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

To Branch or Not To Branch: Here Is The Answer

During periods of uncertainty lies opportunity. Vernon Hill, legendary leader of the former Commerce Bank in Cherry Hill, New Jersey, took advantage of the last time bankers were contemplating the future of branching by beating them over the head with his high profile and rapidly expanding branches. Can another Commerce Bank eat our lunch this time around?

Only if you develop a decade long strategic plan that maps the decline in branch prominence. If you are a shorter term strategist, and you want to grow, then branching remains on the table because it remains high in importance when customers are asked why they bank where they do. Even if they do not frequent their local branch, they tend to bank where a branch is nearby.

But what kind of branch? The Financial Brand did a showcase piece on innovative branch designs. I don't know which one is best, if any, but do know that the answer to proper design lies in your target customers as identified by your strategy. So, the branch question, be it design, location, and staffing, should be driven by the type of customers you are targeting, as identified in your strategy. If you haven't identified your target customers in your strategy, read no further and go do it.

But for those that know who they are targeting, the branching decision should be built on analytics. Branches represent such a significant expense, and average deposit size to achieve desired profitability has gotten so large, that we can no longer decide to branch at a location that is convenient to one of your directors.

Here are what I believe to be the critical pieces of information in determining where to branch:

1. Where are your customers now? Banks often have concentrations of customers that are in towns where they have no branches. This could be a significant starting base to grow your branch. I attended a banking conference recently where the presenter said your best source of new customers are the neighbors of your existing ones. If you have a solid foundation of households within a geography, that is a great start for a successful branch. Note I'm not suggesting branching just to bank existing customers, as that would erode overall profitability. But existing customers are the seedlings for new customers. So identify where your customers are.

2. Are there enough opportunities to bank your target customers in the new market? If you specialize in banking doctors and dentists and there are paltry few in the new market, I'm lost why you would consider going there. The exception may be that your niche rests on the loan side of the business, and funding those loans evolves from a more general strategy to generate funding. But if you can't dominate your niche in a certain geography, consider going somewhere where you can.

3. Is the market growing? Household and business growth demographics are pretty easy to obtain, either through government sources or systems such as your MCIF. Deposit growth and market share, and number of branches in a market (see tables) are available via the FDIC website. Are deposits increasing? Are competitors struggling? Are average deposits per branch increasing and of sufficient size to achieve your desired level of profitability?  

4. Are bankers available to staff the branch? In nearly every strategic planning session I attend Senior Managements place great emphasis on successful strategy execution on their people. There is no substitute to having the type of staff with the greatest likelihood of successfully executing your bank's strategy in your new market. You want to fail? Put no emphasis on branch staffing. You'll fail. I guarantee it.

5. Is a reasonable site available. I'm a realist. You can set your branch up for failure if you don't find a reasonable site. The term reasonable is in the eye of the beholder, but if you are tucked in the middle of a dying strip mall, that may not bode well for your visibility and your brand. Find a location where your people can succeed.

6. Can you de-branch painlessly? This is a new question for your branch analysis. There will come a time when your contemplated branch, and other branches in your network, will be unnecessary. Customers will be accustomed to banking online and/or via mobile, advice and problem solving can happen via the phone or in-person visits to the customer, and the psychological attachment to the branch will be gone. Can you close shop without incurring significant expense? 

I don't think branching is dead. But I do think that the need for marquis, high cost branches is waning, and smaller and more tech savvy branches will emerge as the norm. I also think staff per branch will decline, but capabilities per staffer will increase. The importance of getting your next branch decision right is critical to successful execution of your strategy. Don't let your director bully you into putting one near his/her house.

How do you think branching decisions should be made?

~ Jeff

Does your bank achieve positive operating leverage?

When a significant portion of your cost structure is fixed, then growing revenues should generate positive operating leverage... the cost of generating the next $100 of revenue should be less expensive than generating the previous $100.  This fundamental logic stands behind the banking industry buzzphrase, economies of scale. The fixed cost of your IT infrastructure is less on a relative basis for a $1 billion in assets financial institution (FI) than a $500 million in assets FI.

Because it is intuitive, doesn't make it so. Over the course of the past 10 years, the number of FDIC-insured FIs decreased by 23% (see chart). The average asset size per institution increased from $753 million to $1.7 billion. Clearly, part of this consolidation wave was attributable to FIs striving for economies of scale and positive operating leverage.

Has this consolidation, partly designed to give surviving institutions scale so they can spread relatively fixed costs over a larger franchise, resulted in positive operating leverage? My research into the subject says no.

One measure of achieving positive operating leverage is the efficiency ratio, defined as operating expense divided by the result of net interest income plus fee income. The lower the efficiency ratio, the greater the profitability. As an institution grows and is able to spread costs over a larger base, the efficiency ratio should go down.

But over the past ten years, efficiency ratios have risen in every asset category in both banks and thrifts with the exception of the very largest (>$10B in assets) banks (see charts).

The efficiency ratio measures how much in operating expense it takes to generate a dollar of revenue. So what if revenues (net interest margin, or fee income) are on the decline? Naturally, the efficiency ratio will go up. To further isolate expenses, I reviewed how expense ratios, defined as operating expenses divided by average assets, fared for our industry (see chart).

