By S. Scott MacDonald, Ph.D.
The world is rapidly changing and the best bank boards are always looking down the road in an attempt to continually improve and modernize their institutions to serve their communities better. Below, I have outlined a few of the more pressing strategic questions bank boards should be asking.
Prepare for and Continue to be Mindful of Economic Conditions
The economy continues to struggle to get traction. A total lack of fiscal policy and monetary policy that pegs the return to risk at zero are both hindering a full recovery. This has forced the Federal Reserve into heroic and unprecedented measures. They have increased their balance sheet over fourfold, kept short-term rates at near zero for almost six years, and purchased nearly 80 percent of net new issues of mortgage-backed securities using quantitative easing. We all know interest rates must increase “someday.” The question is when is someday and how much will they increase?
Bank boards should be asking, “Do we truly know the degree of interest-rate risk on our books?” Interest rates could increase sooner and faster than we expect, and the banking industry has been reaching up the yield curve by increasing their holdings of longer-term assets, in particular, mortgage-backed securities. Don’t feel alone; the Fed is the worst offender. In a recent article in the Wall Street Journal, Scott Hein from Texas Tech University argues the Fed would fail its own stress test due to significant interest-rate risk. The Fed is borrowing short-term by paying 25 basis points for bank reserves and investing primarily in longer-term treasuries and mortgage-backed securities, similar to many savings and loans in the 1980s. This massive and unprecedented increase in the Fed’s balance sheet will inevitably lead to much higher levels of inflation and a corresponding increase in interest rates. The Fed is unlikely to be able to unwind this gracefully. Don’t do as the Fed does by reaching for yield with longer-term assets. You don’t have a printing press!
Build and Maintain a Superior Balance Sheet
A high quality balance sheet is critically important today. There are many parts to a strong balance sheet: high capital levels; a diversified, high quality portfolio, which is not overweight longer-term, fixed-rate assets; and strong liquidity built on a solid core deposit base and limited noncore borrowings.
Maintain a strong capital base. A strong capital base takes into consideration the regulatory environment, the strength of the bank’s balance sheet and the board of directors’ risk appetite. Capital is needed to meet regulatory requirements, but, more importantly, to support the strategic direction of the institution. Regulators look to capital as one of the indicators the board and management fully understand the level of risk the bank has assumed and is prepared if everything does not go as planned.
The second purpose of a strong capital position is strategic. The more risk the institution assumes the greater levels of capital needed or are expected by regulators. Those institutions with the greatest growth or acquisitions opportunities in their future need additional capital. Institutions with concentrations in loans, products, geographic areas or other income sources, might warrant additional capital to support these activities as well. Bank boards should ask, “Do we have sufficient capital to support our strategic objectives?”
Finally, having sufficient capital today might not be enough. The last thing you want to do is start looking for capital after you actually need it! Bank boards should also ask, “What would we do if we needed to raise capital?” Develop a contingency capital plan by working from the inside out. Start inside the board room: If the bank had an opportunity or was in need of additional capital, would you be willing to contribute additional capital? If the answer is not as positive as you hope, you must determine what you are not doing correctly to make it attractive to your own board and management? Then look outside the board room. “Where could we raise additional capital if needed?”
Maintain a high quality diversified portfolio. Be mindful of all concentrations, whether they be in loan types, asset maturities, products, geographic areas and even people. One problem we face in diversifying our portfolio is the tools in our tool belt. If we only have one tool, a hammer, all problems look like nails. Diversification out of real-estate loans, for example, often requires retooling. If our loan officers are primarily real-estate lenders, asking them to start making cattle loans might be a stretch! We must either retrain or retool to maximize their productivity. Diversification of loan types, products and geographic areas is also an opportunity to expand our reach into new markets by employing new talent with new skills. Bank boards should ask, “Do we have the right talent in the right places to fulfil our vision for the future?”
Strong liquidity. A solid core deposit base with limited noncore borrowings are the building blocks to strong liquidity. Similar to capital, you don’t want to start looking for liquidity after you need it. Today, our ability to grow is no longer limited to our ability to grow core deposits. Banks have many more funding sources available to fund growth, e.g., noncore borrowings. But those same funding sources represent contingent liquidity sources that once used, are no longer available as liquidity sources. In fact, many of the recent bank failures were due to an over dependence on noncore borrowings. Today’s low interest rates mean brokerage companies’ money market accounts are less attractive and have left many community banks flush with deposits. As interest rates begin to increase, however, returns offered by the brokerage houses will improve and put pressure on banks’ deposit sources and with it, potential liquidity needs. Bank boards should ask, “As interest rates increase and loan demand picks up, will we have sufficient liquidity?”
Build and Maintain a Strong Management Team
Most community banks view their people as their single greatest asset. Community banks are in the relationship banking business rather than the transactional banking business. Community banks develop and nurture their relationships with customers to provide superior financial services. Building and maintaining a strong management team is central to this approach. To be the best, we have to train our staff to be the best. The staff in a community bank often wears many hats and must be able to contribute in many areas. Bank boards should ask, “Do we have a high quality training program that supports our staff in being the best providers of superior financial services?”
