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BirdsEye View

2006 mid-year outlook

My last article about commercial bankers hit a nerve for many of you. John Romano, SEVP of Bank of Smithtown writes, "In our market, there is an abundance of commercial lenders available, but finding one that mesh cohesively with the retail banking group is a challenge. The individual needs to be truly a team player, and in many organizations that I visit...the lending group operates in their own silo. While many banks support this notion since lenders are key drivers of bank profitability, I believe it slowly erodes the overall level of the bank's ability to execute its value proposition. If left unchecked, you wind up with a divisive working group... with the customer ultimately being the loser."

Robert Bailey, President of Bay community Bank, says, "I think your article is right on the money. Our financial services competitors have done this for years. Over the years we have wondered why the C+, Div. 1 athlete that made a career in insurance or brokerage made more than us. It's because they would sell and were willing to accept the risks of selling as long as there was higher compensation. One key is to have both short term and long term, incentive plans. The short term plan gives the immediate rewards to the top sellers and the long term pan keeps them from taking their book of business elsewhere".

Dick Stifel, EVP of 1st Source, adds, "In my hiring practice I place strong emphasis on participatin in sports activities. Sports require commitment ro self and others, discipline and desire. MBA is unnecessary for all but the largest commercial positions. sense of urgency, decent abstract reasoning skills and idea orientation are a lot more imoprtant than GPA. "sales" skills are necessary for a lender if he or she is to successfully "sell" the deal to the client and the bank!"

All these comments are right on the money!

Every six months I put my foot in my mouth and share my thoughts on key trends and themes I see in our industry for the coming half year. Below is my outlook for the second half of 2006. As always, I'd be grateful for any thoughts and comments on what works and what doesn't in this all-important arena. Looking forward to hearing from you,

2006 Mid-Year Outlook

This year has thus far been the year with no surprises. Annual trends identified in my December BirdsEye View are still valid, although some developments have taken place on several fronts. Here is what I see happening between now and yearend:

The margin turns a corner

  • The yield curve is normalizing and steepening as we speak. Continuous Fed rate hikes combined with inflation pic-a-boos are getting the market to finally believe that perhaps long term rates deserve to be higher than they have been.

  • Many deposit markets will remain highly competitive with no relief in sight. "Pretend" core accounts (the 5%+ Money Market account, a.k.a. the indefinite maturity CD) are sprouting everywhere, most with compelling metallic names ranging from gold and platinum to titanium and other mysterious metals. Too many banks are desperate for funding, which causes broad extreme behaviors (vs. specific market kamikazes) and further margin squeezes.

  • The spread game is back, but be careful how you play it. Asset sensitive banks are celebrating the normalizing yield-curve, and others are rushing to originate fixed rate assets without prepayment penalties. How quickly we forget the agony of the rapidly declining rate environment...

  • Asset/liability models aren't delivering: models and reality don't mesh. Many models are mathematically accurate yet their predictions, from arte shock impact on interest income to balance sheet and margin reaction to yield curve slope changes, do not resemble what actually took place. As always, it's all in the assumptions. Revisiting your ALM model if it doesn't agree with your recent historical experience is important, since that experience will be repeated soon.

  • Balance sheet leverage strategies and coming home to roost: costly and difficult to unwind. Balance sheet leverage strategies look great when the next quarter appears anemic and the market is willing, but they deeply hurt when it's time to unwind and take one's lumps. The market has historically welcomed this effort to front end losses and sprinkle the earnings for several years to come, but the sew-saw nature of these strategies grows old fast.

  • There's a wide range of bank response to the rising and steepening rate environment, from heavy margin compression to great expansion. While almost all banks professed to be asset sensitive in early 2005, too few have experienced margin expansion in the ensuing months. This experience will repeat itself for the remainder of the year.

