Banks measure all sorts of key performance indicators; which are the ones that show the strongest connection to how these institutions are valued? Jeff Marsico of The Kafafian Group joined the Purposeful Banker podcast to talk about his articles on this topic, and what he found.
Helpful Links
For Financial Institutions, What Drives Value? (Part 1)
For Financial Institutions, What Drives Value? (Part 2)
Rethinking What Commercial Banks Measure
Innovate With an Eye Toward Revenue
Podcast Transcription
Jim Young: Hi and welcome to The Purposeful Banker, the podcast brought to you by Precision Lender, where we discuss the big topics on the minds of today's best bankers. I'm your host Jim Young Director, of Communications at Precision Lender and I'm joined today by Jeff Marsico. Jeff is the EVP of Bank Strategy, Profitability and M&A for The Kafafian Group.
The Kafafian Group is a finance strategy and operations consulting firm that works with community banks across the country. Jeff is also, in his spare time, a blogger. He posts his thoughts on hit site, Jeff For Banks. You may recall we had Jeff on earlier this year for the episode titled Commercial Banks: Set Your Strategy, Target Your Customers, Then Execute.
This time we're going to talk about two recent posts Jeff wrote titled Financial Institutions, What Drives Value. We'll have links to those pieces in our show notes as always.
So Jeff, first, thanks for coming back on the show.
Jeff Marsico: Hey, Jim. Good to be back.
Jim Young: Hope I got all the descriptions of you and the many hats you wear correct during the intro.
Jeff Marsico: Yeah, you don't want to overplay it because it starts to get too long.
Jim Young: All right. Well, let's start with some context on these two pieces. What was it that prompted you to sit down and write them?
Jeff Marsico: Just like folks at Precision Lender we go to a lot of banking conferences and as part of that ... I mean, certainly, we're there to meet and discuss and exchange ideas with bankers, but I love going to those education sessions, because trade associations are usually really good about keeping them very educational and germane to the topics of the day.
One such conference I went to, I think the might have been the Financial Managers Society, had a Performance Trust person, Performance Trust based in Chicago, and their topic was what drives value and they did some analytics.
First they did a survey of their customer base and Performance Trust specializes in investment portfolio management and things of those items for financial institutions. They asked their clients, what are the generally accepted drivers of institutional value and their responses came back loan to deposit ratios, investment portfolio sizes, net interest margin, efficiency ratios, things of that nature that you would expect to get from their customer base.
So I thought that was a very interesting topic and when I go and attend these sessions, I always say, "Hey, that'd be a great blog post," and that's how I got it.
Jim Young: I just want to clarify here. When we say value here, are we talking about publicly traded banks and shareholder value?
Jeff Marsico: Yeah, we are, but the vast majority of financial institutions in the United States are not publicly traded.
Jim Young: Right.
Jeff Marsico: But since there are so many that are publicly traded, you can use it if you're not publicly traded, let's say Kentucky Bank, what do stakeholders value in a financial institution, and use how publicly traded institutions are traded based on the characteristics of their balance sheet or the profitability. So even though it measures trading multiples of publicly traded financial institutions, certainly, non publicly traded could use that information to say, "Hey, this is what people think are valuable in a financial institution."
Jim Young: Got it. Okay. Let's focus first on part one, which you wrote back in September, and you alluded to this just a little bit, but tell us about the metrics you looked at in this particular post, and why you chose them.
Jeff Marsico: Yeah, so there were a whole bunch of metrics that the Performance Trust folks use, and one of them was a relative investment portfolio size. I didn't think that to be particularly interesting, and that might have been because of their specialty in what they do.
And then they had return on average tangible equity, even though I think return on equity is a very important metric, return on average tangible equity, or ROTE, is, you eliminate the intangible assets that you put on, normally through paying premiums for other financial institutions. So it's more of an investment community type ratio. I would be more interested if it was simply return on equity but they did have return on assets and a proxy for profitability, efficiency ratio, net interest margin, asset size, capitalization.
All of these were very interesting to me to see how investors put multiples on financial institutions based on correlation with these ratios. So I thought that some were interesting, some were not and I talked about the more interesting ones in the blog post.
Jim Young: Okay. What were the ones that interested you the most. In terms of your findings when you did this and kind of created those very pretty charts in your post, what interested you the most and what you found and was there anything in there that was unexpected to you or maybe counterintuitive?