For banks, expense ratios have not budged during the period that resulted in a 23% reduction in FIs. Thrift expense ratios rose materially. I reviewed my company's bank and thrift product profitability reports to see if operating expenses per account declined during the 2000-2010 period. The answer: not one spread product group showed a decline in annualized cost per account. Not one.

Let's look at a couple of highly acquisitive FIs to see if they are achieving positive operating leverage by growing their balance sheets through mergers.

Fifth Third Bancorp

Fifth Third Bancorp is a $110 billion in assets financial institution with 1,363 branches and is headquartered in Cincinnati, Ohio. It has made six acquisitions totaling $32.6 billion in acquired assets between 2000 and 2007. The largest acquisition by far was the second quarter 2001 acquisition of Old Kent Financial, a $22.5 billion in assets bank. I chose this period to offset any impact from the 2008-2009 financial crisis. Clearly Fifth Third undertook acquisitions to achieve economies of scale. Relevant statistics during this period include:

While Fifth Third’s assets grew at a compound annual growth rate (CAGR) of 13.5%, earnings per share grew at a 1.1% CAGR and both the efficiency and expense ratios were higher in 2007 than when the bank was $45 billion in assets in 2000. Positive operating leverage should result in EPS growing faster than asset size because adding the next $100 in assets should cost less than the previous $100. Has Fifth Third achieved positive operating leverage by more than doubling the size of the bank during the measurement period?

 

 

BB&T

 

BB&T is a $157 billion in assets financial institution with 1,791 branches headquartered in Winston-Salem, North Carolina. It made 21 acquisitions totaling $44.6 billion in acquired assets from 2000 through 2007.  BB&T acquired more, and often smaller, financial institutions during the measurement period than Fifth Third.  Relevant statistics include:

 

While BB&T’s assets grew at a CAGR of 12.2%, earnings per share grew at 10.8%. But the efficiency ratio remained relatively steady in spite of BB&T’s net interest margin falling from 4.20% in 2000 to 3.46% in 2007. The expense ratio declined, realizing economies of scale from its asset growth. Although EPS did not exceed asset growth, the culprit lies more in revenue generation than on realizing efficiencies from growth.

This analysis is a simple undertaking to determine if your financial institution is getting the results you want when executing a growth strategy to achieve economies of scale and positive operating leverage. If your results more closely resemble Fifth Third’s than BB&T’s, you should ask yourself why.

Economies of scale should result in lower efficiency and expense ratios, and greater profitability… i.e. positive operating leverage. If you are growing to spread relatively fixed costs over a greater revenue base, then you should measure to determine if you are succeeding. Success should result in better results to peer, industry benchmarks, and downward trends in operating costs per account. Growing absent success in these metrics means you are simply managing a more complex organization for no additional benefit. 

   

Do you measure and hold yourself accountable for reducing relative costs as you grow?

 

~ Jeff

 

Note: The above post was excerpted from a soon to be published Financial Managers Society (FMS) white paper drafted by the author.

Enterprise-wide Risk Management (ERM): Yawn

I attended an industry presentation on ERM this past week put on by RSM McGladrey.  The topic highly interested me, not because it is interesting, but because everybody is talking about it and there are differing opinions about what to do about it. What an opportunity for a non-audit, non-compliance, non-IT, and non-credit blogger to write about it!

First I would like to say that the McGladrey speaker really knew his stuff and was balanced. So often I hear commentary on ERM by advocates that think it is the next best thing to, say, online banking. Well, no it isn't. It is not likely to make your FI a lick of money. That said, here is my criteria for an ERM program:

"A successful ERM will result in reduced losses that exceed the investment made in the ERM program."

~ jeff for banks

Why else would an FI embark on ERM? If the investment in ERM exceeds losses foregone, then don't invest in an ERM program. It's not worth the money. As community FIs, regulators force us to throw enough money down a black hole without us volunteering to do so.

But managing risk across organizational silos is highly fragmented in FIs. It makes sense to coordinate the effort into one area. Perhaps, as suggested by one attendee at the presentation, ERM could streamline risk management efforts to make reporting more relevant, less voluminous, and less labor intensive. If this was a by-product of ERM, then I'm in! I think your Board of Directors (Trustees for CUs) would appreciate reducing the size of monthly Board reports for monitoring risk.

An organization's risk profile looks like the bubble chart below from McGladrey's presentation. But not all risks are equal. If we were to quantify risk across the industry, Credit Risk would rank at 10 for greatest risk (on a hypothetical scale of 1 to 10), but other significant risks would be much lower such as Liquidity and Interest Rate Risk (perhaps 4's). How would a non-audit, non-compliance, non-credit person develop a ranking system for risks?

Look at past experience to determine levels of risk. For example, perform a lookback over a meaningful sample period (perhaps 10 years, or at least one economic cycle) to identify where your FI actually lost money. A second criteria could be to query your personnel with the greatest knowledge of the risk to quantify the possible loss and the likely loss from a certain risk. By developing such a discipline, the FI should determine how much resources, if any, should be dedicated to mitigating the risk.

