Bankers: What Is Your High Definition Destination?

Future Picture: "A high-definition picture that shows in great detail the future as you want it to be." Future Picture and its definition are from James D. Murphy's ("Murph") 2006 tome, Flawless Execution. I liked it so much, I e-mailed Murph at his consulting firm, Afterburner, for permission to quote from it.

Murph and his colleague, Will Duke, called me back. Since the 2006 book, their thought process has evolved. They created a more versatile version of Future Picture, one that can be applied to multiple industries with greater precision. They termed it High Definition Destination ("HDD") in their as-yet to be released book, Courage to Execute. 

In an excerpt of the book, HDD is described as follows:

" A HDD should be so described as to provide a beacon-like objective that drives the entire organization forward.  It should be clear and simple, yet high-definition."

In other words, Future Picture, and it's successor HDD, describe in vivid detail the organization you want to be. So vivid, in fact, that all levels of the organization know it, understand it, and can describe it in less than five minutes. 

I discussed with Will and Murph our industry's vision problem. Many if not most of our banks date back many generations, in simpler times when we had one branch that did all things banking to an entire town. Competition was limited and sometimes non-existent. So our vision started as something like this... Schmidlap National Bank. We're a bank. To the town of Schmidlap. 

Now things are more complex. We are in dozens if not hundreds of communities. Our products sometimes number in the hundreds. We compete with financial institutions that are located within those communities and outside of them. We don't just compete with banks, but also with credit unions (and vice versa), insurance companies, brokerage companies, virtual banks, and non-bank financial intermediaries. 

Yet our vision has evolved to something like this: Schmidlap National Bank. We're a bank. But not just in Schmidlap.

Don't believe me? Take this vision statement from an anonymous bank that I found randomly looking through bank vision statements on the web:

"Our vision is for [bank name] to build value by employing those human, financial and technological resources which will enable and insure its expansion, prosperity, and reputation for superior quality, performance and value returned to the communities, customers, team members and investors it serves."

How about that for a High Definition Destination? There's gotta be a yadda yadda yadda in there somewhere. Does this vision statement read like yours? Even a little bit? Does your vision provide that vivid picture where all employees know your HDD and make decisions and develop tactics to achieve it?

As Murph told me on the phone call, general vision gets general execution. Executing to achieve some general HDD promotes wasted effort. And minimizing wasted effort is critical to flawless execution.

So tell me, how specific is your vision? Do you have an HDD?

~ Jeff

Banking's Total Return Top 5: 2013 Edition

For the past two years I searched for the Top 5 financial institutions in five-year total return to shareholders because I grew weary of the "get big or get out" mentality of many bankers and industry pundits. If their platitudes about scale and all that goes with it are correct, then the largest FIs should logically demonstrate better shareholder returns. Right?

Not so over the three years I have been keeping track.

My method was to search for the best banks based on total return to shareholders over the past five years... capital appreciation and dividends. However, to exclude trading inefficiencies associated with illiquidity, I filtered for those FIs that trade over 1,000 shares per day. This, naturally, eliminated many of the smaller, illiquid FIs.

For comparison purposes, here are last year's top five, as measured during December, 2012:

#1.  BofI Holdings, Inc.
#2.  Bank of the Ozarks, Inc.
#3.  Access National Corporation
#4.  Hingham Institution for Savings
#5.  Texas Capital Bancshares, Inc.

This year's list is in the table below:

BofI Holdings celebrates its third year on this august list. Congratulations to them. A summary of the banks, their strategies, and links to their website are below. 

#1. BofI Holdings Inc. (Nasdaq: BOFI)

BofI Holdings Inc. and its subsidiary BofI Federal Bank aspire to be the most innovative branchless bank in the United States providing products and services superior to their competitors, branch-based or otherwise. In its latest investor presentation, BofI claims that its business model is more profitable because its costs are lower. It supports the claim by highlighting its efficiency ratio compared to peer banks (38.7% versus 68.5%, respectively) and its operating expenses as a percent of average assets compared to peer banks (1.66% versus 3.09%, respectively).So, as a branchless bank, BofI has leveraged its significantly lower operating expenses into profit. That profit led to the top spot in five year total return to shareholders, three years running. Well done!

#2. Marlin Business Services Corp. (Nasdaq: MRLN)

Continuing the theme of niche banks, Marlin is a direct lender providing financing to business so they can acquire new equipment and technology while preserving capital. Since 1997 Marlin has extended $3 billion in financing to small and mid-sized companies acquiring computer software and hardware, telecommunications, medical equipment, and other office equipment. I considered excluding Marlin from my rankings because it started as a straight finance company. But why exclude niche players? Especially if I believe community banks must increasingly be known for some niche to differentiate. I first became aware of Marlin at the Utah Bankers Association Executive Development Program, where a Marlin Business Bank officer was attending. Marlin Business Bank was chartered in 2008 so Marlin could fund its various financing activities. The Bank sports a year-to-date ROA of 2.90% and ROE of 19.6%. Not too shabby.

#3. Fidelity Southern Corporation (Nasdaq: LION)

One of the largest bank holding companies in the Atlanta area, you would first think that Fidelity Southern is the first plain vanilla community bank in the Top 5. But you would be wrong. How often have we seen banks pursue fee-based line of business strategies to augment their spread business but have failed miserably at running these businesses profitably? I know I have seen it more often than not. But Fidelity Southern's fee income to total revenue is between 50%-60%! Nearly half of the fee income comes from their mortgage banking business, boasting over 300 employees throughout the southeast, and ranking 2nd in the Atlanta MSA in purchased home volume. But their spread business is unique also. Over 50% of the loan portfolio is indirect auto, with originations coming from Tennessee to Florida.  Indirect auto portfolios, as many of you know, performed well during the past recessionary period. And Fidelity Southern shareholders have benefited. The bank achieved a year-to-date ROA of 1.24% and ROE of 14.16%. And earned a spot in the JFB Top 5 with a 517% five-year total return. Well done! 

