Sunday, April 13, 2014

Is this the best of times, or the worst of times?

by Dallas Wells

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness

   ~ Charles Dickens, A Tale of Two Cities

Last week there was a very interesting piece from the FDIC that was making the rounds, but I did not have a chance to get to it.  I think it is important, though, and wanted to touch on it while it is still fresh.  As a part of its quarterly industry update, the FDIC released this article, called "Community Banks Remain Resilient Amid Industry Consolidation."  It happened to make think of what may very well be the greatest opening line of any book I have read.  So, for community banks, are these the best of times, or the worst? 

I hear many community bankers continuing to lament the demise of the smaller banks at the expense of the large money center banks.  We have all seen the data on the decreasing number of charters, and more importantly, the growing concentration of industry assets in the hands of a few.  This chart sums up all of those statistics (the definition of community bank for this chart is a little cumbersome - click here for the explanation):

In short, we as community bankers have seen our slice of the pie shrink substantially over the last 3 decades.  This has caused a growing sentiment among community bankers that the future is all about gloom and doom.  I hear lots of complaining about the growing regulatory burden, and the fact that the little guys "just can't compete anymore."  I also hear a lot of people saying that the size threshold to be viable is somewhere around $1 billion in total assets.

I will concede that the current environment is tough, and that some of the smallest banks' days are numbered.  However, to say that the community banking business model is doomed and you need at least $1 billion in assets to survive is ludicrous.  The FDIC article digs a little deeper into the data, and finds some support for my doubts.

The key finding of this study is that institutions with assets between $100 million and $10 billion—most of which can be considered community banks—have increased in both number and in total assets since1985. The number of banks with assets between $100 million and $1 billion increased by 7 percent between 1985 and 2013, while the number of banks with assets between $1 billion and $10 billion increased by 5 percent. These groups of institutions also experienced growth in terms of total assets. The assets of banks between $100 million and $1 billion increased by 27 percent between 1985 and 2013, while the assets of banks between $1 billion and $10 billion grew by 4 percent.

I'll also include a couple of my favorite charts:

As the charts show, the big industry changes are happening to the very smallest and the very largest of banks.  Banks with assets less than $100 million are shrinking (and seeing performance decline relative to peers), and the overwhelming majority of the industry asset growth has landed at banks with assets over $10 billion.  Of course some of this is due to inflation, as $100 million just ain't what it used to be.  However, the bottom line is that community banks over $100 million in assets have done quite well, and are positioned to continue that success going forward.

This article, which I recommend reading, combined with the performance statistics by asset size and direct experience with community banks leads me to a couple of takeaways:

  • There might be an asset size that most banks have to target to cover the growing overhead burden, but it is not $1 billion.  It looks a whole lot closer to $100 million.
  • The smallest banks that do hope to prosper probably cannot do so by trying to be a generalist that is "all things to all people."  Instead, they will need to find a specific niche in which they can specialize and excel.
  • Community banks of all sizes are seeing a divergence in performance.  There are very few that actually look like the "averages" from these studies.  Instead, there are high performers and there are those lagging behind.  Banking truly is getting more complex and moving at a faster speed.  Bankers that embrace this fact and are seeking new strategies, better techniques, updated technology, and partnerships with the right experts are the ones that are far outpacing the averages.

Overall, I think the negativity from community bankers is overdone.  Our business is recovering, and the future still looks bright.  Instead of spending too much time on what is wrong and how unfair new regulations might be, those that are succeeding are embracing the change and seeking the new opportunities that will inevitably come from shifts of this magnitude.  Good luck, and let us know if we can help!

Wednesday, April 2, 2014

Does Cost of Funds Matter When Pricing Loans?

by Dallas Wells

Bankers live by the old 3-6-3 rule.  Pay 3 on deposits, charge 6 on loans, and be on the golf course by 3 o'clock.

I have heard that tired old joke more times than I can count.  I still chuckle at it, as I do all banker jokes (just don't make the "Banker's Hours" joke to my wife - she does not find it amusing).  So while the days of getting in that much golf are long gone, does the basic pricing philosophy still have merit?  Are we making this business way too complicated?

