Bankers: You spend like drunken sailors.

As a former sailor, I take offense to the post title. As if I spent my family's food money on alcohol while on shore leave. I only spent my food money.

But the phrase is synonymous with spending money without direction or regard to consequence. And sometimes, we bankers fall into the trap of not considering our operating expenses as strategic investments.

On December 8th I am speaking at the Northwest Bank Executives conference in Seattle. My topic: Ten Things Banks Should Do, But Generally Don't. One of the ten is "not considering operating expenses as strategic investments".

As an example, let's take an average $1 billion in assets financial institution. The below table was drawn from a peer group analysis my firm performed for a client. Dollar amounts are annual averages for each expense category of 13 financial institutions with an average asset size of $1.0 billion. 

At a time when so many banks are challenged to grow revenues, marketing expenditures represent 2.1% of all operating expenses. And that includes professional services, such as consultants that have little to do with winning the next customer.

Strategically, this hypothetical bank spends $30.4 million per year. Now let's assume you had this thirty mil to execute a strategy to build your bank for a sustainable future. Whatever that strategy may entail, could you not find the resources to fund it?

But we are often bound by legacy. We have seven people in Deposit Ops, and need a new piece of technology or another person and therefore must increase our budget by 7%. Three percent increase in Loan Servicing, and another 5% in IT, etc. etc. etc.

What if you blew up your budget and started constructing an infrastructure, footprint, and employee base hyper-focused on executing your strategy? Instead of 20 branches staffed with six transaction processing pro's each, you need only 16 branches, strategically located, with four higher paid relationship building go-getters per branch. 

This hypothetical bank spends $1.2 million/year, or 4% of total operating expenses, on data processing (not including personnel). Can we allocate that sizable chunk into core and ancillary systems specifically designed to serve our core customers, as per our strategy, in a superior fashion to the financial institutions that spend wide and far to satisfy every constituency? Perhaps we should recognize the importance of the digital distribution system and appoint the appropriate executive to be its champion. 

As McKinsey director Somesh Khanna states in an interview titled "The Bank of the Future" on who should drive the digital strategy in a bank...

"I actually think that it’s less dependent on the role. It’s much more dependent on the person. If the person is someone that is able to visualize a future, get the organization rallying around a bunch of different objectives, and inspire people to actually pursue that path, it’s their real leadership capabilities that’ll come to bear to pull off digital agendas."

So you build your digital strategy around such a person, allocating an appropriate slice of the budget pie to develop your bank of the future for the benefit of your constituencies. Or is our digital strategy champion hyper-focused on installing ATMs that are ADA compliant?

I am not proposing an academic exercise. I am proposing considering every dollar you spend as an investment. And you should invest in your strategy, not your legacy. 

Can we shake our budget mentality, and view our operating expenses as investments into the bank we want to become? I hope so.

~ Jeff

What is the better banking strategy: low expense v low deposit costs?

Here is a question that dogs us: should we follow a strategy that drives top quartile performance in operating expenses or cost of deposits? If your answer is "yes", your execution better be flawless. Because the two don't often go together. In my search, described below, only one bank made top quartile performance in both categories.

The low operating expense bank typically comes with a limited branch network. Bank futurists think this a good thing since branches are millstones around our collective necks. So in order to attract deposits, these banks tend to use premium rates to get people comfortable with not having a nearby branch. 

Low expense banks tend not to have sophisticated commercial banking operations too. Preferring instead to focus on residential real estate lending combined with transactional commercial real estate lending. By transactional, I mean the bank may resort to price to get deals, and not extensive customer relationships, as many of these customers don't value relationships anyway.

Conversely, low cost of deposit banks tend to have more expansive branch networks to get core retail and business account balances. Anecdotally, the most often heard reason a business customer objects to opening an operating account at a bank is because it lacks a nearby branch. But, admittedly, that could just be an objection that is not the "real reason".

Also, low cost of deposit banks tend to be heavy commercial lenders, both commercial real estate and business loans. That requires a good product set, and lots of resources. Asset-based lending requires much greater borrower interaction than plain vanilla commercial real estate lending.

So which strategy results in better performance? I went to the numbers (see table), and it's tough to tell.

I searched for banks of a certain size ($1B - $20B in assets) to eliminate trading anomalies from very large and very small banks. I also controlled for capital levels and asset quality to limit the number of factors impacting pricing. 

The picture is not totally clear on which strategy delivers the better returns or higher trading multiples. To be sure, both sets of top quartile banks are well run and rewarded with relatively high trading multiples. And they have delivered very good results, as indicated by their 3-year price changes.

So, which one is better? I think it depends on each financial institution's individual circumstances. Do you operate in slow to no growth markets? Perhaps a low operating expense/cash cow strategy is appropriate. 

Is your FI in business-rich markets and your niche is concierge-like service to tech firms? Well the low cost deposit strategy with higher expense ratios may be appropriate. 

Whatever strategy you choose, I implore you... to choose. The zigging and zagging, the all things to all people, the yes, yes, and yes strategies are misallocating resources and driving our financial institutions into homogenized and commoditized, irrelevant, soon to be sold and quickly forgotten memories that our 7,000 brethren that have been sold since the early '90's have become.

Are we going to let it happen?

~ Jeff