#4. Eagle Bancorp, Inc. (Nasdaq: EGBN)

EagleBank, founded in 1998, is a traditional community-based business bank, serving the metro Washington DC market. The Company has posted 19 consecutive quarters of increased net income at September 30... a consistent financial performer. It had a 4.31% net interest margin and a 52% efficiency ratio for the third quarter. Commercial real estate and commercial and industrial loans make up 74% of its loan portfolio. Loans are funded 86% with core deposits, allowing the bank to maintain a superior net interest margin. Another key to the bank's strong efficiency ratio is average deposits per branch. At September 30, the bank had $3 billion in deposits with only 18 branches, for an average of $166 million per branch. Eagle is run by Ron Paul, a highly respected real estate investor/developer. Interesting how so many high performing financial institutions have CEOs from other industries. I salute Eagle's 463% five-year total return to their shareholders.

#5. Bancorp, Inc. (Nasdaq: TBBK)

Founded in 2000, The Bancorp creates customized banks for affinity partners in the healthcare, payments, and institutional banking industry. According to its third quarter investor presentation, the bank's greatest revenue comes from pre-paid cards (35% of revenue), followed by revenues from a traditional community bank (22% of revenues) that manages $1.4 billion of the $4 billion asset balance sheet. The branchless community bank operates in the Wilmington-Philadelphia market. Yet another niche bank for our Top 5. The strategy delivered a year-to-date ROA of 0.59% and ROE of 6.89%, and a 453% five-year total return to shareholders. Congratulations! 

There you have it! The JFB all stars in top 5, five-year total return. The largest of the lot is $4 billion in total assets. Bank of America... not here. Jamie Dimon, ditto. PNC, sports a Steelers-like record. But, congratulations to all of the above that developed a specific strategy and is clearly executing well. Your shareholders have been rewarded!

Are you noticing themes that led to these banks' performance?

~ Jeff

Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

Five Ideas on How to Consolidate a Bank Branch

Fellow blogger Jim Marous asked me what I thought were hot stove issues for banking in 2014. Top of my list, branch consolidation.

During the second quarter 2013, bank branches generated a relatively low 2.04% total revenue as a percent of average deposits. Average deposits per branch were approximately $53 million. This is according to my firm's profitability measurement peer group. Total revenue includes asset spread from branch-originated loans, liability spread from deposits, and fee income. 

So let's do some math: 2.04% x $53 million = $1.1 million. On the surface, this looks good for a branch that might cost $600 thousand per year in operating expenses. But hold on. What about paying for that army of operations, IT, compliance, finance, and executives back there at home office? According to my firm's profitability peer report, support/overhead centers cost branches approximately 0.99% of deposits. In the case of the $53 million branch, that's $525 thousand per year. Where are the profits now?

The cold hard truth resulting from the math is that branches have to be larger to deliver meaningful profits. Many if not most financial institutions are looking hard at smaller branches in smaller markets to consolidate and create a bigger branch that can deliver better results.

But what should you do to minimize customer attrition and negative perceptions if you decide to consolidate a branch? I have a few ideas.

1. Personnel - It all starts with your people. If you are consolidating a branch into another in the next town over, select your best people to run the consolidated branch, ideally with residents from each community. And by best, I don't mean longest tenured. By best, I mean those that have the greatest potential to execute on your strategy. 

2. Communicate with community leaders - One of the most often cited reason for leaving a struggling branch open is the perception closing it would have with the community. I suggest sending a bank executive, with your current/prospective market/branch manager to sit down with key community leaders to communicate your decision process, identify how you will continue to benefit the community although you won't have a brick and mortar facility, and ask how your financial institution can continue to play a meaningful role in helping community leaders execute their long-term plans. Then take those ideas discussed and execute on them.

3. Be charitable - I am an advocate of giving branch/market managers a charitable budget for small ticket giving such as to the local little league, scout troop, etc. I also believe that financial institutions should focus their charitable dollars and time around few causes so they can have the maximum impact. Look for an opportunity to support a cause important to the residents of the community where you are consolidating the branch, either through dollars or time, and ideally both. 

4. Be social and be local - Here is an idea that will have your compliance officer spinning... have locally run social media accounts that focus communication with people in very small geographies. That's right, I'm proposing having a Schmidlap National Bank Morris County New Jersey Twitter account @schmidlapnbmorris. By being local, following local residents, promoting local causes, and highlighting local events, your bank will be followed back by locals that find value in what you are communicating. And don't forget to add personality to the account. Nobody likes to follow a bland Twitter account that tweets the daily CD rate. If you closed the Parsippany branch, you could keep Parsippany residents better engaged by being the go-to source for super-local news, events, and causes.

5. Lend, lend, lend! - In the months before and after a branch consolidation ensure that your business development folks focus dedicate resources to finding business in the affected community. Make sure to actively communicate your continued commitment with signage such as "Another project financed by Schmidlap National Bank".

Those are my ideas. What are yours?

~ Jeff

Banking Is Not Small Business Saturday

The holidays are upon us and the public relations blitz is on so we patronize small businesses for Christmas shopping. Why? Do small businesses have a unique value proposition that larger stores do not? Or are we relying on nostalgia and some David versus Goliath goodwill to drive us into the arms of local shops?

I have news for you. The latter is a failed business idea. For example, in my town, we have two relatively small lumber yards only because the NIMBY's kept Lowes out. If Lowes secured the necessary permits to open shop, bye bye small lumberyards. So the local owners think they perpetuated their business model by keeping out a competitor. How about offering something customers value greater than price, Mr. Lumberyard Owner?

Walk into a Lowes, and you are overwhelmed with the selection, and probably have difficulty finding somebody knowledgeable to help you with what you need for your project. If somebody does help you, there is often a line of people waiting for that worker's attention. Why doesn't the local owner differentiate there? But no. My wife refuses to go to one of the lumberyards because the workers' treat her like she doesn't know what she's talking about. In other words, they chose not to deliver something valued by customers. 

