Betting on Tech

When Greg Carmichael walks into a room at Fifth Third Bancorp’s Cincinnati headquarters dressed in a blue suit with white shirt and tie, he looks like a banker rather than an IT guy. He is both, actually. Carmichael has worked for Fifth Third for 13 years, rotating through a series of high level positions at the bank. But he’s a technology guy by education and by training, with a bachelor’s degree in computer science, having joined Fifth Third in 2003 as the bank’s chief information officer after holding similar positions at Emerson Electric and General Electric.

The move to make Greg Carmichael president and CEO of the $142 billion asset institution is a sign of the times. It’s not just that banks have to adapt amid enormous change in customer expectations, but they have to make smart decisions about where to invest in the midst of slow economic growth and tight margins. And at Fifth Third, the board of directors has decided that the 53-year-old Carmichael is their man. “Technology is obviously part of Greg’s background, but only one of the factors that has shaped him into the leader he is today,” wrote Marsha Williams, the non-executive board chair, via email. Still, she added, “We believe that Greg has unique skills and experience, which are highly applicable to the evaluation of potential investments, especially in the fintech space.”

Carmichael, who became CEO in November 2015, will have a lot of work to do transforming his bank. Fifth Third plans to spend an additional $60 million this year on technology upgrades. It increased spending last year by $75 million on compliance and risk, much of it by adding 373 employees in those areas, while reducing staff in other areas. It tried to cut spending by exiting markets where it didn’t have a strong market share, like St. Louis and Pittsburgh, while offering early retirement packages to employees in other parts of the bank. Still, despite those efforts, Sandler O’Neill + Partners analyst Scott Siefers estimates Fifth Third’s costs will go up 5 percent this year, while its revenue growth will lag behind at just 2 percent, giving it negative operating leverage. Carmichael says the unfortunate math is a temporary issue, as the investments need to be made now to improve efficiency and growth in the years ahead.

“Technology has been a big driver in manufacturing for the last 30 years in taking costs out,” says Carmichael, who knows the lingo of manufacturing, terms such as supply chain management, Six Sigma and just-in-time inventory. “It hasn’t been as big a player in the transformation of financial services.”

But investors are waiting to see some results from all this spending: Total returns as of mid-May have underperformed regional U.S. banks in the last three and five years, according to Chicago-based independent research firm Morningstar. As of mid-May, Fifth Third was trading close to book value, in contrast to the late 1990s, when it traded at five times book value. After years as a top performer before the financial crisis, Fifth Third has weathered the crisis with a reputation as a solid, cost-efficient bank, but not as a top performing one. Will Carmichael be able to change that?

Understanding where Fifth Third is now requires understanding where it’s been. Fifth Third was one of the top performing banks in the nation in the 1990s. (The bank took on its unusual name when Third National Bank and Fifth National Bank merged in 1908.) Under CEO George Schaefer, a West Point graduate who served in Vietnam (and had a degree in nuclear engineering), the bank took on a hard-charging sales culture. Schaefer was known as a penny pincher, and a reporter once described his office furniture not as antique, but shopworn. At the same time, Schaefer made a series of bank acquisitions that were highly accretive to earnings, including Old Kent Financial Corp. in 2000, which added $30 billion in assets to the balance sheet. Before closing on any deal, Schaefer asked managers to come up with 40 different ways to trim costs, one executive told the Cincinnati Enquirer in 2001.

This philosophy has paid off to this day, according to Chief Strategy Officer Tim Spence. While other banks ended up with three to four banking platforms after multiple acquisitions, Fifth Third combined technology and operations after its acquisitions to save costs. Today, when the bank needs to do an upgrade, it doesn’t have to accommodate three to four different banking platforms, which could cost three to four times as much. “It’s an underappreciated asset, having good discipline for the last 20 years,” Spence says. “It’s a source of differentiation.”

Kevin Kabat replaced Schaefer in 2007 as chief executive officer and cleaned up bad loans from a period of aggressive growth in commercial real estate before the crisis. Between 2008 and 2010, the bank booked $9.2 billion in loan provision expenses, according to Morningstar. Kabat eventually righted the ship, improving asset quality and raising capital. Part of the strategy to build capital was selling off an extremely successful payment processing business that Fifth Third had developed in-house, now called Vantiv, which it spun off through an initial public offering in 2012.

