Bank Product Pushing: Is this our strategy?

Banking has taken a beating in the media and court of public opinion in the past two years. Some of it has been unfair, particularly with how banks were associated with subprime mortgages (very few were originated by banks) and how community banks were lumped in with the practices of very large financial institutions (FIs). But if we are to be honest with ourselves, some of it is deserved and we should take positive steps to repair our image, better serve our customers, and lead us into the future.

This post is part of a three part series regarding strategies to improve our image and move us forward. The three parts include:

1. Executive compensation;
2. Fees;

3. Product pushing

In previous posts I wrote about Executive Compensation and Fees. This post will focus on Product Pushing.

In either a bank strategy session or an educational session, I can’t remember which, a speaker gave an anecdote about shopping for a mattress. A couple enters a mattress store and a salesman, most likely on commission, rapidly approaches them as they walk through the door and says “may I help you”? The couple, in unison, say “no thank you, we’re just looking”. They were just looking… in a mattress store?

Now I don’t know how much you know about mattresses. I know very little about them. But I have to believe that simply looking at a mattress would not be helpful in making an informed “buy” decision. I would need help. But I also think my reaction to an oncoming salesman would be similar to the couple’s reaction. We possess an automatic defense mechanism from being sold to.

In this context, doesn’t “just looking” in financial services seem more unlikely than the mattress analogy? But this is what customers do when they visit a bank’s website to peruse product offerings without ever contacting the bank. We avoid the human interaction because we don’t want to get sold.

Financial services, though, are very complex. Banks typically offer dozens if not over 100 traditional spread banking products. If our FI offers investment, insurance, and/or trust products, the list can grow exponentially. Why do customers not seek us out for help? Why are they “just looking”?

I think there are two reasons: 1) they do not view us as advisers, and 2) they view us more as salesman. We have perpetuated this view by emphasizing cross sales in the branch, pipelines for lenders, and gross production from our investment reps. This emphasis puts greater value on the point-of-sale, or transaction.

The result is that bankers are not perceived as acting in the customers’ best interests. Take the video below as an example of how our industry is viewed. The protagonist needs advice, probably from his parents, to help protect him from a product (in this case a credit card) pushed on him by a banker using giveaways as a promotion. This is classic product pushing, regardless of what is right for the customer.

But what if the bank took a different approach? Perhaps the parents have a great relationship with their local banker, and trust his or her advice. They consult the banker regarding their son going to college and the banker suggests a savings-account collateralized credit card that sports lower interest rates and where the parents can monitor usage.

This may not be a better transaction than giving the son a credit card knowing he is likely to run up the balance at high interest rates. But it increases the loyalty of the parents, and makes it more likely the son will bank with the same person as the parents because of this loyalty. The bank enjoys the higher balances from the parents, and ultimately wins the business of the son once he graduates and enters his earnings and borrowing years. But this philosophy won’t help the banker meet his or her quota of the product de jour.

Which situation would be better? The short-term, walkie-talkie giveaway for a high interest rate credit card would certainly be a better short-term winner for the bank. Long term is a different story. So why are banks perceived as pursuing the short-term strategy? Could it be the incentives we put in place? Could it be the capabilities of our staff responsible for relationship building? Or is it simply misfortune?

We have to ask ourselves the very strategic question of how we want to be perceived? Perception is mostly within our control and is strongly influenced by the people we hire, the manner in which we compensate them, and the strategy we pursue. I have not been in a strategy session where bankers chose to promote the product de jour, push products on customers, or resemble the mattress salesman. We should align our actions with our strategy.

~ Jeff

Bank Strategy Tweetup: Here's how I think it would go...

I recently read a funny post by Don Cooper on how he thought the birth of Jesus would have went if Joseph was able to tweet about it (see the link below). This got me thinking how a bank strategy session would go if we conducted it via Twitter. Below is an abbreviated tweet stream of how I envisioned it going down.

@bankceo Welcome to our first ever strategy tweetup! Today we will set bank strategy in 140 characters or less.

@bankconsultant I hope this strategy tweetup thing doesn’t reduce our fee.

@banklender Every second I spend in this mind-numbing strategy tweetup I can’t be with customers, having a power lunch, or be on the links.

@bankmarketer This strategy tweetup thing is the best idea EVER!

@bankfinance REMINDER: Request an ROI on this tweetup thing from @bankmarketer

@bankconsultant Ok everyone… let’s role with this tweetup idea. What are this bank’s key strengths?

@banklender Lenders

@bankmarketer Our website

@bankceo Me

@bankfinance We have no strengths.

@bankconsultant Moving on… what are weaknesses that we must address?

@bankmarketer Branch people, because they can’t sell.

@bankceo Branch people, because we have the wrong people in the wrong seats.

@bankfinance Branch people, because our cost of funds is too high.

@banklender Branch people, because they’re not lenders.

@bankconsultant Alright, let’s talk vision. If we were to look out five years, what should the vision of this bank be? Where do we want to go?

@banklender [eyes rolling]

@bankmarketer To be the best bank we could possibly be by positioning ourselves to create value for customers… and world peace.

@bankceo To provide superior service to our customers: retail, business, not-for-profit, ethnic, non-ethnic, under-banked, over-banked, [exceeds 140 characters]

@bankfinance I never got the “vision thing”.

@bankconsultant Alright, @bankfinance insists we get specific on financial targets. Where do we see this bank’s ROA in 3 years?

@bankceo We have to be careful putting a number out there bcause we don’t want the Board to pull this doc in 3 yrs and hold us accountable.

@bankmarketer What’s an ROA?

@bankfinance 2%! [Thinks to self: Do we have to pay @bankconsultant for this?]

@banklender The ROA would be great if lending didn’t have to pull this bank like we were Budweiser Clydesdales hitched to a beer wagon.

@bankceo Thanks to all 4 joining our first strategy tweetup. It was very productive and we clearly have our marching orders for the future!

The above, of course, is a figment of my imagination. However, if you're bank actually had a strategy tweetup, please notify me and we will be happy to put your guest post on these pages!

Have a great holiday season everyone!

~ Jeff

The Birth of Jesus: As tweeted by Joseph
http://bit.ly/908Tkq

Bank Fees: Are We Out to Get-em?!

Banking has taken a beating in the media and court of public opinion in the past two years. Some of it has been unfair, particularly with how banks were associated with subprime mortgages (very few were originated by banks) and how community banks were lumped in with the practices of very large financial institutions (FIs). But if we are to be honest with ourselves, some of it is deserved and we should take positive steps to repair our image, better serve our customers, and lead us into the future.

I would like to look at three issues regarding our profession:

1. Executive Compensation;

2. Fees; and

3. Product Pushing

I focused on Executive Compensation in my last post, and would like to focus on fees here.

Fees are an absolute necessity to developing profitable products. For example, it costs a financial institution (FI) on average $388 per year in operating expenses to originate and maintain a non-interest bearing checking account (see chart).

