Welcome to part two of our series, “Profitability Profiles.” If you want to know more about the thinking behind these blog posts, you can check out the intro in part one, “The Story of Deadweight Bank.”
If you just want a TDLR version, here goes:
Most banks consider themselves “relationship banks,” but do they really know what that means? What constitutes a good relationship, or a bad one? And how can they attract more of the former?
To find out what “relationship banking” looks like in reality, we did some deep dives into the data of a group of real (but anonymous) banks. We pulled out some of the most interesting stories – ones with themes we think will resonate with many of readers – and are sharing them in this series.
Reminder: We’ll be walking through some of the cases, and showing how PrecisionLender can help, in our May 11 webinar.
Okay, now on to the story of “Bank of Surprise.”
Bank of Surprise
For the second bank in our deep dive on relationship profitability, we’re looking at a $30+ billion bank on the East Coast. The bank has been a solid performer for years, putting up impressive growth numbers without sacrificing profitability. The bank is efficient and runs a squeaky-clean loan portfolio that has primarily focused on non-owner occupied CRE and multi-family real estate.
When reviewing their relationship profitability, though, we were struck by how little of the commercial bank’s profits comes from those loans, despite their pristine credit quality and above average yields. This bank stood out among the group of institutions we examined because it generates a whopping 68% of its total commercial income from deposits.
In fact, outside of the top quartile of most profitable relationships, the bank doesn’t generate any net profits from loans. Given the bank’s reputation in the marketplace as a real estate-centric bank, we were taken aback by those results. They show that this solid real estate bank is quietly wrapped inside a much larger and more profitable commercial deposit gathering operation. And we were not just surprised by the results, but by how the bank’s RMs go about generating those results.
Enough, in fact, to dub them, “Bank of Surprise.”
Income by Relationship Profitability Quartiles
“A Deposits Generating Powerhouse”
Bank of Surprise has done a fantastic job of collecting profitable commercial deposits, with the commercial book generating a loan/deposit ratio of 70%. The average customer carries a deposit balance of more than $210k. This certainly doesn’t look like the typical real estate-focused regional!
The deposits are particularly strong for the most profitable customers. The top 25 customers carry an average deposit balance of more than $140 million, and 16 of them carry no loan balances whatsoever. In short, though Bank of Surprise prides itself on being a smart real estate lender, it’s really a deposit-generating powerhouse. That’s what’s driving its performance. And many of those big deposits have nothing to do with real estate.
Many of Bank of Surprise’s most profitable customers come from the financial world, representing clearing services, escrow accounts, investment companies, or REIT accounts. Where they do have loans, they are often C&I loans. Of note, the loans for the top quartile customers are not just given away to win those big deposit balances; the loans have an ROA of 1.32%, versus 1.10% for the overall loan portfolio.
In contrast, Bank of Surprise’s bottom quartile customers have a very different profile. They lose money on a substantial amount of loans ($1.8 billion in loans across more than 35,000 customers in this quartile), but unlike the top 3 groups, they do not make it up with profitable deposits. Quartile 4 customers carry similar deposit balances to customers in Quartiles 2 and 3, but the bank pays higher rates (50+ basis points higher) and the balances have much shorter durations, resulting in very little net income.
ROA by Profitability Quartile
“A Painful Misuse of Capital”
As with most banks, Bank of Surprise’s bottom quartile customers include a handful with credit issues. The Quartile 4 loans soak up a disproportionate amount of capital (more than 8x the middle half of the portfolio), but high loan loss provisions aren’t the only reason they’re unprofitable. Many of these loans are also mispriced. The net interest income on these loans is just 0.25% of average balances, compared to 2.20% for the overall portfolio. Once loan loss provisions are added, those loans lose 2.66% on balances. That is a painful misuse of all that capital.
Loan Spreads by Customer Profitability Quartile
A Balanced Approach Among the RMs
The customer data for Bank of Surprise seems to show two strategies: 1) A typical CRE focus, and 2) A sophisticated, big balance deposit focus. Typically when we see divergent strategies like this, we expect to see it even more clearly amongst the RMs, with each specializing in one strategy over the other. Once again, we were surprised, as we saw little evidence of specialization. Instead, most RMs carried a balance of CRE lending and big deposit accounts.