I get some version of this question on a regular basis.  In fact, I would say that the majority of community banks still use dome form of what I call "cost plus" pricing.  That is, to price a loan, you take your current cost of funds and add some spread to it based on the perceived risk level of the loan.  If you get a request for a longer term fixed rate loan, then you find some way to match fund it and add your spread to that funding cost.  In fact, this is exactly how I was taught to price loans earlier in my career.  Our rule of thumb was to seek a spread of 4% - that was 3% to pay the bills, and that left us a roughly 1% profit (targeting a 1% R.O.A.). 

There are several issues with this approach.  I'll cover what I see as the 2 biggest problems.

1.  Not all Margin is Created Equal
Focusing on a "cost plus" method to create margin leads us to take on more incremental risk.  First, banks using this approach will invariably over-value loans and under-value their securities portfolio.  Compared to their cost of funds, many banks barely make a profit.  However, a 150 basis point spread over cost of funds on a short, highly liquid portfolio of agency bonds should not be compared directly to a 350 basis point spread over cost of funds on a commercial real estate loan portfolio.  Which would you rather earn?

Second, and more problematic, is that this often leads to bank charging too much for short floating rate loans and too little for longer term fixed rate loans.  Earlier this week I spoke with a bank that was pricing a large commercial real estate loan for a strong prospect.  The deal was to be a 5 year term, based on a 20 year amortization.  The prospect had an offer in hand for a floating rate at 1 Month LIBOR + 2.50%.  They told the bank that if they matched that rate, the deal was theirs.  They thought that was way too cheap, so they countered with a 5 year fixed rate of 4.35%.  With a cost of funds of around 0.30%, they felt that this rate got them a better spread, as they are fighting against margin compression.

Did they make the right decision?  I plugged the loan into our Loan Builder calculator to find out.

The structure they proposed translated to a spread of 2.20% over LIBOR (the calculator used the swap market to translate a fixed rate loan to a floating rate loan).  This is a VERY common mistake.  We see banks loading up on 5 and 10 year fixed rate loans.  They tell us that is "all the borrowers want."  However, that is largely due to the fact that they are way over pricing shorter loans.  They have "sticker shock" with the floating rate loans, and so are pushing borrowers to what is a much better deal out on the curve.  This is all driven by the fact that a 3 handle (or even a 2 in this case) does not meet the hurdle of the "cost plus" pricing.  (By the way, if this bank had wanted a 5 year structure, they could have made the floating rate loan at LIBOR + 250 and used an interest rate swap to make it a 5 year loan at 4.65%.)

2.  A loan rate prices the deal for its prospective term - cost of funds is a historical number
When we price a loan, we are setting the rate at which we will be compensated for all of those future cash flows.  Cost of funds is a historical number.  Even if you determine the current rate on all liabilities for cost of funds (as opposed to interest expense from accounting statements), that number was still built in the past as those liabilities were put on the books.  This means that if rates rise, our cost of funds is built on lower rates, and we will be under-pricing our loans.  Conversely, if rates fall, our cost is based on higher rates, and we will over-price our loans.  A picture tells the story better than I can.  This chart shows cost of funds for all banks between $100 million and $1 billion in assets (from FDIC call report data) compared to 3 month T-bill rates:

At inflection point sin the markets, these numbers can diverge quickly.  The highlighted area shows how T-bills dropped quickly late in 2008 and early 2009 (as the financial world came unhinged and the stock market crashed).  We entered a much lower rate environment, but our cost of funds had not yet caught up with the markets.  If you continued to use "cost plus" you were likely way out of the market on most new deals.  The loan market is simply too competitive now.  Why would borrowers care if you have a high cost of funds?  Do they want to pay more because of your funding structure?  Do they care if you have high overhead that you need to cover?  Conversely, should you charge much less than the market will bear for loans just because you have a funding advantage?  Of course not - that advantage should show up as wider spreads and better earnings.

So, if using cost of funds is not right, how should we price loans?  After all, we are not actually match funding every deal that comes through the door, are we?  of course not.  However, that does not mean we should ignore the yield curve.

This post is already long enough without jumping into a full blown methodology for pricing loans, so instead I will summarize.  We need to price with the yield curve in context.  If we can focus on what we call "Managed Spread" (that is, if we can consistently price on the right side of the curve at any given duration), then we can ensure that we have efficiently priced for interest rate risk.  If we are taking more risk, we should be paid accordingly.  If we are taking less risk, then we can and should expect a lower return. The yield curve tells us what the markets are expecting in terms of future rates, so using it to price is the best way for us to prepare our balance sheet for that future.