Are we that much different in community banking? Do we rely on some "feel-good" marketing message to drive customers to us instead of Wells Fargo? Do we hope that George Bailey will deliver us from irrelevance? Why should customers bank with you instead of the omni-present Bank of America? Because I got news for you... they haven't. The top 50 banks in the USA, less than 1% of all banks, boast 76% of all banking assets. 

The people have voted, and community banks are losing.

Why? Because we have difficulty answering the question "why bank with us"? Sure, we'll come up with some answer that says "service" or something intangible and, apparently based on the facts, unnoticeable. But have we really identified what differentiates or can differentiate us from the big boys, and built the systems, processes, and people around delivering on that promise?

Or do we keep telling ourselves in management meetings that we have better service than them, and then break into a loan committee meeting to lower our price or terms on a commercial real estate deal we're trying to win from PNC?

Don't rely on your own Small Business Saturday so customers bank with you because they are sympathetic for you.

So I ask you: why bank with you?

~ Jeff


Note: After penning this post I read an article about Small Business Saturday that said $68 of every $100 spent in local small businesses was re-spent in the community. For chain stores and online stores, that stat was $48 and $0, respectively. So there's a good part of the story to build on, in addition to creating a value proposition that customers care about. Also a good lesson for community financial institutions. How much deposit money is re-invested locally compared to the big boys? Don't forget about the in addition to...

Bankers: Are We Accountable?

Twenty years ago there were 14,000 FDIC-insured financial institutions. Today that number is cut in half. The reasons are many. And yes, some are beyond our control such as population mobility, technology, and the need for some scale to invest enough to remain relevant. But, as my one-time Division Officer, Lieutenant Proper, once told me: "Be careful pointing your finger, because the other three are pointing at you."

I recently made a presentation to staffers and advisers to the Pacific Coast Banking School (PCBS) regarding what I would change in the curriculum. My theme was that if we keep teaching bankers the same things, and expect different results (i.e. not cutting our industry by half), then we are insane. I don't think I'll be invited back.

Banking is an industry that is particularly susceptible to external forces such as interest rates, business and consumer confidence, and the economy (both local and national). So if things go wrong, there is plausible deniability as to what or who is responsible. Strange that when things go right, it's difficult to find plausible deniers. But I digress.

Because of the external forces that impact results, it is typical to gravitate to holding ourselves accountable to things under our direct control... i.e. our expense budget. Volumes and balances... not my fault, there's no loan demand. Margins... not my fault, the irrational competitor down the street is being too aggressive. Profits in fee based businesses... not my fault, soft insurance market.

I find this when analyzing client profitability reports. Nobody wants to absorb the costs of support centers, such as HR, IT, and Marketing, or overhead centers such as Finance or Executive. Hold them accountable for their direct profits, because that is what they can control. It reminds me of Louisiana Senator Russell Long's quip in the 1950's... "don't tax you, don't tax me, tax that fella behind the tree." I suppose if nobody finds value in support centers to the point they agree to pay for it, we should eliminate those costs.

I think the answer to move our industry forward by establishing an accountability culture is to identify a few, transparent metrics that are consistent with strategy that hold managers accountable for continuous improvement. To overcome macro-economic factors, use trends and comparatives. For example, if you hold branch managers accountable to continuously improve their deposit spreads, compare them to the average and top quartile deposit spreads of all of your branches. The result of this accountability should be continuous improvement in your bank's cost of funds compared to peers. But instead of managing at the "top of the house" (i.e. bank's total cost of funds), we burrow down to the managers responsible for generating funding.

But since there is some art and science that goes into developing management information to establish accountability at the ground level, those managers that don't shine will frequently lob darts onto the results. But bankers that are committed to identifying and executing on a strategy that differentiates them from the remaining 7,000 FIs, should identify the metrics that correlate to successful strategy execution. 

And when managers challenge the message to dilute their accountability, senior leaders must be exactly that...

Leaders.

~ Jeff

Bankers: What is the value of your strategy?

A colleague and I recently had a healthy discussion about what agenda items to include at strategic planning retreats. He was strongly in favor of showing summary level financial projections for "business as usual" at the financial institution. Showing value creation, or erosion, from doing the same things you have been doing will highlight the need for staying the course or strategic change, in his opinion.

He is right. So often we get bogged down in philosophical debates on what to do about branches, technology, loan growth, expense control, and yes, vision, that we forget that whatever strategic direction the group decides should find its way, long term, to the FIs bottom line to increase the value of the franchise.

It does not matter if you are a stock held bank, mutual bank, or credit union. Your strategic direction should increase the value of the franchise, whether you measure aggregate value (mutual, credit union), or shareholder value (stock bank). Why would you initiate strategic change if it doesn't result in increased value? Even the non-stock bank/CU wants to live another day. Perhaps their Boards of Trustees have a lower capital appreciation hurdle. But doing nothing and eroding the value of the franchise is a sure sign that you will not have the resources or relevance to continue serving your other, non-shareholder constituencies into the future.

So what is enhanced franchise value? Since I have been involved in banking, investors focus on two metrics: price/earnings and price/book. The market places a multiple on these metrics. For example, I used Tompkins Financial Corporation's core earnings per share in the below table. The market currently values TMP at 14.8x earnings. Assuming the market continues to value TMP at 14.8x, you can arrive at the per-share valuation of the stock. For you non-shareholder owned institutions, use an industry p/e and apply it to your aggregate earnings to come up with your franchise value.

The projected business as usual eps grew at a compound annual growth rate (CAGR) of 5.4%. The Board may have determined that this was not enough. So strategic change must take place. After debating strategy and what success would look like in executing strategy, the bank was projected to increase earnings at a 10.4% CAGR. The Board's expectations on capital appreciation was 8%, because the bank's dividend yield was 3.32%. This would equate to a shareholder total return of 11.32% (8% capital appreciation plus a 3.32% dividend yield). The strategy, therefore, is projected to increase the value of the franchise.