According to my company's profitability database, FIs collect $24 in fee income per checking account per year, on average. That leaves $364 to be made up in the spread. As my banker friends know, re-investment rates are at all time lows. If an FI can re-invest checking balances at a market rate of 2.43%, as was the case in the second quarter of this year, a checking account would have to carry an average balance of $15,000, just to break even!

For the non-banker reading this post, if there are any, this may be an epiphany to you. Checking accounts are not inexpensive to maintain. Since re-investment rates that drive the spread are largely out of an FIs control, we turn to fees. This makes perfect sense.

But fees are under attack, as the link to a recent Wall Street Journal article indicates. It is part of conventional wisdom that all fees charged by FIs are bad, and forced on the public by insidious bankers. How did this perception come about?

Probably as a result of the logic presented above. In order to make deposit products profitable, fee income is an important part of the revenue stream. But this drive to increase fees came at the expense of reputation risk. I'm talking about the decisions bankers may have made with little discussion about how the application of this fee or that will be perceived by the FIs customers and the public at large.

An example of fee income gone wild is the order of check presentment to maximize overdrafts. You know what I'm talking about... ordering the checks received during a business day so that the large ones are presented first, causing an overdraft, and the subsequent checks are all overdrawn as well. If we presented them in a different order, the FI may have honored most of the checks. This may have sounded like a good idea when the vendor presented it to us, but the accumulation of decisions like this has led the public to draw its conclusions that we are "out to get them". We must consider this possibility in future decision making.

Recent legislation and regulation has put pressure on fees. The opt-in requirement that has the potential to reduce overall deposit fees has not resulted in wide-scale deposit fee declines (see chart). But the Durbin Amendment to the Dodd-Frank Act was worrisome, and now that the Fed has proposed reducing interchange fees from an average of $0.44 per debit transaction to $0.12, we will seek new revenue sources and expense reductions to offset the loss.

But while looking, we must ask ourselves the following questions:

1. Are we providing value that the customer should be willing to pay us for?

2. Is this fair to both our FI and the customer? and

3. Are we delivering the product and service as efficiently as possible?

I think if the answer is yes to all three, then customers should be willing to incur changes to their deposit products that allows their FI to profit fairly from their business.

If we answer no to any one of the three, then we will be encouraged to try old tricks... charge fees with as little transparency as absolutely required, and run the reputation risk we have so willingly accepted up to this point.

~ Jeff

WSJ Article: Why Checking Fees Keep Going Up
http://online.wsj.com/article/SB10001424052748703865004575648603199758586.html

Compensation Conundrum: Do banks pay CEOs too much?

Banking has taken a beating in the media and court of public opinion in the past two years. Some of it has been unfair, particularly with how banks were associated with subprime mortgages (very few were originated by banks) and how community banks were lumped in with the practices of very large financial institutions (FIs). But if we are to be honest with ourselves, some of it is deserved and we should take positive steps to repair our image, better serve our customers, and lead us into the future.

I would like to look at three issues regarding our profession, and focus on Executive Compensation in this post:

1. Executive Compensation;

2. Fees; and

3. Product Pushing

Executive Compensation

My commentary may be the equivalent of digesting castor oil for some readers and it may not earn me fans in the executive suites of the very large FIs. But I do not think the value some executives deliver is commensurate with their compensation.

An egregious example is Charles Prince, former CEO of Citigroup. He took control of the behemoth bank when the stock traded in the $50’s, left amid huge losses in subprime mortgages when the stock price fell into the $30’s, and it is now trading at around $4. He didn’t receive severance, but he somehow received compensation and benefits of around $29 million at departure (see link). Was he worth it? I think I could have delivered that performance for much less.

In an era where community banks differentiate themselves on service and relationships, it is mysterious why we pay executives so much more than those responsible for delivering the service and building the relationships. I understand in a community bank environment executives serve this function also, but community FIs should examine their compensation strategies and the makeup of their employee base to determine if both are consistent with executing a relationship driven strategy. Paying the senior executive several multiples more than those that determine the success or failure of your strategy may not be a very good practice. See table below.

The CEO compensation in the table is highly skewed towards smaller banks, as my experience has been that they typically make more. However, I don’t want to suggest that CEO’s or other executives make less. On the contrary, I am suggesting that those most responsible for executing on your strategy are compensated more.

I understand the most extreme examples reside in mega-banks, but the video below represents how our entire industry may be viewed.

 

How can a community FI achieve a state where successful customer relationship staff are compensated more? The FI should look within itself. What percent of staff are dedicated to serving existing customers and winning new ones versus staff that is behind the scenes? In my experience, community FIs over-invest in outdated processes that should have long ago been replaced with technology. Having less support personnel frees up greater resources to elevate the quality of relationship management staff, improve retention of such employees, and differentiate you from the mega-bank.

What are your thoughts on your FIs compensation strategy?

I will discuss Fees and Product Pushing in future posts.

~ Jeff

Link to Charles Prince story

http://www.marketwatch.com/story/former-citigroup-ceo-prince-to-get-295-million-plus-bonus

Link to BLS stats
http://www.bls.gov/oes/current/naics2_52.htm

The Tale of Two Banks, One Town

This blog post idea occurred to me several months ago but I have been hesitant to commit to print. My first inclination was to describe the main characters of the drama without actually naming them. This stems from the age-old maxim, "if you don't have something nice to say...". But the third quarter improvement to profitability by both banks represents a return to the way it has been over the past decade... the smaller bank outperforms the larger one. I'm talking about First Commonwealth Financial Corporation ("FCF") and S&T Bancorp ("S&T") of Indiana, Pennsylvania.

Most readers have no idea where on a map you can find Indiana, Pennsylvania. It's very name says "opposite", two states in one name. But if you bother to look at a map of the state, you will find Indiana in the James Carville description of Pennsylvania: "you have Philadelphia and Pittsburgh and Alabama in between". Indiana is in the Alabama in between. Think Punxsutawney Phil. Not exactly a budding metropolis; and yet it has two multi-billion dollar banks headquartered there.

Both banks have been experiencing loan problems. The problems stemmed from that unquenchable desire to get bigger. Indiana and its surrounding communities lack the growth that can support such ambitions. So both institutions determined in the conference rooms in the executive suite to expand lending beyond their geography. Those decisions amplified their credit problems in a challenging environment. At September 30th, FCF's non-performing assets as a percent of assets (NPAs/Assets) were 2.70% and S&T's were 2.05%. Not disastrous, but not that good, either. Lending outside of your expertise, either by industry, types of loans, or geography, oftentimes ends in bad results.

But in the midst of their challenges, S&T continues to outperform FCF. Year-to-date, S&T had an ROA of 1.07% and FCF had 0.24%. This was not an anomaly. S&T has had a superior ROA in every year that I reviewed (2001-2009). This flies in the face of the economies of scale crowd, that are running around to bank executives yammering for them to get larger or get out. As the chart below demonstrates, FCF has been larger than S&T.

Some will object to my use of ROA as a proxy for profitability. But lets dispense of a debate on proper ratio analysis, and strip down financial performance to its rawest form, net income. Although FCF has always been larger, S&T has always delivered superior net income to their shareholders (see chart below). How could such a larger financial institution be outdone by its smaller competitor across the street?

