Yesterday, JP Morgan Chase (the “Bank” or “JPM”) released their 100+ page 2016 shareholder letter, and as usual, it was chocked full of insight that every banker should understand. For example, we will cover how JPM has one of the most unique stock buyback programs in our industry. We will explain why it works, the intestinal fortitude this takes and why more bankers should take this risk. In the analysis below, we will largely leave JPM-specific performance to the equity analysts and focus our attention on items in the report that pertain to the community banking industry.
1: Return on Equity
As can be seen below, the consumer and community bank division of the Bank did an impressive 18% return on equity and has a target of 20%. Only about 400 community banks that we know of have a target ROE in that range. It is also interesting to note that their commercial bank, composed of larger corporate accounts has a lower ROE at 16% versus a target of 15%. Why is it lower? The answer is the revenue side of the equation, as the competitive nature of the larger accounts limits both pricing and fees.
2: Efficiency and Technology
The Bank’s consumer and community bank division improved its efficiency ratio 3% down to an impressive 55% (note above). How did the Bank do this? They controlled labor expenses while increasing their investment and use of technology. Where community banks have around 12% of their customers using mobile platforms, JPM has closer to 70% using mobile. Where community banks pay over $2.00 to process a transaction, on mobile, JPM’s cost is about $0.03. That is a huge difference and the more customers JPM can get using mobile, the greater their efficiency will be. This means that banks like JPM will have more operational leverage which means great flexibility in pricing, attracting talent and making shareholders happy.
Community banks that don’t think about a “Mobile First” strategy will find that they will be at an increasing disadvantage. From the above graphic, you see that the goal of JPM is to get their efficiency ratio below 50%, knowing that this is just a short-term milestone. The real goal of JPM is to get their efficiency ratio below 40%.
Every community bank should have a plan on how to reduce their branch footprint; move more customers onto mobile and online; restructure their loan process, so it is not just scanned images but fully digital; move quickly to electronic onboarding of customers; and provide a variety of mobile-centric tools to make your customer’s lives easier. If you doubt this, read on.
3: Tangible Capital Growth and Buyback Strategy
JPM equity benefited by increased multiples on banks but that is only part of the story. The net result is that over the last five years, JPM’s equity appreciated at a very impressive annualized 24.4% rate. Increasing multiples only partially explain that, as that has been a fairly recent phenomenon. In addition to core bank performance, there is something else going on. As you can see below, tangible book value has grown at a very consistent 7% per year.
How is it so consistent? The answer is that JPM has an active stock repurchase program and has invested over $25B in repurchases over the last five years. What? How does that work, as that means that JPM is repurchasing stock at levels that other banks fear to go.
Most banks, like CenterState, have active stock buyback programs when the stock price gets close to book value. This is a no-brainer as long as you have plans to improve performance in the future (and who doesn’t). However, the above chart shows that JPM is repurchasing stock when equity levels are as much as two times tangible book value. That is a high multiple where only a small handful of banks dare to go. The reason why JPM does this is that they take a longer view of the marketplace and instead of focusing on the equity performance kick in the next year, they focus on the equity performance kick four to five years out. Future cost savings, performance increases, capital appreciation and the compounding effect of multiple stock repurchases, and now the math works. The strategy has paid off handsomely as can be seen by their equity trajectory above.
4: Increasing Customer Satisfaction
Not only does the Bank use technology to gain efficiencies, but it has a stated goal of using technology to increase customer satisfaction. Faster home mortgage processing, peer-to-peer payment apps, and digital account opening redesign are all examples of this. Combine technology with an improved employee training program, and you get an increase in customer satisfaction with 91% of your customers saying good things about you.
At CenterState, we talk a lot about not only finding profitable customers but finding profitable customers that we want AND that are likely to change. When we interview a potential customer and find out that they are at JPM AND they are happy, we know it probably isn’t worth our effort to try to move that customer onto our platform. Where in the past we would try, now we recognize that the sales cycle is too long and the acquisition costs are too high.
On the consumer side, JPM sees deep opportunity in increasing their payment innovation to reduce cost and drive satisfaction. The Bank is putting effort into making sure they are “top of wallet” in Apple Pay and other platforms in addition to pushing their person-to-person payment application and creating more loyalty products.
5: Technology Investment
Last year, JPM spent $9.5B in technology. That is about 10% of total revenue. Of that, $3B, or 3% was spent on new technology. How does this compare to your budget?
