From a business standpoint, there is no one good way to make money running a bank. Successful banking is the result of doing a lot of little things right. It is providing good customer service, bundling your products, having engaging marketing, a solid sales culture, fantastic underwriting, and profitable client management to name just a few common endeavors that separate a top performing bank from an average performing bank. When it comes to business models, banks generally fall into one of five categories, each with their strength and challenges.
Smart banks understand their strength and weaknesses and choose a model to best amplify their core competencies and the environment. Knowing your model gives bankers the ability to drive strategic and tactical decisions in order to take full advantage of their platform. Unfortunately, many banks do not proactively choose a model and don’t use their model as a basis for strategic decisions. As a result, often times their actions run counter to their very balance sheet. The classic example is a bank that relies on driving profit from loans and leverage, yet strives for yield over liquidity in their investment portfolio.
This is more than just one group’s opinion. Statistically, if you download the data on all 5,400 banks and look at how they make their money, you find that banks generally tend to cluster around one of five business models.
Here is a quick summary and some characteristics of community bankings most common models:
Loans Drive Profits
This is the most popular category for community banks in the U.S. Here, these banks are characterized by high net interest income and high gross loans to total assets. Margins are average, but the bank drives profit by having a higher than average percentage of customers to assets and customers to employees. This bank is usually good at gathering deposits (although not always at the lowest cost) and solid about originating loans. The investment portfolio is usually kept to a minimum and historically this type of bank has been more asset sensitive. As a result, this profile usually outperforms in a rising rate environment where loan growth is present. While credit shocks tend to hit this type of bank hard, the good news is that earnings are usually stable, thus year to year variability is kept low.
There are a number of banks that drive profit through operating, deposit and capital leverage. More than just an asset play, this type of bank usually goes after a niche customer base and gathers a particular stable asset and then adds leverage. This asset play is often accompanied by high fees such as those banks specializing in 7(a) SBA production, leasing, medical receivables or similar. This business model excels in a low rate, low volatility and stable credit environment like the one that we are in now. While this grouping had some of the widest volatility of earnings, they tend to be positively skewed, in that they more often than not produce an above-average performance.
Trading/Investment Driven Banks
This group represents the smallest cluster of banks, but the business model here is to marry cheap deposits with either investment leverage or an asset class that can be booked and sold either through securitizations or pooled sales. Auto, home equity, utility receivables, insurance premium financing, leasing, and other similar asset classes are just some of the ways that community banks execute on this business model. Depending on the leverage and asset, this model usually excels in a stable or falling rate environment. One notable point about this business model is that while there are only a handful of banks that have discovered a true arbitrage opportunity, most of these banks have stellar two to three year periods only to be met with below average performance when rates or credit moves. These banks had the largest standard deviation of earnings.
Fee Drives Profits
Of all the business models, this is one of our favorites as it tends to outperform in almost all markets. Trust, insurance and payment-related banks fall into this category that is characterized by low leverage, limited credit exposure and fees generated through operational risk. The downside of this model is that usually there are either high fixed costs or high barriers to entry, thus scale of either assets or customers are usually important. This business model usually exhibits the smallest volatility of earnings (with the exception of 2008).
High Margin/Low Leverage
Unlike banks that rely on a diversified loan portfolio to drive profits, these banks usually choose to specialize in a single loan category such as credit cards, student loans or equipment financing to drive profits through margin. Banks employing this business model are usually characterized by higher than the average cost of funds, lower leverage, and higher net interest margins. Liquidity is usually kept high as a counterbalance to credit and these banks usually have a developed credit model to allow for both credit and marketing/sales arbitrage. While these banks usually outperform in all markets, they particularly excel in middle rate markets that are stable as to credit and interest rate movement.
Of course, most banks are hybrids of the above and drive profits a number of ways. Further, many banks have a business model that just doesn’t reveal itself through the statistical clustering of the multiple performance variables that we looked at. The advantage of having a clear business model is that it allows management to focus its resources in a particular area and improve over time. It is no surprise that banks with a discernible business model tend to outperform hybrid banks by a material margin. If you look at the top 100 banks and remove those banks with one-time asset write-ups and/or one-time gain on sales, you will find that banks with one of the above business models make up almost 70% of the banks.
The next time you talk strategy, review these business models to see if it is worth evolving your bank into more of a focused banking machine. Having an understanding of what business model or mix of business models you are employing help you better set strategic direction and gives you a clearer picture of your risk. Having intent in your business model happens to be a hallmark of a high-performing bank.
Submitted by Chris Nichols on January 17, 2019