Tuesday, December 12, 2017

Banking's Top 5 in Total Return to Shareholders: 2017 Edition

For the past six years I searched for the Top 5 financial institutions in five-year total return to shareholders because I am weary of the persistent "get big or get out" mentality of many bankers and industry pundits. If their platitudes about scale are correct, then the largest FIs should logically demonstrate better shareholder returns. Right?

Not so over the six years I have been keeping track.

My method was to search for the best banks based on total return to shareholders over the past five years. I chose five years because banks that focus on year over year returns tend to cut strategic investments come budget time, which hurts their market position, earnings power, and future relevance than those that make those investments.

Total return includes two components: capital appreciation and dividends. However, to exclude trading inefficiencies associated with illiquidity, I filtered for those FIs that trade over 1,000 shares per day. This, naturally, eliminated many of the smaller, illiquid FIs. I also filtered for anomalies such as recent merger announcements, mutual-to-stock conversions, and penny stocks. 

Before we begin and for comparison purposes, here are last year's top five, as measured in December 2016:

#1.  Independent Bank Corporation (Nasdaq: IBCP)
#2.  Waterstone Financial, Inc. (Nasdaq: WSBF)
#3.  Summit Financial Group, Inc. (Nasdaq: SMMF)
#4.  MBT Financial Corp. (Nasdaq: MBTF)
#5.  BNCCORP, Inc. (OTCQX: BNCC)


Here is this year's list:


#1. Old Second Bancorp, Inc. (Nasdaq: OSBC)

Old Second is a single-bank holding company headquartered in Aurora, Illinois. It has $2.4 billion of assets and operates twenty five branches in the western suburbs of Chicago.  The Bank, Old Second National Bank, lost a whopping $156 million in 2009 and 2010. Whopping because it went into those years with $247 million in tangible equity. How did they lose it? Bad loans. Their non-performing loans (NPL)/total loans ratio peaked at 12.54% in 2010, and between 2009-12, the Bank charged off over 11% of its loan portfolio. That got regulator's attention in the form of a May 2011 Consent Order
(CO). But they didn't bury their head in the proverbial sand. They hit their challenges hard, and had the CO lifted a little over two years later. Quite an accomplishment given the gravity of their problems. Today, NPL/total loans is a manageable 0.94%, and the Bank ROA/ROE year-to-date is 1.22% and 11.61% respectively. These comeback kids have delivered a 958% total return to shareholders over the past five years. Welcome to the list!



#2. Independent Bank Corporation (Nasdaq: IBCP)

Independent Bank dates back to 1864 as the First National Bank of Iona. Its size today, at $2.8 billion in assets, is smaller than it was a decade ago. It is a turnaround story because the bank was hammered with credit problems between 2008-11, when it lost over $200 million. In 2011, at the height of its problems, non-performing assets/assets was nine percent. Today that number is 2.6%. Exclude
performing restructured loans, and that number plummets to 0.38%. Net charge offs are negligible. In
fact, year to date they have a net recovery. Interestingly, IBCP recently announced an acquisition in northwest Michigan, five years after they sold 15 branches in the northeast part of the state. Times change. And IBCP has delivered a five-year total return to their shareholders of 620%. This is their third straight Top 5 recognition!



#3. Summit Financial Group, Inc. (Nasdaq: SMMF)

Summit Financial Group, Inc. is a $2.1 billion in asset company headquartered in West Virginia, providing community banking services primarily in the Eastern Panhandle and South Central regions of the state, and the Northern and Shenandoah Valley regions of Virginia. Summit also operates an insurance subsidiary. In 2012, the company had net income of $7.0 million on assets of $1.4 billion.
Today, the company has annualized net income of $13.2 million. Actually, the Bank had a one-time after tax litigation settlement (from a 2002-04 event) of $6.2 million. So their normalized net income is $19.4 million. A 50% growth in assets, and a 177% growth in net income. Positive operating leverage! And Summit has a couple of new acquisitions under their belt. One in 2016 and one this year. This marks Summit's second consecutive year in the Top 5! Well done!






#4. HMN Financial, Inc. (Nasdaq: HMNF)

Similar to Old Second, HMN is a turnaround story. It is the holding company for Home Federal Savings Bank, a $715 million in asset thrift headquartered in Rochester, Minnesota with retail banking and loan production offices in Minnesota, Iowa, and Wisconsin. In 2007, the Bank had $1.1 billion of assets, $11 million in net income, and a 1.01% ROA. Then, kaboom! Over the next four years the Bank lost $58 million. A princely some to a Bank with $107 million of capital at the time. In 2008, the Bank had $216 million of Construction & Land Development (CLD) loans, 12% of them were either past due or on non-accrual. As the saying goes, in CLD, when the music stops, you don't want to be the one without the chair. And HMN found itself without a chair. So they took TARP, and
aggressively dealt with their asset quality problems, and shrank their balance sheet quickly to bolster capital ratios. By 2014, they cut the balance sheet in half. And since that time have grown loans over $200 million and deposits over $130 million. Today, they earned an 0.89% ROA, although that number has been bolstered by negative loan loss provisions. Their NPL/Loans shrank to 0.56%. Quite a recovery indeed and their shareholders that jumped in during the bleak days were rewarded!




#5. Parke Bancorp, Inc. (Nasdaq: PKBK)

Parke Bancorp, Inc. is the holding company for Parke Bank, a $1.1 billion in assets commercially focused community bank based in southern New Jersey, serving Philadelphia and its suburbs. Unlike the three of the banks above, this is not a turnaround story. Their ROA has been greater than 1% the past five years. In fact, I can't explain exactly how they do it. I'm going to have to ask Vito Pantilione, their CEO. One strategy is limited branching. They have only seven, averaging $120 million in
deposits per branch, which is nearly twice The Kafafian Group (my firm) peer average for branch deposit size. Their cost of funds is slightly above average, at 86 basis points. But their non-interest expense/average assets was 1.40%. You read that right. Apparently, Vito is cheap. Their NPAs/Assets has always, to my recollection, been above their peers. But their charge offs are not. And they have a 5.02% yield on their loan portfolio. Pretty good. That's why they returned 580% to their shareholders the past five years!