The bank’s continued ownership stake in Vantiv contributed nicely to returns in 2015, including a $331 million gain on the sale of Vantiv stock. That helped Fifth Third become the top ranked bank in the $50 billion plus asset category in Bank Director’s 2016 Bank Performance Scorecard, with a return on average assets of 1.26 percent and a return on average equity of 11.14 percent.

Some analysts discount that performance, saying it was the result of a one-time gain and did not accurately reflect the bank’s underlying profitability. Marty Mosby, the director of bank and equity strategies for broker/dealer Vining Sparks, says Fifth Third’s profitability has slipped in recent years. Net income fell from $361 million in the first quarter of 2015 to $327 million in the first quarter of this year, when it reported an 8.3 percent return on average equity and .93 percent return on average assets-well off its performance for full year 2015. “It hasn’t been able to generate a lot of momentum over the last couple of years,” Mosby says. “The low-cost strategy that they have embarked on has run its course. Now what’s happening is competitors have been investing in new products and services and rolling out new ways to digitize transactions. The part about being a low-cost provider is sometimes that technology can put you behind the curve.”

Greg Carmichael is meeting this criticism head-on. For starters, he’s perplexed that the bank hasn’t gotten credit for the Vantiv sale. “It’s a very important franchise for us that we built and birthed and IPO’d and sometimes, I don’t think we get strategic credit for that,” he says. Other than the development of Vantiv, he admits the bank is playing “catch up” when it comes to investments in technology, partly because the recession forced the bank to focus on credit and capital issues. “When you don’t spend money, there is a backlog of work that needs to get done,” he says. “The challenges are how to grow the franchise and reposition the franchise to serve our customers in the way they want to be served, which is more of a digital infrastructure.”

Ten years ago, according to Carmichael, 80 percent of transactions were handled in a branch. Today, it’s 20 percent. The bank was on track to close more than 100 branches within the last year, and has begun building branches that are a fraction of the previous size, which typically spanned 4,200 square feet versus new builds of 800 or 1,200 square feet today. Personal bankers have replaced tellers, and they can do the teller’s job as well as open accounts and take care of problems at the same time. “Branches are still important,” says Carmichael, who notes that proximity to a branch is still the number one reason people pick a bank. “But the size and number of branches you need are very different.”

The bank has rolled out smart ATMs that have video screens in case customers need help from a staffer, and it’s testing a new branch design that would allow 24-hour access to advisors or mortgage lenders via video screen. Fifth Third is in the process of digitizing its entire mortgage platform and making the customer experience seamless between mobile, online and the branches. Another investment is simplifying the account opening process by automating anti-money laundering procedures, which are needed to comply with federal know-your-customer rules. The bank also has recently installed check capture technology inside the branches, to eliminate the need for couriers to go back and forth with all that paperwork.

“We are pushing through to make the investments we need to be successful and get those paybacks quicker,” he says. Carmichael’s philosophy is to never celebrate the rollout of a new technology platform or service, but to celebrate its achievement of business outcomes. If you do roll out a new product or service, you need to make sure the service will be marketed to the right customers and the company’s employees must be trained to talk about it. “We won’t take on any project we can’t execute well,” he says. “We won’t take on anything we don’t think will deliver significant value to our shareholders.”

When Carmichael is considering a new technology, he asks three questions: Does it improve the bank’s ability to serve customers? Does it drive efficiency? Does it create a better experience for customers? “Not every problem needs to be solved with technology,” he says. “But when technology is a solution, what technology do you select? Is it cost efficient? How do you get it in as quickly as possible?” Also, you have to maintain it going forward, and hold management accountable for the business outcomes that result if the technology is deployed correctly.

The $60 million spend this year will be a high watermark. Next year, the technology spending should drop, so overall spending would be roughly $73 million on technology during the next three years, according to a quarterly earnings presentation. Equipment upgrades and products are not the only thing Fifth Third is spending money on. The bank has said it plans to hire 120 information technology staffers this year, so it will have roughly 1,000 total, a 27 percent increase since 2012.

The bank also made some changes at the top of the house, recruiting from outside the world of banking. Carmichael hired Tim Spence last year from consulting firm Oliver Wyman, where he was a senior partner in financial services. At the age of 37, he’s the youngest person in the C-suite at Fifth Third. Reporting to Spence will be Steve D’Amico, who will serve in the new position of chief innovation officer. He was recruited this year from consumer goods manufacturer Proctor & Gamble, where he served as director of design innovation.

