Financial Profiles of High-performing Community Banks
By Paul McAdam, SVP, Research and Thought Leadership
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In my recent articles I’ve explored various facets of community bank performance, mainly based on the characteristics of their customer bases. This month’s article profiles high-performing community banking organizations and specifically examines the financial metrics that differentiate the elite performers from the rest of the pack.
Industry Profitability Rebounding, but Not as Much for Smaller Banks
After a couple of very tough years, banking industry profitability rebounded nicely in 2010 and 2011 (see Figure 1). The positive upward trend continued in 2012 as the FDIC recently announced that first quarter commercial bank profits topped $35 billion. If this momentum holds, the industry will generate full-year 2012 profits of approximately $140 billion – nearly on par with record industry profits attained in 2006.
But a thorough examination of this industry data reveals that a swelling portion of post-recession profits have been generated by the largest U.S. banks. Pre-recession, the top 10 banks generated an increasing share of industry profits, peaking at 53 percent in 2007. What you don’t see in this chart is that in 2008 and 2009 the top 10 banks remained profitable as a group – albeit barely – while the banks below the top 10 collectively lost money. As the economy improved, the share of industry profits generated by the top 10 accelerated to 70 percent in 2010 and moderated to 63 percent in 2011. Conversely, from 2004 − 2007, banks with assets of less than $1 billion generated 11 percent of industry profits on average. In 2011 they generated only 6 percent.
While the profitability of community banks (assets of less than $1 billion) as a whole certainly improved post-recession, their average return on assets (ROA) has not rebounded as significantly as that of larger banks with assets exceeding $1 billion (Figure 2). In contrast, the average ROA of community banks fell just short of larger banks’ average ROA pre-recession and slightly exceeded it during the downturn from 2007 – 2009. So, industry profit dynamics have clearly shifted. The question is whether the shift will be permanent.
We see a similar pattern for efficiency ratios. The gap between community and larger banks was fairly constant through 2007 at 7 − 9 percentage points (Figure 2). The efficiency ratio gap widened during the recession to 20 percentage points in 2009 as the revenue-generating efficiency ratio of community banks declined while that of the larger banks actually improved for a couple years. Post-recession, the efficiency ratio gap between community and large banks remains wider than it was pre-recession.
High-performance Community Banks
While the financial rebound of the community bank market has lagged, it is absolutely possible for smaller banks to outperform the market as shown through extensive analysis of an FISTM database derived from eight years of bank Call Report data compiled by SNL Financial. The FIS database includes 4,380 banks with assets of less than $1 billion. We divided community banks into three tiers of performance – high, mid and low performing – based on ROA. The high performers comprise the top 10 percent of community banks based on ROA, the mid performers represent the middle 80 percent, and the low performers represent the bottom 10 percent.
On average, the high performers have consistently achieved an ROA above 2 percent. The mid performers’ average has been in the 1 percent range. The low performers were generating a sub-standard average ROA before the recession, which has been in negative territory since 2008 (Figure 3).
Our analysis examined statistical relationships between roughly two dozen bank financial metrics and ROA during the eight-year period to determine the metrics that are most strongly associated with ROA and did the best job of differentiating high from low performers. Of no surprise, metrics associated with credit quality were most predictive of bank performance. Credit quality can make or break a bank – particularly in the economic environment of the past few years. But beyond credit quality we uncovered several additional metrics that deserve special attention.
Yield on loans is a key differentiator of performance among the three bank segments (Figure 3). On average, all community banks’ loan yields plummeted during the recession, but high performers did a better job of managing their loan portfolios. Analysis revealed several key actions taken by the high performers to preserve loan yield.
- They consistently maintained higher loan pricing.
- They had more-diversified loan portfolios. Higher performers tended to have fewer commercial real estate and construction and land development loans. However, they had consistently higher concentrations in traditional commercial and industrial loans, farm real estate and farm productions loans, and consumer loans. And the high performers were not over weighted in residential real estate.
- High performers were more effective in shifting and rebalancing their loan portfolios as the recession hit – for example shifting out of commercial real estate and into agricultural.
Because of higher loan yields, the high-performing community banks were able to maintain net interest margins 50 − 100 basis points higher than lower-performing community bank peers (Figure 4).
How community banks managed their deposit portfolios was also a key differentiator between high performers and others. As the recession hit, high performers more quickly shifted their mix of deposits into core deposits and DDA balances. This effective management of deposit interest expense helped them maintain an impressive NIM in the face of declining loan yields.
As you can see in the Operating Expense Ratio chart (operating expenses divided by average earning assets) on the right side of Figure 4, high performers did a much better job countering the downward trend in net interest margin and fee income by managing operating expenses. As the recession took hold in 2008, they did an exemplary job of moving quickly to keep expenses under control. In contrast, the operating expense ratios of the low performers climbed as the economy declined.
Figure 5 profiles the 2011 operating expense ratios of the three bank segments. Again, we see that the high performers surpassed their peers across the board in managing expenses. While the differences in the salary and benefits and occupancy and fixed assets expenses of the three segments seem modest at first glance, basis points matter significantly in banking. The typical community bank in our analysis had earning assets of approximately $200 million. At this asset level the 16 basis point difference between the high- and mid-performing banks in salary and benefits and occupancy and fixed assets amounts to a $320,000 expense advantage for the high-performing banks.
The category of “Other Operating Expenses” is where high-performing banks gained their clearest advantage. This category includes items such as data processing, telecommunications, marketing and consulting and advisory expenses – and the high-performing banks excelled in managing all of them. But expenses associated with loan collections and real estate owned account for the biggest difference between the segments in this “Other” category. High-performing banks maintained significantly lower loan delinquencies and charge offs and gained additional operating expense advantages as a result.
What’s becomes clear in examining a variety of metrics that separate high performers from their peers is that high-performing banks managed the bank for growth and did not simply try to save their way to prosperity. From 2004 − 2011, the high-performing banks experienced an average annual increase in operating expenses of 3.9 percent while operating expense of the mid-performing banks grew by an average of 3.1 percent.
A Culture of Performance
How did the high-performing community banks consistently accomplish these impressive results? Clearly these companies didn’t perform this well by accident because they performed well across all of the key financial metrics we analyzed. We can assume they have strong leadership and performance-based cultures. But the opportunity we’ve had to speak with executives from high-performing community banks within the FIS client base in recent months provides insights into key drivers of high performance. Such banks are very good at:
- Focusing the entire organization on a highly visible and easy-to-understand strategy
- Driving accountability throughout the organization
- Simultaneously managing multiple challenges
- Formulating timely reactions to changes in customers and competition
- Introducing innovation in response to market demand
- Managing operations that are flexible and able to respond to change quickly
- Maintaining high levels of quality control with less variability in processes
They leveraged these skill sets to overcome persistent challenges facing community banking organizations during the past several years. We can all learn from these institutions.
We’ll continue to explore themes of differentiation and high-performance banking in future newsletter editions. If you have any thoughts or comments regarding bank performance that you’d like to share, you can feel free to contact me at firstname.lastname@example.org.