Key lessons:

  • Margin dependence is risky even if things are going your way

  • Short term leverage strategies have long term implications, often negative

  • Core funding is always beautiful

The year of the deposit

  • De novo branching is only a partial answer. The hugely ambitious branching announcement of 2005 have been scaled back to yield more moderate over-capacity in our business and less drain on earnings. Yet, the amazing success of Commerce Bank and its emulators, coupled with steep acquisition prices, continues to drive others to look for successful branch expansion strategies and tactics. As I other strategic initiatives, some banks have been exceptionally successful, while others languish. Overall, all realized that this isn't the silver bullet we hoped it would be, and many are scaling back de novo efforts while upping the breakeven expectations from the traditional 3 years to 24 and even 18 months.

  • Banks need better articulated deposit gathering and pricing strategies. The mega banks have figured this one out, and have typically established in each of their major markets a desired position relative to other banks, say the bottom quartile or the market median. SuperCommunity banks have traditionally been more opportunistic in this area, yet, as a result, they cannot claim a specific position in the customer's mind. Nor can they give customers the peace of mind of knowing that their rate will always range around a certain market position, thereby compelling customers to shop around for rates. Banks' ALM committees might wish to give some thought to a desired market position vis-à-vis pricing that will allow the sales forces to claim certain pricing points consistently.

  • Low revenue credit for core deposits from 2000-2004 is putting a damper on deposit growth as core funding regains its glory. During that period, low rates caused deposits to become marginally profitable, which took the wind out of many a retail franchise sails, and reduced loan officer interest in deposit gathering. The worm has turned, but sales forces are not as fast in turning their ship around.

  • Acquisitions will remain expensive as buyers vie for coveted deposit-rich sellers; while deals are heating up, the market is unlikely to rationalize in 2006. Too many high loan-to-deposit ratio banks and land-locked foreign banks that are looking to expand in the US are willing to pay high prices for mediocre performance banks.

  • Banks aren't getting their share of growth in deposit markets. Deposits are growing at a robust 8-10% nationwide, and at even higher clips in some markets. However, banks aren't getting their fare share of this growth, as non-banks' share of financial assets continues to grow and eclipse bank deposit growth. If your deposits aren't growing as fats as you'd like, it sometimes isn't a market issue but an execution issue...

  • Deposit gathering is a retail business; it's OK to get hokey in Retail (back to the toaster). Retail is a fun and hokey business, the antitheses to old-fashioned banking. Just visit any Abercrombie and Fitch and you'll know what I mean. Winning I consumer banking will require some nods to retailing, including the fun part: celebrations, recognition events, lots of sales and contests.

  • Technology is on your side (remote capture; Check 21). Technological advances continue to help SuperCommunity banks combat larger branch networks with remote capture at the customers' site for small business and electronic banking as a solution for consumer needs. Size becomes transparent if a customer can literally have a branch in their own office, using remote capture technology.

Key lessons:

  • Never take your eye off the core funding ball

  • The market for deposit growth is there

  • Simplify your product offering

  • Guerilla warfare is a good thing

So many loans, not enough funding

  • Loan growth in commercial real estate will decelerate as conduits and foreign lenders disintermediate the banks. CRE securitization and other secondary market activities are booming, and, as always, margins start shrinking as the market becomes more efficient.

  • C&I loan growth is robust, but still slower than CRE growth, while catching up. The economy is growing at a good clip, and C&I loans are heating up as well. Many SuperCommunity banks are experiencing double digit growth in C&I lending, which, although impressive, still does not match the CRE growth, since those loans are much larger. The good news is that, as V&I loans grow, they are often fully or partially self-funded, thereby easing the pressure on deposit growth that resulted, in part, from the rapid growth in CRE lending.

  • Competition for deposits is fierce in many markets. Robust loan growth across the board puts further pressure on deposit growth. Funding is the call to action in 2006, and the trend will continue well into 2007.