Here's how total return looks for you chart geeks, with the lower green, and flat line being the S&P 500 Bank and Thrift Index.





There you have it! The JFB all stars in top 5, five-year total return. The largest of the lot is $2.8 billion in total assets. No SIFI banks on the list. Ask your investment banker why this is so.

Congratulations to all of the above that developed a specific strategy and is clearly executing well. Your shareholders have been rewarded!

Are you noticing themes that led to these banks' performance?


~ Jeff



Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.

Monday, December 04, 2017

Checking Analysis: The Betamax of Bank Products

Don't think about how it is. Think about how it should be.

Now apply this philosophy to business checking. If we did, would we continue to offer Analysis Checking or some variation of it? 

Yet we do. Even though the Dodd-Frank Act eliminated Reg Q, that pesky reg that did not allow banks to pay interest on business demand deposits. Because of Reg Q, in place for over 80 years, banks created Business Analysis Checking, where a business earns credits to offset fees based on their balances. See a Union Bank of Richmond, VA description of a typical Business Analysis Checking account. 

But it doesn't stop at the checking account. Businesses want to earn interest on their excess funds. So they determine how much to leave in their non-interest bearing, analysis checking, and then sweep the excess to some interest bearing vehicle, such as a money market account, or, gasp, a repo because prior to the financial crisis deposit insurance only extended to the first $100,000 of a business's deposits. Repo's are generally collateralized. So there is all sorts of complications going on to run a checking account and to pay business interest on guaranteed funds.

Does it have to be?

I say no. And because highlighting a problem without proposing a solution is whining, I propose the JFB Alternative to Business Checking Analysis. Or the JFB Business Banking Cash Maximizer. 

My firm measures product profitability on an outsourced basis for dozens of community financial institutions. As a result of this line of business, we are able to see product spreads, fees, and costs. And by costs, we measure the average organizational resources to originate and maintain a business checking account. The average for all of the banks in our profitability universe was $590.50 in operating expense per year.

We also calculate the spread using coterminous funds transfer pricing (FTP), and the actual fees assessed to those accounts. That combination of spread and fees was 2.14% of balances during the second quarter 2017.

Knowing the operating cost per account, and revenue generated as a percent of balances, you can calculate the average balance needed to be maintained to cover the account's costs. Said another way, it's breakeven balance. See the table.


Based on the average operating cost per account, and revenue as a percent of balances, the average account holder would need to maintain an average balance of $27,593.46 to cover the bank's costs.

Hold on though. Nobody is average, right? Our universe of business checking customers vary on their account utilization. Some are high cash businesses, that frequently make a night drop of deposits requiring our tellers to validate and make the deposits. Others are no cash, and use our RDC machines to deposit a relatively small amount of checks.

You see that I divided account types into quintiles to make this distinction. What this requires is a way that your core system can put a code to determine which quintile each account belongs. I believe this can be accomplished by the oft-cited with few practical installations... Artificial Intelligence, or AI.

Your core tracks transaction types per account. Each transaction type uses a certain amount of bank resources. You don't have to come up with a dollar amount, highly contrived by the way, of each transaction. Such as an ACH costs the bank $18.65. But what you can do is say that in terms of resource utilization, an ACH takes 2x the resources used by an RDC deposit. So, for example, an ACH might have an 8 on a scale of 1-10 for resource utilization, and an RDC might be a 4.

By scoring transactions by resources used, you can then divide your business checking customers into the above quintiles, and assign a cost per account accordingly. The aggregate dollars it takes your bank to originate and maintain business checking accounts remains the same, at $2.975 million. But the cost per account is broken up by resource utilization.

So the one-person law firm that RDC deposits 20 checks per month might be designated a Low Activity quintile, and be assessed a $354.30 operating cost. While the cash-driven marijuana shop that drops off loads of cash over the teller line each day, would be rightly assessed $826.70.

Now you have the means to determine the minimum average balance to cover costs. Anything over that amount, is paid interest. No sweep. No analysis, at least not in the past use of the word. No multiple statements. And no human intervention.

Just an easy account to explain to your client. And an easy one for your client to manage.

Let's send Business Checking Analysis to the Betamax pile of history.

Are any of my readers doing this?


~ Jeff



Saturday, November 18, 2017

Bank Dividends: Go Ahead and Drink The Kool Aid

Dividends are no longer sexy. So says Rob Isbitts, a Forbes contributor in a recent article that he penned. Not sure they ever were sexy, but he has a point. Read the article, make your own judgement.

Or read on. Today I had another debate with my colleagues about discount rates. You know, those rates you learned in Finance class, CAP-M, or Ibbotson Build-up? Yeah, text book stuff. Don't hear much about either on CNBC these days.

I view things simplistically. If you are going to project out into the future, say in strategic plan projections, then you should discount back to present day to determine if your strategy is adding or eroding value. A key component to the calculation is the discount rate.

So here is my simple definition of what your discount rate should be: The annual capital appreciation rate expected by your investors. That differs based on business model, in my opinion. If you are executing a fast-growth strategy in a slow-growth market, you may be taking larger risks. Therefore, your investors should expect greater capital appreciation, and therefore a greater discount rate.

If you grow more slowly, and closer to your market growth, you would likely be executing a less risky strategy, and you should consider a smaller discount rate. But your investors would still expect equity-like returns. Common stock remains the lowest rung on the capital hierarchy, regardless of strategy employed. 

Absent a change in your market multiples, your stock's capital appreciation should move in tandem with your earnings growth, or possibly your book value growth, or some combination of the two. That is typically how banks are valued. So what if in executing your strategy, you're projecting 6% earnings compound annual growth? I doubt your investors would be happy with 6% annual returns. How do you deliver the returns they are expecting?

How about the dividend?

Let's look at Territorial Bancorp in Honolulu, the holding company for Territorial Savings Bank. Why Territorial? Aside from my affinity for Hawaii because I lived, worked, and went to college there, they are a highly capitalized thrift that converted from mutual to stock form in 2009. Their capital ratios are not an issue.

Territorial had an inconvenient truth in their 2016 10k, or annual report for those that don't speak in SEC forms. See the below chart.