The bank has nearly 200 RMs, and its bottom 35,000 customers collectively lose $27 million annually. Yet none of its RMs has a money losing portfolio. Production is balanced, with the top 10% of RMs generating around 46% of the total income. Instead of the top RMs carrying all the most profitable customers, we see the RMs carry a mix of customers from across all four profitability quartiles. This is different from the top-heavy RM performance charts we typically see at other banks. (Like Deadweight Bank, for example.) Bank of Surprise's top RMs just have more customers; especially more customers that carry loan balances.
The chart below summarizes the 50 most profitable RMs (They carry more than 75% of loan balances and more than 60% of deposit balances):
Bank of Surprise Top 50 RMs
As you can see, most are balanced between income generated from loans and deposits, whereas the bottom 150 are much more concentrated in deposits. Bank of Surprise’s top RM generates most of their income from deposits, and actually carries a deposit book north of $1 billion.
Also of note is that, for the top 50 RMs, spreads on loans actually go up as we move down the ranking (it is noisy but is clearly a trend, as the dotted line indicates). This holds true when we include loan loss provisions, so it’s not simply a function of better credit quality at the top end. In other words, Bank of Surprise’s very best RMs do a great job of discounting loan pricing strategically in order to grow their overall portfolio sizes. That trend reverses at the bottom end of the RM scale, as spreads deteriorate quickly, showing that the least profitable RMs are underpricing loans and NOT generating volume with the discounts.
Prescription
To summarize, Bank of Surprise is a profitable and well-run bank, but the commercial bank has been generating the majority of its income from deposits. And now, with the glut of deposits that have arrived throughout the industry over the last year, generating big deposit balances is not the differentiator it used to be. The bank needs to find ways to maximize profitability beyond their deposit book. These are a few of our suggestions.
Get Better at Measuring Cross Sell
You may have noticed we didn’t focus much on fee income in our analysis of Bank of Surprise. That’s because the bank can’t provide the data.
This is actually a shockingly common scenario. Our clients tell us cross selling and generating fee income are a TOP PRIORITY throughout the bank, and that they want to focus attention there inside of the PrecisionLender platform. But when we ask questions about current performance, they shrug their shoulders. They aren’t measuring it very well, because the data is buried inside too many different systems. They feel it’s an impossible problem to solve.
It’s not.
We have plenty of banks that have overcome this challenge and can compile non-interest income by client from all the various systems. These are banks of all sizes, using all the major core systems. There’s really no excuse for not removing these silos. If you want to cross sell effectively, you MUST be able to measure how you’re doing. It is worth investing in, especially for an institution like Bank of Surprise, with so many large deposit accounts and so much focus on cash management.
Once banks have that visibility, they can move on to honing in on tactics that improve cross sell rates and follow through.
Adjust Profitability Hurdles by Segment
As we’ve noted, Bank of Surprise has some very different kinds of customers. They have some typical loan-only real estate borrowers, and they have some deposit-only customers with massive balances. The top RMs are figuring out how to reduce loan spreads in order to generate volume, but this is clearly not a universal winning strategy. Rather than setting global profitability and spread guidance, Bank of Suprise should be much more granular by customer profile (current balances, growth potential, industry) and by RM (require additional sign offs from bottom performers but NOT top performers).
Run Off Bottom Quartile Deposits
Over the last several years, RMs have been pushed to aggressively cross sell deposits. That is no longer necessary for Bank of Surprise. They should absolutely continue that strategy for certain customer types (see segmentation point above), and even consider doubling down on their clear success with financial customers. However, the bottom quartile of customers carries $1.7 billion in deposits that barely break even using an FTP methodology. In reality, many of those deposits that cost 0.75% are sitting in fed funds and bleeding red ink.
Bank of Surprise should revisit their standard commercial deposit pricing and be willing to continue paying up for the best accounts but let some of the other balances roll off. This is especially true since that same quartile has by far the least profitable loans. Profits would actually improve if some of these customers walked out the door.
See Anything Familiar?
Chances are you may have seen a little of your bank in the story we just told. If not, you’ll likely come across an issue that hits close to home at some point in our series.
If you’re looking to make some improvements on the relationship profitability front (and really what bank isn’t?) you should attend our upcoming webinar on the topic. We’ll walk through common problems we’ve seen and how PrecisionLender’s platform can help you solve them.
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