The overall earnings outlook for most banks in the coming years is challenging. Examining various aspects of your bank’s strategic plans may help improve your profitability.
Strategic Planning: Re-Examining Your Bank’s Core Profit Model
by Charlie Cameron
Evaluating and reacting to changes in the business operating environment is always a key part of the strategic planning process. Community bankers know all too well that the level of legislative and regulatory changes to their industry has come at a fast pace in recent years. Further, the impact of the overall level of government intervention in the economy has resulted in — or at least contributed to — a number of additional challenges for the banking industry, including today’s extended low interest rate environment.
As banks evaluate their current and possible future operating environment and plan strategically for the future, boards and management are recognizing the near- and potential long-term impact of these industry issues on their basic business model and the core profitability. Today’s challenges for many community banks include:
- Lack of organic growth opportunities in a comparatively weak economic environment
- Tight capital markets and new Basel III capital rules
- Aggressive non-bank competitors
- Continued net interest margin compression, due to the extended low interest rate environment and generally weak loan demand
- Pressure on noninterest income
- An array of new consumer compliance regulations, particularly in the mortgage lending area
- Higher operating costs from increased regulatory compliance and information systems upgrades
- Market driven delivery channel changes
These challenges raise several questions for boards and senior management to contemplate as they develop their strategic direction and specific objectives, goals, and strategies for the next few years, particularly relative to growth, core profitability, and product lines.
Growth
In a continued slow economic environment, boards and management will need to answer some basic questions as they plan for growth. Do our current markets and product channels offer our organization sufficient opportunity for organic growth? Is market expansion through acquisitions a preferable and more profitable growth strategy?
In addition, banks will need to assess how the Basel III capital rules will impact their ability to grow assets while maintaining expected dividend streams and meeting other holding company cash flow needs. For some banks, asset growth will be less important than simply improving their current earning asset mix. That is, growing loans as a percentage of their earning assets.
Core profitability
As they plan for the next few years, most bankers agree that maintaining or improving net interest margin in an extended low interest rate environment will be a difficult challenge. A key to meeting this challenge, of course, will be loan growth. Bankers will need to assess whether loan demand, their current lending market territories, and their risk tolerance guidelines will provide their bank with sufficient opportunity to sustain or improve the percentage of loans to total earning assets.
Besides increasing loan volume, banks should consider other strategies to enhance revenue in a sustained low yield investment environment. For example, many banks have utilized bank-owned life insurance to offset the impact of low investment yields.
Benchmarking will also be important. What core profitability benchmarks must improve in order to overcome potentially lower average net interest margins in the coming years (e.g., noninterest income/average assets ratio and noninterest expense/average assets ratio)? What should these new benchmarks be in order to meet return on assets and return on equity goals?
Other profit planning considerations should include:
- If mortgage rates increase, resulting in a decline in secondary mortgage loan volume, what strategies can be employed to replace the potential related decline in non-interest income?
- Which information systems investments are critical to our product lines and overall strategic vision and will positively impact the bottom line through improved efficiencies, enhanced revenue, or long-term growth?
- Is outsourcing a preferable approach to addressing elements of the increasing compliance risk management requirements of the organization?
Products
A review of product lines should always be a part of long-term strategic planning. In today’s operating environment, banks should assess whether current lending products and delivery channels are adequate to generate net loan volume growth. Other timely strategic questions to address regarding product lines might include:
- Is originating nonqualified mortgages under new regulations an acceptable risk to our bank?
- How can our bank differentiate its electronic product lines (e.g., card services, internet banking, mobile banking) in the marketplace and improve related profitability?
- What product and service lines can grow without further leveraging capital (e.g., brokerage, trust, secondary market mortgage lending)?
Overcoming challenges
While the banking industry has benefited over the past couple of years from improved asset quality, lower related loan loss provision expense, and dramatically lower cost of funds, the overall earnings outlook for most banks in the coming years is challenging.
Driving this pessimism is the industry’s reduced ability to leverage capital under Basel III rules, the seemingly ever-increasing regulatory compliance burden, increased information systems costs, and weak economic conditions, including very low investment yields.
For the industry, it is not business as usual in the strategic planning area. Overcoming these issues and challenges will require boards and management to challenge core elements of their bank’s basic business model driving core profitability.
Charlie Cameron, Partner, Financial Institutions
charlie.cameron@CLAconnect.com or 314-925-4300