The power of three suggests that things that come in threes seem wittier, more understandable, and more memorable than things that come in other numbers. This concept is utilized in comedy, academia, and banking. We identify the three most important concepts that high-performing community bankers are deploying today to drive profitability and decrease risk. We call it the “2018 Trinity” of community banking.
One: Commercial Lenders As Stakeholders
High-performing community banks understand that employees are the most important asset at the bank and incent them accordingly. Employees serve customers, represent the bank to the community, bridge senior management, and clients, defend the bank against competitors and work as a team to create value that is greater than any one person can create. To get the most value from lenders, community banks must align the lenders’ goals with the bank’s goals.
Lenders should be incented with the goals that the bank is targeting and the higher the achieved goal for the bank, the higher the incentive for the lender. The bank’s goals may be based on revenue, profitability (measured as return on assets, return on equity, or shareholder value added), or some other subjective goals like service or relationship value. Whatever the chosen goals might be, lenders must be compensated (either monetarily or otherwise) to maximize these goals.
Banks that do not align their lenders’ compensation with the bank’s goals realize some very perverse results. We observe at banks that do not properly incent lenders often get the following:
- Limited fee income generation and reduced credit spreads;
- Low cross-sell rates for deposits; and,
- Greater advocation of substandard credits.
This is not surprising because lenders have many competing goals and if a bank will approve a loan at a 2.50% margin, why bother to negotiate a higher spread with the borrower unless the lender has some incentive to do so? We observe some lenders that are not properly incented often give away fees, lower loan spreads and target lower credit quality simply because the bank’s goals are either not clearly defined or because the lender has no incentive to do otherwise.
Two: Expand Window of Historical Credit Analysis
Most credit officers believe that the past can predict the future and that is why banks analyze historical financial performance. We agree that historical data remains a viable way to forecast future performance. However, it is where you look at the past that matters the most.
Currently, most banks look back three fiscal years to analyze borrower’s performance and conduct their underwriting. But, this is the wrong place to look for historical financial performance if you want to predict a borrower’s ability to service debt in the next downturn. Looking at the last three years of performance considers the borrower’s performance in a steadily and modestly expanding business environment. The real litmus test for borrowers should be their performance in the last recession.
How the borrower fared from December of 2007 through June of 2009 is the best reflection of that obligor’s paying ability. If a borrower performed adequately in the Great Recession when GDP decreased by 4.3%, then that borrower (adjusting for their current financial wherewithal and position) would be a good credit today. Banks do not need to do a full underwriting for financial statements from 2007 to 2009, but this is the most predictive credit period for obligors and banks should consider every borrower’s performance during this period.
Three: Lifetime Value of Customers
In the banking industry, one of the most significant predictors of profitability is the lifetime value of customers. Below is a graph showing the return on equity (ROE) on a commercial loan ($500k, average credit quality, investor CRE, priced at 2.50% margin over the cost of funding). The graph shows the expected ROE on the loan with different loan terms. Short-term loans tend to be less profitable because of the upfront costs associated with sourcing, underwriting and booking a credit.
However, the same loan becomes more profitable after the sunk and upfront costs are incurred, and then revenue continues on autopilot. The graph above does not capture the following added benefits of a longer credit:
- As the loan becomes more seasoned, the principal is also reduced at the same time the property and/or business is more likely to appreciate. This creates a greater collateral cushion later in the loan thereby reducing the risk for the bank.
- Just the act of making payments repeatedly reduces the risk for the bank and creates loyalty by the borrower. A customer that is on their 60th payment for a loan is more likely to pay, all things being equal than a borrower that is on their third payment. Further, the longer the payment history, the more likely the customer is to provide a referral if asked.
- Cross-sell opportunities increase as the customer becomes a longer and stickier client of the bank.
Community banks should create products and strategies that lengthen the expected life of the client relationship with the bank. There are many ways to do this – including, commercial loan prepayment provisions, assignable and assumable loan structures, treasury management products, mobile banking and selecting true relationships over transactions. One good starting point is to reconsider reluctance to longer-term commitment terms. The average life of a five-year loan is only two to three years, well below the optimal ROE level as shown in the graph above.
Creating a better compensation structure to take into account both risk and profitability, expanding credit analysis to emphasize the last recession, and extending the lifetime value of your customer base all are proven ways to dramatically increase the long-term profitability of a bank. While we cannot honestly distill a complex part of our industry into three axioms, the above are three simple strategies that community banks can deploy to immediately bolster return, create more profitable relationships and reduce credit risk.
Submitted by Chris Nichols on August 29, 2018