They have under-performed bank stocks and the wider market over the past five years. They are not a poor performer though, having a year-to-date ROA of 0.89% and Efficiency Ratio of 56.5%. The challenge may be their balance sheet growth, only 4.1% per year, on average, since 2011 (see table). The Hawaii population is projected to grow 3.46% over the next five years.



One way Territorial is trying to improve shareholder returns is through dividends. Their dividend has grown at a CAGR of 22% since 2011, even though their EPS has grown at a CAGR of 8.5% over the same period. In 2016, that resulted in a dividend payout ratio of 52.3%, up from 29.1% in 2011. Quite a commitment to the dividend. An 8.5% annual EPS growth, combined with a 2.8% dividend yield, should result in a total annual return of 11.3%. That assumes no change in Territorial's price/earnings multiple. Not too shabby. 

So why don't others deliver higher dividends to stoke shareholder returns, especially if their balance sheet is growing slowly, and their EPS growth is not enough to meet shareholder expectations? Why maximize profitability only to accumulate capital?

Territorial is working their capital position down from a very lofty perch post-conversion. Clearly dividends are one part of their strategy, as well as share buybacks. The buybacks are typical for a converted thrift. Although don't get me started on the logic of issuing shares at $10 only to immediately start buying them back at a higher price.

What if, as Territorial "normalizes" their capital position as per their capital plan, they have to cut the dividend? This is a common objection I hear from bankers for not increasing their dividend and payout ratio. They don't want to cut it. And suffer the consequences. Like GE recently did.

The Board and executive management of Territorial have this covered, in my opinion, in the form of a special dividend. In 2016, their regular quarterly dividend was $0.18/share. In December, they declared a special dividend of $0.20/share, in addition to their regular dividend. They recently declared a special dividend this year of $0.30/share, payable in December. Once their capital levels return to "normal", if the special dividend reduces capital ratios, they can reduce it or eliminate it altogether, without impacting the regular dividend.

But no, bankers object because their shareholders will grow to "expect" the special dividend. As if active shareholder relations programs can't mitigate this risk. 

As a result, many keep banging the growth drum to stoke EPS and therefore shareholder returns. As if growing faster than the bank's markets can continue ad infinitum. If it doesn't pan out, we turn first to cost cutting (largely within our control). Then to buy-side M&A (less within our control). And if we fail to deliver shareholder returns by these methods... then sell-side M&A (within our control). 

And, alas, we have fewer than 6,000 banks.


Are you drinking my dividend Kool Aid?


~ Jeff


Saturday, November 04, 2017

Schmidlap Bank, A Division of Community Bank

"We want to keep our charter because the OCC is a more distinguished regulator." Seriously, that is what a bank chairman told me when arguing to keep his bank's charter during merger negotiations.

But I try not to judge. Perhaps, if I thought the argument weak, which I did, there was something else behind it. Something like "we've spent 100 years building the reputation of this bank and 'poof', it's gone at the stroke of a pen." Or, "my grandparents, parents, and now me served on the board of this bank and I owe it to their legacy..."

Why not just say that? Perhaps there is little evidence of the benefit of your 100-year brand, so it's a difficult argument to make. But more difficult than claiming the OCC is a better regulator? 

In more recent merger discussions, however, I have heard more refreshing arguments that it is not necessary to re-brand every nook and cranny of your bank into one. Because one key argument to combine brands is the efficiency of advertising into one or more media markets. Does this make sense today?

I think not. Take the accompanying picture, all from my Twitter, Facebook, and LindedIn streams. Three different "promoted" posts. All specific to me. Based on all the intel gathered on me. My neighbor, or even my wife, see different ads. So combining names so you can realize synergies in your billboard strategy doesn't make sense like it did 20 years ago.

More success stories of the divisional approach are cropping up in our industry. One of my favorites is the affinity brand Red Neck Bank, a division of All America Bank. All America Bank is a traditional community bank located near Oklahoma City, and has been around since the 1960's. And yes, they recently switched names from Bank of the Witchitas. But did they have to? For the traditional bank, I'm not so sure.

Aside from the traditional bank, they thought out of the box, and established a digital-only division to appeal to a specific niche. And it has done well. Marvelously well. Even though it has not reached the "critical mass" that your investment bankers insists that you need. See the accompanying table.


On a more traditional front, I point to UNSY Bank in upstate New York. This bank, unlike All America Bank, is relatively new, having been formed in 2007. It's strategy, however, is to build brands that resonate closer to the communities where they operate. For example, the $349 million bank has only four branch locations, each USNY Bank. But they operate as Bank of the Finger Lakes, or Bank of Cooperstown, divisions of USNY. Their financial performance doesn't seem to be hampered by bifurcated branding.

The divisional approach is becoming more important as relatively small financial institutions worry about keeping up with customer preference, technology, and regulatory changes. Although I mock the investment banker that always seems to think your institution needs to be twice the size you are now, regardless of the size you are now, there is merit to achieving a certain size.

Merits that include: increased stock trading multiples, greater employee development opportunities, the ability to absorb regulatory costs, and greater resources to invest in technologies to afford you a long-term future.

But you need not give up your name to get a merger of like-sized institutions done. Nor dump your local brand for a homogeneous one that spans geographies.


~ Jeff


Wednesday, November 01, 2017

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Quarterly Financial Markets & Economic Update- October, 2017

I love this time of year.  The leaves are changing colors and soon fall will give way to winter.  I cannot say I love the cold, bitter winter, especially when the roads are bad from snow and ice.  The markets have not given way to anything, with long term bonds still trading in a tight range and short term rates having risen from Fed action.  The economy moves along at its own pace.  We saw a strong second quarter, with GDP growth at 3.1%, and we know from the recent past that the third quarter should stay strong but weakness comes again in the fourth quarter.  This year, we may see a weaker third quarter due to the effects of Hurricanes Harvey, Irma, and Maria and the destruction left in their wake.  The overall forecast for GDP in 2017 is 2%.  Actually, the forecast for 2018 to 2020 is also 2%.  What else is new?

Fed Tightening
The Federal Reserve continues its tightening campaign.  They are expected to raise the Fed Funds rate for a third time in 2017 by another 25 basis points in December, 2017.  Why?  I suppose it is because they said they would raise rates three times this year and they are stubbornly sticking to what they said.