The bubble chart above contains too much in the form of risk categories, as most categories have sub-risks. The McGladrey presenter mentioned having 20-25 risks worth monitoring and mitigating, although he was not married to it. As ERM evolves, we have to guard against monitoring so many risks that the processes that result are inefficient in their application and ineffective at preventing those risks that represent the greatest potential loss.

For example, I was evaluating processes in a client's deposit operations function where one of the ladies in the department sorted through a large stack of checks for two hours each day. I asked why she did it. She said the Bank had a check fraud about seven years ago, and therefore she had to manually review all checks over $5,000. I asked what a fraud might look like. She didn't seem clear. I asked how many she has prevented since the undertaking. She said none.

Here was an FI that allocates two employee hours per day to prevent a fraud that she probably would not prevent. The investment in resources significantly outsized the risk. I put to you that this example will be all too familiar if we implement ERM without evaluating the size and likelihood of risk. And processes, like government programs, last forever.

This past economic cycle made clear that the single greatest risk FIs face is credit risk. I don't see this changing. Even FIs that failed due to liquidity had their woes start with credit risk, including the credit risk in the FIs investment portfolio. So let's not fool ourselves into thinking that somehow "employee fraud", or some other risk, ranks nearly as high.

But there are risks that can have materially negative impacts on our business. So a CEO and Board can efficiently and effectively monitor the greatest risks to the safety and soundness of the FI, consider implementing a well thought out ERM that is focused, efficient, and effective.

Any thoughts on what such an ERM program would look like?

~ Jeff

Product Profitability Anyone? The JFB Pro-Growth Matrix

A bank attorney spoke at a recent Financial Managers' Society (FMS) meeting that I attended. His topic: Leadership. His thesis: Analytics should be the basis for strategic decision making. He offered an interesting fact: 40% of critical decisions in U.S. companies are made from the gut. This style of decision making was romanticized by Jack Welch in his popular 2001 book: Jack Straight from the Gut.

But in reading Welch's tome regarding his successful years at the helm of GE, it is clear that he was far more analytical than the book's title indicates.

Community FI's are similar to other companies in their strategic decision making. Often, critical decisions are made from the gut or based on past experience that becomes more irrelevant as industries, such as ours, rapidly transform. Such disruption gave rise to strategic advisory firms that break down strategic decisions to the facts important to increasing the likelihood of positive outcomes.

One such firm is the Boston Consulting Group (BCG), creator of the Growth-Share Matrix that depicts the potential for a company's products based on growth prospects and market share. Intrigued by BCG's concept and the ability to illustrate facts to improve decision making in FI's, I created the jeff for banks (jfb) pro-growth matrix.

Instead of using market share, as in the BCG model, I utilized net revenue per product. For loans, this was calculated as a percent of the product portfolio as follows: coterminous spread - provision + fee income. For deposit products the formula was: coterminous spread + fee income. This data was pulled from my firm's profitability database for all FI's that subscribe(d) to our profitability outsourcing service.

I chose to use net revenue instead of product profits because of the step-variable nature of an FI's cost structure. Most costs are fixed until a certain level where employees struggle to get the work done and the FI must invest in people and/or technology to increase capacity. If revenues decline, it is not typical for expenses to decline, as banks don't often let people go or scale down operations like a mortgage origination shop or a brokerage firm. Therefore, focusing on the products that drive the greatest revenue through a relatively fixed expense base would be closer to a realistic alternative for FIs.

I measured for both the fourth quarter of 2000 and 2010 to look at how our industry has changed. Change it has! Gone are the days that core deposit products generate net revenue between 4%-9%, as depicted by the "Stars" from 2000. That is because the re-investment rate, or credit for funds, for deposit products has dropped dramatically as a result of the interest rate environment today, particularly at the low end of the yield curve. Many readers may have experienced their treasurer lamenting they don't want any more deposits because they have no place to put them. That phenomenon is represented in the pullback of deposit products from 2000 to today.

But even in our historically low rate environment, core deposit products linger near the "Stars" box. Because revenues are low, some have drifted into the question marks. Interest rates are beyond our control, but if the net revenues per product decline, and much of the decline is outside of our control, then to move "Question Marks" to "Stars" may require an analysis of our expense base and the processes in place to support those products. Are we using technology to its fullest capacity? Do we still engage in outdated processes to protect from a risk that is negligible today?

Another interesting point from the jfb pro-growth matrix was that commercial real estate (CRE), much maligned since the recent crisis, remained in the Question Marks camp, albeit knocked down a notch because of the decline in the 3-year compound annual growth rate (CAGR) used to calculate the Market Growth portion of the chart. With today's elevated loan loss provisioning, CRE continues to contribute to an FIs profitability with above average net revenue generation.

Time deposits have declined on a CAGR basis since 2007, as noted in its position on the chart. In 2000, time deposits had a CAGR of 4.65% and net revenue of 0.53%. Today, CDs CAGR is -8.69% as FIs backed away from this expensive funding source because there is no loan demand. Why book a CD when its current coterminous spread is negative, which is where it stands today? But even when CDs had a positive spread, this product remained unprofitable.

