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The Art of High-Performance Banking


Lost in the din of meltdowns and bailouts, troubled loans and failed banks, is this hard fact: Healthy, well-run community banks all over the country are expanding, making loans and ringing up consistent returns on assets of 1.50-2.00 percent and more.

How are they doing it? Our writers asked bankers in the West and Midwest, and industry observers in the East, what the secret was, and found both commonality and differences based on geography and other factors.

One California bank relies on stringent underwriting of commercial real estate loans, and another has avoided CRE entirely to focus on other profitable and less risky niche markets. In the center of the country, a bank in Kansas and one in Missouri are seeing strains in their residential real estate loan portfolios but are benefiting from low interest costs and robust loan pricing. Elsewhere, bankers and consultants are looking at measures of profitability other than the traditional return on average assets.

These banks’ strategies differ, but their stories confirm that the community bank model works, even amid the carnage of the Great Recession.

Excelling in California

While more than a few California banks have been hit hard by huge losses in the financial crisis — and some have even failed — two banks in the state stand out for their continued high performance.

The $163 million-asset Home Bank of California in San Diego has been able to minimize loan losses within its commercial real estate portfolio due to stringent underwriting criteria, and the $118 million-asset Murphy Bank in Fresno has avoided CRE losses altogether because it doesn’t make those kind of loans at all. Rather, it sticks to lucrative niche products such as mobile home loans, vehicle loans and high-mileage leases, and farm and other small business equipment loans.

Both banks continue to post returns on asset and equity ratios that the entire industry would envy in today’s environment.

Byron B. Webb III, chairman and president of Home Bank, said the secret to low loan losses on CRE loans is tailoring debt service ratios for each of its deals, to determine how large a loan each piece of property can support.

“We always approve each deal using a worst-case scenario,” Webb said. “Historically we’ve had very low loss rates and we’ve also been fortunate in being able to identify borrowers who’ve been able to service that debt.”

Moreover, each property is not only appraised by an outside firm, but Home Bank utilizes “a second set of eyes” by having one of its directors with real estate expertise also analyze the deals, said Bob J. Bray, executive vice president of Home Bank.

But perhaps one of the most important reasons why the bank has not suffered the kind of losses that have besieged many of its peers in the state is that the bank has avoided making massive amounts of land development, construction and condo conversion loans, Bray said.

“Those three items caused the failures of most banks,” he said.

Home Bank’s net chargeoffs to loans was 0.35 percent at June 30, compared the average ratio of 1.54 percent for commercial banks in California with assets between $100 million and $300 million, according to the FDIC. Its noncurrent loans to loans ratio was 1.83 percent, compared to the average ratio of 4.13 percent for its peers.

Overall, its performance ratios have been far superior to its peers. At June 30, its return on assets was 2.19 percent, compared to a negative 0.69 percent for its peers, and its return on equity was 22.59 percent, compared to a negative 5.44 percent.

In 2008, Home Bank converted from an industrial loan charter to a state commercial bank charter so that it could offer checking accounts and more products, such as mortgages and additional commercial loans. Webb and his team are currently hiring business development officers and designing and launching new products such as cash management and commercial and industrial loans.

Webb said the intent is to both diversify the bank’s portfolio and raise its profile in the Pacific Beach area of San Diego.

“There are several big banks in town, but we are the only community bank in Pacific Beach, and we would like everyone in Pacific Beach to be our customer,” he said.

Webb admits the expansion of its model will bring challenges.

“When you specialize at something, you typically can command a high margin,” he said. “But we made a decision based on the long-term interests of the bank, and while we expect margins to be not as wide as they were in the past, we’re hoping to make up for it in volume by increasing our presence in the community.”

Murphy Bank also started as industrial trust and loan in 1984, but in 1997 converted to a commercial bank.

In the 1980s, the bank entered vehicle lending and leasing, and has been able to garner a niche by offering high-mileage leases on fleets for businesses, said Mike Falge, president. In the 1990s, Murphy Bank added another niche product — mobile home loans.

“At that time, the California real estate market was in turmoil, so several very large institutions stopped doing mobile home loans,” Falge said. “We filled that void and since we are so small, we didn’t have to recreate Bank of America’s program.”

The product is less risky than many mortgages, because borrowers — typically retirees — tend to put huge downpayments after selling their homes, such as $100,000 on a $150,000 mobile home loan, Falge said.

And the product is lucrative — Murphy Bank currently charges an interest rate of 6–7 percent on such loans.

Chairman and CEO Jim Templeton said the bank is able to charge higher rates because it takes a lot of expertise to appropriately underwrite mobile home loans, considering that the bank also has to appraise the value of the amenities that can come with a mobile home park, such as swimming pools and golf courses.

“We have no collection department,” Templeton said. “We are so small and this is so labor-intensive, if you make a loan, you have to live with it. It’s a really good way to get lending officers to make really wise decisions.”