But raising the Fed Funds rate is not the only tightening going on.  Add to that the end of “QE,” or quantitative easing, which was the Fed’s bond buying binge that loaded up their balance sheet to over $4 trillion.  They have spent the last several years maintaining the current levels of bonds that they own.  They have seemed fairly nervous about their large balance sheet, so in September, 2017, they announced that they would allow bonds to mature or pay off in October- by $4 billion in Agency mortgage backed securities and $6 billion in Treasuries, for a total of $10 billion. But they won’t stop there.  The monthly amount will eventually rise to $50 billion.  Thus “QT,” or quantitative tightening, has begun, with uncertain consequences and disruptions to our markets, interest rates, the economy, liquidity, and the banking system.  All of this is happening while the markets widely expect the President to nominate a new Federal Reserve Chair to replace Janet Yellen, whose term as Chair ends in February, 2018.  Interestingly, her term on the FOMC does not end.

The tightening continues unabated, despite modest economic growth and stubbornly low inflation.  In fact, inflation has been less than 2%, the Fed’s presumed target, since 2009.  Neither GDP or inflation look to soar anytime soon, leaving us with Fed actions that will put upward pressure on short term and long term that will lead to lower GDP growth and lower inflation.  Something doesn’t seem right about this scenario, does it?

What Does the Economy Need?
Okay, I have been reading my economic textbooks, studying my data, thinking about the markets, and wondering about the Fed.  Why are they continuing to raise rates?  I theorize that they believe the unemployment rate is too low and will cause wage inflation.  They believe in the Phillips curve, which has an inverse relationship between unemployment and inflation.  They may also have seen an uptick in inflation earlier this year and thought they were right in raising rates.  Have they noticed that inflation was transitory and has now been falling?

The unemployment rate is low on the surface, at 4.2% in September, 2017.  The low unemployment rate in and of itself does not indicate that 7.6 million workers have multiple jobs to make ends meet, that the labor force participation rate of 63% is near a 40 year low, the pool of available workers is at 12.4 million persons, and that baby boomer retirees have given way to workers of less experience.  The Fed worries about wage growth soaring and driving higher inflation expectations.  I don’t think they have to worry too much; median household income in 2016 was $59,039, while in 1999 it was about the same at $58,655.  That is seventeen years!

I was fortunate to see a presentation this summer by Dr. Lacy Hunt.  He showed an enormous amount of historical economic and market data including real interest rates, debt levels, money supply, the velocity of money, GDP, inflation, productivity, and employment measures.  High debt levels compared to GDP, low velocity of money, low productivity, and low savings rates have conspired to keep GDP growth lower than historical averages, both on a real and nominal basis.  Downward pressure on inflation has been the result and Fed actions are only pushing inflation lower.  Tightening will bring higher short term rates, but may push GDP growth and inflation even lower.  We really don’t need either one to move lower right now.  Dr. Hunt demonstrated through his research that the extremely high debt levels are keeping GDP at low levels, keeping inflation at low levels, and keeping long term interest rates at low levels.  He believes we will remain in this situation for the foreseeable future.

Fiscal Policy
We are not seeing activity from Washington DC.  There have been several failed attempts to repeal and replace Obamacare.  Tax cut and tax reform proposals have been floated.  I really didn’t hear much about helping small business in them.  There isn’t much mention of infrastructure projects.  We are at a standstill when it comes to fiscal policy.  I believe that tax cuts will spur economic growth, but only if they do not increase government borrowing and the federal deficit.  As Dr. Hunt would indicate, increased government borrowing would only exacerbate the debt-to-GDP ratio, which has been greater than 100% for the past six years, and further weaken economic growth.   

Many other good ideas have been presented, including ones to improve education, job training, and worker skills to better match the job openings of today and the future.  We have seen the elimination of several regulations; the lifting of burdensome regulations will help everyone.

The Kilonova
Did you see the major announcement by astronomers on October 16th?  NASA captured pictures of an extremely huge collision of two neutron stars.  This occurred 130 million years ago, but the signal didn’t get to Earth until August 17th, which was only a few days before the solar eclipse in the US on August 21st.  (We managed to score some of the eclipse glasses and observe the 80% eclipse here in PA).  The collision is called a “kilonova,” and it led scientists to see bright blue debris and massive amounts of platinum, uranium, and gold being created.  In fact, there was an estimated $10 octillion in gold created!  That is $10 billion, billion, billion.  Now that would create some economic growth!

Thanks for reading!  DJ 10/17/17







Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Monday, October 23, 2017

Bankers: What's Your Art of War?

I will occasionally quote Sun Tzu from his seminal book, The Art of War. I am not trying to imply that winning battles and winning in a competitive marketplace is the same thing. One leads to lessons learned, perhaps a loss of wealth, but never death and conquest.

But Sun’s wisdom cannot be ignored. He was a Chinese general, strategist, and philosopher that lived over 2,000 years ago. His book is a must read at military academies and business schools alike.

One such quote I would like to share and discuss practical application is:


If you know the enemy and know yourself, your victory will not be in doubt.


I use this quote as it relates to a financial institution’s situation analysis, environmental scan, or whatever you choose to call it. What I believe Sun meant: the general that knew his enemy’s weaknesses, and exploited them, and knew the enemy’s strengths, and avoided them, wins.

And I believe this to be the case with your competition.

I am moderating a planning retreat for a client this week. And in so doing, we have prepared a peer group financial condition and performance analysis for the bank’s strategy team. But it doesn’t go far enough. Executive Management’s personal knowledge of, and research into the strengths and weaknesses of their competitors is essential to building a strategy to expose their weaknesses and dodge their strengths.

Some information will be based on competitive actions in the marketplace. Much of it, however, can be gleaned from publicly available information.

Let’s go through the data with one such competitor.