One reason is net interest margin. In all periods that I analyzed, S&T had a superior margin. Year to date, S&T's margin was 4.04% versus 3.88% for FCF. This flies in the face of the asset quality stats noted above. If S&T has a lower amount of non-performing assets, then it should have a smaller margin because it presumably lends more conservatively. Better credits would seem to demand lower loan coupons, one would logically think.

Another reason S&T consistently outperforms FCF is efficiency ratio (net interest income plus non interest income divided by non interest expense). Year to date S&T efficiency ratio was 52.11% versus FCF's at 61.29%. Similar to the other ratios, S&T was superior in every period analyzed. I understand efficiency ratio is impacted by the superior margin, but there is more to it than that. S&T simply operates more efficiently, spending their operating expenses prudently. This works against the economies of scale gang because S&T is over 30% smaller than FCF in total assets.

Both institutions engaged in M&A over the past ten years. S&T acquired two financial institutions totalling $1.1 billion in total assets for $261 million, equating to a purchase price of 2.4% of assets acquired. FCF acquired three financial institutions totalling $1.6 billion in total assets for $274 million, or 1.7% of assets acquired. Although I feel it safe to say that S&T was less acquisitive, I do not think "to buy or not to buy" is why there is such a disparity in financial performance.

If not size, if not M&A, if not geography, then why does one consistently outperform the other? I do not think the obvious needs to be said, unless it is in the boardroom of First Commonwealth Financial.

~ Jeff

Special note: I am not making stock recommendations here. So don't call your broker to make a trade based on what I write. If you saw the performance of my stock portfolio, you would know what I mean.

Book Report: Community Banking Strategies by Vincent Boberski

A     The title of this book compelled me to read it, and I'm a better consultant for having done so. Strategy consultants such as me focus on keeping clients at least 10,000 feet up when discussing where we want to go in the next five years. But this doesn't mean that our knowledge base shouldn't be in the weeds. This book does a deep dive into the weeds of balance sheet management.

The author is very experienced in bank investment portfolio management. It appears as though the majority of his long career has been spent here. So his insights and analysis were critical to teaching me, and possibly you, about seemingly mundane yet important topics such as tax efficiency, derivatives, and BOLI.

At first I was becoming disappointed with the book, expecting to hear the author's point of view on what community financial institutions ("FIs") need to do to succeed in our brave new world. I realized the book was not going to go there when he started making references to specific Bloomberg screens.

But the author's detailed look at what type of investments should and should not be in an FIs portfolio and the characteristics of those investments was very instructive to me and any executive at an FI that is outside of the Treasury function. If you are an experienced FI portfolio manager, this book may not be for you. However, it makes a great refresher and an important reference book on the bookshelf. It can also help the experienced portfolio manager explain complicated financial instruments to other senior managers and the board of directors.

Here is what I liked about the book:

1.  Spoke specifics about various bonds and instruments to include in a FIs bond portfolio;

2.  Gave specific instructions on how to analyze those instruments;

3.  Taught me more about BOLI than I thought I needed to know but probably should know;

4.  Was published in 2010, so it has up to date lessons learned;

5.  Provided a great primer on derivatives to manage interest rate risk. A great quote: "Never manage interest rate risk through your customers". The author demonstrated how to give customers the loan they wanted and hedge the risk.

Here is what I didn't like about the book:

1.  Some may view it as overly technical and in the weeds, as I did when I first started calculating the cost of liquidity in my head (don't try this at home without proper supervision);

2.  Directs most of the book to balance sheet management. It does not discuss the customer aspect very much.

However, the minuses are very minor considering the pluses. I don't think there is another book out there for the non-portfolio manager to understand what is going on in 20%-25% of the FIs balance sheet, in pricing committee, or asset-liability management. This book will help you immensely in that regard, and I highly recommend it.

~ Jeff

Book Report note: I will occasionally read books that I believe are relevant to the banking industry. To help you determine if the book is a worthwhile read for your purposes, I will review them here. My mother said if I did not have something nice to say about someone, then don’t say it. In that vein, I will only review books that I perceive to be a “B” grade or better. Disclosure: I will typically have the reviewed book on my Amazon.com bookshelf on the right margin of this blog. If you click on any book on the shelf and buy it, I receive a small commission; typically not enough to buy a Starbucks skinny decaf latte with a sugar-free caramel shot, but perhaps enough to buy a small coffee at Wawa.

Constructive Criticism: The death of candor.

"When two men in business always agree, one of them is unnecessary." ~ William Wrigley, Jr.

"We would have had more time to discuss strategic objectives if Jeff dispensed of his comic routine." So went a piece of feedback I received from a participant in a strategic planning session that I was moderating. My internal reaction... argue back, defend my position, convince myself that the problem is with the person giving feedback.

But hold on, I tell myself. This is a valuable piece of information not designed to make me look foolish, but to make me a better consultant. I can learn more from a piece of constructive criticism than I can from self accolades or a feeling that all is well. Wouldn't I be better off to view this piece of constructive criticism as manna from heaven instead of an insult? In the heart of this piece of criticism is instruction on how to improve. I would be remiss to let it pass.

Dale Carnegie, in his 1944 book How to Stop Worrying and Start Living dedicates an entire section to how to keep from worrying about criticism. One technique he espouses is to constructively criticize yourself. It will help you become a better form of yourself, but also help you be more open and worry less about receiving constructive criticism from others.

I am a consultant. Community financial institutions ("FIs") pay my firm for helping them, primarily in an advisory capacity. I have found that those executives that are more open to constructive criticism tend to perform better. When performing a traditional SWOT analysis, I often quip that any bank that has significantly more strengths than weaknesses is a good sign to short the stock. High performing FIs tend to identify more weaknesses than strengths.

But today's business environment is difficult, and Community FIs' leaders are understandably more paranoid today than in the past. This elevates their defenses from accepting constructive criticism. This puts pressure on advisers to construct a message that all is well, or what is not well is somebody else's fault. But would I be doing my clients a service by telling them all is well when the facts are to the contrary? Why would an executive want to believe everything they are doing is the right thing up until the time they are shown the door?

Some resistance to criticism is healthy. In fact, I would put most criticism such as nagging, nit-picking, or the "see how I'm right and he/she is an idiot" in the unproductive category that should role off of one's shoulders like a droplet of rain. Not only is this type of criticism unhealthy in itself, but it closes us off to the constructive type.

I often write and speak about the pace of change in the banking industry. Strategic decisions made today will impact our institutions for years, and perhaps generations ahead. These decisions would be better if we had the ability to look back and evaluate our past, and openly debate the future. If we are closed to constructive criticism, our strategy will be inferior... period.

I have experienced many executives that are closed to criticism. Many are what may be termed, "message managers". They spend a lot of time managing what others say to them, their colleagues, and their Board of Directors. They set up meetings to filter and control the message. They hire advisers that tell them what they want to hear, and avoid ones they cannot control. This may appear to be a good short-term strategy, driving the institution forward without having to zig or zag. But an institution that can only be as good as one person is one that has a limited future.

