Saturday 24 July 2010

The Folly of Peer Groups

A bank CEO once told me that peer groups get you to that lazy place. He was referring to being mediocre. Yet we continue to use peer groups in banking to guide us to where we want to go.

I am not against peer groups. My company uses them to determine where a company is at a point in time. But because financial information on competitors is so readily available in banking (we must report to the FDIC our quarterly results and it is available to all), we become over-reliant on them.

Regulators fall victim to this trap too. I have read countless exam reports that cite UBPR (Uniform Bank Performance Report) statistics as evidence that a bank is doing well or needs fixing. For example, an examination may cite a bank’s efficiency ratio as compared to peer as a reason why the bank is lacking profits (the “E”, or Earnings, in CAMELS ratings).

But UBPRs are done by asset size and region. See below for a snapshot from an Umpqua Bank of Portland, Oregon UBPR. Their peer group is all commercial banks with assets greater than $3 billion. That’s the only criteria. If Umpqua chose to measure success by these standards, they would surely strive for mediocrity. Something I doubt Ray Davis would be pleased with.

Suppose a bank has a significant wealth management division. This typically drives up efficiency ratios and would therefore compare unfavorably to peers without similar operations. Should senior management focus their efforts on reducing the efficiency ratio because a short-sighted examiner said so?

No, I would think that is not the way to run your bank. I frequently tell bankers not to let examiners run their business. What qualifications do they have to do so? But bankers can’t let peer numbers run their business either.

Comparison to peer ought to be the result of executing your strategy, not the impetus behind your strategy. We have a client that evaluated their position in their markets, their potential, and therefore their best strategy to succeed. Then they identified the peers that had balance sheets similar to the one this bank strived to attain. They dubbed this peer group their “future peers”.

They then evaluated their current position and identified peers that looked most like them today. They dubbed this peer group their “present peers”. As they implement their strategy, senior management is tracking their progress from their present to future peer. In other words, they utilize a peer group as a tracking mechanism for executing strategy, not to determine the bank they want to be. That came first. In my opinion, this is a very positive manner to use a peer group.

I think banks should use peer groups as diagnostic tools, to hold themselves accountable for top tier performance, and move towards those peers that may be executing similar and successful strategies. I do not think they should be used to determine the bank you want to be or to achieve “peer performance.” To me, this would be a recipe for mediocrity indeed. How does your bank/thrift/cu use peer groups?

- Jeff