FFKT Farmers Capital Bank Corporation (the “Company”), Frankfort, KY

FFKT is a financial holding company which had four wholly-owned bank subsidiaries at year-end 2016. The Company provides a wide range of banking and bank-related services to customers throughout Central and Northern Kentucky. It had four bank subsidiaries including Farmers Bank & Capital Trust Company ("Farmers Bank"), Frankfort, Kentucky; United Bank & Trust Company ("United Bank"), Versailles, Kentucky; First Citizens Bank (“First Citizens”), Elizabethtown, Kentucky; and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”), Newport, Kentucky. In February 2017, the Company merged United Bank, First Citizens, Citizens Northern, and FCB Services, Inc. (“FCB Services”) into Farmers Bank, the name of which was immediately changed to United Bank & Capital Trust Company (the “Bank”).

At year-end 2016 the Company had the following wholly-owned nonbank subsidiaries: FCB Services, a data processing subsidiary located in Frankfort, Kentucky; FFKT Insurance Services, Inc., (“FFKT Insurance”), a captive property and casualty insurance company in Frankfort, Kentucky; and Farmers Capital Bank Trust I & III, established to issue Trust Preferred Securities (“Trups”), a hybrid Tier 1 Capital instrument.

How do I know this without having inside information about the Company and Bank? It’s in their Annual Report. FFKT is not a client, and I do not know any non-public information about them. 

The Company had asset quality problems, which they appear to have beaten. In 2013, their non-performing asset/asset ratio was near 5%, down to 2% today. Still high relating to other financial institutions, but the trend is very favorable.

The Company did two things to increase profitability either at the end of last year, or early this year. One was to consolidate bank charters from four to one, the cost of which was accrued mostly during 2016 and was executed in February of this year. The other was to restructure its balance sheet by pre-paying senior debt, deleveraging its balance sheet and increasing its net interest margin.

And it has worked. Investors' patience paid off in a second quarter ROA of 1.08% and a 9.40% ROE. Where will the Company turn to keeping the positive trend? Since investors have been patient for the Company to rebound, it is fair to assume that there is little appetite for strategic investments that don’t have very quick payback periods. And upon review of the balance sheet, there is opportunity to improve today and impact financial performance in the very near term.

The Company’s yield on earning assets was 3.92% for the second quarter, placing it in the 25th quartile amongst its peers. The culprit is a low loan/deposit ratio that has been as low as 67% in the past five years, but has grown to 73% in the second quarter. Although the loan portfolio has not grown much. The increase in loan/deposit ratio was mostly attributed to sparse loan growth combined with deposit decline. Commercial Real Estate ("CRE") loans grew from 29% of total loans in 2013 to 38% in the second quarter.

So the bank is growing CRE loans to improve its yield on earning assets.

I discerned all of this from public information either in their SEC (Annual Report) or FFIEC (Call Report) filings.

But there’s more. In their Annual Report, the Company disclosed its CRE underwriting criteria as follows:

Commercial Real Estate
‘Commercial real estate lending made up 41% of the loan portfolio at year-end 2016. Commercial real estate lending underwriting criteria is documented in the lending policy and includes loans secured by office buildings, retail stores, warehouses, hotels, and other commercial properties. Underwriting criteria and procedures for commercial real estate loans include:

● Procurement of Federal income tax returns and financial statements for the past three years and related supplemental information deemed relevant;

● Detailed financial and credit analysis is performed and presented to various committees;

● Cash investment from the applicant in an amount equal to 20% of cost (loan to value ratio not to exceed 80%). Additional collateral may be taken in lieu of a full 20% investment in limited circumstances;

● Cash flows from the project financed and global cash flow of the principals and their entities must produce a minimum debt coverage ratio of 1.25:1;

● For non-profits, including churches, a 1.0:1 debt coverage minimum ratio;

● Past experience of the customer with the bank;

● Experience of the investor in commercial real estate;

● Tangible net worth analysis;

● Interest rate shocks for variable rate loans;

● General and local commercial real estate conditions;

● Alternative uses of the security in the event of a default;

● Thorough analysis of appraisals;

● References and resumes are procured for background knowledge of the principals/guarantors;

● Credit enhancements are utilized when necessary and/or desirable such as assignments of life insurance and the use of guarantors and firm take-out commitments;

● Frequent financial reporting is required for income generating real estate such as: rent rolls, tenant listings, average daily rates and occupancy rates for hotels;

● Commercial real estate loans are made with amortization terms generally not to exceed 20 years; and

● For lending arrangements determined to be more complex, loan agreements with financial and collateral representations and warranties are employed to ensure the ongoing viability of the borrower.’

So the bank has rigorous underwriting criteria for CRE loans done within policy. I have found this typical for banks emerging from credit problems.

Growing the portfolio fast enough to improve near term performance, and being mindful that they don’t want to revisit their credit problems of the past, indicates that this Company may be willing to sacrifice price for quality, therefore making them aggressive pricers in the market to get deals done. What I term the “it’s better than we’re getting in the investment portfolio” philosophy.

Competing banks should take note, and position themselves to win business accordingly, either on speed, service, structure, or deeper relationships with borrowers.

All of this information and more are publicly available about your competitors, even if they are not SEC filers. All must be Call Report filers.

Could I be wrong? Of course. But the combination of publicly disclosed information on a competitor, plus your bankers’ knowledge of how they act in the marketplace, can give you a competitive advantage over them should you invest the time into the research, and respond accordingly.


Know your enemy.


~ Jeff

Wednesday, October 11, 2017

Bank Lending: Shifting Emphasis from CRE to C&I

Although bank commercial real estate (CRE) lending has been more profitable than commercial and industrial (C&I or Business Loans), both now AND immediately after the financial crisis, regulatory CRE guidelines are causing financial institutions to consider a switch of emphasis to Business Lending.

Here are my thoughts on how to do so.




Your thoughts?

~ Jeff

Sunday, October 01, 2017

Bank Products: Blah Blah Blah

At a recent banking conference, Ray Davis of Umpqua Bank took center stage to tell of his journey from a small, Oregon community bank to a regional powerhouse. He mentioned products only briefly. And product was not part of the bank's success. I thought, Why?