Now, my firm does not serve TMP so the above numbers are only hypothetical. Except that I used actual core eps from 2007-12 for the business as usual row. I also have no inside information on what the Board of TMP expects in capital appreciation or total shareholder return. I only use the above as an example.

But in the throes of developing strategic direction, and the future of your bank, is it not important to demonstrate, in financial terms, what success would look like and how it adds value to business as usual?

What are your thoughts?

~ Jeff

Note: Even though my bank stock portfolio is currently making me look like an investment genius, mostly because of industry-wide price performance, I make no investment recommendations in this blog, or anywhere for that matter. You should not invest in any security based on what I type on these pages.

Bank M&A: The Concept of Relative Valuation

It depends. How often do advisers such as doctors, lawyers, accountants, and yes, investment bankers say that? Asking if an offer to buy your bank is a good one depends on numerous factors, as investment bankers' fairness opinions state in excruciating detail.

What value a buyer ascribes to your institution does depend on many things. One key factor, though, is the buyer's currency. More specifically, where the buyer's stock is trading on a price/book or price/earnings basis.

Let's look at two deals.

Deal 1: FNB Corporation (NYSE: FNB) of Hermitage, PA, buying BCSB Bancorp (Nasdaq: BCSB). 

Deal 2: 1st Constitution Bancorp (Nasdaq: FCCY) of Cranbury, NJ buying Rumson-Fair Haven Bank and Trust (OTCQB: RFHB) of Rumson, NJ.

According to the table, BCSB received a higher valuation. Or did it? 

At this writing, FNB trades at 255% of tangible book value per share, and 14.6x earnings. 1st Constitution, on the other hand, trades at 101% of tangible book, and 10.5x earnings. So, although the nominal value paid for Rumson-Fair Haven by 1st Constitution is less than what FNB paid for BCSB, it appears from the table that Rumson-Fair Haven shareholders got the better deal, all other things being equal.

Assuming there is not tangible book dilution or earnings accretion (which we know is probably not true, but most of the assumptions to show dilution/accretion are unknown to us), Rumson Fair-Haven shareholders are set to receive a 37% pickup in tangible book value and 224% pickup in EPS. BCSB shareholders are set to increase EPS 252% but will also incur tangible book dilution of 33%.

The valuation differences between the buyers probably explains why FNB is paying the transaction consideration in stock, and 1st Constitution is trying to use as much cash as possible while still qualifying for a tax free exchange for selling shareholders that elect to take 1st Connie stock. 

So, when evaluating what buyers would be willing to pay for your institution in a merger, you should also consider the value of the consideration received. Just because a buyer can pay a higher nominal value, doesn't make it a better deal.

~ Jeff

Bank Shareholders Are Only One Seventh of the Equation

I am guilty. Guilty of elevating increasing shareholder value to Napoleonic heights. I annually rank the top five financial institutions by total return to shareholders. I write about developing a strategic plan that results in financial returns that satisfy shareholders. I confess, I contributed to the notion that the shareholder matters above all else.

But many, if not most state business corporation laws don't agree. Take my home state, Pennsylvania, Title 15, Subchapter B Fiduciary Duty, Section 515 Exercise of Powers Generally...

"In discharging the duties of their respective positions, the board of directors, committees of the board and individual directors of a domestic corporation may, in considering the best interests of the corporation, consider to the extent they deem appropriate:

(1)  The effects of any action upon any or all groups affected by such action, including shareholders, members, employees, suppliers, customers and creditors of the corporation, and upon communities in which offices or other establishments of the corporation are located.

(2)  The short-term and long-term interests of the corporation, including benefits that may accrue to the corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the corporation.

(3)  The resources, intent and conduct (past, stated and potential) of any person seeking to acquire control of the corporation.

(4)  All other pertinent factors."

So, as I read (1) above, shareholders are certainly in the mix of parties impacted by a board decision. But so are members, employees, suppliers, customers, creditors, and communities of a corporation. I don't think the order in which the law was written constitutes a ranking. As I read it, and mind you I've never passed the bar, all constituencies have equal weighting.

Shareholder held banks are not not-for-profits. They make money to grow, be safe and sound, invest in personnel and technology, give back to their communities, and yes increase the value of their franchise for shareholders. Boards should be mindful that profits are as much for other interested constituencies as the shareholders. In other words, to a board member, hearing an employee say "I love working here", a customer say "I love banking here", should resound similarly to a shareholder saying "this is a great investment".

Banks used to be owned primarily by retail investors. As the industry consolidated, banks became larger, and retail investors became weary due to the financial crisis, institutional owners filled the breach. These investors care little about the employee that loves to work there, or the customer that raves about extraordinary service. Well, they do care if it ends up dropping more money to the bottom line that can be returned to shareholders in some fashion.

Institutional shareholders are much stronger, and more concentrated and vocal advocates for shareholder returns than the retail shareholder, who once took pride in investing in the local bank. Just because they are louder, should they be at the front of the line? Or should we all read our respective state's business corporation law on fiduciary duty of directors?

~ Jeff

Guest Post: 3rd Quarter Economic Review by Dorothy Jaworski

QE3 Taper—Never Mind

If you are a fixed income investor, you are still shell shocked. Throughout the summer, the great bond market selloff of 2013 continued on. Treasuries, Agencies, mortgage backed securities, corporate, municipals- all were battered because the markets believed that the Federal Reserve was about to cut the amount of, or “taper,” its $85 billion of monthly purchases of long term bonds.

The Fed had been telegraphing a taper since April and May, when Bernanke and the Fed governors began giving mixed signals. By the time the September FOMC meeting arrived, 100% of Wall Street believed the taper would be $5 billion to $20 billion per month. What did the Fed actually do? Nothing. Well, never mind!

So why did the Fed decide not to taper QE3? I can see five reasons: 1) the government shutdown and its negative effect on GDP was looming, 2) data releases had become weaker, including housing data, and job growth was weakening, 3) the markets had already tightened long term rates, as unwelcome as that has been, 4) the velocity of money remains at a 50 year low, and 5) a nascent upswing in consumer and business loans this year could be cut off, reverting to deleveraging. The Fed’s own mixed messages caused the extreme selloff. They have no one to blame but themselves.