Lastly, the sheer gaggle of products in the "Question Marks" quadrant indicates an opportunity for FIs. Using analytics, product managers have the opportunity to migrate marginally profitable products into either "Stars" or "Cash Cows". Knowing where you do and don't make money is a critical starting point, and positive action based on analytics can improve your FIs financial performance.

How do you use analytics for critical decision making?

~ Jeff

Guest Post: First Quarter Economic Update by Dorothy Jaworski

The World Around Us

World events are impacting our markets. Unrest in the Middle East has already changed governments in Tunisia and Egypt. Protests and internal fighting in Libya have led to an international coalition bombing the country in order to establish a “no-fly” zone. Saudi Arabia and Bahrain also face protests. Triple tragedies in Japan from the 9.0 magnitude earthquake, the giant tsunami, and the ongoing nuclear emergencies have us all unsettled.

Moody’s Rating Service never sleeps and has downgraded the debt of Spain, Greece, and yes, Japan. Oil prices keep rising and we’ve seen a 15% increase in gas prices since year end 2010. So far, about half of the positive economic impact of the surprise 2% reduction in social security taxes and small business tax cuts are gone because of higher gas prices. It may not take long before the remainder is gone, too.

It is no surprise then that the confluence of these events chipped away at the stock market rally and set into motion the inevitable correction. Stock markets had been rallying nicely since the Federal Reserve unveiled their $600 million quantitative easing program, commonly known as “QE2,” in November. Actually, stock markets are up nearly 100% since the Fed was in the midst of their first quantitative easing program in early 2009. One of the Fed’s QE2 goals, as stated by Chairman Bernanke, was to improve the stock market. In that, it has succeeded.

But the other stated goal was to keep longer term interest rates low or push them lower; this has not been accomplished. The bond markets had other ideas, selling off continuously since November, until three year through ten year Treasury yields had risen by over 100 basis points, peaking at increases of 130 to 140 basis points over November levels. It was not until stocks began to correct in early March that rates began to fall some-what, or about 25 basis points, as investors bought Treasuries and other bonds in a flight to quality because of all the uncertainty in the world.

Fundamentally, stocks should continue to do well in this, the third year of the rally. Corporate profits are strong and companies are sitting on a $2 trillion stockpile of cash. Mergers and acquisitions are continuing at a brisk pace. Prospects for economic growth are gradually improving, with 3% to 3.5% expected this year, and consumer and business confidence has been rising. The S&P 500 forward price-earnings ratio of 13.5 times is well below the historical norm of 15.5 times, so there is room to continue the upward trend, if world events cooperate, that is.

The Missing People

I usually do not obsess over economic data but I have been trying to figure out why the unemployment rate managed to drop from 9.8% to 8.9% in just three months, without a commensurate improvement in the number of jobs created. There has not been a drop of this magnitude in the unemployment rate in so short a time since 1958, when I was an infant. So, let’s look at some of the recent numbers and you will probably join me in asking “Where are the missing people?”

Payroll employment rose by 407,000 in the past three months, or an average of 135,000. Household employment, which incorporates the self-employed, rose by 664,000, or an average of 221,000.

Now, let’s look at the other data: Over the past three months, the number of people reported as unemployed has dropped by 1,028,000, the pool of available workers dropped by 1,206,000, and the total labor force dropped by 704,000. Where are these people, when there were not enough jobs created to account for the drop in unemployed persons? Why are they missing? If they didn’t get jobs, where are they?

We are creating average monthly payroll growth of 135,000 and household growth of 221,000, or barely enough to absorb new entrants into the workplace, and we are supposed to believe that the ranks of the unemployed dropped by over a million and the unemployment rate has miraculously dropped by nearly 1%! Ridiculous!

Growth for 2011

Economists were stampeding over each other to raise their GDP forecasts to 3.5% from 3.0% for 2011 earlier this year after the surprise tax cuts for consumers and businesses. Even the Federal Reserve raised their forecast range to 3.4% to 3.9% from the prior 3.0% to 3.6%. Then they all got another surprise from surging oil prices (currently over $100 per barrel) and gas prices (currently up almost 50 cents from the end of 2010), so the higher growth projections may have been a bit premature. At this point, we will probably see the originally projected 3%, given the still rising oil and gas prices, high unemployment, higher interest rates, and still weak housing markets.

To put this 3% growth rate into perspective, it would be only slightly better than 2010’s rate of 2.7% and equal to the average rate of GDP growth from 2000 to 2004. But 3% is tremendously above the recent average between 2005 and 2009 of 1.0%. We long for the glory days of the 1990s, when the average growth rate for the decade was 3.8%.

But, dream on, because the long term historical average is 3.2% since World War II, so we are close to average. I will note that GDP for 4Q10 was a record $14.86 trillion (annualized basis), which is above the prior record set in 4Q07. Consumers, businesses, and governments – state and local – are improving slowly. Very slowly. Enough to keep the Fed on hold with short term interest rates near zero – until unemployment falls from today’s high levels – from real job creation not just missing people.

Putting It All Together

Since my NCAA bracket did not turn out too well – I had Temple, Pitt, and Syracuse among others – I am forced to focus on the rest of the madness in the world. It really is true that our markets are closely tied to what is happening elsewhere and not always what is happening at home. Other than protests and natural disasters, there is one theme that has been garnering attention – that of soaring food and energy prices.