Stuck on the topic, I jotted down the products that I remembered from when I landed my first banking job in 1985 while Davis spoke. I never claimed to have a great attention span. And I used those hotel notepads. Someone has to use them. Here was my list:

Products Circa 1985
Mortgage loan
Car loan
Personal loan
Home equity loan (?)
Business loan and line of credit
Commercial mortgage loan
Construction Loan

Checking account (business and personal)
Savings account (business and personal)
Certificate of deposit (business and personal)

Merchant services (?)
Trust

Then I wrote down how that list has changed.

New Products: Circa Today
Money market accounts (although could be classified as hyped savings)
Investments
Sweep accounts/cash management
Hedging
Options

The hedging and options might be categorized as features of business loans, versus products in and of themselves. But let's not quibble over insignificance.

What do you notice about the above lists?

What I notice is there is little difference in the products of today and the products when MacGyver developed improvised explosive devices with his shoes.

Bank products, at their base, have not changed. So, perhaps, instead of developing complexity in our product set, we should look to develop simplicity. Wouldn't we all benefit from more simplicity?

What sparked this post was a recent article in ababankmarketing.com written by Mark Gibson and Kevin Halsey of Capital Performance Group in Washington DC. It was a precursor to a presentation they gave at the ABA Marketing Conference in New Orleans titled "How to Build Remarkable Products". One of their slides from that presentation is below.


This slide, and another I was privileged to see, dubbed as one of the most popular by the authors, speaks nothing of product. In fact, I will confess to you that when I hear bankers talk about products, product management, product design, etc., I have no idea what they are talking about. Bank products have been the same since I've been in banking.

Yes, there are different features to products, such as high interest rates for checking account customers that engage in specific behaviors, or option-based CD's as developed by Neil Stanley of The CorePoint. Still a checking account. And still a CD.

Distribution is different. Back to my notepad, I penned the 1985 distro points as person-person, in-branch, telephone, and ATM. Today we could add online, mobile, and social (for customer service). As a list, not very impressive.

However, in terms of customer utilization, distribution has been massively disrupted.

Sure, bankers can tick off all of the new features added to that standard product list, as mentioned above. But new products? Hardly.

So why not simplify? Like Southwest did when they went with one airplane model. Why not have a personal checking account, that is non-interest bearing up to a certain average balance, which could differ based on customer utilization that could easily by solved by AI, and bears interest above that level. Same with business checking, now that we can pay interest on those accounts. 

Savings accounts could easily have sub-accounts. Like the proverbial envelopes in the night stand drawer that tucks money away for certain things such as Emergency, Vacation, and Holiday. I believe PNC did this with the Virtual Wallet account. To me, Virtual Wallet is nothing more than a practically thought out savings account. 

I recently commented to a bank's strategy team that I thought the days when bankers could rely on sleepy money are coming to an end. The 13-month CD special trick, where the CD reprices at the lower 12-month CD when it matures, is over. A business model that relies on the stupidity of your customers will die. Imagine a customer getting a text from a financial management app that says "your bank is screwing you". It may not say that, but it would say that a CD is maturing and the rate it will role into is below market.

No, we can no longer rely on sleepy money. But perhaps we should focus Marketing on touching the customer in every phase of the buying journey instead of concocting schemes to complicate products, tinker with pricing, and rely on Rip Van Winkle customers. This is what I believe my friends at Capital Performance Group were emphasizing.

If I were a marketer, I would focus on simplicity in product design. And sophistication in the customer acquisition or relationship expansion funnel.

But I'm not a marketer. 

~ Jeff


Sunday, September 17, 2017

An Open Letter Calling For The Establishment Of The Consumer Beverage Protection Bureau (CBPB)

I'm fed up and not going to take it anymore! So I am proposing to my state's Senators to submit legislation to form the Consumer Beverage Protection Bureau (CBPB).


Dear Senators Casey and Toomey:

I am a citizen of your fine state and am writing to strongly encourage you to submit legislation to establish a Consumer Beverage Protection Bureau. The establishment will serve to protect the citizens of our fair land from the aggressive and deceptive practices of the beer industry.

For too long, the beer industry has been praying on our citizens. Luring us into beverage centers with cardboard cutouts of attractive young women or the likes of Kevin Harvick and Dale Earnhardt Jr. Such marketing tactics have had a disparate impact on those that fancy attractive women and NASCAR fans. Note that I made no reference to the identity of those clearly in the beer industry's cross hairs as I now have adopted political correctness in my protest letters. And don't get me started on Busch beer clearly targeting plaid shirt-wearing mountain folk. smh



Once the beverage centers lure you in, past the attractive woman or Earnhardt Jr. cutout, what do they feature? Expensive, high margin craft beer. Not the more reasonably priced Busch. We are bombarded with images and smooth marketing schemes of Troegs, Harpoon, and Flying Dog. The deception gets worse. Anheuser-Busch fools us into believing craft beers such as Elysian, Breckinridge, and Goose Island are brewed in small batches by people with long, scraggly beards. Not so. They are owned by Anheuser-Busch, who is in turn owned by beer conglomerate InBev. From Belgium! 

Gentleman, this is our new Battle of the Bulge!

Here is what I propose. Form the CBPB, that is within the Federal Alcohol Administration, yet is not accountable to the FAA or the President of the United States. In addition to investigating such deceptive practices, the CBPB should have examination authority over large beverage wholesalers to ensure that their practices are "fair", whatever definition they drum up for that term.

Give the CBPB the power to:

- Rescind or reform contracts;
- Demand monetary refunds;
- Disgorgement of violators' assets;
- Return of property;
- Restitution;
- Compensation for unjust enrichment;
- Payment of damages or other monetary relief;
- Public shaming of a beer distributor's violation;
- Limits on the activities or functions of a person;
- Civil monetary penalties

In this way, the CBPB can stop the practice of beer distributors from upselling a Hoppy Ending Pale Ale to the college student that just wants a PBR. The added compliance costs may put the small beverage distributor out of business in favor of their larger brethren, limit beer drinker choices, and raise prices. But let's face it, those small operators are not likely to support lifer politications anyway, and who wants that?

No, creating a government bureaucracy accountable to nobody creates jobs, and is a great gig for smart people like Jeopardy winners that can solve complex problems in the form of a question, such as "What is Fair?"

This madness must end! Support the CBPB!

Sincerely, your faithful servant that believes the government can solve what "ales" us...