Europe

We landed on the shores of Europe in August. What we experienced was the vacation of a lifetime. What we saw were beautiful old cities, castles on the riverbanks of the Rhine, breathtaking cathedrals, and the wonders of Paris and the friendship of citizens of the small towns near Metz. What we know is that we will go back. What we felt and learned was that the European people are confident that the worst of the recession is over in Euroland.

GDP reflects that, too, as Europe’s economy grew by +0.3% in 2Q13 and is expected to grow by +0.2% in 3Q13. Perhaps part of the reason for our bond market selloff is that the flight to quality due to Europe’s prior problems is abating.

She Devil to Head the Fed

Janet Yellen, affectionately nicknamed “She Devil” by Washington and Wall Street, has finally been nominated by the President as Fed Chairman. Her nomination had been in doubt until Lawrence Summers withdrew from consideration. Wall Street gets the Chairman they want—the one with a decade of Fed experience and the one most likely to continue Bernanke’s policies. She spent time in the Fed with the Maestro, Alan Greenspan. She has hopefully learned to deal with a crisis aggressively and to take actions and make statements that are credible, not like the mixed messages we received for the past six months regarding QE tapering.

I feel bad for Ben Bernanke; he will not get to finish what he started. When “normal” recovery finally arrives, She Devil will get the credit. If all goes well, she will take over as FedChairman at the beginning of February, 2014.

But it will not be all smooth sailing for our favorite dove. She will inevitably face crisis and have to deal with it decisively. Greenspan faced the 1987 stock market crash when he was new and in the late 1990s, faced the Asian currency crisis and the collapse of Long Term Capital Management, and the stock market crash of 2000.

Bernanke, as we all remember well, faced the bursting of the housing market bubble and the 2008 financial market crisis with the Lehman Brothers bankruptcy. We must believe that the toughness implied by her nickname will guide her through trouble.

Government Shutdown and Default Danger

We are in the middle of the 18th government shutdown since 1976. One estimate is that 83% of the federal government is still functioning—something about “essential”—so it is not much of a shutdown. We have great Washington drama with both sides refusing to give ground on their issues. But give they must, negotiate they must, to avoid the unspeakable horror of a default on US debt that would destroy trust in our nation and trust in the dollar.

A drop dead date of October 17th for default was given by Treasury, but this date seems suspect, with expected receipts in October of $200 billion and $25 billion in interest payments due, it is hard to understand why default would occur mid-month. Maturing debt could be rolled over and replaced with new debt without breaking the debt ceiling.

But regardless of when that date arrives- someone, anyone in Washington, are you listening? Debt default is not an option. You must act now. As this newsletter goes to press, only days before the October 17th date, I cannot imagine that a default will occur. I must believe that a midnight deal will happen.

The shutdown is impacting the release of economic data of government data, the timing of which is poor as the data had been weakening prior to the doors of 17% of the government being closed on October 1st. The private data being released has been weak, most notably the ADP private payrolls report, which showed measly job growth of 166,000 in September, after 159,000 in August.

Remember, the government payroll report for August showed measly growth of 169,000 for the month, with the labor force participation rate down to 63.2%, the weakest since the late 1970s. The unemployment rate continues to drop, most recently to 7.3% in August, from hundreds of thousands of workers exiting the labor force. This is not a good trend.

Jamie Dimon

We were hoping that there would be a savior to the great bond market selloff of 2013, a voice of reason able to reassure the markets. We usually look to the Fed, but not this time. We were hoping it would be someone like Jamie Dimon. But, alas, we learned in the 3Q13 J.P. Morgan earnings release why he has been in hiding—he has his hands full of legal issues.

JPM reported the first quarterly loss since Dimon’s tenure as CEO with $9.3 billion in legal charges in the 3Q13. This brings the legal reserve at the Bank to an astounding $23 billion! We know he continues to defend JPM from the ongoing extortion fines (recently $900 million) from the federal regulators, UK regulators, and the SEC over the London Whale’s bad trades. We know he continues to defend Bear Stearns from the ongoing demands of state and federal regulators for more and more money for mortgages that defaulted.

But $23 billion—Wow! Stay tuned.

Thanks for reading. DJ 10/13/13

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.

Sea Story: Anti-Submarine Warfare During Operation Desert Shield

This week somebody asked me for a sea story from my Navy days. Although many colleagues and bankers know I was in the Navy, I can't recall anybody asking me for a story. So I told the one below. They seemed interested, and I thought you might be too. If you were looking for banking insights, you'll have to forgive me for this post.

In September 1990, the guided missile cruiser USS Biddle (CG-34) in-chopped into the Mediterranean Sea with the aircraft carrier USS Saratoga battle group en route the Red Sea. This was after Iraq invaded Kuwait, and tensions were high. I picked up the Biddle (see photo) via a CH-46 Sea Knight helicopter. You know, the big troop/supply carrying helo with two big blades. That harrowing ride and jump to the Biddle is a sea story in itself. But I digress.

The Biddle was tasked with merchant interdiction. If you remember back to Operations Desert Shield and Storm, the "coalition" was intercepting merchant ships, stopping any sort of supplies reaching Iraq via the Red Sea or the Persian Gulf. Biddle stopped the first merchant ship, and the most during the operation.

One evening, I was vigilantly on watch. Which means I was wearing headphones in front of a wall of electronic equipment. Captain Harlow, our CO, came over the 1MC (ship-wide speaker), sheepishly announcing that we were DIW (dead in the water, i.e. not moving), and he wasn't sure why. Next morning divers from the Saratoga were going to check things out.

Turns out, we lost our rudder. That's right, we dropped a rudder into the depths of the Red Sea. My fellow shipmates joked we were doing some anti-submarine warfare and we dropped rudder hoping to hit one.