Some of the Middle East protests are in response to higher food prices, which, according to the IMF, are setting new records. So far, these dramatic price rises have not worked their way permanently into the prices of other goods and services. That is because our economic recovery is still fragile and increases in prices may not be sustainable.

Consumers likely will pull back spending in response to high prices, leading to weakening economic growth. We count on the Federal Reserve to watch inflation developments closely and they are seeing excess capacity, high unemployment, low wage and salary gains, and continued weak housing markets.

Today’s issue is to reduce unemployment; tomorrow’s issue may well be fighting inflation. Expect the Fed to keep short term rates low for an “extended period” of time, just as they promise us each month. Expect the Fed to remain angry over the bond market’s reaction to their QE2 program. For all we know, they may be plotting QE3. Stay tuned!

Thanks for reading! DJ 03/21/11

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.

 

Book Report: The Lords of Strategy by Walter Kiechel III

B+ This book, written by a journalist and former editor of Fortune magazine and editorial director of Harvard Business Publishing, tracks the growth and philosophical evolution of strategy. It focuses on three strategy firms in particular: Boston Consulting Group ("BCG"), Bain & Company, and McKinsey & Company. In its entirety, I would suggest that it would be a very beneficial read for banking industry consultants, and a beneficial read for executives at community FIs.

How business is done is often, if not mostly, evolutionary. Understanding how  we moved from the days when small businesses in small towns dominated the landscape, to how merchants operated in our large pre-industrial revolution cities, the emergence of large industrial firms, the birth of the corporate man, to where we are today is important to understanding today's business climate.

Management "fads" came and went. These fads were often touted by strategy firms and their army of elite business school educated consultants. This book tracks the evolution of strategy from its early days in the 1960's at BCG to where we are today. Strategy's emergence, and its evolution, being driven by what the author terms the "fiercing of capitalism", i.e. the escalation of competition beyond a few firms and the shortening of competitive advantage driven by technology.

This created fertile ground for strategy's ascendancy and the firms that touted its virtues. Understanding the genesis of strategy and its evolution is an important step in its development and implementation at community FIs and is the basis for my recommendation for the book.

From my perspective, it was interesting to note how strategy became in vogue and how our pre-eminent strategy firms differed in their approach. Creating teams to ponder in a conference room, ruminating how strategy should be formulated and executed is foreign to relatively small consulting firms like mine. We don't develop techniques in our firm's interior. Instead, we develop it across the table from clients, while on the phone with colleagues, or at conferences listening to experts and gauging bankers' opinions.

My world is foreign to BCG's, but it was instructive for me to learn of their methods. Knowing how they do it can only help me do it better. I think it can help you too.

Here is what I liked about the book:

1. Gave detailed descriptions of how strategy came about at BCG, and how it grew and flourished not only at that august firm but also Bain and McKinsey;

2. Introduced the key players in strategy's development, not only at the above firms but also at Harvard Business School;

3. Described strategy through each stage of its evolution, and used interviews with key players in the evolution.

Here is what I didn't like:

1. Focused only on three strategy firms and Harvard Business School. Did other B-schools or consulting firms participate in a material way?

2. The author gave me several vocabulary lessons, such as when he said an author "continued to sound the tocsin" (sound the alarm). Fortunately, I read it on a Kindle and could highlight and get definitions for the difficult words. This is probably a pet peeve of mine, and I should be more thankful that I can now use "tocsin" in a sentence.

But the book is very well put together and thorough in its review of how strategy came to be. I found it a very worthwhile read and recommend it to you.

~ 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.

Core Deposits Drive Value

The title of this post is common community FI phraseology. I hear it often, and use it often. My epiphany came when I performed research for a client that subscribed to the Return on Equity school of thinking. This FI had a high percentage of funding coming from CD's and FHLB borrowings, a relatively low loan to deposit ratio, and focused on generating profits within the investment portfolio.

The FI performed very well on an ROE basis. Its relatively low net interest margin, due to high funding costs and low yield on earning assets, was more than offset by very low operating costs. The FIs CEO lamented at his low trading multiples. I decided to dig into why his multiples were so low. It turned out that the best indicator for trading at high multiples was a low cost of deposits. I performed this research about ten years ago.

Dial forward to today and I decided to test again if the cost of deposits as value driver is still true. The results are in the table below. I searched for profitable banks & thrifts with at least 1,000 daily trading volume that had non-performing assets to assets less than 3%. The search yielded 101 banks and 30 thrifts. Not a large number but in order to get reasonable values I had to control for inefficient trading and asset quality.

Banks in the top quartile (best) cost of deposits traded at a 17.4% premium to bottom quartile performers in price to earnings multiples and a 35.5% premium in price to tangible book multiples.

Thrifts top quartile performers traded at an 18.9% and 30.2% premium on price to earnings and price to tangible book, respectively.

But could this be relating to their margin or yield on earning assets? I tested for yield on earning assets and the answer was no, there was no positive correlation between trading multiples and yield on earning assets.