This has been an ongoing conversation for us with most of our clients, so there will be more posts to come on this topic.  Stay tuned - a feel free to contact us if you want to discuss your specific situation.

Tuesday, April 1, 2014

Upcoming Webinars

by Dallas Wells

Over the last couple of years, our firm has worked with LexisNexis (formerly Sheshunoff) to provide webinars as a part of their banking series.  These events are well done by LexisNexis, and are an excellent resource for community bankers as they cover a wide variety of topics.  Today I wanted to point you to a couple of sessions that we will be leading in April.

First up, on April 15, is "Interest Rate Risk: Prepare Now, Prosper Later" by Chris Thompson from our Country Club Bank Capital Markets Group.  Chris is an entertaining speaker, and will cover the impact that the Fed's tapering of asset purchases will have on fixed income markets, and how banks can best respond in their investment portfolios.  Click here for a description and to register if you are interested.

Next up, on April 23, is "Managing Liquidity Risk" with yours truly.  My session covers the evolving world of liquidity risk.  Regulators view liquidity issues as one of the eventual problems of the longer duration assets growing on bank balance sheets, and we must also contend with new expectations from Basel.  Since we also face low overnight rates and a very steep yield curve, bankers are facing a tough balancing act between current earnings and future risk.  We will cover regulatory expectations as well as some suggestions on how to continue making money while also managing the risk.  Click here for a description and to register if you are interested.

Wednesday, March 26, 2014

A Shifting Yield Curve

by Dallas Wells

Over the last few months, we have seen an interesting shift in the interest rates market.  With the FOMC's "low rates forever" stance, both short and intermediate rates had remained anchored at record low levels and traded in a narrow range.  However, that is changing now as the economy slowly thaws and the Fed moves (albeit at a snail's pace) back towards normalcy.  The belly of the yield curve is now where the action is, as the markets try to figure out not if rates will rise, but when and what pace.

Over the weekend Sober Look had a great summary of how the 5 year sector of the curve has been the most active.  The post, called Shifting focus in the treasury markets, is short and worth the read.  However, the two charts below tell the story:

So, what are the implications for banks?  Here are a few to get you started:

  • The most obvious repercussion (since we get monthly statements to tell us how we are doing) is in the bond portfolio.  The durations of most bank bond portfolios fall squarely in that 3 to 5 year range, meaning most of what hold was purchased in a lower rate environment.  While tightening spreads in nearly every asset class helps offset some of the move, most are still looking at losses.  This is causing al kinds of angst, including discussions about changing accounting treatment to Held to Maturity and about changing allocations going forward.  All are worth discussing, just make sure you remember that your liabilities are showing gains as rates rise - you just don't get that consistent third party reminder.  Don't panic over one part of your balance sheet just because it declines as rates rise (as it is mathematically destined to do).  Continue to look at the overall balance sheet, and make investment decisions in context.

  • With rate increases moving down the curve, we are getting closer to the area where our deposits are priced.  It may be time to dust off that deposit pricing game plan so you don't get caught by surprise if your competitors stat moving.

  • Rates in the belly of the curve have nearly tripled from their lows.  Where are your loan rates?  We still see loan rates that are more reflective of spring2013 rates than current rates.  Make sure you are being compensated for the risks you take - our free Loan Builder calculator can help.

  • Does this change your rate conviction?  We talk to a lot of bankers that think this is just another blip, and that later in the year rates will return to rock bottom levels.  However, we also hear from those that are convinced that this is the start of THE big move up.  I'm not smart enough to know who is right, but I know I had better be prepared for either scenario by at least understanding what will happen to my balance sheet.  If you don't like the answers, then you need to consider some ways to mitigate that risk.  Is it time to look at derivatives?

These are definitely interesting times, as we are finally seeing some rate movement in the part of the curve that has a more direct impact on community bank performance.  Let us know if we can help you think your way through what may come next.

Saturday, March 22, 2014

Bank Merger Market Overview

Contact Shelley Reed, Managing Director at CC Capital Advisors for more information.

Click here for a printable version of the report.