The closest dry dock to get it fixed was Toulon, France. We were in the Red Sea. Check Google Maps. We're not talking a brief trip, here. And we had to navigate the Suez Canal. If you ever experienced the Suez, and I suspect most readers have not, it is very narrow. It can only accommodate a North Bound convoy, followed by a South Bound convoy. Never the two at the same time. Sometimes you feel as if you can throw a rock from your ship and hit land, it's so narrow.

Captain Harlow was a stubborn man. He did not want to be towed in the North Bound convoy. Instead, he decided to steer by the screws. That means using our propellers to make turning movements to guide us through the canal. We slowed the North Bound convoy down so much, Egyptian authorities made us pull off to the side and wait for a tow. So the remaining North Bound convoy, and the following South Bound convoy passed us in our misery.

The next day, and the next North Bound convoy, a US frigate, I can't remember the name, stopped to give us our tow. A frigate, for the uninitiated, is one of the smallest warships in our fleet. A mighty cruiser, on the other hand, is one of the biggest.

We took our tow, and the North Bound convoy of shame, all the way to Toulon.

But hey, I was able to get off the ship in Toulon and spend Christmas with the family. So there's that!

And that's my sea story. I don't know if there's a lesson here, except check your equipment before leaving port.

~ Jeff 

What will our depositors do when rates rise?

The subject has been on the minds of bankers for years now. The continued extension of the Fed's easing policy through possibly 2016 has given us a sense of security. But this pro-longed period of low rates, burgeoning core deposits, and uncertainty about what our depositors will do next should keep us restless.

For those that rely on yield for returns, it has been a tough time. Retirees, insurance companies, and bank treasurers have found it difficult to earn money in fixed income. Some have been able to squeeze gains out of bonds as rates fluctuated downward, but the second quarter flip from an unrealized gain to an unrealized loss in bank investment portfolios brought reality home to treasurers.

I'm not certain what depositors will do when rates rise. But I analyzed what they did the last time the Fed raised Fed Funds Rates in mid 2004. On June 30, 2004, the Fed raised the Fed Funds rate from 1% to 1.25%. Over the next two years, the Fed raised rates 16 more times, ending at 5.25% on June 29, 2006 (see chart).

The last Fed action prior to the 2004 rate rise was June 2003, when the Fed Funds Rate stood at 1%. Surprisingly, bank cost of deposits at that time was 1.43%. Note that all deposit and cost of deposit data was for quarterly periods, where Fed Funds rates were on the date they were raised. But once the Fed started moving rates up, bank cost of deposits lagged the movement upward. When the Fed ended its tightening in June 2006 at 5.25%, bank cost of deposits was 2.68%, a significant spread.

What did depositors do during this period? They moved money from core accounts (all deposit accounts less time deposits and brokered deposits) to non-core, as shown in the chart below.

But not to the extent one might think. Yes, non-core deposits as a percent of total deposits grew from 32% in June 2004 to 38% in June 2006. But core deposits did not decline during that period, growing 8.3% during the two year span. But time & brokered deposits grew 48.7% during the same period.

By the time the Fed stopped tightening in the second quarter of 2006, core deposits represented. 61.8% of total deposits. Today, core deposits stand at 77.8%. So, if past is prologue, then we can anticipate that although our overall core deposit base may not decline, time deposits are sure to increase. 

This analysis reviewed what happened to FDIC insured deposits across the U.S. How that money will flow between institutions is a result of efforts made by financial institutions today to win the loyalty of customers once rates begin to rise. Will they stay with you, or go across the street? Is it in your hands, or the hands of fate?

~ Jeff

You Can't Buy a Customer's Love?

I recently attended the ABA Marketing Conference in San Antonio where a speaker from USAA said something similar to this post's title. Really? How do I explain the branding study by a client that identified Ally Bank as the most recognizable brand in their market?

As most readers know, Ally is the former bank-finance arm of General Motors (GMAC). They required a substantial capital infusion from Uncle Sam to keep them solvent during the financial crisis. I don't think they have many, if any branches. So how do they earn "most recognizable"? My money is on their ad budget. In other words, they bought their fame. Love? No. Head above the crowd? Looks like it.

This flies in the face of conventional wisdom spoken so eloquently by the USAA speaker. How could blast, one directional messaging still yield results in today's engagement world? And if money can buy customer love, what can community banks with limited ad budgets do to survive?

USAA is highly regarded in banking circles for their omni channel marketing approach. But I find it interesting that their representative took the position that budget heavy blast messaging was not effective at gaining customer loyalty.

Why? I'm a veteran and USAA insurance customer. I cannot recall speaking to a live person from the insurance or bank side. But I see plenty of TV ads during prime airtime, receive a couple of e-mails per month, and occasionally receive direct mail from them. Is this how to win my love? Perhaps. I'm not sure. But, according to their actions, they must think so.

But I do know most community banks cannot afford this path. We don't have the resources. So what are we to do?

Customers switch banks when something happens that compels them to do so. For each customer, it may be a slightly different "something"; a declined credit, difficulty sending a wire, accidentally bounced check, a bad experience with their banker. The key to be the bank they go to once "something" happens is to be on top of their mind when they decide to switch. Ally and, yes, USAA, do that through their ad budgets. You, on the other hand, must work harder and smarter to be that top of mind bank.

Traditional advertising can play a role. But actually knowing potential customers can go a long way. Do your employees, front line and support staff, participate in community organizations? Are they on LinkedIn and do they follow your bank's LinkedIn profile?

Does your bank blog, and interact with community members on the blog? Have you positioned your employees as subject matter experts on the blog, and host community based education sessions such as "How to Finance a Small Business"? Does your brand have personality, such as supporting the local sports team(s) by using Facebook post factoids on team athletes, and wearing team colors in your branches before a big game?

Whatever path you choose to combat big bank big ad budgets, ensure it is consistent, constant, integrated, interesting, relevant, and genuine.  USAA is thought to be best in class in omni channel engagement. You can be genuinely best in class. But you have to build the strategy and execute it.