There are imperfections to this analysis, though. Upon review, larger banks with greater trading volume also trade at higher multiples. This is probably the result of a greater pool of institutional investors due to volume requirements. Additionally, although trading multiples are beginning to show signs of improving, the overall trading of the banking sector has not returned to normal.

But ten years ago my analysis demonstrated that FIs with better deposit mixes and therefore lower cost of deposits enjoyed greater valuations. And today, the results are very similar. So why do so many FIs doggedly stick to asset-based business strategies?  Some, such as Sandy Spring Bancorp (see slide below), have been generating value from the liability side of their balance sheet and continue to do so.

According to Sandy Spring's latest investor presentation, the bank pursues a "strategic focus on small business, middle market and affluent retail customer relationships". Anecdotally, most small and mid-sized businesses do not borrow. So serving them, one would think, would require a focus on deposit relationships.

It appears as though Sandy Spring is winning, having 23% of their deposits in non-interest bearing DDAs and a cost of deposits of 0.49% in the fourth quarter. They trade at a 16.2x earnings multiple and at 130% of tangible book. It should be noted that Sandy Spring is headquartered in Maryland, a state that has experienced its fair share of credit challenges, hence the relatively low price to tangible book multiple from other top quartile banks.

Do you believe core deposits drive value? If so, why, and if not, why not?

~ 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.


Disclosure: My company has served as a strategic advisor to Sandy Spring within the past twelve months.

Experienced Bankers Wanted for Mediocre Bank

"He's not ready" is the response I often hear when I ask why a sharp banker is not part of the FIs senior leadership team. I hear it from senior leaders, industry executive recruiters, and industry consultants. But when I hear this, let me share with you what my internal voice is saying: "I want to make myself feel better by diminishing your perception of the value this clear up-and-comer can bring to our team."

If the talented individual we are speaking of is not yet good enough to serve in a similar role to me, then, ipso facto, I must be more talented than him. That is one reason I was so impressed with a southeast bank president that said to me "look around, you don't see many executives over the age of 45 because they don't get it [the new way of doing business]." This CEO must not have bought the "he/she's not ready" line.

This attitude is not exclusive to executive ranks. I recently recommended an acquaintance of mine to a regional business banking executive who agreed to take a look at his resume. The result: doesn't have business banking experience. This was true, but knowing the "type A" nature of this individual, I had little doubt he would be successful learning "credit", knocking on doors, and building relationships. Instead, this bank wanted an experienced banker. To which my internal voice said: "experienced at doing commercial real estate transactions and scoffing at directives asking him to build a full relationship."

Another version of the above is when I hear "he doesn't understand credit." I have heard this from FIs currently experiencing credit problems. Apparently it is worse to hire someone that must learn credit than to hire one that has already proven challenged in the endeavor.

Dave Martin, an industry consultant with NCBS, recently wrote in an American Banker opinion piece (see link below, may require subscription) "when we put the wrong person in a job or allow the wrong person to stay in a job, we undermine our businesses." But personnel issues are frequently cited by FI executives as to why they are not succeeding in this strategic initiative or that. And they are not willing to make the necessary changes to move their business forward. Instead, they are in search of "experienced bankers."

Arkadi Kuhlmann, founder and CEO of ING Direct USA, was quoted in a recent Harvard Business Review piece on hiring practices by Fast Company cofounder William Taylor (see link below), "if you want to renew and re-energize an industry, don't hire people from that industry. You've got to untrain them and then retrain them. I'd rather hire a jazz musician, a dancer, or a captain in the Israeli army (see link below to my post on hiring a vet). They can learn about banking. It's much harder for bankers to unlearn their bad habits." If you believe the concept of hire for attitude and train for skill is true, how do you remake your employee base?

First, the FI should clarify the strategy. Understanding where you are going is a critical yet under appreciated step in identifying the people needed to get you there. It requires vision and a roadmap to achieve the vision. Do you know where your FI is going?

Second, you must identify key positions that are important cogs in the wheel to executing strategy. I already made reference to banks that want full relationships with their business customers yet their lending team is chock full of commercial real estate transaction folks with little interest beyond their current pipeline. But if relationship building is the strategy, are your branch personnel up to it?

I have witnessed FIs build confusing and inefficient workarounds to the shortcomings in branches. One reason is that experienced branch managers tend to come from the old school, where taking care of customers once they come in the door is job 1, followed closely by ensuring the branch balances and branch cash is not off. Well, last I checked, not nearly as many customers are coming into branches anymore.

FIs pursing the "relationship" strategy fail to recognize that a relationship occurs between two people. If you hire for attitude in the branches, and get a good go-getter with a positive outlook as branch manager, but proceed to pay her minimally with little upside, she will seek promotions out of the branch. This recently happened at the branch where I bank.

Branch manager is often a destination position for those that were promoted through the teller ranks and have no need to be the bread winner. For those type A people we may want in the branches, branch manager is frequently a waypoint position until something better comes up. Not a particularly effective way to execute on a relationship strategy. But branch managers are critical to our strategy.

