Why do some banks grind it out and struggle to produce a 9% return on equity ("ROE"), while other banks such as Bank of America and Chase produce 20% plus ROE for the same business segment? One answer is that banks that produce an above-average ROE either have a more profitable customer segment focus, more profitable products, or a more profitable business model.
Tag: Relationship Profitability
We recently spoke to a frustrated banker who was amazed that a regional bank was trying to poach his existing customer by quoting the borrower a credit spread of 1.65%.
We were recently working to close a commercial loan when the lender officer paused the closing. He did not want his bank to spend legal fees to clarify some tax-transfer issues (costs which the borrower also refused to cover). The legal bill would be between $2 and $3k. We asked the lending officer to calculate the legal costs versus the loan’s net present value (NPV) of income – the lender gave us a puzzled look. We quickly calculated the lifetime income of the loan versus the legal fees for the lender, and the lender proceeded to close the loan within two days.
As we all know, things aren’t always as they appear. In the classic image below on the left, the two horizontal lines are of equal length. In the below image on the right, you can see both a young fashionable woman looking away and an old woman’s left profile (which one do you see?). We won’t even get into the blue/black/gold/white dress debate. Similar illusions can be found in commercial lending.
If you are looking for a sweet spot of a new customer segment then we submit to you that you should be going after accountants, CPAs and tax preparers (collectively, “accountants”). While you might have competition, this group is less banked than the doctors, dentists and other medical practitioners, plus accountants are almost equally as profitable. When you consider that the average accountant provides a bank with five or more business or household referrals per year, the total profitability jumps almost to the top of the list.
The latest Consumer Financial Protection Bureau’s report HERE sends a message to banks and highlights the current status of credit marketing in partnership with educational organizations. In this space FIA (the old MBNA), Capital One and UMB are the three largest. While the trend towards more reasonably based bank products and fee disclosures have been changing for a while, we now can get to see the outcome.
As loan pricing becomes more competitive, the opportunity to book high quality credits at thin margins presents itself more and more. A 2% margined loan represents about a 9% risk-adjusted return on equity (depending on your cost structure), which is below most bank’s cost of capital. As such, there is every reason to pass on the credit and let another bank book the loan. However, before you do, consider the following points:
EPS is increased
Listen, some bankers fear making loans below a 4% margin like I fear Florida sinkholes. To put that in context, I wear an avalanche transceiver whenever I am in the State. This makes bank meetings a little awkward, but gives me a fighting chance to be found when I get swallowed up. By the State’s own website, they refer to sinkholes as a “fact of life” which is why Florida is the only state where banks have to consult the “Sinkhole Clearinghouse” database before making a loan.
Part of the problem with banking education is that it is incomplete. Banking schools like Stonier and Pacific Coast Banking School are good but they just teach part of the picture. They can talk about how to underwrite a loan or understand risk, but they leave a chasm in understanding about the true risk of underwriting. Outside of banking schools, most loan officers these days are self-taught practitioners in the art of lending and have learned their knowledge through a series of trials by fire.