  • Market rationalization is unlikely to occur for the remainder of 2006

  • Regulators don't like loan-to-deposit ratios over 100%; start polishing your secondary liquidity plan. The regulators did not react when LTD ratios grew beyond the 100% mark, but as banks started climbing north of 125%, with the help of FHLB advances, brokered CDs and other funding sources, the regulators put their foot down. Several bank acquisitions in the past 18 months were motivated solely by the need for additional deposits. Those banks that have not resorted to acquisitions are spending time improving the detail and measurements of their secondary liquidity plans, which have caught the regulators' attention as deposit stability and growth fall short of expectations.

  • The definition of a true core deposit is a moving target. The proliferation of "faux" core deposit accounts brings to light the new nature of deposits. While the "hot" money market accounts fall under the core deposits category, one can debate whether they are less stable than CDs these days. The question is now on the table for the first time in years: what truly qualifies as a core deposit?

  • Esoteric funding sources abound, but will the regulators accept them? Given the uncertain behavior of these new money market accounts and the proliferation of programs such as CDers, regulators might be re-evaluating the definition of core deposits and their expectations of banks with respect to liquidity positions.

Key lessons:

  • C&I lending is still the backbone of the business

  • Rapid CRE growth is slowing down; what will you sue to replace it?

  • Landing CAN be about relationships, not just about loans; Is it time to rename your loan officer and change your incentives to reflect your expectations for relationship selling?

Credit cannot get any better

  • Yet reserves are under pressure from the SEC and the accountants.

  • Conflict between the SEC and the regulators regarding reserves remains unsolved, and the SEC is winning. Banks nationwide are finding that the general allowance are going by the way of the dodo, with limits of no more than 10% of total reserves set by the most liberal of accounting firms. Further,

  • Is cash accounting the answer? Morgan, Stanley analysis indicates that the most significant variable to accurately predicting future stock prices is cash income. Is this a precursor to eliminating reserves altogether and moving to pure cash accounting? I don't think so, but do see the continued shift, albeit a slow one, to greater transparency in the financial statements .

  • Credit will worsen as the cycle turns; liberalized terms, covenants and razor-thin pricing will come home to roost in 2007. We all know that what goes around comes around, and this credit cycle is no different. As credit worsens throughout 2007, the battle for reserves will ease and the OCC, the champion of deeper reserves, will gain footing.

Key lessons:

  • What goes around comes around

  • Cash accounting is the single best predictor of stick price performance

  • Budgets need to incorporate credit deterioration in future years

The payment business

  • We're all in it whether we intend to or not. Many SuperCommunity banks feel that Payments are the big guys' domain. However, all of us owe a significant portion of our non-interest income to payment income streams such as debit card, merchant services, NSF, courtesy overdraft etc. It is an important business to all of us, and focusing on it will yield additional revenues if effectively managed,

  • Some core payment streams have already been threatened, e.g. Wal-Mart interchange fee case. Not all the income streams in this business are safe, as evidenced by Wal-Mart's victory in the courts.

  • Checking volumes continue to slide while electronic payments grow. The day has finally come when electronic payments have surpassed both in actual volume as well as in growth rates their paper brethren. The trend will continue as plastic increasingly becomes cash-like in consumers' minds, and no transaction is too small for the debit card (have you visited Starbucks lately and seen how many of their $5 purchases are done by a card?)

  • Opportunities exist in both traditional payment elements (debit card, NSF) as well as new ones (remote capture). Retail and commercial customers alike have greater receptivity and more need for payment services, and technology is right there with them, providing new solutions almost daily. Remote capture at the customers' site reminds me of the cell phone. In the not-too-distant past, cell phone were the big bucks expense, and the monthly fees almost negligible. Today, companies give the phone away just to get the service fees. Remote capture for commercial customers will take the same path, and the banks that are first to market will win big.

  • This space will get crowded within the year. This is one of those moments in time when the opportunity window is already beginning to close. I don't know of a bank that hasn't (a) introduced remote capture, (b) is fixing to introduce remote capture of (c) evaluating when to introduce remote capture. We already know how narrow the window was for the courtesy overdraft product, and this innovation will follow a similar path.