Friday, March 21, 2014

Concerns for 2014

by Dallas Wells

In discussions with bankers around the country, we have noticed some meaningful changes in attitudes.  Notably, the answer to the "what keep you up at night" question is different than it was just a couple of short years ago.  That sentiment is captured nicely in a survey done by CB Resource, Inc. and published in their newsletter.  As they note in the intro:

Over the last four years community bankers have ranked the Regulatory Climate as their #1 challenge...Overall, when reviewing the comments, there is an uptick in optimism, and surprisingly, this year's results had little mention of Mergers & Acquisitions as a solution to bankers' challenges. 

While regulatory concerns remain at the top of the list, there has definitely been some shifting lower in the list.  Here is this year's top 10 from the survey:

The interest rate environment is now the top concern after regulations, and it is followed by loan growth, which is of course very much entwined with concerns about rates (and asset yields specifically).  While our conversations naturally focus on the rate environment, that certainly fits with what we are hearing.

So, how does that compare with prior years? 

Interest rates and loan growth have moved up on the list, ahead of things like asset quality and the economy as focus has shifted from survival back to performance.  That is a good sign for the banking business, but also means that competition is fierce, as most banks are on that same path and paying attention to the same opportunities. 

One other interesting note is how the responses differed by size:

The larger banks in the survey are less worried about regulations, and more concerned about the economy and interest rates.  That is likely a reflection of the resources the larger banks have to deal with the regulations, leaving their executives to focus more on growing the bank and improving earnings. 

This leads me to some food for thought:

  • These results, along with the performance by asset size reported by the FDIC, is showing some bifurcation between the smallest community banks and those over $1 billion in assets.  Will this drive the eventual consolidation that everyone keeps expecting?  Is $1 billion the magic asset number?
  • If everyone is worried about interest rates and loan growth, how can you differentiate yourself?  You are not likely to win just by always undercutting the competition.  Make sure you keep some consistency and discipline in your loan pricing process - our Loan Builder is a great starting point (and it's free).  Many community banks are also considering derivatives for the first time. 
  • I also see capital starting to slowly work its way up the list.  Look for that trend to continue as Basel III is phased in and our growth outpaces the ability to raise new capital.
Go check out the newsletter from CB Resources that has the full survey results and analysis.  It is well done and worth a few minutes of your time.

Thursday, March 20, 2014

Community Banks and Big Data

by Dallas Wells

An article caught my eye this week, mostly because of the implications for community banks in this industry.  The article is from the Long Island Business News, and is entitled "Banks bristle as feds eye more reporting data."  First, a few quotes from the article:

The Federal Deposit Insurance Corp., the Federal Reserve and the federal Office of the Comptroller of the Currency are all considering protocols that would require banks to provide more data in their quarterly call reports. Such reports have already grown significantly – from 18 pages in 1986 to 29 pages in 2003 to nearly 80 pages today – and could expand even more if federal regulators have their way.


Camden Fine, president and CEO of the ICBA, said quarterly reporting has “ballooned in size and complexity” over the years, “and now occupies a substantial amount of reporting institutions’ time and resources.”
“This expanded use of information collection represents yet another reporting burden that taxes community banks while providing no real tangible benefit,” Fine said in a statement.
The ICBA is urging regulators to exempt institutions with up to $10 billion in assets from the new requirements, allowing those smaller institutions to devote their resources “to serving their customers and promoting local economic growth, and less to dealing with regulatory red tape.”

For starters, I have a ton of respect for Cam Fine, and applaud all of the wonderful work he and the ICBA do for community banks.  I fully understand that community banks are feeling the squeeze from many directions, and I've personally felt the pain of meeting new reporting requirements.  However, my fear is that exempting small banks from these kinds of requirements will do more harm in the long run than good, as small banks may fall behind in the all important "data race."