Fifth Third doesn’t have an R&D lab with a staff separated from the rest of the bank and dedicated to inventing things, like its competitor U.S. Bancorp does. Nor does Fifth Third have the reputation of being highly innovative, like a BBVA or a Capital One Financial Corp. “We wanted somebody [in hiring Steve D’Amico]… who had a great track record of taking people who were successful business people to begin with, and helping to inculcate the innovation methods, a culture of openness to what’s happening in the outside world and a real discipline about the way you manage the commercialization pipeline,” Spence says. “We want to build innovation into the business lines and be a point of openness to innovation.” Why someone with a design background, instead of a background in IT? Design is more about how people want to live their lives, Spence says. You want to step away from technology for the sake of technology, and say, how does financial services fit into the way people live?

When you listen to Fifth Third executives talk about technology, you get the idea that they are more focused on developing practical solutions to everyday problems than staying on the cutting edge. In that sense, the bank hasn’t strayed far from its no-frills culture under Schaefer. After all, digitizing the mortgage platform or getting rid of couriers probably won’t win many awards. The bank’s mobile device doesn’t have a person-to-person payments feature. Seventy-five percent of banks in the $100 billion asset category and above have a person-to-person payments feature on their mobile apps, according to research firm FI Navigator, which studies mobile applications. The bank’s chief technology officer, Joe Robinson, says existing software on the market doesn’t work well, and the bank is waiting for better options expected in the near future. On the other hand, Fifth Third was one of the first large banks to allow mobile customers to view their account balances before logging in. The service was introduced in June 2014, and roadblocks from vendors to getting it launched led Robinson and others to develop the mobile app in-house. Thirty-nine percent of the bank’s households are using the mobile app, according to the bank.

“We are moving to solve customer problems,” Robinson says. “Everything we do is really focused on driving outcomes. You aren’t going to see a lot of energy that doesn’t connect back to some sort of outcome, even if it’s testing an idea. Some of the programs, there is clarity around what the outcomes are and what you’re trying to accomplish.”

That same conservative approach can be seen in how Fifth Third has transformed its loan portfolio in recent years. With the memory of the financial crisis still fresh, Carmichael is continuing Kabat’s de-risking of the bank. The bank wound down its wholesale mortgage business after the financial crisis, and is reducing its exposure to indirect auto lending. The bank has significantly reduced its exposure to commercial real estate loans, while boosting its core deposit ratio from 67 percent in the fourth quarter of 2007 to 83 percent in the fourth quarter of 2015. The nonperforming asset ratio for portfolio loans has also fallen from 1.10 percent in 2013 to .70 percent in 2015. The goal is to make the bank stronger in case there is another recession.

Of course, investors want to see growth. With interest rates as low as they are, and with the U.S. economy growing at just 2 percent annually, opportunities to grow earnings and revenues have been slim. Carmichael is shifting the focus to where he sees strong growth opportunities and stability, particularly in residential mortgages, C&I lending, wealth management, payment services to commercial clients such as health and retail businesses, and capital markets. He hopes that stability also will lead to more consistency in earnings. During the fourth quarter, Fifth Third announced a $100 million charge off for a loan made in 2007 that was backed by student loan securitizations. “It caused investors to question their story,” says Siefers, the Sandler O’Neill analyst. The securitization market for such loans had dried up, and Carmichael says executives made the decision to take the hit, rather than hold on to the loan, but he admitted that Fifth Third has a history of such inconsistent earnings. “My commitment is that we’re going to change that,” he vows.

Is it time for investors to love this bank again? Ken Usdin, an analyst with investment bank Jefferies, has a buy rating on the stock. He sees past the expenses of 2016 and thinks Fifth Third will regain operating leverage in 2017, with revenue growth outpacing expenses. He thinks the bank has a strong earnings profile and unrealized value in Vantiv, the stock of which it has not completely sold. Mosby estimates the bank has another $1 billion in untapped revenue from selling its remaining stake in Vantiv. “This windfall gives them the chance to emerge on the other side if they do the right things and evolve in a way that’s not wasteful,” he says. Siefers thinks investors will give Carmichael a bit of a chance to invest in the future, realize growth and improve earnings. “This is going to be a pretty telling year for Greg Carmichael,” he says.