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Hitting Performance Targets in an Off-Target Economy

By: Bill Poquette, Katie Kuehner-Hebert, Elizabeth Whalen

In interviews with management of several top-performing community banks across the country in recent weeks, BankNews writers found more similarities than differences in their business plans. They have survived and generally thrived through a challenging four-year period that has unleashed strains seldom seen before on borrowers, loan portfolios, profit margins and investment strategies.

Among common threads in these banks were an emphasis on relationship banking, strong capital, conservative lending and investment strategies, dealing aggressively with problem credits and considering new business lines to diversify revenue streams. Optimism was a common theme, but so was the realization that 2012 will be another year of weak economic data, low interest rates and still spending too much time resolving problem loans.

Net Interest Margin Pays in the Midwest
By Bill Poquette, editor-in-chief

The No. 1 factor making First National Bank of St. Louis a top performer through the industry’s recent troubles is net interest margin, according to President Rick Bagy, who calls it “extraordinarily high” (4.11 percent through the nine months ended Sept. 30, 2011). With $1.4 billion in assets as of Sept. 30, First National is actually in the St. Louis suburb of Clayton, Mo., where it competes with several local banks as well as the likes of Bank of America, BMO Harris Bank, PNC Bank, U.S. Bank, Fifth Third Bank and Regions Bank.

“The Fed lowered rates and we were aggressive in lowering the rates we pay depositors — somewhat too aggressive,” he said, “but now everybody is catching up with us.” The bank began lowering rates in 2007 and now has them pegged about as low as they can be, Bagy believes. He is projecting rates being “pretty flat” in the upcoming budget year and NIM maintaining near its current level.

“And the other thing we did,” said Bagy, “we stopped lowering the prime rate at 4.5 percent. Customers didn’t like it and initially we met a lot of resistance.” At the time, many banks were running off customers or asking them to move their loans, he points out. “We give people time and we work with them. The nature of our customer base is closely held companies. We’re friends with these people and they are good people. So we’ve worked with them and in retrospect I think they appreciated our approach. By keeping our loan rates higher we had the income to be able to be patient with people. If we hadn’t we probably would have had to be more aggressive.”

A second factor high on Bagy’s list of contributing factors to high performance is getting seriously into residential mortgages about 10 years ago. “We always had a department,” he said, “but it was two people and one product. We made you a two-year fixed rate loan and that was it.” Then, in 1998, the bank hired a lender who had run the mortgage operation for another holding company. “He started building it up and for the last three years in a row we’ve had refinancing booms and that has been very helpful,” Bagy said.

Something else that has been good for First National is its correspondent department, which Bagy called a huge source of low-cost funding. “Five years ago I didn’t think it was that cheap,” he said, “because retail deposits were at a similar rate. But recently it has been 0.25 percent and we’ve got money coming out of our ears. This has enabled us to be much more aggressive in repricing the retail deposits down, although we tried not to get too carried away because someday we’ll want these people.”

Besides lowering the cost of funds, the Fed has been a huge help, in Bagy’s view, in enabling banks to buy more municipal bonds. “We had essentially none, a few million dollars,” he said. “They changed the rules so that we can buy more.” The yields are so much better than the Treasuries, he pointed out. “Six-month Treasuries were 2 basis points today. Why would you bother?”

Being a high-performer has also meant Bagy and his colleagues spending a lot of time on problem loans. “We’ve had significant charge-offs in this bank, which we’ve never had before,” he said. “We have had a concentration in real estate — residential and commercial — which has served us well for 90 out of 100 years. That has been hit hard. We used to meet about once a quarter on problem loans but for the last three or four years we have met every two weeks. The loan officers know there is an urgency to get things fixed and quite a few customers have been able to get straightened out one way or another with our help.”

When it comes to cutting expenses, “There really has not been any magic bullet,” said Bagy. “We had a hiring freeze for years. Now we still hire people but whenever someone leaves, our human resources people have to convince me we need a replacement. And almost anyone who retires isn’t replaced.” Bagy also noted that because the business has changed so much, branches that used to have 10 people now have five. “And those five aren’t doing anything,” he said, half joking.

In terms of new sources of revenue, “We haven’t done anything very creative,” Bagy said. “We have gone into the commercial leasing business. We have done automobile leasing for 10 years, but now we have hired a person to do business leases such as computers. We have also looked harder at indirect paper. We were in it, we got out of it, now we’re getting back into it. It is mostly used cars and the yields relative to market rates seem to have improved over what they were five years ago.”