What are you waiting for?

~ Jeff

Bar Rescue: Bankers Edition

My buddy Dave Gerbino and I are speaking about product profitability at the ABA Marketing Conference in San Antonio next week (Monday, September 23rd, 11am if you're in town). While developing our presentation, Dave drops Bar Rescue on me.

Never heard of it, I said. Apparently, it's a Spike TV reality show where a bar expert (great job!), Jon Taffer, helps owners turn their flailing establishments around (see video clip).

Dave said product profitability reminded him of Taffer badgering bar owners for their liquor cost. How much are they paying for their liquor and what is their gross margin? Most didn't know. Should they know?

That's a rhetorical question. But, let's be honest, most of us don't know our liquor cost. I read fascinating articles and hear endless speeches on big data, data analytics, deep data dives, relationship profitability, customer profitability, and segment profitability. But nary an article, speech, or mention of product profitability. It is the Rodney Dangerfield of big data. It gets no respect.

Its absence is peculiar. Peculiar because it is a pre-requisite for most other profitability endeavors. How do you determine customer profitability without cost per account? That's an output of product profitability. Go ask your deposit operations clerk how she spends her day. Will she say she spends two hours working on your Main Street branch overdrafts, or ABC Company's wire transfers? No, she'll say she spends two hours working on checking overdrafts. 

Do you calculate customer profitability using Return on Equity (ROE)? How do you calculate the "E" allocated to the customer? You do it by risk characteristics of the product(s) used by your customer. Again, an output of product profitability.

So where is your product profitability? What's your liquor cost?

~ Jeff

FYI: Dave Gerbino and I will be speaking more on this subject at the ABA Marketing Conference on Monday, September 23, 2013 at 11am in San Antonio. They think so many marketers are interested in their liquor cost that they made us repeat our performance at 1pm.

Loan Pricing: Must It Be So Complicated?

When it comes to pricing loans, my experience tells me we use competitor pricing as our de facto pricing model. For consumer and residential loans, where rates and fees appear on the competitors' websites, it's not so difficult. But for commercial loans, I suspect we follow anecdotes such as what customers tell us or what friendly competitors murmur to us at a cocktail party. We tell loan committees that this is the rate and structure needed to "get the deal done".

In comes the loan pricing models. Some are expensive. Some are free, such as the one recently mentioned by my friend Dallas Wells of Asset Management Group, an ALCO consulting firm based in Kansas City. 

Now, I have never been a commercial lender. But I'm a student of the lending function, and listen intently to senior managers discuss loan pricing in profitability improvement meetings that I moderate. That's where I hear the stories of the competition, irrational pricing, yadda yadda yadda.

I recently had two students from the Pacific Coast Bankers School (PCBS) ask me about how to risk price loans. Why they asked me, I don't know. Although I'm no loan pricing expert, I have my opinions. And my opinion is it should not be as complicated as those "in the know" would like us to believe. So for you, fair readers, I developed this simple loan pricing model (see table).

Four inputs, you say? Well, there is some back room gears at work too. For example, the loan duration should be calculated by the loan cash flows and repricing characteristics. Is it a five year, 20 year amortizing commercial real estate loan? Then perhaps the cash flow calculation pegs the loan duration at 4.3 years, as it does in this model.

The transfer price, or charging the lender a cost of funds for the borrowed money, is typically derived from a rate index, such as the Federal Home Loan Bank yield curve, for the same duration borrowing. That would have to come from Finance and be blended for odd-lot terms, such as 4.3 years.

Capital allocation should be determined by a risk adjusted return on capital model (RAROC). I described this in greater detail in a previous post. But this analysis would have previously occurred, and be assigned based on loan type code and the internal risk rating.

If your bank performs product profitability, a natural calculation from this model is operating cost per account based on type code. If you do not have product profitability, you can analyze your approximate operating cost per account or use industry benchmarks.

And lastly, the provision expense associated with this type of loan and risk rating should be driven by your Allowance for Loan and Lease Loss (ALLL) methodology. You already do this, I guarantee it (insert Men's Warehouse founder voice).

There you have it. Now you have a well priced loan that accounts for credit risk through the provision and RAROC calculations. Interest Rate Risk is accounted for in the transfer price, as this is taken from the same duration market instrument. You also account for other key risks through RAROC such as liquidity and compliance risk. 

Price by this method, and you are accounting for the risks, costs, and desired margin of each loan. You can overlay deposit products to hit your ROE targets in a similar vein.

Price by this method, and you can determine if doing a loan at a certain price point, as told to you by your borrower, may or may not be a mutually beneficial pricing structure. Banking is one industry where success is driven not only by your ability to build relationships that are not price driven, but also by not being as stupid as your competitors. If the market price is too low for your appetite, have the courage to walk away.

What else should be considered in pricing a loan?

~ Jeff

Are Your Customers & Prospects Lovers, Haters, or Swingers?

I recently attended the Pacific Coast Bankers’ School at the University of Washington as an observer. Instead of observing, I went to learn from the many quality industry professionals and college professors that make up the faculty. One was Michael Swenson, a Ford Professor of Marketing at Brigham Young University. 

During his class, he discussed a case where the American Plastics Council (APC, now the Plastics Division of the American Chemistry Council) was trying to get people to feel better about using plastic. It seemed to me that the advertising campaign that ensued was specifically designed to get you to respond “plastic” when confronted by the pimply teenager at the supermarket checkout line that mumbles “paper or plastic”.

After spending millions, the APC was getting no traction. In fact, public opinion of plastics was getting slightly worse. That must have been an uncomfortable conference call.

So the APC brought in some fresh blood to figure out what to do. I can’t recall the agency they hired. But their approach was to divide their constituents into three groups: lovers, haters, and swingers. I think Professor Swenson called them the love group, hate group, and swing group, but I like my names better.