But building a strong management team is still not enough. We must retain them and prepare for succession. Community banks have historically suffered from a future talent gap at the top, but it is more severe this time. Some of our best and brightest are the aging baby boomers and there is a smaller and smaller population of qualified folks coming up the ranks. What is the solution? Train and develop it. Find it externally. Buy it. Or sell into it. Training and developing young staff is typically preferred, but this can be years in the making. Opportunistic hires as well as acquisitions of other institutions or teams are more immediate, but more costly and could dilute the bank’s culture. Bank boards should ask, “What is our long-term plan for succession?” Without a viable long-term succession plan, the board should ask the very difficult question, “Will we maximize the value of the bank by exiting the business?”
Prepare for and Continue to be Mindful of New Regulatory and Compliance Requirements
We must continue to change the regulatory environment as we can. However, this new environment is here to stay for a while. We must build a new banking model that not only accepts the new environment, but also can be successful in it. Know when to hold ‘em, know when to fold ‘em, know when to walk away and know when to run! Train your staff extensively. Create a culture that makes regulatory compliance everyone’s job.
Embrace New Technology
The bank’s technology will make the difference between a successful and less successful company. “But this time it is different” is a familiar refrain. During the past half-decade we spent much of our efforts playing defense while technology moved on at a dizzying pace. One only needs to visit a Nordstrom’s or Starbuck’s to see the progress made in America’s payment system. Many retailers no longer use expensive cash registers which require you to go to the counter to check out. They now come to you in the middle of the store with a $600 iPhone. At Starbuck’s you can pay for coffee using your iPhone and a QR code. No money needed. With all this new technology, bank boards should ask, “Do we have all the technology we need, or have we fallen behind?” Employ all the new technology you can and eliminate the perceived “large bank technology advantage.” It’s much less expensive than it used to be. Then hand your customers your business card with your cell phone number on it! Let them know you are their financial consultant, available 24/7!
Re-evaluate and Modernize the Branching Model
Branch banking has been the lifeblood of many institutions over the past two decades. When moving into a new market, the branch was often seen as the only viable means of announcing our arrival. Today, however, the expense and low returns to the brick-and-mortar branch require a re-evaluation of this long-time method of delivering services. Many banks have too many branches, or they are too large, or in the wrong location. Just as we have been slow to adopt new technology we have been slow to adopt new methods of delivering services. Bank boards should be asking, “Is our branching strategy appropriate going forward?” “Are our branches the appropriate size and in the correct locations?”
The role of the brick-and-mortar branch will change dramatically in the next decade. The airlines, for example, have a well-orchestrated push to reduce costs by guiding passengers to “self-serve” using ticketing kiosks. Ditto grocery stores, gas stations, automobile insurance and Internet shopping. Banks have resisted and held fast to expensive structures to provide the most common banking services. Smart ATM machines, like ticketing kiosks, allow for smaller branches and fewer staff. Teach your customers to self-serve with technology. I hated the airline kiosk a few years back, now I often choose it over a ticketing agent! The branch bank is not dead. It just needs to be modernized for the new technology age.
Controlling Noninterest Expense
Controlling costs must be a strategic objective, not a once-a-year exercise. Improving earnings is not just about generating more income, but also about controlling or reducing expenses. Bank boards should ask, “Do we have a strategic cost-control program?” Surprisingly, many don’t. Employees fear the words “cost control.” Yet, staff is often the best resource for controlling overhead. Ask them to involve their entire departments. Create incentives for great ideas. If our people are the best, let them dazzle us with their ability to contribute!
Generating Noninterest Income
Larger banks generate almost twice as much noninterest income to total assets as smaller institutions. This is often due to staff being unfamiliar with the products the bank offers, rather than not charging fees. Bank boards should ask, “Do we have the all the products we need? Is the staff knowledgeable about them? Are they priced correctly?” For community banks, it’s not about fees. Fees are a bad word to customers, yet we are the guiltiest in promoting this. When was the last time you paid a FEE for a nice steak dinner? Hopefully, the price paid was commensurate with its value. It’s not about charging fees. It’s about delivering superior financial solutions at a reasonable price. The real opportunity comes from offering dessert with the steak dinner. That is, do we offer all the products our customers might want or need? Does our staff even know there’s a dessert menu?
Boards spend a good deal of time looking in the rear view mirror, looking over historical financials. But the real questions bank boards should be asking are the strategic ones. The best boards spend their time looking out the front windshield determining where we are going rather than where we have been!
S. Scott MacDonald, Ph.D. is President and CEO, SW Graduate School of Banking Foundation, Director, Assemblies for Bank Directors, and Adjunct Professor, Edwin L. Cox School of Business, Southern Methodist University, email@example.com.