Asked to define First National, Bagy responded, “We try to be a retail bank but by far and away the bulk of our assets are commercial. We consider ourselves a business middle-market bank. We do business with people and we do business with closely held companies, family owned businesses. We will have 14 branches soon so we have become a good retail bank. I never wanted the funding to be more than about half commercial and about half retail. That’s why we kept opening branches. It’s cheaper to do it wholesale, but I saw what happened to Continental Illinois 30 years ago. I don’t know if they would even accept a retail account. And one day they were gone.” First National opened one new branch in 2011, “But we don’t have any branching plans other than that, Bagy said. “Nothing is in the works.”

Bagy is a firm believer in being loaned up — 100 percent or more — with the bank’s ample capital and generous supply of fed funds from correspondent bank clients. But loan demand currently is weak. “Everything we do now we’re stealing from somebody else. We don’t do anything where there’s something new,” he said. “I can’t tell you the last time someone has come in here and said I want to build a factory to make widgets or build a new office building. It just doesn’t happen. And it would be foolish to build anything because there is so much empty space out there.” A lot of businesses that used to own their own buildings are renting because it is so much cheaper, he pointed out. “We have a lot of commercial real estate loans,” he said, “and the good thing about that is they don’t pay off real fast. But we have to make a lot of loans just to stay even, about $10 million a month. The last three years we haven’t made $10 million a month.”

First National’s return on assets through nine months of 2011 was 1.37 percent and Bagy is projecting a respectable 1.28 percent in 2012. “We’ve done as well as anyone in St. Louis,” he said. “Our ROA has been extraordinary, considering. But we haven’t grown; we’ve shrunk.”

Fortunately, earnings in dollars have increased every year, much of which has been pumped into loan loss reserves. And someday, he knows, his 4.25 percent NIM will drop back to a more normal 3.50 percent and home refinancings will go away as interest rates rise.

Naming his top challenge for 2012, “I want to be pristine by the end of the year,” Bagy said. “I want to get my problem loans resolved so we can focus again on growth and not be so inwardly focused like we have been the last three years.”

The Importance of Relationships in the East
By Elizabeth Whalen, contributing writer

If the leaders of The National Capital Bank, The Bank of South Carolina and ServisFirst Bank met to share their strategies for success, they would find they have a great deal in common. All three have focused on lending and investing conservatively and on building strong relationships with their customers, communities and employees. And that focus has paid off.

The National Capital Bank, founded in 1889 in Washington, D.C., had its best-ever earnings year in 2010 and is on track to do even better in 2011. Chairman and CEO Richard Didden said the bank tends to be on the conservative side in general, and his brother Jimmy Didden, who is president and director, said the bank has not changed the way it underwrites loans in the last 30 years.

“There are times when a conservative bank will not perform as well as it would like to because it’s not taking big risks, but it’s in times like these that it comes back around,” Jimmy Didden said.

The Diddens, whose family has run The National Capital Bank since its founding, also pride themselves on being loyal to their employees — the average officer has a tenure of more than 20 years at the bank — and their community.

“We’re a $355 million bank. We will have given, by the end of the year, in excess of $250,000 to more than 50 nonprofits in the community that we serve. That’s what a community bank is, us helping the community. In return, they feel very loyal to us,” said Richard Didden.

Since opening in 1987, The Bank of South Carolina in Charleston has maintained its commitment to its original vision of serving a specific market: local businesses, the people who own and operate those businesses and people who want a high level of service.

“I think relationship banking really paid off in the last downturn because we don’t make loans to put assets on the books. We make loans to develop relationships,” said Hugh C. Lane Jr., president of The Bank of South Carolina.

The bank enters into relationships with customers carefully by finding customers through referrals rather than advertising. The bank’s focus on relationships helps drive its profitability by keeping its loan losses low.

In order to build successful banking relationships, the bank works hard to know and understand its customers and to reward its employees.

“Our stable of lenders has about 300 years of lending experience in this market,” Lane said. “Our greatest asset is not on our balance sheet, it’s our employees.”

ServisFirst Bank, which is headquartered in Birmingham, Ala., and has branches in Alabama and Pensacola, Fla., opened in 2005 and already has more than $2 billion in assets. ServisFirst’s president and CEO, Tom Broughton, has been a banker for more than 30 years and he considers ServisFirst an “urban bank” that offers the products, services and technology of a big bank combined with the service style of a community bank.

