA calculation is unchanged by a reduction in risk; ROE paints a more accurate picture of the deal’s profitability.

The Case for Strategic Value
Assume your bank won that deal and three years have now passed. When calculating that relationship’s profitability, knowing what you’ve earned to-date has a purpose; however, your competitors care only about what that deal looks like today and if they can win away that customer and all those future payments.

That’s why the best-performing banks consider what’s in front of them to lose, not what has been earned up to this point. This is called the relationship’s “strategic value.” It’s the value your competition understands.

When assessing a relationship’s strategic value, banks may identify vulnerable deals that they preemptively reprice on terms that are more favorable to the customer. That sounds heretical, but if your bank’s not making that offer, rest assured your competitors will.

The Right Information, to the Right People, at the Right Time
Once your bank has decided how it will measure profitability, you then need to consider who should get that information—and when. Banks often have good discussions about pricing tactics during exception request reviews, but by then the terms of the deal are usually set. It can be difficult to go back to ask for more.

The best-positioned banks use technology systems that can provide easily digestible profitability data to their relationship managers in a timely fashion. Relationship managers receive these insights as they negotiate the terms of the deal, not after they’ve asked for an exception.

Arming relationship managers with a clear understanding of both the loan and relationship profitability allows them to better price, and win, a deal that provides genuine value for the bank.

Then you can start answering other questions, like “What’s the secret to your bank’s success?”

The Secret to a Low Efficiency Ratio


efficiency-5-31-19.pngOne of the most important metrics in banking is the efficiency ratio, which is generally viewed as a measurement of how carefully a bank spends money. Following this definition to its logical conclusion, the more parsimonious the bank, the lower its efficiency ratio should be.

But this common understanding fails to capture the true nature of what the efficiency ratio actually measures. It is in reality a fraction that expresses the interrelationship between the two most dynamic forces within any business organization: the growth of revenue and expenses.

Looked at this way, the efficiency ratio is actually a measurement of effective spending—how much revenue does every dollar of spending produce. And embedded within the efficiency ratio is a simple but extraordinarily important concept that is the key to high profitability—positive operating leverage.

But first, let’s look at how the efficiency ratio works. It’s an easy calculation. The numerator, which is the top half of the fraction, is expenses. And the denominator, which sits below it, is revenue. A bank that reports $50 of expenses and $100 of revenue in a quarter has an efficiency ratio of 50 percent, which is the benchmark for most banks (although most fall short).

However, not all 50 percent efficiency ratios are created equal.

Consider two examples. Bank Cheapskate reports $40 of expenses and $100 of revenue in its most recent quarter, for an efficiency ratio of 40 percent. Coming in 10 percentage points under the benchmark rate of 50 percent, Bank Cheapskate performs admirably.

Bank Topline reports $50 in expenses and $125 in revenue in its most recent quarter. This performance also results in an efficiency ratio of 40 percent, equivalent to Bank Cheapskate’s ratio. Again, an impressive performance.

While the two ratios are the same, it is unlikely that most institutional investors will value them equally. The important distinction is how they got there.

The argument in favor of Bank Cheapskate’s approach is simple and compelling. Being a low-cost producer is a tremendous competitive advantage in an industry like banking, which has seen a long-term decline in its net interest margin. It allows to a bank to keep deposits costs low in a tight funding market, or back away from an underpriced and poorly structured credit in a competitive loan market. It gives the bank’s management team optionality.

The case for Bank Topline’s approach is probably more appealing. Investors appreciate the efficiency of a low-cost producer, but I think they would place greater value on the business development skills of a growth bank. In my experience, most investors prefer a growth story over an expense story. Bank Topline spends more money than Bank Cheapskate, but it delivers more of what investors value most—revenue growth.

To be clear, the choice between revenue and expenses isn’t binary—this is where positive operating leverage comes in.

Positive operating leverage occurs when revenue growth exceeds expense growth. Costs increase, but revenue increases at a faster rate. This is the secret to profitability in banking, and the best management teams practice it.

A real-life example is Phoenix-based Western Alliance Bancorp. The bank’s operating efficiency ratio in 2018 was an exemplary 41.9 percent. The management team there places great importance on efficiency, although the bank’s expenses did rise last year. But this increase was more than offset by strong revenue growth, which exceeded expense growth by approximately 250 percent. This is a good example of positive operating leverage and it’s the real story behind the bank’s low efficiency ratio.

The greater the operating leverage, the lower the efficiency ratio because the ratio is relational. It is not solely a cost-driven metric. At Western Alliance and other banks that focus on creating positive operating leverage, it’s not just how much you spend—it’s how many dollars of revenue each dollar of expense creates.

To understand the real significance of a bank’s efficiency ratio, you have to look at the story behind the numbers.