Society is moving away from constructive criticism. Instead, we are gravitating to a non-constructive sound bite mentality. This makes for poor strategic decision making. As leaders, we must re-train ourselves how to give and receive constructive criticism. The future of our industry is dependent on the collective knowledge of all members of our team, be it colleagues or advisers. Let's get the conversation rolling!

Is your community FI open to candid, constructive dialog?

~ Jeff

Links to good articles on constructive criticism:

2001 Inc Magazine article:
http://www.inc.com/articles/2001/08/23257.html

Strategic Management Solutions (SMS) white paper:
http://www.sms-hr.com/articles/Criticism.PDF

Guest Post: 3rd Quarter Economic Update by Dorothy Jaworski

What are the Markets Thinking?

Bond markets have been the big winners in the third quarter. Rates have fallen to incredible lows; Pimco, a large money manager, has referred to them as “Eisenhower” lows because they were prevalent in the 1950s. Treasuries are the biggest winners of all with the 2 year yield now at 0.43%, the 5 year at 1.26%, and the 10 year at 2.49%; the 5 year and 10 year yields fell 75 and 58 basis points, respectively, since late June.

Mortgage rates have followed Treasury yields down, with the 30 year mortgage rate down about 50 basis points. I believe that this extraordinary situation is actually a flight to quality because of fears that had been accumulating in the markets – over European debt, the possibility of another recession, the expectation that the Federal Reserve could begin buying bonds again, and sheer uncertainty over what the true health of the economy, fiscal policy, and unknowns, such as the impacts of health care and financial reform legislation and low consumer and business confidence.

Stock markets performed exceptionally well in September after a summer selloff that took the Dow below the 10,000 level again. The index has fallen below or risen above 10,000 an incredible 295 times since first attaining that level in 1999! (Thanks, Doug Ingram). Earnings are improving and the projected price earnings, or “PE” ratio for the Dow is 12.1 (currently 14). For the S&P 500, the projected PE is 12.5 (currently 15). These are not overvalued levels by any means. One fact I noted was that S&P 500 companies are sitting with cash levels of 10.2% of total assets at June 30th. This huge amount of cash “on the sidelines” is the result of risk aversion leading to a classic liquidity trap. As the outlook improves, these companies will seek higher returns through investments. Still, with stock markets having done so well during September, I would have expected rates to rise somewhat. Instead, they barely budged.

Catch 22

Above trend GDP growth will not come until there is job growth and job growth will not come until there is above trend GDP growth. Second quarter real GDP grew at 1.6% after growth of 3.7% in the first quarter. Real final sales are growing ever so slowly at 1.0% in the second quarter and 1.1% in the first quarter. This level of growth is too slow to create sufficient jobs to recapture the 7.6 million jobs still lost during the recession, leading to our catch 22.

So far in 2010, private employers have added 723,000 jobs, well below the pace of prior recoveries. High unemployment is restraining spending but there are signs that employment is improving. Job openings reported by the Labor Department in July were 3.04 million, representing a year-over-year increase of 30%. An August report by Challenger, Gray, and Christmas showed that layoffs have declined dramatically, to a monthly average of 56,000 since June, 2009 and have been below 100,000 for fourteen consecutive months for the first time since 1999-2000. Year-to-date layoffs are down 65% from the same period last year –good news indeed.

The Recession is Over

What if you declared the end of a recession and no one cared? Well, if you are NBER, or National Bureau for Economic Research, and you wait fifteen months to declare that the recession was over in June, 2009 (its duration was 19 months), no one will care. We declared that it was over late last summer, because we saw the strong positive change in the data. Economists certainly are a cautious breed but we should take their declaration as a positive sign that they believe the economy has achieved growth strong enough to continue. Rebuilding of depleted inventories and increased capital spending helped to get GDP growth back on track in the summer of 2009 and into 2010.

Low interest rates and easing actions by the Federal Reserve have aided the recovery, although it is strongly being debated right now whether the Fed should be doing more. Every month, we keep getting their pledge to “keep rates low for an extended period of time” and their promise that, if the economy slips further, the Fed may begin additional purchases of securities in the marketplace to add money to the system. When we needed action in the second quarter, the Fed did not act. We are improving slightly in the third quarter, so I don’t expect any action from them.

What is really needed is an approach to get banks back to lending, which is not helped by increased capital requirements and FASB’s proposal to subject loans to mark-to-market accounting, which could introduce frightening volatility into bank earnings and capital.

But, I digress… Inflation is very low right now and with yearly core inflation at 1.4% and slipping, we are approaching the lower end of the Fed’s target range of 1% to 2%. Some of you Phillips curvers believe that low inflation is one factor behind the high unemployment rate. If you are unemployed, you may not feel that the recession is over. But jobs are slowly being added, as some of the uncertainty is removed from the markets. Improvements in employment will lead to more spending by consumers and businesses, which could ultimately stabilize the housing market. Home prices are improving on a year-over-year basis, according to Case Shiller, by about 4% to 5%. Uncertainty about a housing recovery has been holding back growth. Future tax rates and compliance costs are also causing uncertainty, most notably from the still unresolved situation with the Bush tax cuts set to expire in 2011, health care costs, and financial reform costs.

Putting It All Together

We are looking at low rates for a long time. The Federal Reserve will keep the short term Fed Funds rate at 0% to 0.25% well into 2011 and likely into 2012. It’s been said that negative interest rates are not an option, thus the Fed must inject money into the system in other ways, such as buying securities. This newly created money must ultimately come through the system, into banks, and come out as loans to consumers and businesses. Until this happens and confidence gets a lift out of the doldrums, GDP will continue on its slow growth path.

With short term rates anchored by Fed policy, long term rates will remain in check as well, due to subdued inflationary expectations. I do believe that the bond markets are wrong right now – that longer term rates are too low and that they will make their adjustment with the 5 year Treasury returning to 2% and 10 year Treasury returning to 3% in the next six months. However, even with these adjustments, rates are still incredibly low, and still “Eisenhower” low!

Update on My Favorite Machine – the Large Hadron Collider,“LHC”

The LHC is now speeding protons around its circle at the speed of light and crashing them into each other at total energy levels of 7TeV, which is still only one-half of its planned energy levels of 14 TeV in 2016. They are researching particles generated by the collisions. It took 100 years for scientists to discover all of the known particles in physics and only 4 months for the LHC to rediscover them. Sadly, the recession affected funding to the programs and upgrades have been delayed by one year. The Collider will have planned shutdowns in 2012 and 2013 and is expected to keep running until 2030.

Thanks for reading! DJ 09/29/10

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

The Economy of Scale Myth: Go Big or Go Home

I wrote a post a couple of months ago regarding diseconomies of scale under the premise that at some asset size-point, getting larger does not impact your efficiency and expense ratios in a material way (see link to that post below). Yet in spite of my efforts, bankers and industry experts continue to bang the drum for economies of scale. I decided to take a second look at the data to see if I was wrong in my premise.