My first thought was, how could somebody “love” plastic? Not that there is anything wrong with that. But the context was that plastic had some positive influence in this group’s lives, such as the local little league switching from a chain link to a plastic-based fence just before their son Timmy (or Justin in modern day) plowed into the fence shagging a deep shot to left. So you get the picture where this group’s heads were (see video).

The hate group generally was of the tree hugging variety... plastic clogs landfills, never biodegrades, kills Flipper, etc. Swingers were indifferent. You may add a funny line now.

Based on the results of the study, you would think the APC would go about changing the hearts and minds of the haters. It’s human nature to try to get those that don’t like us to like us. But you would be wrong. Instead, the APC set to work on the swing group.

Here is where the big learning moment came for me. Instead of parading swingers into a room to do a focus group [insert joke here], the APC brought in the lovers to learn why they felt the way they did about plastic.

They took what they learned from the love group, and began a campaign to change the hearts and minds of the swing group through the eyes of the love group. And it worked.

Aha! *insert light bulb on top of head*

~ Jeff

Much Maligned Banking Business Model: Lean and Mean

Does your financial institution pursue a relationship driven strategy? If so, you would be in the majority for community FIs. If not, you are much maligned.

In my last post I identified five things I don't understand. One was "Our Money Is No Different Than the Bank Down the Street". I discussed my confusion as to how bankers could believe this and still pursue a more expensive relationship driven strategy. Instead, why don't you get lean and mean?.

I discussed this with bankers I met at the Pacific Coast Bankers School, where I am currently serving as a Faculty Fellow. As an aside, I'm still not sure what that means, except I go to class to form an opinion about the school and its subject matter. But I digress.

The bankers here did not have an appreciation for the business model of a California bank, who shall remain nameless, that sports a near 1.50% ROA, and trades at over 3x tangible book and 18x earnings. The model, is designed to be highly efficient, having an efficiency ratio in the mid 40's and an expense ratio (non-interest expense/AA) at about 2.3%. In other words, this bank is cheap.

If my experience is any gauge, most community FIs choose a more expensive business model, the relationship driven model. This strategy typically delivers a higher net interest margin, because customers won't dump you at the slightest price variation, and is more expensive as the FI invests heavily in relationship managers and high touch service.

But what does the market think of the two models?

I took a look at publicly traded FIs between $1B-$10B in assets, that had ROA's greater than 1%. I controlled for fee income businesses, as high fee income FIs skew the ratios significantly. So the FIs had to generate less than 30% of total revenue in fees. The criteria delivered 61 FIs. I then split them up into top and bottom quartiles based on the expense ratio. The results are in the table below.

Although community FIs choose the higher expense ratio, higher net interest margin strategy, the markets currently reward the more efficient FIs with higher trading multiples. 

This does not make Porter's "low-cost" model superior, as it calls into question the sustainability versus the "differentiation" strategy, especially for community FIs that lack the scale of our largest banks. But I think it's time to get off of our high horse and recognize, as Michael Porter did, that the low cost model is an option.

Any thoughts on low cost versus differentiation?

~ Jeff 

Five Things I Don't Understand

Some people see far more gray areas than I do. When common sense, reason, and facts support one direction, I am confused why we don't move in that direction.

If I listed everything I don't understand, you would be reading a long, long time. So I will limit myself to five things that recently confused me, and are relevant to banking.

1. Vision Doesn't Matter

I hear this a lot and a recent quote from General Colin Powell convinced me to put this on top. At a recent speaking engagement, he was reported to have said "If you want to make sure to keep moving forward, have a destination." I can't think of many, if any, renowned strategists that believe vision doesn't matter.

But I can't think of many financial institutions with a vision that clearly identifies a hoped for future. Most vision statements read like they came out of a Dilbert cartoon.

I think smarmy vision statements are the reason I often hear bankers and their consultants say vision doesn't matter. If you can't point to your hoped for future, communicate it and inspire your team, then maybe your bank doesn't matter. Could this be the reason for the incredibly shrinking number of financial institutions? I only wish those consultants saying vision doesn't matter would go away instead.

2. Our Money Is No Different Than the Bank Down the Street

If you believe this, then price is your only differentiator and the only way to achieve an advantage over your competitors is efficiency. Look to Oritani Financial Corp. as an example of this. But believing that you sell a commodity and pursuing a "relationship" strategy confuses me. Building a high quality staff of employees empowered with building customer relationships is more expensive than building efficient processes, using efficient systems, with a small number of high deposit branches needed to be a price leader. 

If you believe you sell greenbacks, dump the relationship platitude and get efficient.

3. We Need Experienced Bankers

Back in 2010 I wrote that our drive for experienced bankers limited banking's talent pool. Specifically, I was writing about hiring veterans. The corporate world is chock full of leaders brought in with little experience and taking those corporations to extraordinary levels. Think of Southwest Airlines Herb Kelleher, or IBM's Lou Gerstner. In banking, I identified the top 5 total return financial institutions. One was BofI Holdings Inc., whose CEO was a former consultant. Go figure.

Look through the long list of bank failures since 2008. Most were run by experienced bankers. So excuse me if I'm at a loss as to our fascination with finding more of them.

4. Finding Joy in Other's Failures

So, if you read my bio, you know I'm a Yankees fan and I'm fielding lots of questions about how I feel about Arod. Personally, I don't know Arod. Based on my limited knowledge of him, I don't think I would like him. He comes off as an extreme narcissist. But I refuse to boo the guy, or take joy in his downfall from baseball royalty. Perhaps when I reach perfection, I would be more comfortable taking pleasure in watching others fail. But I don't see that happening in my lifetime.

Failure is not testimony to your intelligence. It is testimony to your effort, and wisdom.

5. Employees Don't Match Your Strategy

Strategy shifts faster than culture. If you are moving your financial institution away from being transaction focused to relationship focused, yet leave the transaction focused people in place, you are setting yourself up for failure. How often do I hear from bank leaders that they are having difficulty getting their employees to do what they need them to do in our new banking world? 

Daily.

What is confounding you?

~ Jeff