Murphy Bank is also the largest lender of farm and other small business equipment loans guaranteed by the California Capital Access Program (Calcap) of the California State Treasurer’s office.

Like Home Bank, Murphy’s asset quality is better than its peers; at June 30, its chargeoffs to loans was 1.26 percent and its noncurrent loans to loans was 1.66 percent. Its performance figures are also enviable, with an ROA of 2 percent and an ROE of 14.28 percent.

The bankers at Murphy are now happier than ever that they did not make massive amounts of residential construction loans in the Central Valley, as more than a few of its peers that did so have since failed.

“We knew that real estate values were not going to go up forever and so we kept a tight rein,” Templeton said. “We have a small body of shareholders who don’t care if we grow to $200 million or $500 million, so we’ve had the pleasure of finding niche markets that are very profitable.”

High Performers in the Heartland

Steve Handke, president and CEO of Union State Bank in Everest, Kan., is of the opinion that whatever hits the coasts of the United States eventually finds its way to the center of the country. “We’re OK up to this point,” he said, “but I’m not sure we’re through all the problems, particularly with residential real estate.”

As a student of other banks’ numbers, Handke is seeing more residential real estate losses than in the past among what he considers the best banks in Northeast Kansas, which he attributes to consumer stress factors such as loss of jobs and divorce. “Even though we’re very immune, being in Brown County, Kan.,” he said, “the recession with its falling real estate values is still affecting the banks in this rural, agricultural area.”

Union State, with assets of $160 million, has a loan mix of about 40 percent agricultural, 30 percent residential real estate and 30 percent commercial. Agriculture has had another strong year with above-normal prices for last fall’s crop.

The bank’s chargeoffs are coming in its real estate portfolio, comprised of 1–4 family consumer residential loans.

“I think we’re having our first borrower who just decided he wants to walk away from the mortgage,” Handke said. He describes the trend as being like “little fermenting bubbles” rising through the real estate portfolio. “It’s not like there is a massive problem, but there’s just a little bubble here and there and every one of those bubbles costs us $10,000 or $20,000.”

Union State is seeing 50 basis points of additional loan loss risk in every loan. “Probably we need to be reserving 50 basis points of our whole loan portfolio,” Handke said. Because of the additional risk, Union Sate has been aggressive with its loan pricing. “Bank capital is at a premium right now, lending is incredibly risky and we need to get paid for that,” he added.

Handke likes the low interest rate feature of the current economic environment. He believes rates will stay low for another year or two, and that is good for his bank “because our net interest margins are wide.”

Handke also sees a benefit from the current troubles in a healthier competitive climate. “We have good community bank competition now,” he said. “It’s healthy and reasonable and we’ve gotten rid of all the mortgage brokers and all of that nutty stuff that didn’t make any sense.”

Union State has also used its consistently good earnings to expand its footprint, and Handke has opted for a pair of healthy bank acquisitions. In early 2008, “We had a chance to buy an asset-impaired bank at a cheaper price or a creampuff at a high multiple and we decided to go with the creampuff,” he said. “Buying a clean bank at that point, without any asset problems, interest rates falling, earnings going through the ceiling — it’s been a good buy.”

Another acquisition is in progress, which fits that mold.

Handke concedes to being lucky as well as “doing a few things right” on the way to a projected ROA of 1.5–1.6 percent pre-tax for 2010. He seems happy with that, and most other community bankers would be, too, in today’s environment.

Sounding much like Kansas banker Steve Handke, Jack Hopkins, president and chief operating officer of Community Bank of Raymore, Mo., doesn’t want to give anyone the impression his institution is not feeling the effects of the recession. “We’re seeing some stress in our loan portfolio we haven’t seen in the 11 years I’ve been here,” he said.

Raymore is on the southern edge of the Kansas City metropolitan area in fast-growing Cass County, a geographic location he calls a blessing because of the lack of high concentrations in any sector of the economy. “Our unemployment rate is probably average, but we don’t have an inordinate number of people in our county who are out of work.”

He suggests a lot of banks are suffering because of residential construction and development loans. “We just didn’t get into that in a big way because we didn’t think the banks in our area were being paid appropriately for the risk they were taking,” he said. “I love that kind of lending, but we just didn’t see that we could do it and get paid adequately.”

As much as anything, “Our loan policy has helped us stay out of trouble,” Hopkins said. Most banks were making loans based on appraised values only, he suggested. “We want 80 percent of cost or value, whichever is less when looking at commercial real estate or anything like that.”

Community Bank of Raymore also likes the borrower to have some skin in the game so he or she will be less inclined to walk away when trouble comes. “We’ve also looked at cash flow all the way along and had multiple sources or repayment,” Hopkins added.

Community Bank of Raymore has done a good job or recognizing problems early. “We work our past dues pretty aggressively, keep in touch with our clients and try to work with them as best we can,” said Hopkins, “if they’re willing to work and as long as there is something to work with.”