Banking, even for the very smallest institutions, is growing in complexity by leaps and bounds.  The more sophisticated banks are starting to run circles around competitors, and large part of that success is built on a better understanding of their own business.  Here are some of the traits we see with the highest performing community banks:

  •  They have a deep understanding of their customer base, including at least a general understanding of what constitutes a profitable customer (hint: it is rarely your biggest borrower)
  • They obsessively measure the results of their decisions, especially on things like pricing and marketing.  What worked?  What didn't?  And how do we know?
  • They know the key metrics of their business inside and out.  These banks don't just have a fuzzy general idea of where they stand - they know precise numbers for risk and profitability.  We have seen this for several years, and are responding with new services like our Drill Down Reports and Loan Builder.
  • They continually try to find new ways to gain insight into their business.
I bring this up because generally the biggest complaint about increased regulatory reporting is that our systems will not handle the new requirements.  For example, back when banks were asked to start differentiating between owner occupied and non-owner occupied commercial real estate, most core systems did not have a field that tracked each loan.  While we waited for that to be added, we had to go back and reclassify hundreds or thousands of loans, adding a code in a customized field in the core.  The ICBA is right - it was a lot of work, and it certainly did not directly benefit our customers.  However, aren't we glad that we that information now?  Doesn't it benefit us to know more about our real estate exposure by property type?

The future in our industry is hard to guess at in many ways.  One thing, though, is absolutely certain, and that is that big data is here to stay.  The banks that do well will be those that figure out a way to better manage and use their own data for competitive advantages.  If regulatory requirements push the core vendors to speed up the process, then so be it.

Now, if we want to talk about how some of that data we send them will be used by groups like the CFPB, then that is another issue...and we will take all of the help from Cam Fine and ICBA that we can get!

Tuesday, February 25, 2014

IRR Modeling: Static vs Growth Scenarios

by Dallas Wells

Optimism among bankers is slowly increasing, as a steeper yield curve and gradually thawing loan markets give a glimmer of hope for net interest margins.  This optimism is being reflected in many interest rate risk models, with projected income finally looking like it will improve in the coming 12 months.  However, as is always the case with models, we need to be aware of what is driving those results.  For many of the banks we work with, the current environment of excess liquidity is skewing model results and potentially hiding some earnings risk.

The issues lies with the fact that we almost always measure our risk using a static balance sheet.  Why do we assume this?  I'll defer to the regulators via the 2012 guidance:

8. When no growth scenarios for measuring earnings simulations are mentioned, can you clarify what no growth means?
Answer: "No growth" refers to maintaining a stable balance sheet (both size and mix) throughout the modeling horizon. Financial regulators are concerned that including asset growth in model inputs can reduce the amount of IRR identified in model outputs. For example, if model inputs predict significant loan growth occurring after a rate shock, new loans are often assumed to be made at higher interest rates. This has the effect of reducing the level of IRR identified by the model. If this assumed growth does not occur, the model would underreport actual IRR exposure.

 All of that makes sense, and we stick with static balance sheets as our baseline modeling scenario.  We will of course test the impact of growth or mix changes, but measuring against policy limits is always done with no growth.  For every dollar that matures, we assume it is replaced in the same category at current market rates.  And, as in most models, we assume that current market rates in a flat rate scenario is going to be somewhere very close to where we are currently booking instruments of that type.  To see the potential issue with this methodology, let's look at an example from a current client.

Here is how they priced their time deposits last month:

They did a fantastic job with pricing those time deposits.  The dark line on the chart represents the FHLB advance curve, so they were able to generate $5.6 million of deposits at a cost well below the wholesale market rate.  This, in a nutshell, is the value of the franchise, as they can use this below market funding to generate positive spreads with little to no interest rate risk.
However, here is the change in the balance sheet over the last quarter:

The bank was able to cut the cost of CDs by 10 basis points and IRAs by 17 basis points, leading to a decline in monthly interest expense (rate driven) of $14,806.  Balances, however, dropped by $7.6 million during those same three months.

When assuming a static balance sheet, we forecast that all CD balances will be replaced, and they will be replaced at current market rates (which in most models, is at least very close to the rates at which we are currently booking CDs).  Here is what that looks like for this bank:

At these offer rates, CD costs will drop by 28 basis points, IRAs will drop by 26 basis points, and balances will stay the same.  The result is that annual interest expense is forecasted to drop by nearly $400k. 

However, what rate would we really need to pay to maintain balances instead of shrinking?  Can we really expect to cut another quarter point + from time deposits and keep the balances?  This anomaly is very likely understating potential interest expense, both in the base case and in rising rate scenarios (since the base rate is used as our starting point in the rate shocks).  The same phenomenon is present in many loan portfolios.  We are forecasting that our current rates will generate steady balances, when in reality, balances are dropping.  What rate would we need to offer to keep those balances steady, and what would that translate to in declining interest income?

