Wednesday, 21 August 2013

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 

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