Jeff Marsico: Yeah, I thought, for example, the ones that I thought were most interesting were capitalization, their study on capitalization where you achieved higher priced tangible book multiples in the marketplace up to a certain capitalization point meaning tangible common equity to tangible assets.
If you were right around the nine percent area that cohort generally received the higher trading multiples. Then they started going down as banks got over the nine percent trading multiple. In other words, investors thought there was too much capital in the financial institutions and we're not gonna pay premiums for having that excess capital.
So up to a point, there was a correlation in trading multiples for tangible common equity and tangible assets after that point, which was nine percent, there was a decline. So I thought that was pretty interesting.
Very similar, you saw the same in loan to deposit ratio. Since the 2014 the loan growth in the United States has exceeded deposit growth in the United States and therefore, loan to deposit ratios have been on the upswing. This has been helping banks net interest margins, but it also has been reducing the banks liquidity.
So similar to the capitalization ratio, up to a certain point investors awarded higher price to tangible book multiples for having a higher loan to deposit ratios. In other words, those banks in the 70 to 80 percent loan to deposit ratio received the highest price to tangible book ratios in the market. So those were the two most interesting.
Others I think you might expect to see a positive correlation in trading multiples is in the profitability, the return on average assets, the higher the return on average assets the higher the price to tangible book ratios. That was pretty linear. Efficiency ratio, very similar. The lower the efficiency ratio, which is how much an operating expense it takes to generate a dollar of revenue. So the lower the better. The lower the efficiency ratio the higher the price to tangible book multiples.
And then one I've written on on several occasions and spoke to a lot of bankers about, the asset size. There's a positive correlation between the size of the financial institution and the price to tangible book ratios. That one is pretty intuitive, there are multiple reasons for it. One is the preponderance of institutional investors that now invest in financial institutions.
Generally two thirds of the share ownership of financial institutions are owned by institutional investors. Those investors like to see a lot of trading volume in stock. A lot of liquidity in the stock. So they can not only get into it efficiently but also get out of it efficiently. So they tend to look for larger financial institutions and therefore you end up pricing up the trading multiples of those institutions. We always knew there was a correlation between the size of the institution and the trading multiples it traded at. This is just another data point that proves the point.
Jim Young: Going back to the tangible common equity and tangible assets and then the loan to deposit ratio ones. So there's that sort of, you kind of mentioned that sweet spot. You get up to a certain point and then you get past it and the value starts to drop. Was that sweet spot for each about where you thought it would be? And is there sort of a lesson that you derive from that if you're a bank looking at those numbers?
Jeff Marsico: Well yeah. I think there's a lesson in that liquidity remains important and the more liquid the bank in a rising rate environment the less likely the bank is to engage in hot rate promotion that drives up their cost of funds.
So if you're liquidity is all used up in a rising rate environment then you tend to be more anxious for funding and you're the one that tends to run that seven month or that 13 month CD special in the local paper. So I think that having a little bit of a war chest of liquidity to fund a growing loan book is important to investors. I was surprised it was in the 70 to 80 percent, I thought it might be somewhere in the 80's even in the upper 80's because liquidity management is much more sophisticated today than it was back in the last rising rate environment of 2004 to 2006.
There's a lot more avenues that banks can use, a lot more levers that they can press to get more liquidity. So I was surprised that it was in the 70 to 80 percent as the sweet spot. I would think it would be in the 80 to 90 percent.
Jim Young: If I'm understanding it correctly, and keep in mind this is the non banker asking the question, you mentioned about liquidity but there's also a little bit of a penalty, investors don't want to see backs that are essentially hoarding what they've got either?
Jeff Marsico: Yeah, correct. If you look at the very largest financial institutions in the United States I think JP Morgan might be in the 60's loan to deposit ratio. So we have extreme bar belling in the United States in terms of who owns the assets in the banking industry. So you look at the very largest financial institutions, they tend to be on the lower end of the loan to deposit ratio where you'll see more community financial institutions tend to be on the higher end.
Jim Young: Right. Okay. So let's go on to that second post that you wrote in October. What prompted you to go and revisit this topic?
Jeff Marsico: I get comments in my blog and another bank consultant based in Kansas City, Missouri asked me what do you think is the correlation to free funds, in other words non interest bearing deposits. And I took a look at transactions accounts as a percent of total deposits to see if there was a correlation in place to tangible book ratios based on who had the best, or the highest proportion of checking accounts to the lower proportion.