~ Jeff Marsico




Sunday, September 10, 2017

Bankers: Five Ways to Use Profitability Data to Move You Forward

Accountability is a dirty word. It evokes images of finger wagging, stern looks, and sheepish floor staring. I'm sure at one point of the word's evolution it wasn't this way. Words and phrases earn their reputation by those that use and receive them. In banking, it is what we made it to be.

On a recent Pennsylvania Institute of CPA podcast, Bob Kafafian from my firm was asked how to use management information. Bob's response resulted in a follow-up question by a Midwest banker friend of mine. 

And since I am scheduled to speak about it at a Financial Managers Society breakfast tomorrow, I'll answer it.

Here are my ideas on how to use Management Information to create a positive accountability culture.

1. Hold branch managers accountable for revenue growth. Revenue growth equals deposit spread (coterminous using funds transfer pricing, or FTP), loan spread less provision (for loans that the branch is responsible for generating), and fee income. Imagine if Wells Fargo branch managers were accountable for this, instead of number of accounts per customer. Fake accounts with little or no balance generate little or no spread. But draws operating expenses from support centers. Imagine if your branch managers were accountable for this instead of deposit dollar growth. Would you be getting that desperate phone call asking for a rate exception to keep the money at the bank?

2.  Hold lenders accountable for their portfolio ROE. You read it right. That's an "E", not an "A".
Lending is a risk business, and aside from the provision expense, and net-charge off rate, those loans require equity to support them. If you allocate equity by product based on your institution's risk experience, then you know how much equity your institution requires. It should be part of your capital plan. Drill that down to the loan level, you can create ROE hurdles when lenders price loans, and measure their pre-tax ROE on their entire portfolio using the coterminous spread, less provision expense, less operating expense per loan type, to calculate the lenders' actual ROE for their portfolio. Imagine!

3. Hold support centers accountable for a decreasing relative cost per balance sheet category. If measuring a deposit operations department, then the operating expense from deposit operations as a
percent of deposit balances should decline long-term in a growing institution. It is the very definition of economies of scale. Notice I say long-term, because you don't want to defer investment in personnel or technology in fear of causing an upward blip in your trend. That's managing by budget that has caused executives to reduce innovation so they can make their budget.

4. Rank. Nothing should be more motivating than ranking branches, lenders, and support managers in achieving their goals as measured by Management Information than seeing where they rank among their peers. Including a ranking report of your twenty branches by revenue growth, and profitability,  in a sales meeting should put smiles on the faces of those at the top, and a look of determination on the faces of those wanting to get there.

5. Reward. Incentivize your personnel for achievement. Let's turn that frown upside down when we talk of accountability. Deposit Operations costing 16 basis points of deposits three years ago, and 12 basis points today, is an achievement that should be recognized by the entire institution. The same for ROE improvement for lenders, or pre-tax profit improvement by branch managers. Let's not foster a culture of fear, recrimination, and public floggings. Let's raise up our achievers!


I frequently speak of financial institutions' over-investment in under performing branches. Those investments of our precious operating expense dollars could be used in more promising areas. Instead, we limit resources to the very things that could lead us to a more sustainable future. Using profitability information to incentivize the right behavior will create a culture of achievement, and help us make more efficient decisions to better serve customers, reward employees, and improve performance. 

How do you use Management Information to run your bank?

~ Jeff


Note: This is my personal blog and I mostly refrain from direct sales pitches. But since I firmly believe 1) every financial institution should do this, and 2) few have the resources to do this, I offer this...

My firm, The Kafafian Group, does profitability reporting on an outsourced basis because we recognize the challenge community financial institutions face in building their own model, and running it quarter after quarter. If interested, call Gregg Wagner, our practice leader, at 973-299-0200 x114 or reach him at gwagner@kafafiangroup.com. 


Tuesday, August 29, 2017

Banks and Bungee Cords

Your relationships, your job, your life comes with baggage. I recently made the analogy that there are bungee cords affixed to your belt. Some hold you back. Some propel you forward.

And it applies to banks too.

In a traditional SWOT analysis, there are things within your control (strengths, weaknesses), and things outside of your control (opportunities, threats). But what are the forces that propel you towards your strengths and opportunities? Or towards your weaknesses and threats?

These forces are mostly within your control. Should you choose to embrace the challenge.

Do you?

Here are the forces I see for bankers that pull them back, toward their weaknesses and threats:

1.  Regulators. OK, I'm playing to the audience. But regulators don't want you to veer off the beaten path. Keep it plain vanilla. Build a bank that thrived in 1963. Ask those bureaucrats this question: "How many businesses have you run?" Because you would swear by their swagger they were Richard Branson or Elon Musk.  

2.  Seargents. If you have hired me, or have read what I have written, you would understand that I believe there are "old-schoolers" in your organization that cause tremendous friction to progress and change. 

3.  "No Mistakes" Culture. The amount of energy that banks commit to being 100% in compliance, find no audit findings, or, gasp, no Matters Requiring Attention on their exam, is monumental, in my opinion. Some operations managers' evaluations and, in some circumstances, variable compensation is dependent on clean audits. What does that get you? Hyper conservatism in compliance. And a whole lot of "we can't do it" from executives. It's killing our industry.

4.  He's/She's Not Ready. This is a common reason I hear why banks don't elevate forward thinkers to the executive suite. They fear those "crazy ideas" they have in management meetings, or the fact that they are willing to accept some risks old school bankers would not. Better to keep them suppressed deep in the bowels of our organization and let others pilfer our future customers than to risk innovation through calculated risk taking.


Here are the forces that I see can propel bankers forward:

1.  Allowing Experimentation. And, 'gasp', failure. I'm not talking "bet the bank" failure. But a failure that may bust your budget is not Armageddon. It is an opportunity to learn, and help you implement the next innovation. Not the reason to look back 10 years and think, 'we tried and failed 10 years ago and, dag nabbit, we are not goin' to try again!'

2.  Fire Seargents. They are not that important to your organization. In fact, they are destroying it. And when you give them their packing papers it sends a message to the masses... "We are a forward looking bank. Backward thinkers take notice."