Thinking out-of-the-box is one answer

  • Out of the box thinking at SuperCommunity banks around the country pays big dividends. Consider the following examples:

    • First Interstate Bank and correspondent banking plus processing plus credit card plus ATM driving

    • Sterling Financial and financing the timber business

    • First Citizens and funeral parlors

    • Eastern bank and correspondent banking

    • MidFirst and servicing mortgages with hair on them

    • Webster and HSAs

  • All these banks are in the SuperCommunity Bank space, yet they engage in businesses that are perceived to be in the mega-banks domain. Others have engaged in small forays into various lines of business that have yielded huge returns on small volumes, say $25-$50 million. These businesses, such as small equipment leasing, aren't scalable for most banks. In fact, growing them rapidly almost always results in credit problems. But having several one- and two-base hits contributes to earnings without compromising the bank, and can be accomplished by banks of all sizes.

Key lessons:

  • Critical mass is important in fewer businesses than we think

  • Building new lines of business is painful but doable

  • Executive leadership is crucial to success

  • Retail can become a major bottom-line contributor

What's on the regulators' mind?

  • BSA/AML are still kings, but giving way to commercial real estate as the top regulatory concern. BSA/AML still rule and will continue to dominate the regulators' focus for the rest of the year, but CRE is being teed up as the next major issue banks will have to deal with, particularly as it pertains to capital requirements and concentration management.

  • Business continuity is back on the map. In the wake of Katrina and Rita, banks nationwide are beefing up their DR activities and plans. These two catastrophes showed us all that planning is inherently inadequate when it doesn't include the flexibility to deal with the unexpected. This time, almost all vendors and other reliable industry partners could not deliver services, from telephone to cash, which resulted in serious and lingering problems. The regulators are mindful of these issues, and are applying additional tests to Disaster Recovery and Business Continuity.

  • ALM might be next on the regulators' radar screen, and liquidity planning is already there. Given the explosive growth of CRE and the two disasters mentioned above, ALM is taking the back seat to other regulatory concerns. However, liquidity planning is firmly in their cross-hairs.

  • Credit scrutiny will come up in 2007 if for no other reason then for the credit deterioration which I anticipate will take place. The focus on a real estate bubble might not pan out for the rest of the year, but 2007 will see pockets of meaningful price adjustments and credit issues, especially in the condo and investor markets.

Don't forget your ALM

  • Current model results do not build confidence in the information output.

  • Banks of all sizes need not be sitting ducks as the yield curve changes shape and level. Hedging has traditionally been the purview of the mega-banks. It requires sophistication and financial flexibility that is rarely resident in SuperCommunity banks, and transaction costs are too high for small institutions. However, as the market broadened, and hedging instruments proliferated from the vanilla to butter pecan and other flavors, banks of all sizes are giving renewed consideration to capturing profits using derivatives. The Fed's continued frequent rate moves has created a brand new environment in which financial institutions operate, and hedging might be one of the few ways available to banks to deal with these rapid changes, since balance sheet shifts are time consuming, and fully matched books are elusive.

  • Solid understanding of interest rate risk is a pre-requisite to any hedging activities. Before you dabble in hedging, develop your own expertise and ensure you know what the instrument will do to your income streams. Even no cost options have a cost, so proceed with caution.

Key lessons:

  • ALM is a core bank risk

  • ALM models may be very complex but that doesn't make them right

  • If you don't understand what the model is saying or why, change the model

Summary

  • Overall, the industry continues to be profitable but growth rates are decelerating

  • More banks are experiencing profitability hiccups and margin pressures

  • Funding is the call to action in 2006

  • Managing the fundamentals is more important in 2006 than ever

  • Risk management sophistication is needed for the basics: credit, interest rate, liquidity, operations