What Are the Ingredients of an Extraordinary Bank?

January 30th, 2018

strategy-1-30-18.pngHow do you run an extraordinary bank? If there was a common theme on the second day of Bank Director’s Acquire or Be Acquired conference in Phoenix, Arizona, it was a focus on the secret sauce that enables certain banks to outperform the rest of the industry.

One of the day’s first sessions dug into the stories behind a group of emerging regional banking champions—public banks, where at least 15 percent of their total assets comes from acquisitions made over the past five years. The efficiency ratios of these banks are lower than their peers, meaning that they spend a smaller share of net revenue on operating expenses. These banks are also more profitable, reporting higher returns on assets. Not coincidentally, analysts expect these banks to grow their earnings per share at a faster pace than other banks in the years ahead.

The emerging regional champions benefit from economies of scale, which is reflected in higher stock valuations. If you look at all major public banks nationwide within different asset ranges, there is a consistent increase in the future price-to-earnings ratio as you step up in size. The average ratio for banks with less than $5 billion in assets is 12.9 times future earnings, according to S&P Global Market Intelligence. That increases to 13.4 for banks between $5 billion and $10 billion in assets and 14.4 for banks with between $50 billion and $100 billion.

The one exception to this trend is the country’s biggest banks, noted Scott Anderson and Joe Berry of Keefe, Bruyette & Woods. The forward price-to-earnings ratio drops to 12.7 for banks with between $100 billion and $250 billion in assets, and it falls to 12.4 for banks above $250 billion. It is not hard to understand why this is the case, given that the current regulatory framework imposes heavier compliance and capital burdens on the biggest banks. Just as importantly, JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. each exceed the statutory limit of 10 percent of domestic deposits, which precludes any more acquisitions by these historically acquisitive institutions as part of a growth strategy.

But even though a bigger size still offers benefits to regional banks, it should not be seen as an end in itself. This is not a return to the 1990s, in other words, when the driving force in the industry was bigger is better. “We have never grown our bank just to reach a certain size,” explained David Zalman, chairman and CEO of Prosperity Bancshares, which is based in Houston, Texas and has grown from $335 million in assets two decades ago to $23 billion today. “Our focus has instead always been on increasing our earnings per share.”

Zalman underscored this point by explaining that Prosperity has built its bank on three principles: asset quality, efficiency and deposits. “We believe core deposits are more important than loans” when it comes to identifying banks to buy, he explained. Two other core qualities Zalman looks for in potential acquisition targets are large inside ownership stakes by executives at the acquisition target as well as a cultural match. “When you do a deal, you need to get in deep, get to know the culture and the people and figure out if they want to do the deal. Don’t just negotiate with the CEO,” said Zalman.

This theme was echoed by John Asbury, the CEO of Richmond, Virginia-based Union Bankshares Corp., which has grown from $2.3 billion in assets to $12.2 billion over the past decade. “You have to be careful about mergers of equals,” Asbury says, pointing to the cultural issues that can arise when putting together similarly sized banks. “Culture is the key.”

“Really getting to know a company before you buy it is critical,” agreed Robert Sarver, chairman and CEO of Western Alliance Bancorp., a $20.3 billion bank based in Phoenix, Arizona that has posted organic annual growth of between $1.5 billion and $3 billion in total assets in each of the past three years. “Determining if it will be the right fit is more important than the numbers. You have to have total transparency about what everyone is getting into. There can’t be expectations that are off base.”

Similar themes came up later in the day in a breakout session on the characteristics of top-performing community banks, presided over by Bill Walton, a partner at the law firm Dixon Hughes Goodman LLP, and Tom Broughton, CEO of ServisFirst Banchshares, a $7.1 billion bank based in Birmingham, Alabama. The session revolved around Dixon Hughes Goodman’s recent study of 22 CEOs of high-performing community banks with between approximately $400 million and $7 billion in assets. Relative to their peers, the banks in the study tend to be twice as profitable, experience meaningfully lower loan losses and have efficiency ratios that are 20 percent below similarly sized banks.

These top-performing community banks did not conform to a single archetype, falling instead into three different buckets. Some are full-service community banks delivering a range of financial products and services to consumers and businesses. Others are focused on building and maintaining deep and profitable relationships with small to middle-market businesses. The final group focused on niches in their respective markets, giving them pricing power stemming from a paucity of competition.

Despite these differences, the one thing that all of these top-performing community banks share is an intense focus on talent. “Top-performing community banks are built on top-performing people,” said Walton. “These people are in empowered and accountable situations grounded in decentralized decision-making.” To this end, while all of these banks are efficient operators, they don’t cut corners when it comes to compensation. In fact, just the opposite is true. Compensation at the top-performing community banks tends to be above-market, noted Walton, probably as a consequence of the experience of their bankers.

“It really does come down to the talent,” said Walton. “Both who they are, how they’re trained, how they’re compensated and how they’re managed.”

jmaxfield

John J. Maxfield is the executive editor for Bank Director magazine.