I have been wrong in the past, and readily admit to my errors. I do not possess the personality that requires me to be right, especially in the face of evidence to the contrary. My wife and daughters tell me I'm wrong all of the time. So if my investigations into financial institutions' (FIs) economies of scale indicated that size does matter, I will say so.

Clearly size matters to some point. Banking has a step-variable cost structure that requires a certain amount of fixed expense investments that demonstrates excess capacity until an FI grows to some asset size. The devil is in the details of "some" asset size. Empire builders and investment bankers tend to argue for Mega-Bank, which supports many M&A transactions and higher executive compensation. However, as I searched my database for the top 100 return on average assets (ROAA) FIs for the 2nd quarter 2010, only six percent were over $1 billion in assets. Yet strategy sessions, competitor discussions, and CNBC focus primarily on the Mega Banks.

A note on my data collection. I searched for FIs that had greater than an 1.8% ROAA in EACH of the last four quarters. This tended to eliminate those FIs that benefited from one time gains and focused on those with consistent financial performance. I then manually went through the list to eliminate all of the special purpose institutions and subs of much larger institutions to get a more accurate list. Of the top 100, six were greater than $1 billion in assets, 55 were between $100 million and $1 billion, and 39 were less than $100 million in total assets. The table below shows the medians in selected financial ratios.

Countless strategy sessions I have been privileged to attend speak of what Bank of America and Wells Fargo are doing (not in the top 100). Very few speak of WestAmerica Bank in San Rafael, California (2.05% ROAA, $4.7 billion in assets). WestAmerica is primarily a business bank. Greater than 77% of their deposits were in core deposits (non-CDs) and their cost of funds was 28 basis points. So many banks are trying to reduce their dependence on commercial real estate and construction transactions by becoming more of a commercial bank, yet so few look to WestAmerica to see what they are doing to succeed. Instead, we focus on what Jamie Dimon is saying. We should focus more on what David Payne (WestAmerica's CEO) is doing.

If you are a senior executive of an FI smaller than WestAmerica and I am privileged to have your readership, are there smaller success stories? Must you be over $4 billion to be successful?... Yes to the first question and no to the second. Ninety four of the top 100 ROAA FIs were less than $1 billion in assets.

I have spoken and written about niche banking in the past. I offer an example of an FI that is currently succeeding at it: Live Oak Banking Company in Wilmington, North Carolina. Live Oak opened its doors a little over two years ago and yet it has met the four-quarter criteria of having an ROAA greater than 1.8% over the past four quarters. Live Oak opened to provide capital and other services to the veterinary, dental, and independent pharmacy businesses (see its About Us link below). The bank sells a high percentage of the loans it originates but keeps servicing rights to maintain relationships. At June 30, 2010 it had $209 million in assets and a 2.82% ROAA.

Extreme niche banking like Live Oak's may not be in the cards for your FI. But that doesn't preclude you from having a line of business or product set that you are known for, excel at, that delivers superior profits. After all, who wants to be known as "just another bank"?

Let's not be absolutists, claiming that economies of scale are needed, or that being highly specialized is critical. But the evidence clearly shows that there are financial institutions generating superior returns that are not Wells Fargo, PNC, et al. Let's not limit our universe of business models to study to a select few that have rolled the dice with the scale game.

What FIs do you admire that may not be the biggest kid on the block?

~ Jeff

jeff for banks blogpost: Diseconomies of Scale
http://jeff-for-banks.blogspot.com/2010/08/diseconomies-of-scale.html

Live Oak Banking Company - About Us
http://www.liveoakbank.com/AboutUs.aspx

Does it all have to be about the spread? My thoughts on fee income.

In a previous post I mentioned that my wife and I are refinancing our mortgage because of the extraordinarily low rates available (see link to that post below). As part of the process we received the Good Faith Estimate (“GFE”) of costs associated with obtaining a mortgage loan. A key and expensive component of the cost is title and settlement services. My lender suggested some service providers from their list, but we have a relationship with a local law firm that provides those services. This got me thinking about such services being offered by banks.

According to the GFE, title search, insurance, and settlement services will cost $2,073.75. Now, without giving you too much personal information, we do not live in a mansion. Our house is 2,000 square feet and its value is slightly greater than the average in our community. I recently heard on a personal finance show that the commissions to title agents are 70%-80%. Let’s assume they are something less for refi’s, say 50%. That would equate to over $1,000 of net revenue to the title/settlement agent for each transaction. I repeat that this is a residential real estate transaction refinancing an average home. Commercial real estate transactions and McMansions would generate greater revenue.

Given community banks’ propensity to do real estate transactions, why wouldn’t such a fee-based line of business flourish?

My company measures the profitability of products and lines of business for community financial institutions (“FIs”). Part of this service includes measuring how banks do, or don’t, make money on their fee-based products and lines of business. The chart below demonstrates the pre-tax profit margin since 2006 of all of the fee-based products for those Fis that subscribe to our service.

Community FIs, in general, are not making money with these products. Of course, there are exceptions, such as one of our clients that makes greater than a 20% pre-tax profit margin in their Trust and Retail Investments line of business. But as a general rule, community FIs have not been very successful in this arena. With the potential for diminished deposit fee income due to Reg E and the Durbin Amendment of the Dodd-Frank Act, perhaps FIs should figure out why this is so.

Retail investment services is one common service offered by community FIs and one that has confounded me as to why we can’t generate greater revenues and profits. According to a recent Wall Street Journal article (see link), the minimum commissions and fees expected of an Edward Jones broker is $30,000 per month, or $360,000 per year. Edward Jones’ business model is a main street model, having offices in small to medium sized towns across the country. One would think that a bank broker, similarly located and having the benefit of bank in-house referrals, should be able to outleg the Jones broker. However, Kehrer-LIMRA studies of bank broker productivity tend to hover around $250,000 of annual production.

As an industry, we should be successful in retail investment sales. Bankers, in spite of the recent and daily beatings we have taken in the media, remain a go-to source for trusted financial advice. As the table below indicates, publicly traded brokerage firms make a net profit margin of 17.81% at the median. I realize that the current environment has been challenging for them, but they still are generating profits as an industry. That profit margin includes taxes and all costs associated with their business, such as human resources, finance, and Charles Schwab himself. Therefore, shouldn’t we expect similar returns from our programs? Yet we settle for breakeven or worse. We should set our sights higher.

If we have a broker for every five or so branches, or covering $200 million of our deposit base, we should expect production in the Edward Jones area of $360,000, but certainly no less than $250,000. If we have four such brokers, generating $1 million in fee income, then we should expect a minimum of $200,000 pre-tax profit, fully absorbed. That means paying their share of HR, finance, etc.

Retail investments is one area where community FIs are well-positioned to succeed. But those fee-based lines of business that are consistent with your strategy should be explored, proper attention should be given, and profits should be expected. Those FIs that profitably meet the greatest amount of financial needs for customers already on their books will drive revenues and value that will be difficult to replicate. That is an enviable position indeed! What are your thoughts on complementary fee-based lines of business?

