When you observe Michael Phelps getting out of the pool with those multiple cupping welts, take note – that is what the banking industry needs. We need to do some cupping – around loans, around deposits, around fee income and especially around products. There is no doubt you have cupped yourself, been cupped or at least asked – what is cupping? No matter what your question, it doesn’t matter, because cupping isn’t a real thing, at least in the proven scientific sense. However, what does matter, and what is real, is the need to lift up the surface of banking and pull some customers through. If you have no idea what we are talking about, read on because - will discuss why banks need to perform better, how to perform better and what happens when you put a giant cup over loans and then suck.
The Problem With Our Current Return Level
Right now, our industry produces an 8.2% average return on equity (ROE). That is still below the cost of capital for banks. Attracting capital at that level of performance is hard. Consider, for the past five years, the S&P has produced a return of almost 12% (with dividends reinvested, 9.7% without dividends). That is a comparative return with much more liquidity than the average community bank. A ROE of 8% does not bode well for our long run future, particularly given the fact that we are producing that return against a backdrop of some of the best historical credit the world has ever seen.
E Pluribus Unum
One major reason why we underperform is that the vast majority of banks set their strategy based on their loans. Usually, it is a combination of two factors – loan types that the bank feels comfortable with and loan types that are available in the community. A bank spends the vast majority of their resources on the origination and management of loans. We have a chief credit officer, a chief lending officer, loan committee, concentration reports, ALLL analysis and credit stress analysis. If you add up the portion of your branch network allocated to loans and combine that with the loan process, lending is a bank’s single largest functional cost. In other words, out of many functions, there is one main focus of most community banks.
The question is - does that make sense?
The Problem With Loans
Consider that most community banks are spread banks. That is to say, most community banks make the bulk of their money off the difference of their loan rates and their cost of funds. Given our low rate environment, flat yield curve and near-record tightness in credit spreads, spread income is hard to come by. Add to that the fact that we are at least near the best loan performance in the history of banking, and you can clearly understand why banking is a grind.
Another issue is that loans tend to perform in a very tight range, largely between 4% ROE and 35% ROE. This is to say, the standard deviation or variance between loan ROE is among of the lowest of any bank product.
Sucking The Customer To The Top
Instead of starting with what loans your bank wants to do and then letting that desire drive strategy, what happens if you flipped it around? What happens if you proactively chose the customer segment first and then figure out what it takes to service that customer?
What happens is, you become more profitable. You become like a Live Oak Bank, an Eaglemark Bank or USAA. You become a bank that focuses on a customer niche with a group of profitable products to produce a return substantially in excess of your cost of capital.
Your strategic direction will likely look the opposite of what it does now. Specifically, it might look something like this:
Instead of letting loans drive the bank, you let your customer strategy drive the bank. You choose products, focus on fee generation, excel in deposit gathering and then set loan strategy based on what the customer wants and what is profitable.
In this market, $1 of fee revenue is worth more than $1 of loan revenue. The variance between fee generating customers is greater than loans and fees are only impacted by interest rate risk and credit risk to a minor degree. If we remain in a low-interest rate environment, banks that can generate fees will rise to the top of the performance charts. As such, it pays to focus your strategic resources on fees then deposits and then loans.
By the same token, choosing what products and what product bundles you offer is important and is one of the most important strategic decisions you can make.
However, perhaps the most important decision you can make are what customers you want. If you can architect your bank to be relevant to a profitable customer niche, superior performance will likely follow. Selling more profitable products to more profitable customers is a banking equation that has never failed to produce superior results.
Putting It Into Action
When it comes to setting your strategic course, choose your loans wisely, but your customers wiser. Banks devote an array of resources to loans, but what about devoting more resources to managing your customer portfolio? Why not a Chief Customer Officer to go along with your Chief Lending Officer? Maybe a Customer Committee that focuses on the profitability and engagement with that customer portfolio.
If you look through loans, deposits, fees and products and pull that customer to the top of your decision-making process, you will find that your bank, like Michael Phelps, will outdistance your competition – customer welts and all.
Submitted by Chris Nichols on August 11, 2016