A banker often wonders where best to spend their time in order to have to biggest impact on shareholder return. In this article, we do a quick overview of where you can gain the largest risk-adjusted operating leverage. While bankers generally know this data, many do not appreciate the difference between activities. We look at eight key activities and ask the question – how would our risk-adjusted return on equity change if we increased production by a standard 10% of our current production levels?
It is no surprise that spending your time expanding your relationship with existing customers is probably your best return at the bank. As can be seen in the graphic below, if you can increase production across the board by 10% of your current commercial customer base, you could increase your ROE by 2.35%. This is the best single activity we have found. This compares to increasing your customer base by new commercial customers who can increase ROE a healthy 2.06% or if you just brought in new loan transactions that could increase ROE by a risk-adjusted 1.36%.
The Overlooked Areas
If there is a surprise in this analysis, it is the return bankers get from increasing human capital productivity. Here, a 10% increase in productivity increases ROE by 0.85%. This was greater than we expected as our bank operates at a 57% efficiency ratio. For a bank with a greater efficiency ratio, the return could be incrementally more. In addition, focusing on tax saving strategies such as purchasing tax credits, relocating operations to low-cost tax states or taking advantage of tax-advantage instruments has a material effect on earnings.
Because community banks derive so little relative revenue from fee income, increasing fees by 10% made little difference. In our analysis, we just took the largest category most banks have increased deposit fees, adjusted for volume and let the model run. This activity only increased ROE by 0.11%. In a similar vein, because interest rates are low and deposits are not that sensitive yet, lowering your cost of funds ate up too many resources for little return. The same goes for reducing your loan loss allowance levels.
We need to include a couple disclaimers to this analysis. We modeled the above off CenterState Bank after removing our wholesale fee income lines. This makes us look more like an average bank. However, if your bank has fewer core deposits, greater leverage, a higher efficiency ratio, you may want to adjust accordingly.
The other caveat to disclaim is that we just did this off a one year view. We probably should have looked at more of a lifetime value approach, but started to run into assumption problems and so decided to keep it simple. Also, there are many activities that we wanted to analyze but did not get around to it, so this is not a complete list. In the future, we look do look to take more of a lifetime value approach and look at activities such as loan workouts, M&A, leverage and deposit restructuring.
Until then, hopefully, this analysis has placed your bank’s activities in perspective as you build towards greater ROE. Every activity has a certain operational leverage with some activities being more impactful than others. This analysis may make you reconsider where to focus resources so that you can have the greatest impact on your bottom line.
Submitted by Chris Nichols on June 14, 2017