3.  Continuous Learning. A bank that believes everyone, from the CEO to the newly hired loan operations clerk, should learn, will have a far better chance to being the one bank that survives the non-stop tide of bank consolidation.

4.  Run the bank by strategy, not by budget. Strategy forces banks to look far out into the future. Running by budget forces bankers to look to next year. Where is the puck going, versus where it is. We intuitively know that our industry would not have yielded so much market share to outsiders if we could think outside of our budget. 


So you have bungee cords hooked to your belt. Where are they pulling you?

~ Jeff

Sunday, August 20, 2017

Small Bank-Big Bank: Spending on People, Technology

I was recently slated to speak at an industry conference and I was diligently preparing when the organizer asked if I would be on a panel instead. Fine. But what about my diligent preparation?

I have a blog.

My remarks, should I have made them, were going to revolve around how much large banks spend on strategically significant resources compared to small banks. I took no bias into my search. I ran the data, and here are the results based on bank Call Report data.



The initial news was good. Smaller banks, either under $10 billion in total assets or the smaller group, under $1 billion, dedicate a greater proportion of their total operating expense to salary and benefits. The under $1 billion cohort spends nearly 9% more of their operating expense on employees. This would seem to be crucial, as I frequently hear bank strategy teams identify employees as a strategic advantage smaller banks have over larger ones.

Not so fast. I broke down salary and benefits per employee as well. And in that case, it appears as though the larger financial institutions pay more. The greater than $10 billion banks pay $103,235 per employee versus the under $1 billion banks at $76,411, a 26% difference. That explains why no hands went up at the Pacific Coast Banking School when the director asked how many students went to college to be community bankers.

To further the challenge for small financial institutions, the $1 billion to $10 billion cohort pays 12% more. So if the altruist wants to work for a community bank that is closer to its communities, they can make more with big brother. 

I understand that many, if not most under $1 billion banks are in rural areas, and therefore the salary and benefits disparity may be misleading. But we would be hard pressed to find a college senior that says they'll take a 26% pay haircut and work in Tombstone, Arizona. Although I'm sure there are exceptions.

I'm sure Tombstone is nice. I use as an example recognizable by all. Please refrain from angry comments and e-mails.

My second data search revolved around IT expenditures using the same asset size cohorts. Actually, the Call Report category is Data Processing expense. Although I've been poked for using this 70's-80's phraseology. You know who you are!


A note on the data. It does not include personnel.

The news looks good for smaller banks, spending a relatively larger proportion of their operating expenses on IT. But the larger banks are gaining ground, growing this line item at a compound annual growth rate of 10% over the past 10 years. The banks in the middle cohort spend relatively the least on IT.

What was alarming was how little this expense represented of total operating expenses. Reading industry literature one would think IT would dominate the expense ledger. Not so. 

But it will. 

Were there any surprises in the above tables?


~ Jeff



Saturday, August 12, 2017

Bank Loan Leading Indicators

I recently shared a long ride with a colleague discussing a Capital Plan project we were working on. In Capital Plans, you would typically use baseline projections, usually taken from the strategic plan, and apply adverse events that, based on the bank's balance sheet and strategy, can occur. Even if they are not particularly likely to occur. 

But it's planning. And planning for bad stuff is part of planning. Life isn't all sunshine and rainbows.

As part of our commute discussion, we talked about leading versus lagging indicators of adverse events in order to reduce the impact of such events. Many if not most adverse events are beyond the bank's control. Because risks don't typically come home to roost at the time the Board or Management decide to accept the risk. Lagging indicators are easy, such as the migration from 30-89 days past due, 90+ past due, and non-accrual loans.

But lagging indicators are history. It would've been nice to know that Lee Harvey Oswald was heading to the sixth floor of the Texas School Book Depository. Unless you're Oliver Stone. Then you're wondering who Lyndon Johnson is talking to. I digress. Stopping Oswald or diverting him likely would've ended in a different result.

Can banks identify leading indicators that can reduce risk at the right time?

I was never a lender. And my firm is not in Loan Review or other areas involved with the evaluation of credit. Nor are we an ALCO firm, estimating Interest Rate Risk or Liquidity Risk. But we do Strategic Plans, Capital Plans, Process Reviews and General Advisory that deals with how banks identify and mitigate risk. 

Credit risk remains the greatest risk to a financial institution by far, in my opinion. Not even close. Although examiners and consultants will tick off a laundry list of risks that could put your bank in peril, like reputation risk. The way reputation risk is likely to roost is through liquidity risk. Customers lose confidence in your bank and your liquidity position takes a nosedive. But has many financial institutions suffered as much reputational damage as Wells Fargo recently? And their liquidity ratio is over 40%. They have plenty of liquidity.

No, I'll stand by my credit risk statement. Take the IndyMac domino effect. They had credit problems that came home to roost, Senator Chuck Schumer wrote a letter to the OTS about the bank's problems, and due to the reputation risk customers made a run on the bank. Liquidity is what put them under. Credit is what pushed the first domino.

Identifying leading indicators for credit risk isn't particularly difficult. Finding research that makes the correlation is. But I will list what I think are common-sense leading indicators to credit risk that may very well be effective, and hopefully can be tracked and monitored automatically so we don't have seven risk management analysts on staff hunting and gathering data.

JFB's Credit Risk Leading Indicators
1.  Residential and Commercial Real Estate, and Construction Lending: Trend of days on market (by property type)

2.  Residential and Commercial Real Estate, and Construction Lending: Trend of the difference between initial asking price and actual sale price (by property type)

3.  Commercial and Consumer Lending: Trend of average balance per commercial checking (by NAICS code), and retail checking accounts

4. Residential and Construction Lending: Trend of price index for single family homes under construction

5. Residential, Commercial Real Estate, and Construction Lending: Average checking account balance trends for your customers in the Real Estate Development NAICS

6.  Commercial Real Estate and Multi-family Lending: Trends in occupancy rates.

These are a few that I have seen or make sense to me. Could they be downloaded into a dashboard so bank management could see the trends, and modify risk appetites to curtail new lending in categories that are showing yellow or red? And advise your bank's borrowers on how to navigate difficult times to preserve their business to fight another day?

Do you agree with the above indicators and what others should be considered?

~ Jeff