This is certainly not a new issue, as we have been facing the same basic circumstances for nearly 6 years now.  To this point it has not manifested as bad model results because the balances are not truly leaving the bank, they are simply reallocating to non-maturing deposit accounts that are also at lower rates.  However, that will not always be the case, and at that point, we may have a nasty surprise in the form of a much higher interest expense than expected to maintain our balances.

The methodology is not wrong - this is simply one of those issues that we need to be thinking about.  The simple solution is to run a quick "what-if" where we up the offer rates (or drop them on loans) to where we think they would need to be to maintain balances.  How much does projected income change?  As long as we have a handle on that number, we should be able to avoid both the actual surprise and any regulatory criticism of our baseline assumptions.

Let us know if we can help.

Friday, February 21, 2014

Bank Merger Market Update

CC Capital Advisors, a Kansas City based investment banking firm, provides a variety of advisory services to financial institutions including whole bank mergers and acquisitions, branch acquisitions and divestures, capital and strategic planning.  For more information please contact Shelley Reed, Managing Director, at (816) 968-1511.

Click here for a printable version of this report.

Thursday, February 13, 2014

Marketing Budgets

by Dallas Wells

One of the most trying tasks of being a CFO in any business is managing the budgeting process.  However, the process is especially difficult in a business as complex as banking.  We must allocate the right amount of resources to risk management, compliance, IT, personnel, and maybe even have something left over to try to grow our business.  In my experience, the two toughest areas are technology and marketing.  We know we spend a lot.  Is it enough?  Too much?  Are we spending in the right places?

The Financial Brand posted an interesting article this week specifically on marketing, called "Bank Marketing Budgets: How Much is Enough?"  I remember several specific internal "negotiations" on marketing budgets.  As a numbers guy, I had trouble justifying spending dollars where the return was fuzzy and hard to measure at best.  I even tried (unsuccessfully I might add) to get some interest expense counted in the marketing budget after our marketing director said keeping deposit rates high "made us look better."

The article does a nice job of showing the range of dollars being spent by asset size.  For what it's worth, it looks like 0.07% of assets is pretty typical.  The more interesting question, to me, is HOW those dollars get spent.  In the "old days" marketing consisted of community involvement, ads in the local newspaper, and maybe some direct mail campaigns.  Sound familiar?  That's probably because to some extent these tactics still work.  Only now, we are expected to also expected to market through a bunch of new channels.  Do Facebook likes generate revenue for you?  I have no idea, but a lot of consultants will charge you a ton of money to teach you how to get more of them.

Here are a few random thoughts as you wrestle with this:

  • Be honest in your assessment of your own institution.  You are offering the same products and services.  You say you differentiate with better service and relationships.  What do you think the other eleventy-seven banks in town are saying differentiates them?  If everyone picks the same thing to be better at, are you sure that is the right marketing message?
  • The right people in production and customer facing positions are essential.  I see way too many banks that spend a lot of money to get customers interested, and then they do not have the right staff to follow through on the promises made in the ads.
  • As in everything else we do with banking, you have to measure it to know if it is working.  Can you tie new accounts to specific campaigns?  Does your marketing have an ROI in mind?  Does every campaign have a breakeven that everyone is on board with?  I realize that some marketing will simply cover "brand awareness," but those billboards, radio ads, etc. can get awfully expensive and are nearly impossible to measure.
  • Maybe most important, allocate some of those marketing dollars to your production staff.  Make sure they have resources, and hold them accountable for producing with the dollars spent.
Other than that, we have found that banks that do well with the budgeting process (in general, not just marketing) all follow a similar pattern.  They have very open and frank discussions during the process - the old "just add 5% to what I spent last year" thing does not cut it.  However, once the budgets are set, they do not micromanage those responsible for each portion of the budget.  Let them spend their dollars as they see fit.  If your up front process is right, they will know that next year they will have to answer for what went right, and what did not, and that it will dictate next year's budget.  This will free up your management team from drowning in small decisions (should we donate $500 to the basketball team? should we buy that new server?) that in reality have either already been decided during budgeting, or should be handled by the staff that is most knowledgeable about that particular area.

Margins continue to compress, so expense control will be vital over the next couple of years.  Just try not to lose focus on the overall business while you duck into "cutback mode."