BID® Daily Newsletter
Oct 29, 2012

BID® Daily Newsletter

Oct 29, 2012

STRATEGIC PERFORMANCE & EFFICIENCY


Banking can be serious business, so sometimes a little humor is needed. Along those lines, this morning we share a short story by an unknown author. One night, a man was watching TV when his doorbell rang. He opened the door and found a six foot tall cockroach. The bug grabbed him, threw him across the room and left. The next night, the man was watching TV again when his doorbell rang. The man opened the door and saw the same six foot tall cockroach. The big bug punched him in the stomach and left. On the third night, the man was watching TV when the doorbell rang yet again. He opened the door and the same six foot tall cockroach was standing there. This time the bug kicked him in the shins and punched and broke the man's nose. The following day, the man went to see his doctor and explained what had happened to him the previous nights. He asked the doctor what he could do and the doctor replied, "Not much, there is just a nasty bug going around right now." Hopefully that put a smile on your face as you begin the day. This time of year is packed with strategic planning sessions at community banks across the country. So, as you think about your upcoming session, or smile about a funny event that occurred at the one you just attended, try to see the positive side of things to get through the coming planning year. As you meet in strategic session, consider an industry review by McKinsey. It found U.S. banks earned an average ROE of 7% last year. That performance certainly isn't stellar, but consider how rough it would be as a European bank right now, earning a meager 0%. Despite all of the issues, it is still better to be a U.S. bank than one operating nearly anywhere else in the world. As banks plan for the next 3Ys to 5Ys, one way they are addressing this low ROE issue is to think about the entire business model. Simplification is now the mantra, as banks try to squeeze more from less and reduce costs. The difficulty to address here is that the data finds some 50% of U.S. banks are not earning their cost of capital (which is about 10%). Heavy regulation, low interest rates and a limited opportunity to charge fees are all placing a drag on bank performance. To compete better, banks are looking closely at business lines, geographic footprint, branch networks and the overall business model. In an environment where revenues are down, it makes sense that costs must also be reduced. One big problem here is that around 70% or so of deposit relationships, according to research by Goldman Sachs, do not earn back the cost of capital assigned to those relationships. In short, lower balance deposits without fees to offset are usually unprofitable. Banks are taking a hard look at this as they consider which depositors they want to have as customers and which they may not. Overall, consider the negative impact on ROA due to regulatory reform, environmental costs and other expenses has now reached 37bp. Put another way; these issues have dragged down ROA by nearly 31% since 2007. That drag is enormous and one key reason so many banks are focused on the efficiency ratio and expenses in this strategic planning period. Given that so many banks are focused on improving the efficiency ratio, we offer a quick tutorial. Recall that the ratio is designed to measure the amount a bank spends to generate a dollar of revenue. It is calculated as noninterest expense / (net interest income + noninterest income). To improve the ratio, this means you can increase net interest income OR increase noninterest income OR reduce noninterest expense. As can be seen, the ratio isn't just about cutting expenses, but also about increasing the other two pieces wherever and whenever possible. Management teams and boards often think of a strong efficiency ratio as something around 60%, so it is interesting to note that as of 2Q, the ratio was about 71% for banks under $1B in assets and 60% for banks over $1B in assets. No matter where your strategic planning session takes you this year as you consider ways to improve the business model, be sure to carry a positive attitude. Be sure to spend some time focusing on improving efficiency, as doing so will help boost bank performance and the potential for success.
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