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...

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

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