The manner at which we hire and fire in FIs reminds me of the different styles of George Steinbrenner and the Pittsburgh Steelers' Rooney family. Steinbrenner would make key hires relatively quickly, and would fire them if they didn't work out. The Rooneys, on the other hand, invest significant time into hiring the right people and stick by their decisions (see link below). In banking, I have witnessed us hiring like Steinbrenner, and firing like Rooney. I suspect we should choose one method or the other, and use execution of our strategy as the measurement of whether a person will work out for us.

For community FIs to remain relevant to customers and prospective customers, we must choose a strategy that delivers either a competitive advantage through differentiation or cost leadership. Fortunately, there are still opportunities to deliver cost leadership for some of us, although I would deem it to be a difficult slog to have lower costs than the very large FIs. If we want to differentiate, then how? Most strategy sessions I attend require that the community FIs people be superior in the manner at which we execute strategy. So I ask you, who is executing your strategy?

Do you believe in the "hire for attitude" philosophy or the "hire experienced bankers" one?

~ Jeff


Dave Martin's American Banker piece, "If he hollars 'bad fit', let him go."
http://www.americanbanker.com/issues/176_42/if-he-hollers-let-him-go-1033869-1.html?zkPrintable=true

William C. Taylor's Harvard Business Review piece, "Hire for Attitude, Train for Skill"
http://blogs.hbr.org/taylor/2011/02/hire_for_attitude_train_for_sk.html

My blog post "Be all that you can be"
http://jeff-for-banks.blogspot.com/2010/05/be-all-that-you-can-be.html

New York Times piece "Rooney Method: Build Methodically and Await Rings"
http://www.nytimes.com/2011/02/03/sports/football/03rooney.html?_r=1&nl=todaysheadlines&adxnnl=1&emc=tha27&adxnnlx=1299413029-4gsue0vxqubNBTcVprKO+Q

Guest Post: Fourth Quarter Economic Update by Dorothy Jaworski

Rates Give Us a Wild Ride

Bond market behavior in the fourth quarter of 2010 was one for the record books. Interest rates fell to levels that I have often described as “crazy low.” The two year Treasury yield fell to 0.33% in November, while the five year Treasury fell to 1.05% and the ten year fell to 2.49%. In most of our lifetimes, these rates were unimaginable. What was causing these levels? Was it fear that the economy will not grow? Or was it the often debated and highly feared deflation? Then, just as rates hit these lows, Ben Bernanke and the Federal Reserve announced another gigantic quantitative easing program, called “QE2” by the markets, where they stated they will purchase $600 billion in Treasuries through mid year 2011. The intent was to keep the crazy low rates low, or push them even lower. So what happened?

Rates spiked upward, quickly and almost in defiance of QE2. Congress entered the mix and extended the Bush tax cuts for two years and unexpectedly added new tax cuts for consumers and businesses. Near the end of December, the two year Treasury had risen to 0.73%, the five year had risen to 2.16%, and the ten year rose to 3.47%. Why did rates spike when the Fed obviously wanted them low? Was it the belief that the economy will finally grow or was it Bernanke’s comments on 60 Minutes and in the newspaper that he wanted the stock market to rise? I believe that these comments prompted the markets to sell Treasuries (and all other bonds for that matter) and buy stocks.

Mortgage rates went on the wild ride too with the 15 year rate dropping to 3.25% and the 30 year dropping to 3.875% in early November. By close to year end 2010, both rates were about 1% higher, at 4.25% and 4.875% respectively. This is not good news to the Fed, who obviously thought that low rates could help the struggling housing market.

Alas, this market seems to be slipping once again; housing prices bottomed in April, 2009 and recovered until October, 2010, before resuming a decline. The Case Shiller home price indices have lost their momentum; the year-over-year change in the 20 city index turned negative to -0.8% after nearly ten months of increases. The inventory of unsold homes stands at the equivalent of 9.5 months worth of sales, representing over 3.7 million homes. Add to this the expected foreclosures yet to come and there is a tremendous overhang of supply. No wonder the markets are under pressure.

The Economy is Recovering Slowly

The recent economic data has shown signs of improvement, with GDP growing at a 2.6% rate in the third quarter of 2010; however, this rate is not high enough to increase jobs enough to reduce the unemployment rate. Consumer confidence is still below average at 52.5 in December. And it is no wonder – unemployment is high, housing is weak, income growth is weak due to low inflation, and deleveraging/saving is still occurring. Notwithstanding the strong holiday shopping season, where sales were reported by MasterCard to have risen 5.5% over 2009, consumer spending proceeds at a slow pace.

Congress extended the Bush tax cuts at the end of 2010 for an additional two years (oh, joy, we get to go through this again in 2012) and added a consumer tax cut of two percentage points on social security tax for 2011 and a business tax break for investments in plant and equipment with accelerated deductions. Combined these tax breaks can provide up to 0.5% in GDP growth for 2011, giving us a chance to hit the 3% potential GDP level where jobs can be created in sufficient quantity to reduce the unemployment rate.

While the tax breaks will be good news for 2011, they are bad news in 2012 as GDP will likely slide by the same 0.5% when their effect is removed.

What Will You Remember Most About 2010?