~ Jeff

Wall Street Journal article on Broker production:

http://blogs.wsj.com/financial-adviser/2010/05/20/regionals-raise-broker-production-minimums/

Blog post on mortgage refinance:
http://jeff-for-banks.blogspot.com/2010/08/mortgage-refinance-thanks-uncle-sam.html

Wanted: A Few Good Bankers

Banking is under assault by lawmakers, regulators, and the public. What started as the mortgage crisis, advanced to a Wall Street crisis, and has devolved into what is known as a banking crisis. As consumers began defaulting on loans, the stereotypical media reaction demonized those "bankers" forcing people from their homes. Nary a word seemed to be said about people borrowing money from the banks and promising to pay it back while at the closing table. As the economic dominoes fell, so did banks, failing in numbers not seen since the 1989-91 S&L crisis. The end result, a black eye for our industry that brands us all in a not-so-attractive light.

Because banks take collateral, primarily real estate, as security for loans we are always in a position to foreclose on that collateral if the borrower fails to pay us back. It is far easier for the person that defaults to paint the bank as the bad actor rather than the bank defending itself by saying "we lent them money, they promised to pay us back, and they failed to do so". We don't defend ourselves because we don't want to discuss personal details about our customers. This is a good thing. But the public relations beating we are taking is beyond the pale.

One negative impact is to paint the banking profession with the same broad brush as the bad players during the financial crisis. My firm specializes in working for community banks. Every week I am with management teams discussing strategy and profitability. Frequently, bankers lament how difficult it is to find top talent in key managerial posts. As I look across the table, it is less than common to see younger faces. Why does it seem young up and comers eschew banking?

One answer is branding. Bankers have always been painted in a negative light in pop culture. Think Mr. Drysdale and Miss Hathaway (pictured) in The Beverly Hillbillies or Mr. Potter in It's a Wonderful Life. But banking is mostly a noble profession with many benefits. I note a few here:

1. 
   
   Mr. or Miss Community: If you love where you live, enjoy the people and interacting with them, banking is a great profession. A key part of your job is to get to know customers and prospective customers and meet and greet them at community events. If you enjoy this type of interaction, banking could be for you.
2. 
   
   Home most nights: Jeff Opdyke's writes a Love & Money Op-Ed every week for the Weekend Wall Street Journal. He is a financial reporter covering Asia in his day job. In his latest Op-Ed piece he mentioned he will spend fully 3-4 months of the year on the road. Bankers, on the other hand, spend most of their time at or near home. This allows them to watch their children grow and attend their events, and make time commitments to various charitable organizations or personal hobbies. I, as a consultant, don't have these luxuries because it is variable week by week when I will be in town or not.
3. 
   
   Important to community advancement: This goes beyond (1) above. Bankers could play a significant role in helping businesses get off of their feet and thrive by providing sound advice, financial products,  and, in many cases, financing for local businesses. Currently, there is no better place to obtain business financing than the local bank. P to P lending, the federal government, and other intermediaries are lessening our role in small business formation and financing, but have yet to trump us. If you want to help your community build a sustainable economic future, banking is a profession like no other.

I have mentioned in previous posts that banking is changing at a pace unlike any other in my lifetime. Critical to community banking thriving in this new and emerging environment will be new, fresh faces bringing new ideas to key management positions to carry us forward. If you value the above, consider banking as a profession.

- Jeff

Ficticious Interview: Senator Chis Dodd and Rep. Barney Frank

Senator Chris Dodd (D-CT) and Representative Barney Frank (D-MA) were primary sponsors for the Dodd-Frank Wall Street Reform and Consumer Protection Act which was signed by President Obama on July 21, 2010. Rather than arrange for an actual interview with the lawmakers so they can give me non-answer answers, I envisioned how an interview with the esteemed gentleman might transpire. Here is how it played in my head:

jeff-for-banks (jfb): What is your definition of a "financial crisis"?

Dodd: When Joe the Plumber can't get a loan to buy a multi-million dollar home on Florida's Gold Coast. That's not just a crisis, it's tragic.

Frank: When Fannie and Freddie stop contributing to my PAC.

jfb: How did the Government Sponsored Entities, such as Fannie Mae, contribute to the financial crisis?

Frank: I don't think Fannie and Freddie are financially insolvent. I don't believe they require large bailouts (Note: Actual July 2008 quote by the gentleman from Massachusetts. See video below).

Dodd: Barney just told you they stopped contributing.

jfb: Should individuals be accountable for taking loans they could not afford to repay?

Frank: The necessary evil of capitalism is that there are evil forces intent on perpetrating ill-will on the working class and it is the responsibility of everyone to enlist government officials to stand guard against bad players regardless of the cost and reliance on government because we are here for you, the working class, not the rich.

jfb: Huh??? Senator Dodd, same question.

Dodd: Personal responsibility is so 1950's. It took the 60's enlightenment to end such a fascist concept.

jfb: I read that the Bureau of Consumer Financial Protection will have a $500 million annual budget. Is this accurate?

Frank: I hope not. Creating this bureau was a key provision in Dodd-Frank and a budget that doesn't end in a "B", or better yet, a "T", doesn't demonstrate our commitment to creating a black-hole bureaucracy.

Dodd: No worries. We'll charge it!

jfb: The Durbin Amendment requires the Fed to determine the "reasonable and proportionate" interchange fee that can be charged on debit and credit card transactions. Historically, when has price fixing worked?

Dodd: Nixon did it in the 70's with gas prices.

Frank: (laughs) Son, I understand you're a coal cracker from Scranton, had a hard-scrabble life, and may not understand these things. The Durbin Amendment is not price fixing. The Fed is only going to set the reasonable fee that can be charged.

jfb: How do you envision the Fed determining which systemically risky firms to unwind during a future financial crisis?

Dodd: Although the law is 5,000 pages, we left it up to the Fed to determine how to do that. I'm sure they'll do a good job.

Frank: I envision a panel like on the reality TV show America's Got Talent. Bankers like Jamie Dimon can make their case to Piers, Sharon, and Howie who can buzz him if they don't like his shtick.

Dodd: (laughing) Barney's kidding.

Frank: No I'm not. I love that show. Great concept.

jfb: Will Dodd-Frank solve the problems that created the financial crisis?

Frank: We are creating a financial system with greater government control and a new bureaucracy with a $500MM plus budget with significant powers. What could go wrong?

Dodd: What do I care? I'm outta here!

jfb: Thank you for your time gentleman.

Reminder in case you are an angry politico... the above was a figment of my imagination. Any complaints can be lodged to some government agency with a big budget that was designed so you can cry on their shoulder.

- Jeff

Banking School: Effective Decision Making

On occasion I have the privilege of attending a banking conference in a swanky locale. Last month, I attended a gathering of Pennsylvania bankers at The Breakers in West Palm Beach, Florida. These conferences are typically chock full of opportunities for me to learn something. I feel it my duty to pass what I learn to you in the hope that you will benefit from it, as I have.