And as you might expect, there was a correlation there, so I took a look at all financial institutions that were publicly traded, I eliminated some that were having asset quality problems and the like and had very low trading volumes because those tend to trade inefficiently.
Once I got through those filters, I separated these financial institutions into quartiles. With the top quartile being the ones that had the most proportion of checking to total deposits and the bottom being the least. And the least quartile of checking to total deposits had about 25 percent checking to total deposits on average and they were trading at about 145 percent price to tangible book. And the top quartile had about a 57 percent checking to total deposit. That's a pretty high number and it's a quartile, it's a cohort, and they were trading at 208 percent price to tangible book and the line is linear.
So shareholders do reward higher proportion checking or core deposit banks as opposite to lower proportion core deposit banks.
Jim Young: Tell me again, why checking accounts, in terms of deposits, why was that the metric you were looking at?
Jeff Marsico: It's the hardest account to get.
Jim Young: Okay.
Jeff Marsico: It has the longest sales pipeline. If you have a commercial real estate loan that you're trying to fund a four million dollar commercial real estate loan that you're trying to find, absent anything else going on in your balance sheet, any flow going on in your balance sheet, you just wanna fund that with core business checking accounts. You need 100 of those accounts with an average balance of about forty thousand bucks. You need 100 of those accounts to fund one four million dollar deal.
If you turn and look at your clients and Precision Lender or our clients at the Kafafian Group and say which is harder to do to get that four million dollar CRE deal or to get 100 new business checking accounts. You'll always get 100 net new business checking accounts. So any business model that is difficult to replicate tends to get higher trading multiples and that's a lesson learned if you're publicly traded or not.
Jim Young: Alright, see we've gone through all the numbers in there so, putting your consultant hat on, what would you tell, based off of the numbers that you've got there, what would you tell a client bank that it should focus on? Again, assuming the goal here is greater shareholder value.
Jeff Marsico: It's never a bad time to raise core deposits. So back in 2012 when banks were awash in liquidity and you had the CFO's of the bank saying don't bring me anymore deposits because I don't have any place to put them. That's the time to go and get those deposits. Even though your CFO might be like, oh we have too much liquidity here.
The reason why is the sales pipeline to get those deposits is far longer than the sales pipeline to get those loans. And that's where a lot of community financial institutions find them today is their loan to deposit ratios are nearing 100 and their liquidity ratio's going down and they're saying, hey we gotta go out now and get core deposits. Well that pipeline is much longer. If you were thinking that back in 2012, 2013, you would have those deposits in the house to fund those deposits. It's too late if you're thinking about funding next months or next quarters loan pipeline with core deposits because the sales pipeline is much longer.
Jim Young: Anything else you wanted to point out from these pieces? It's really, again, I wanna make sure our listeners check out your blog, Jeff For Banks, 'cause it's very conversational and it's written in this, hey this is something I was thinking about so I'm going to write a blog post about it. So it's a really enjoyable read. But anything else you wanted to point out from this piece?
Jeff Marsico: Yeah. I think it's important to note that there's greater transparency in deposit pricing these days. So if banks are gonna build a cost of funds advantage, I think the days of running rate promotions and then pulling back on them, it's going to run out.
In other words, it's a lot easier for me to look up what a Goldman Sachs Marcus account is offering and it's a lot easier for me to transfer funds into a Goldman Sachs Marcus account than it was 12 years ago in the last rising rate environment. So if banks are gonna build a cost of funds advantage, which time after time we see investors reward banks with higher multiples for it, they're gonna have to do it based on the mix of their deposits, not based on how savvy they are with moving rates from here to there.
Jim Young: Alright. Well that'll do it for this weeks show. Jeff, again thanks so much for coming back on.
Jeff Marsico: Thanks for having me.
Jim Young: Alright. And a reminder, you can find his work at Jeff For Banks, that's the name of it, just enter that into Google search and you'll come right across it. Again, we'll have the link in the show notes. And again, when Jeff is not blogging he is working hard for the Kafafian Group.
Now for a couple more self serving reminders, if you wanna listen to more podcasts or check out more of our content you can visit our resource page at Precision Lender dot com. Or you can just head over to our homepage to learn more about the company behind the content. Finally, if you like what you've been hearing, make sure to subscribe to the feed in iTunes, SoundCloud, google play, et cetera. We love to get ratings and feedback on any of those platforms. Until next time, this has been Jim Young for Jeff Marsico and you've been listening to Purposeful Banker.
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