Is Bigger Better After All …? - Gonzobanker

Hey GonzoBankers – Could things get any worse in the financial industry for big banks?

• Bear Stearns implodes and gets put on the block by the Fed for an amount less than the value of its office building in Manhattan;
• Citi announces an almost $10 billion loss in Q4 2007;
• Countrywide gets beheaded by the subprime crisis, announcing that 33% of its subprime loans were in delinquency at the end of Q4 2007. Thank goodness for the “rescue” of Countrywide by its Medusa – BofA – in a deal valued at $4 billion;
• Merrill Lynch recorded a mere $10.3 billion loss for the last quarter of 2007; and
• UBS just announced that it will have to deal with the minor issue of a $12 billion loss this quarter.

BofA looked like a shining star at the end of last year. Despite a write down of $5.3 billion in its collateralized debt obligation (CDO) portfolio, BofA managed to earn $.05 per share in Q4, a 96% drop in earnings from Q4 2006.

Not only are earnings ugly at big banks, but the employment prognosis doesn’t look much better. In a report released April 1, 2008, Celent predicts that the U.S. commercial banking industry will lose 200,000 of its 2 million jobs over the next 12–18 months – an unprecedented number, historically – and most of those will be at the big banks.

With all of this front page bad news, I wondered if Cornerstone’s mid-size bank clients were taking advantage of this “big banks on their backs opportunity.” Very few “mid-size” banks or “community” banks (under $1 billion in assets) were stung by the subprime crisis. Mid-size banks weren’t heavily weighted in structured investment vehicles (SIVs), CDOs or a lot of other three-letter investment product acronyms that only quant grads from MIT understand. And, most mid-size banks don’t own investment banks, which had an incredibly bad year in 2007. IMHO, mid-size bank should be attacking this environment like a border collie in weave poles at an agility contest.

In order to get some perspective on the “is bigger better” question, I took a 10-year snapshot looking at year-end 1997 vs. year-end 2007 for “community” (under $1 billion in assets), “mid-size” ($1–50 billion) and “big” banks ($50 billion+). And to keep this exercise from getting too esoteric, I looked only at some blunt measures – ROA, efficiency ratio, ROE, net interest margin and assets per employee. Below is a summary of the results.

Despite the worst year in a decade for big banks, their ROA remained almost flat from 1997, dropping only 13 basis points from 1.05% to .92%, while mid-size banks had the biggest drop of the three groups dropping 35 basis points from 1.28% in 1997 to .93%. By year end 2007 big banks, mid-size banks and community banks were about equal in their ROA.

The simple fact of the matter is that scale matters when it comes to leveraging people, process, and technology. Over the 10 year period, big banks gained nearly 7% in efficiency falling from 62% to 55%. Hey mid-size banks – what the heck is happening? Over the past 10 years you’ve gotten less efficient, increasing your efficiency ratio from 55% to 57%.

Interestingly, you now match the big banks at $6 million in assets per employee, but you’re not translating a huge gain (in 1997 mid-size banks were at $3.4 million in assets per employee) into bottom line efficiency.

Looking at ROE doesn’t change the picture for mid-size banks either. While you outpaced your big brethren in 1997 by a full 1.2% (15.25% vs. 14.04%) a backbreaking 2007 for big banks seemed to break you even more. The result: big banks finished the year with an 8.1% ROE in comparison to your 7.8%.

A look at the margin doesn’t improve the mid-size bank picture. Big banks have remained absolutely flat over 10 years enjoying a not so great NIM of 3.5%. Mid-size banks have lost the advantage they used to enjoy dropping from 4.28% in 1997 to 3.46% in 2007.

Source: FDIC

Now I realize this data is just a snapshot that doesn’t trend all relevant information on a quarterly basis for 10 years, but it does raise a fundamental issue: Why are big banks, from a blunt measurement perspective, looking as good as or better than mid-size banks after a horrific 2007?

Lessons for Mid-Size Banks

1. Diversify your revenue. Despite the alarm bells, a plethora of articles and a gazillion conferences talking about fee income, mid-size banks are still way too dependent on the margin. A lot of strategic planning sessions over the past five years have been devoted to revenue diversification, but unfortunately very little real progress has been made. In Cornerstone’s recently published The Cornerstone Report 2007: Benchmarks and Best Practices for Mid-Size Banks, the median mid-size bank had non-interest income as a percent of revenue standing at a miserly 24%. Most of the big banks are in the 40% – 50%+ range. Folks, it really is time to get serious and innovative in finding new sources of fee income and stop playing lip service to the idea.
2. What in the heck are you doing with all those branches you built (or acquired)? In the 2007 Cornerstone Report, the median mid-size bank closed an ANEMIC six consumer loans per branch per month – down from an already unimpressive nine in our 2005 study. While we don’t have exact stats for the big banks, we know they are chunking out the consumer loans. The median credit union, on the other hand, closed 63 consumer loans per branch per month as found in The Cornerstone Report: Benchmarks and Best Practices for Credit Union 2006. You’ve invested roughly the same amount as big banks per square foot to build all of those branches – now it’s time to get your fair share of the consumer market.
3.  “We all may have gotten a little too heavy in commercial real estate over the past five years” – a comment made to me by the CEO of one of our mid-size bank clients in the south. Since the big banks have muscled mid-size banks to the side in credit cards, mortgages and a host of other products over the past 10 years, mid-size banks have increasingly jumped on the commercial real estate and construction bandwagon. By way of comparison, through 2006 the ratio of commercial real estate loans to capital at mid-size banks stood at a whopping 285% while the big banks rank at a modest 77%. The point is, mid-size banks are not only failing to diversify their revenue, they’re failing to diversify their commercial portfolios as well. This is the area where mid-size banks should be running circles around the big guys. Well, guess what, folks? The CRE gravy train is over and you’re now going to have to roll up the sleeves, focus on C&I AND learn how to lend in our new services economy where the bulk of companies don’t have plants, inventory or equipment.
4. It’s all about the payments. Big banks have woken up in the past several years and have developed payment plans by reviewing payments across their silos and developing strategies to maximize fee income. My experience in mid-size banks is that few, if any, have developed payment strategies. Non-cash payments have grown at 4.6% for the past five years while check volume has been declining at 6.4%. Debit cards are growing at 17.5% and have surpassed credit cards in the number of transactions. ACH is the fastest growing of all at 18.6% per year. While ACH represents only 16% of all non-cash payments, the total value of those payments is 41%. And lastly, ATM activity is down a whopping 25% from the 2004 peak. In light of these trends, mid-size banks need to ask themselves: What is my strategy in the payments arena?

Are big banks better than mid-size banks? Yes and no. By the numbers, the big banks are kicking tail even in the midst of their worst year in the past decade. But mid-size banks continue to flourish, grow and develop niches in the commercial world big banks can’t touch. As a contrarian, I think now is the perfect time for mid-size banks to look at mortgage, to invest in sales training in the branches to sell consumer loans, and to continue to make smart credit decisions in the commercial/C&I world where the big banks have essentially, in a knee jerk fashion, shut off the credit spigot. Come on, mid-size banks – don’t let those numbers continue to prove me wrong.

All for now.
-SAS