There were many good sessions, but the one I found particularly interesting was done by David Martin of Commonwealth Advisors. David competes with me in one of my firm's lines of business and it may not be wise of me to play him up. But I respect Dave's opinions as a result of his decades of industry experience and willingness to share his knowledge. I may not always agree with him, but I have always respected him.

His topic of the day was on making difficult decisions. Banking has changed slowly from the Great Depression to the late 1970's... a little quicker from the 1980's until 2008... and in a major shift since 2008. However, as Dave put it, "bankers and their boards often apply more sophisticated analysis to routine loan and investment decisions than they do to critical strategic decisions". If our industry is undergoing a long-term strategic shift, as I believe it is, we need to chart a course that gives us long-term relevance to our customers, communities, and shareholders.

Here are the eight steps Dave proposed for effective decision making (from Harvard Business Review on Decision Making by Harvard Business School Press, June 2001):

1. 
   
   Set the Stage: This is the collaborative problem solving stage, testing and evaluating exactly what the problems are, presenting balanced arguments, establishing an openness to solutions and constructive criticism that carries into later stages.
2. 
   
   Recognize Obstacles: Cognitive Bias... our industry's bias toward the familiar has been a significant contributor to finding solutions that are small "tweaks" to business as usual; and Group Dynamics... going along with the group, assuming group harmony is more important than accurate strategic decisions... or... individuals dominating the discussion... or... silent dissent that typically results in meetings after the meeting to undermine decisions that were made in the group. Early recognition of these obstacles that subvert the effective decision making process is critical to avoiding them.
3. 
   
   Frame the Issue at Hand: Perform a root cause analysis by repeating the statement of fact and ask the question "Why?". Then identify your decision making objectives you want to reach by defining the performance that represents a successful outcome and painting a picture of what things will look like when the problem is solved.
4. 
   
   Generate Alternatives: Brainstorm solutions. Enlist a devil's advocate. Require details from participants to avoid platitudes such as "get us to the next level". Appoint a note-taker to ensure all ideas are considered and documented.
5. 
   
   Evaluate Alternatives: Use objective analytical discipline to evaluate costs, benefits, time, feasibility, resources, and risks. Also, identify areas of uncertainty and focus on those that have the greatest impact on the outcome of your decision.
6. 
   
   Make the Decision: Set up performance metrics to track progress towards your hoped-for results. Support the decision once it is made.
7. 
   
   Communicate the Decision: Notify those responsible for implementation and that will be affected by the decision. Explain the thinking behind the decision. Clarify what is expected to support the decision.
8. 
   
   Implement the Decision: Generate short-term wins. Monitor progress and fix problems before they grow. Be direct, open, and honest and allow no silent dissent that undermines the effectiveness of implementation in order to return to the status quo.

There are many challenges facing our industry that can be solved by implementing a disciplined decision making process to lead to better strategic decision making. I am confident more will emerge once the regulations resulting from Dodd-Frank start rolling off of the presses.

Rather than allowing these challenges to build up to overwhelming proportions, perhaps we should implement strategic decision making that is disciplined, focuses on the real challenges, and generates alternatives that will lead us into the future.

Alternatively, we could bury our head in the sand, complain about lawmakers and regulators, and pretend all is well with us and wrong with the other guy (see below for the "head in the sand decision making process").

- Jeff

Mortgage Refinance: Thanks Uncle Sam!

My wife and I are in the throes of refinancing our mortgage. The impetus was trading down from a 5.875% rate to 4.375%. This week, we received our loan application package, that includes the Good Faith Estimate (GFE) of mortgage costs, on the lesser-known form HUD-GFE.

Background information: Mortgage rates are at all-time lows due to continued economic weakness, Federal Reserve policy keeping short-term Fed Funds rates near zero, the Fed's policy of buying government bonds in the open market and keeping long-term rates low, and government support for Government Sponsored Entities (GSE's, i.e. Fannie Mae, Freddie Mac) that continue to finance home mortgages. My wife and I would like to lower our monthly payments over the same term we have remaining on our current mortgage. Makes sense to me, then we received our application package.

The package contained 36 pages of difficult to understand disclosures. They required us to affix our signature 23 times. The GFE estimated our settlement charges at $7,941.75. Yes folks, to refinance our mortgage through the same financial institution that currently services (although does not own) our current mortgage, we have the opporunity to pay them $8k. To be fair, only $2,175 goes to the lender, which is paydown points for getting the low rate. Another charge is to fund an escrow account, which sounds ridiculous to us considering we have an escrow account with the same lender on the same property for our current mortgage.

Other charges include title services, including insurance. This is another part of the refinance process that makes no sense. We bought our home six years ago and paid for the title search and insurance at that time. Must it be done again to refinance? Where that requirement comes from, I don't know. But it is emblematic of the perplexity of the mortgage financing business.

This is an example of "We're from the government and we're here to help" good intentions combined with bad results. I think there could be mortgage finance rules drafted in a one or two page piece of legislation that makes it easier on all of us... borrowers, lenders, investors, and regulators.

Here is what I recommend to improve the process:

- For refinancing to the same homeowner on the same piece of property, an electronic title search is all that is required for homes where title insurance has been purchased within the last ten years;

- Permissions to verify income and account information can be done on a one-page letter;

- GFE's can be made much simpler and more condense. I predict my 11 year-old could come up with a more understandable form;

- Create an automated form that enumerates tradeoffs with financing closing costs or paying them. I went through a mathematical exercise because of my knowledge of the industry, re-investment rates, etc. to make my determination. Does or could everyone do the same so they make an informed decision?

- Create an automatic query and bid system once a mortgage application is made to settlement agents and title insurers. My guess is not many of us have "relationships" with these firms, so selecting nearby agents that participate in an electronic bid system would be extremely helpful. The same could be done for appraisers. I think if hotels.com and priceline.com figured this out for hotels, we could get something going for these service providers. These costs can go on the GFE directly from the bid system.

My guess is costs for the title, settlement, and appraisal engine would come down as a result of the competition. Right now, borrowers probably go with the company(s) recommended by the lender. This puts a premium on getting and staying on the lenders' recommended lists, which probably equates to many expensive dinners and tickets to great seats at sporting events.

At the end of the day, borrowing money and using your home as collateral should be easier, much easier, than it currently is. I think if we sat back and asked ourselves, "what makes sense here", the process would be a lot different... and probably less expensive for the borrower, less difficult for the lender, and easier to regulate.  What are your thoughts on the mortgage process?

Guest Post: Second Quarter Economic Update

What’s Bothering the Markets?

There used to be an old adage in the stock market: “sell in May and go away.” This year, it certainly seems to be the case. Stock markets did quite well this year into April then began to sell off relentlessly in May; in the meantime, bond markets moved higher, especially Treasuries, as investors sought the safety of bonds. Interest rates have been driven to incredible lows. The month of June has not been much better; after trying to rally from lows, stock markets keep getting battered back. It’s almost as if there is some invisible hand keeping the Dow near 10,000 and the S&P near 1,050. Wait! These were the 1999 levels for these indices. One lost decade later, we are still there. Did you know that since 1999, the Dow has risen above and fallen below the 10,000 mark an astounding 280 times! (Thanks to Doug Ingram for that bit of history).