JPM is in the process of a complete end-to-end digital banking platform where all their products are available via mobile. Data mining; cybersecurity; mobile wealth management; cash management; all digital loan origination and admin complete with alerts; small business online lending, communication (chat and instant messaging); better integration to Quickbooks; bill payment and business services are just some of their top initiatives.
On the back end, JPM has pushed more to the Cloud, as they streamlined their agile software development process and standardized their developer took kits. In addition to leveraging machine learning for fraud and cybersecurity, JPM has a new internal product called “COiN” that automates the review of legal documents and pulls out and compares salient features. This is said to save 360,000 hours of manual review time. We bring this up because the Bank will ultimately use this for loan documentation. Consider that approximately 80% of loan servicing errors in are a result of contract errors or misinterpretation and this can be a huge improvement in efficiency.
How does this compare to what you are working on?
6: Balance Sheet Growth
The Bank had most of their balance sheet growth (28% year-over-year) in consumer lines, credit cards in particular that contributed to their earnings growth. Both small business and commercial loans grew at approximately 10%. These rates are just slightly above the average growth rates for community banks.
In reviewing their customer engagement, the bank has plenty of upside to fuel future retail growth. Last year, they grew their new customer base by 4% which means that most of the current growth has come through better retention and deeper relationship development. JPM appears to be the primary bank for 70% of their retail customers and 50% of their small business customers. 66% of JPM’s clients only have a single product line with the Bank and only 10% of the Bank’s small business customers uses the “triumvirate of banking” – checking, credit card and merchant services. These numbers are similar to community banks and underscore a key opportunity that we all have.
On the commercial side, the Bank grew clients 13% last year, loans by 18% and deposits were flat. The Bank was the number one multifamily lender last year and looks to do the same this year. Last year the Bank introduced a new digital platform to help gather the Bank’s products and provide a series of alerts and functionality to improve the experience of the commercial customer and lower cost. The Bank will use this platform to make a larger push in 2017 in a handful of key markets, notably California, Boston, D.C., and Miami.
JPM just recently increased their minimum wage to between $12.00 and $16.50 per hour depending on geography. JPM also increased their benefits package for all employees to where it now totals $11k per year. In addition, JPM’s training budget is $325mm, or about 33 basis points of revenue. The Bank has set initiatives to look for more women, minorities, and veterans to promote and gives 22 basis points of revenue to various non-profits. This is in addition to allowing employees a set number of paid hours per year to support various causes. The Bank also invests another 30 basis points of revenue in external job training efforts for various programs throughout its footprint.
Along with technology, cybersecurity gets a healthy mention in the report. Last year, JPM created a separate division called the Financial Systemic Analysis & Resilience Center (FSARC) in conjunction with seven peer banks and the U.S. government. The goal is to share information and best practices and to have more of a coordinated effort.
JPM’s philosophy to cybersecurity is the classic “kill chain” approach that plays defense using layers of controls over each stage of the cyber threat life cycle (from early warning to inbound/ outbound prevention and detection, to response and recovery). In the last year, JPM has “shifted left” which means they are attempting to increase their effectiveness in detecting and preventing malicious activity at the earliest points in the life cycle. For example, last year they rolled out web browser isolation technology that reduces the risk of employee compromise through phishing. More anomaly detection, improved monitoring, implementation of a new risk-decisioning engine and better training (employees and clients) were all material efforts last year.
9: Interest Rate Risk
The Bank has expended more effort in managing their interest rate risk and has moved their operating philosophy to expect a 2% overnight rate in the current cycle. This is 1% higher than last year’s assumptions, and with $2.4B of “earnings-at-risk”, this rate move should greatly improve their earnings as they have been active at hedging their asset duration. Further, the Bank now has a more robust predictive model that helps manage the interconnectivity of credit and liquidity that is connected to interest rate risk.
10: Various other items that we learned
JPM’s Risk Committee meets weekly, now given their complexity they probably have to, but you can tell that there is a strong culture of risk given the emphasis that it received in the annual report. In addition, the annual letter spends a material number of pages talking about what regulatory and public policy improvements the Bank would like to see going forward. If you are looking for a roadmap of improvements that you can take a thought leadership position in your community on, these 29 pages will give you a good start to draw from.
Of course, there are many more tidbits, but we have tried to pull out the top 10 in order of impact of ideas that you can use immediately for your bank. For the complete annual letter, go HERE and to read the line manager’s letters, you can go HERE.
Submitted by Chris Nichols on April 05, 2017