Take Time Now to Sweat the Details
Ed Krei, Managing Director, The Baker Group
Promontory Interfinancial Network is dedicated to helping banks meet their balance sheet management goals with innovative solutions that combine technology and a nationwide network of thousands of financial institutions. We talked with bank strategists who shared what community bank leaders should be thinking about now to help their banks in the future.
Right now, there are five things I would tell banks that they should do in the context of their balance sheets.
1. Understand and communicate your bank’s performance capacity.
The first thing is to use good financial modeling and financial forecasting techniques to develop a clear and comprehensive vision of the performance capacity of your bank over the next 3 to 5 years. You’ve got to know what your bank is capable of doing. And you need to communicate that capacity with your shareholders.
The expectations of your shareholders may be based on pre-2008 performance. They may think that, as the economy comes back, bank performance will also come back to that level. This isn’t the case. Bank margins are under incredible pressure because of the low-interest-rate environment. We may be seeing a little bit of relief because of improving loan demand, but not a lot. The old days of shareholders expecting an 18% ROE and a 1.25% ROA might be behind us, at least for the next few years.
So that’s where to start: control your bank’s destiny by understanding and clearly communicating performance capabilities with your bank’s stakeholders.
2. Resist performance complacency.
Just as banks have to have a clear understanding of their capacity, they have to really dig into what they are able to control. Banks can’t change the fact that interest rates have been at or close to zero for five years or more. But there are a lot of things they can control.
Start by establishing robust branch performance measurement criteria. I don’t believe community banks should just go out and slash and burn branches—that’s the absolute wrong way to approach improving performance. Branches may be expensive delivery mechanisms, but they also continue to be, and will remain for a long time, an important part of reaching the customer and satisfying their needs.
Banks also have to recognize that their branches are expensive, so they have to use them effectively. Banks need to challenge themselves to establish strong branch measurement criteria with goals and performance expectations. This might result in some branches being closed or relocated, but banks shouldn’t go in with the attitude that they have to cut 10% - 20% of their branches across the board.
Banks should have that same discipline with how they price loans and credit. That means looking at funding costs, origination costs, ongoing overhead expense, and the cost of risk. I’m the first to admit that it’s exceptionally competitive right now, but that doesn’t mean that banks don’t know what their targets should be. And if what they’re doing is going to leave them short, banks need to challenge themselves to find other opportunities.
3. Focus on risk management.
For bank leaders, now’s the time to use all the tools at their disposal to understand how their banks will perform as interest rates go up. They need to consider the level of risk that they’ve taken through mismatches of asset durations relative to liability durations, the risks associated with optionality in their balance sheet, and how much extension risk they’re taking on in their assets. They need to look at the potential impact of the outflows of “surge deposits” that have flowed into banks over the past five years. They also need to understand the effect of the Reg Q repeal on funding costs as interest rates go up, and more and more business customers are demanding interest on their checking accounts.
To understand all of this, banks have to dig into their relationships with depositors to make sure that they understand which relationships are more rate-sensitive and which are less rate-sensitive to build an asset-liability (AL) model. This is probably more work than they’ve had to do on an AL model before, but the output of an AL model will only be as good as the assumptions about these relationships. So banks have to be willing to spend the time to understand the potential impact on their liquidity position, their funding costs, and their interest-rate risk.
This is also the time that banks should go in and do a scrub-down of their credit administration area. They should make sure they are filing continuation statements for security interests and that they are filing mortgages correctly.
When real estate values are going up, some of those things may not be an issue. But all of a sudden when real estate values start going down and banks get into tense situations with customers, banks have to make sure that they are doing things correctly—particularly with documentation.
4. Position your bank for customer retention.
It’s important that banks emphasize customer retention, but that means that they first need to understand which customers are likely to stay when interest rates go up. Some customers will move regardless of a bank’s efforts to keep them, and banks should plan for this. A lot of banks are saying they have all the deposits they need and that they don’t need core deposits, but if I’m a banker, I will try to get all the deposits I can from every A-plus, gold-plated customer, because those deposits will be worth something in 2 - 4 years, and they’ll be much harder to get then.
That thinking extends to cross-selling. Banks need to look at their significant relationships and try to expand each customer’s use of their products and services to tie them more closely to their bank. That’s what bankers should want: strong, multi-faceted relationships, not just single accounts.
Banks have to be cognizant that their customer relationships are constantly being attacked by other intermediaries, and they have to work to retain their best customers.
5. Invest in your people.
One key to every community bank’s future is getting and keeping the best people and investing in them. The highest-performing community banks now operate with less people, not more (relative to bank size), and they continually build and improve upon their first-level supervisory skills training to help their folks develop and take on greater responsibilities. These employees have higher performance expectations put upon them by the institution, so greater compensation is warranted. As a result of having better compensated people, these banks tend to have lower employee turnover, which often translates into more consistency in their customer service and which remains central to how community banks compete. Now, there are some pretty big uncertainties when it comes to the economy. But that doesn’t mean we should stop competing. Loan demand is picking up, particularly in the metropolitan areas. But as community banks are casting their nets for that business, they also have to be introspective. Banks should be taking a close look at their institutions and take the time now to attend to the details that make an institution successful, including the products, processes, and people.
If you’re a banker, ask yourself the question: “Why would a customer want to do business with me?”
Then focus on making it easier to deliver that.
Edward A. Krei is a Managing Director and Board member for The Baker Group, a consulting firm that provides investment portfolio and interest rate risk management to community banks nationwide. He is a frequent speaker at banking and investment conferences, an instructor for financial institution regulatory agencies and a faculty member of numerous banking schools. http://www.gobaker.com