So what gives? What is wrong with the markets now? We can’t blame it on the Internet stock bubble of ten years ago. We’ve lived through one of the worst recessions and financial market crises of our lifetimes. The stress of September, 2008 to March, 2009 was beginning to be erased by an economic recovery, as signaled by stocks that rallied over 60% from fearful lows to levels that supported growth. Then came this May and June, and it feels like the market psyche is slipping back to emphasizing the negatives. Don’t get me wrong, there are plenty of negatives to go around – Greece and Europe debt crises, China growth issues, a weak employment report for May and unemployment at 9.7%, fear of a “double-dip” recession, weakening data, the BP gulf oil spill, low business confidence, and continued deleveraging by consumers and businesses.

Government and regulators are contributing to the pessimism with financial reform legislation that does not even address some of the causes of the crisis, new FASB proposals to impose harmful mark-to-market accounting on bank loans, and the looming expiration of the Bush tax cuts in 2011. Bummers all. Jim Cramer describes it as a “malaise,” or a general lack of optimism. I describe it as the sound of thousands of vuvuzelas buzzing at a soccer match!

Is There Anything Good Out There?

Now that I have depressed you completely, let’s take a moment to cheer up. Yes! There are positives in the economy and in the markets. In the first five months of 2010, jobs grew by nearly 1 million. Granted, we lost over 8 million jobs since December, 2007, but gaining 1 million pretty quickly is good. (Now I admit many of those jobs are temporary census workers, but these are people working too). Housing prices bottomed based on the Case Shiller indices months ago and are now up almost 4% to 5% on a year-over-year basis. Existing and new home sales fell sharply in May, but this followed the unusually high months of March and April that contained the $8,000 tax credit.

Inflation and expectations for it are both low; inflation is not a serious risk as GDP growth remains steady but below levels (3% to 4%) that can be inflationary. In fact, the battle against the real enemy, deflation, is being fought by the Federal Reserve with easy money. Interest rates, especially Treasury yields and mortgage rates, are at very low levels, which can help consumers and businesses with new loans (if they ever want to add to debt) and refinancing. And our eternal ally, the Federal Reserve, has pledged to keep short term interest rates low for an extended period of time, creating a friendly growth environment indeed. Ben Bernanke has always pledged to print more money, and drop it from helicopters if need be, to kill deflation.

We worry about all of the negatives mentioned earlier. They can lead to a loss of confidence in the economic recovery that is underway. For employers to add jobs, that confidence is essential. For consumers to spend, that confidence is essential. On the positive side, we are now in the fourth consecutive quarter of an economic recovery that started last summer. Most economists believe that the growth momentum will continue at a pace of 2.7% to 3% into 2011. Then we have to worry about federal tax increases, i.e. the Bush tax cuts expire, and state and local government tax increases as these states and municipalities struggle to balance budgets. States are wrestling with reducing projected June, 2011 deficits of $112 billion, according to the Financial Times. Let’s hope the projections of GDP at 3% come true when these tax increases occur.

Putting It All Together

The economy should grow 2.5% to 3% in 2010 and about the same in 2011. This recovery is slower than those we have seen historically, but “slow,” after the crises we have endured is preferable to “no.” Negatives in the markets have been holding us back, in addition to “inventory” issues that I have continued to stress. Two of the inventory issues have been improving – manufacturers adding to goods on the shelves and the pool of available workers declining slightly – while the other two remain weak-houses on the market and bank loans declining.

Short term interest rates are low and can be expected to remain that way until economic recovery is assured and unemployment drops“way” back from its high level near 10%. We are looking at the Federal Reserve holding the Fed Funds rate at 0% to .25% well into 2011 (mid-year at least). Some economic formulas that predict the Fed Funds rate, most notably the Taylor Rule formula, show that this rate should be negative 1.75% right now, making 0% look pretty high. It’s been said that negative interest rates are not an option, thus the Fed must inject money into the system in other ways, such as buying securities. Longer term rates should rise slightly, by .25% to .50%, once the flight-to-safety comes out of the bond market and yields return to where they were before May. But large increases in long term rates are not expected as inflation remains tame for the foreseeable future and the Fed battles the evil of deflation.

Thanks for reading! DJ 06/29/10

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Diseconomies of Scale

Have you ever driven on a highway by yourself and forget, if even momentarily, the highway you were on and where you were going? I hope most of you answered yes or I have to make a doctor's appointment. The same sensation you feel for that split second while driving is, at times, what I feel in some strategy sessions I am priveledged to attend.

A common discussion in these strategy sessions is 'how do we grow'? Frequently, I will ask 'why do you want to grow'? The answers typically come back with some variation of achieving economies of scale to leverage the infrastructure to enhance shareholder return. This is particularly true of today's banking reality, where regulators and politicians are heaping non value-added costs on financial institutions. So the easy answer is let's get bigger, right?

Of course there is some merit to growing to a certain size so adding another compliance officer or another branch doesn't tank this year's earnings. But the million dollar question is what is the "certain size"? A bank CEO once told me that his investment banker told him the ideal size was twice his current size, no matter what size he was at that time.

The table below, derived from averages of the last ten years of efficiency and net operating expense ratios, indicates there are advantages to being larger. But look carefully. The advantage diminishes as the asset size grows, to a point where it is not particularly compelling.

The drive for growth in banking always concerned me. Banking is driven by balance sheet, not the income statement like most industries. Banks revenues are the result of the size of its balance sheet. You want to grow revenue 10%, you must grow the balance sheet 10%, all things being equal.

Not so difficult, one might think, if you grow from a $500 million in assets financial institution to a $550 million one. But what if you're a $10 billion bank? Now you must grow another billion to get your growth. What do you do if your markets can't support that growth? You must buy other financial institutions or reach for growth outside of your power alley (either your geography or into lending areas where you have little experience). The result may be fine at first. But as Warren Buffett once quipped, "You don't know who's swimming naked until the tide goes out". Many financial institutions were found to be naked over the past year and a half.

Perhaps it is time to consider a different strategy. If, for example, slow but prudent growth leads you to grow your balance sheet, and therefore earnings, at five percent per annum. This is typically not an acceptable long-term return for equity investors.

But if you are generating sufficient profits, and you don't need to grow capital at a rapid pace to keep up with growth, you could pay higher dividends, delivering acceptable shareholder returns. In this manner you may be taking the growth your markets can deliver, without forcing you to seek growth that is beyond your control (i.e. M&A) or put undue risk on your balance sheet (i.e. lending outside your expertise).

There are strong leanings to grow. I know of banks that are located in the same small town. One grows faster than the other, and is very proud of the accomplishment. Senior management and the Board of the smaller bank lament that they have not grown as quickly. In this context, growing is not a business judgment or a shareholder return issue, it becomes an ego issue. There is no greater testament to the role ego plays in the size of a bank than to see Bank of America and Wachovia's drive to be the highest skyscraper on the Charlotte skyline. Wachovia was winning until their near collapse. But their building was impressive!

What size do you think is big enough?

- Jeff