2010 was an eventful year to put into the books. The Fed kept easing with QE1 early and QE2 late. The bond markets turned on the Fed at the end of the year and rates rose. A volcano named Eyjajallajokull (still no one can pronounce it) erupted and disrupted travel in Europe for weeks, a BP oil rig exploded causing a giant oil spill in the Gulf of Mexico, a European debt crisis riled the markets as Greece and Ireland faltered, a “Flash Crash” in May sent the Dow Jones Industrial Average down 1,000 points, or 9%, in minutes because of “fat fingers” and sent investors out of stocks, vuvuzelas buzzed at the World Cup matches, and the Large Hadron Collider started smashing lead ions instead of protons and got closer to recreating the Big Bang on a small scale.

Locally (editor's note: Philadelphia area), we survived last winter’s Snowmegeddon, and our sports teams gave us exciting times. The Flyers gave us a great ride into the Stanley Cup Finals, Roy Halladay pitched a perfect game and a no hitter, and Cliff Lee returned home to pitch with the Fab Four. The new Miracle in the Meadowlands in December did much to grow the legends of Michael Vick and DeSean Jackson, but the Pack put an end to the excitement.

The S&P 500 rose 13% in 2010, while the Russell 2000 rose 25%. Commodities continued their bubble performance, with gold up 29% and oil up 15%. Bonds turned in a slightly positive performance for the year, despite the dramatic fourth quarter selloff in all things fixed income.

What About 2011?

I love to project, but I, like most analysts, get caught up in the moment. Rates just rose about 100 basis points for most longer duration securities while short term rates did not budge. I believe that the economy will achieve 3% GDP growth for 2011, despite the nagging issues and no help from the housing market. Unemployment may be able to fall below 9% with 3% GDP growth. Inflation will remain low – with core CPI (excluding food and energy) between 1.0% and 1.5%. As we know, food and energy prices have been rising, so overall CPI could exceed 2%.

The Federal Reserve will not raise short term interest rates during 2011; their statements basically have told us they will keep rates low for an “extended” period of time. More importantly, they will not raise rates or tighten with unemployment at such high levels. Long term rates already rose in the fourth quarter, but I expect these rates to continue to fall back and trade within a narrow range all year, provided inflation stays tame.

One risk to my forecast is that if gas prices continue up from the current $3.00 per gallon, GDP will slow, unemployment will stay high, and all bets are off.

Putting It All Together

When I wrote my last newsletter in September, I referred to the then low rates as “Eisenhower” lows, which then fell to “crazy lows.” When I wrote the following: “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!” I never dreamed that that type of price action would occur so violently in just a six week span! Stay tuned!

Thanks for reading! DJ 01/08/11

 

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.

Book Review: The True Leader by Jamie Marsico

A+ I enjoy reading books, both fiction and non-fiction. When I read a book related to banking and I perceive it as a “B” grade or better, I’ll tell you about it here in my blog. This is an exception. The True Leader has no relation to banking. To those blog readers expecting my humble opinions on banking, I apologize. But to those blog readers who are parents and/or grand-parents of children 8-12 years old, bear with me, if you will do me the honor.

Less than a year ago, my 11 year old daughter, Jamie, wrote a book, The True Leader. I encouraged her, thinking the journey on its own would be worth the effort. A few months ago, she completed it and said she was ready to seek publication. Publication! I could not discourage her. We went through the cycle, seeking publishers, proof-reading, then finally editing. It was a lot of work, but when Jamie said “nothing is going to stop me from getting my book published”, I was immediately onboard with her.

And Thursday, April 29th was the day… the day her book went for sale on Amazon.com and other retail outlets. I cannot describe in words the pride I feel the day I saw the first proof from the publisher, the day I saw it online, and as I write this. Imagine, an 11 year old writing and publishing a book. Could your 8-12 year old be inspired by such a story? It reminds me of the story of S.E. Hinton, the teenage author who penned “The Outsiders”, the story of the “socs” and the “greasers”… friction among teenagers from different backgrounds.

The True Leader, however, is a fictional tale that centers on an Alaskan wolfpack fighting to preserve their land from wolverines. Toko, the protagonist of the tale, is followed from birth through many battles with their competitors, until maturity when he grows to be pack leader. It speaks of loyalty, survival, and leadership. I found the story fascinating, even though I’m outside of its demographic. Of course, I have a bias, but would your child or grand-child enjoy such a tale that was written by a peer?

Here is what I like about the book:

1.  It has a lot of action. There are many battles between wolf and wolverine, all described in details as seen by the book’s 11 year old author;

2.  It is a metaphor on life, the maturing of a wolf-pup to a true leader;

3.  It is written by an 11 year old. How else could you best encourage an 8-12 year old than, “look, this book was written by a 5th grader”.

 What I didn’t like about this book:

1.  Nothing. I am admittedly biased. The author is very special to me.

If such a book would interest you, I have placed it on my bookshelf on the right margin of this blog. You can also visit and join our Facebook Fan Page (see link below), tell your friends, and/or go directly to Amazon (also, see link below). Me and my family appreciate your consideration and your valuable time.

- Jeff

http://www.amazon.com/True-Leader-1-Jamie-Marsico/dp/098269380X/

http://www.facebook.com/pages/The-True-Leader/103725609671597?ref=ts&v=wall