Broughton said that ServisFirst’s geographically diverse loan portfolio and conservative investment portfolio helped its bottom line.

“In Huntsville, we have a concentration of defense contractors, and because of budget cutbacks, it’s possible that the government contractors could be hurt, but that won’t affect our agribusiness customers in southeast Alabama,” Broughton said.

ServisFirst invested carefully; it never bought any collateralized debt obligations, private-label mortgage backed securities or trust-preferred securities.

And the bank works to attract highly qualified employees. “We try to be a place where talented bankers want to work. We have some people who have a lot of industry expertise. That’s been our key strength,” he said.

The leaders of all three banks are confident they will continue to succeed, but they are realistic about the continuing challenges presented by low interest rates and the weak economy. Managing the net interest margin and expanding loan volume can be particularly challenging.

ServisFirst’s strategy is to focus on making loans for equipment that has a finite lifespan.

“Something like a crane, that will last 25 years,” Broughton said, but “every 200,000 miles, trucks wear out. Things with a finite lifespan, we try to finance that.”

Diversity is Key to Success in the West
By Katie Kuehner-Hebert, contributing writer

Bank of the Sierra does not believe in putting all of its eggs in one basket.

Indeed, the Portersville, Calif., bank board’s penchant for diversity across business lines dramatically mitigated the effects of the housing crisis on the bank’s commercial real estate portfolio. As such, the bank and its parent, the $1.35 billion asset Sierra Bancorp, has been able to earn money and pay dividends to its shareholders every year during the downturn.

In the third quarter alone, Sierra Bancorp’s net income nearly tripled from a year earlier, to $2.5 million.

Moreover, its strength enabled the company to raise capital twice from investors — and not from the Troubled Asset Relief Program. After yielding $21.3 million from a private placement in 2009, Sierra Bancorp yielded another $22 million in 2010 from a direct offering of 2.3 million shares of its common stock.

“The challenges in 2008 were downright harrowing and in those times, we thought it was better to have too much capital than too little,” said James C. Holly, president and CEO of both the bank and its parent. “Now, we are well-positioned to get through the turmoil and when we emerge, we will be well-positioned to grow the bank, either organically or through acquisitions.”

Bank of the Sierra’s accomplishments have been recognized several times, with U.S. Banker last June ranking it the eighth best performing community bank in California with assets of less than $2 billion. At Sept. 30, Sierra Bancorp’s annualized return on equity was 5.09 percent and its return on average assets was 0.63 percent.

During the recession, Bank of the Sierra did not participate in loan sales, but instead formed a special asset department to work out its problem loans.

“Most of those problem assets were to small businesses that we’ve known for a long time, and we thought we could work them out better — and we owed them that, to get them through the recession,” said Holly, who founded the bank in 1977. “We probably have more troubled debt restructuring than most banks our size, but we think it’s characteristic of a community bank trying to work with its customers.”

Nonperforming loans to total loans at Sept. 30 was 6.40 percent, about the same level as a year earlier. However, performing restructured troubled debt balances increased by $22 million, or 176 percent, as the bank continues to work with borrowers to resolve potential problem credits.

Holly anticipates that loan demand from both consumers and businesses will pick up in 2012. Bank of the Sierra would particularly like to increase its ag lending for both production and farm mortgages, as well as its specialty business of lending warehouse lines of credit to mortgage companies, to fund their loans until they can resell them in the secondary market. Currently, ag loans comprise about 10 percent of the bank’s portfolio and its board would like to increase that percentage to 20 percent; warehouse lines of credit comprise about 5 percent, and its board would like to increase that to 15 percent.

Holly expects that the economic recovery will continue to be protracted, but that in 2013, Bank of the Sierra’s performance ratios will rebound — though not at pre-crisis levels because regulators are now requiring more banks to hold more capital. At the height of the boom, the bank was posting ROE above 20 percent, but Holly expects the definition of a well-performing bank after the recession will be one with an ROE ranging from 12 percent to 15 percent.

“Still, we’ve been generating net income every year and dividends every year and few banks are doing that conjunctively,” he said. “We have kept shareholders intact and have preserved the bank from the worst. We have come through this, but in terms of financial performance, we can do ever so much better.”

Copyright (c) January 2012 by BankNews Media