He describes the bank’s approach to past-dues as “pretty much blocking and tackling,” not using “a lot of high-tech stuff.” Management has looked at concentrations in individual loan portfolios and overall loan policy. The loan-to-value ratio on single-family residential loans was adjusted slightly a year or two ago when housing prices slipped significantly.

Fee income has also helped the bank perform at a consistently high level. “We have a large trust department that has been a big help,” Hopkins said, “and deposit-generated fee income has been very strong.” Not having a large transaction-account base is common to many troubled banks today, he believes.

“We started working 10 or 11 years ago changing our account structure to make it very attractive for folks to have their primary checking account with us,” Hopkins said. Today, the bank is predominantly funded with checking accounts. Early adoption of rewards checking to increase fee income “has worked extremely well.”

Looking ahead, Community Bank of Raymore is looking for future profitability from three branches acquired about a year ago, all in Cass County. They’re not “huge profit-makers yet,” but two competitors were eliminated and the bank now has a presence in Harrisonville, the county seat.

For now, Hopkins projects the $150 million community bank’s 2010 ROA will be 1.35 percent minimum and perhaps as high as 1.80 percent, depending on additions to reserves due to rapid loan growth.

ROAA: The Measure of Measures?

While the return on average assets of commercial banks plunged in 2007 and 2008, the performance of some community banks was favorable. However, some in the industry caution about the reliance on ROAA as a stand-alone measure of performance. This may be due, in part, to the fact that profitability is not just a function of external economic conditions, but can be greatly affected by other factors. One bank may perform well when their peers are suffering.

“ROAA, on its own, is not the best measure to evaluate our bank’s performance over a longer period of time.” said James Basey, chairman and CEO of Centennial (Colo.) Bank. “But the areas that sum to ROAA should be areas to review and to identify parts that are out of range with other banks. Assessing those differences can be helpful. ROAA on its own does not bring clarity to performance evaluation. Banks that produce superior risk-based results on the capital that investors bring to the organization over the economic and interest rate cycles will be successful.”

“The fundamental business model may be sound, [however,] high provisioning may be reducing ROAA, even in many cases driving it negative,” said Bill Handel, vice president, research and development for Raddon Financial Group in Lombard, Ill.“One-time actions can impact ROAA and not be repeatable in future periods.”

Handel recommends looking at ROAA in conjunction with other ratios, such as the efficiency ratio, before declaring one community bank to be performing well while others are not. “There are many things that affect profitability including management, product offerings, local markets and credit quality,” says Chris Cole, senior vice president and senior regulatory counsel for the Independent Community Bankers of America. “Burke and Herbert Bank in Northern Virginia is much more profitable than many banks in southwestern Virginia. This is due to many reasons — the types of financial products it offers its management, how it deals with commercial lending, [and other factors].”

Handel posits that differences in ROAA from one bank to its peers may be explained by the primary markets one bank serves relative to competing institutions. “In the current environment, the most common explanation for the disparities in ROAA within a state relate back to several factors, he explained. “First, what are the lines of business in which the institution focuses? A heavy orientation toward real estate lending (either commercial or residential), especially if they portfolio a significant portion of their residential loans, has clearly led to higher provisions and lower ROAA. Second, the risk tolerance of the organization will play a role as well. The decision to engage in subprime lending is the obvious example, but there are many other similar types of decisions that were made five to 10 years ago that are clearly impacting ROAA now.”

Handel said that high performers have several common attributes. “They stuck to the niches or business lines within which they had the greatest level of expertise and experience,” he said. “They continued to focus on margin management, even as net interest margins in the entire industry declined virtually every year for the past 15 years. They diversified revenue sources, not becoming overly dependent on any one source of income.”

James Wheeler, an attorney and head of the banking practice at the law firm Morris, Manning & Martin LLP in Atlanta, believes that aggregate comparisons of ROAA must be qualified. First off, the playing field for community banks is often different from state to state. “Some states are clearly more regulatory than others,” said Wheeler. In Georgia, he explained, nearly 80 percent of all financial institutions are under some type of regulatory limitation — be it consent order, memorandum of understanding or board resolution. “Such regulatory limitations prohibit those banks from various activities and various opportunities, until they right their ship,” he added.

But Wheeler said that within a state, many factors influence profitability and need to be considered when discussing performance. “Some banks entered the great recession significantly better poised to prosper,” he added. “For example, they concentrated on real estate loans, but had other niche lending practices or were over-capitalized.”

“Bank performance needs to be reviewed and considered over a period of time, several quarters or years,” said Basey. “The performance should be understood relative to the bank’s strategy. Reviewing the performance with banks with similar size and strategy can be helpful in understanding areas of difference that impact performance.”

Sections of this article were written by Katie Kuehner-Hebert, a contributing writer in San Diego; Bill Poquette, editor-in-chief of BankNews; and Jim Romeo, a contributing writer in Chesapeake, Va.

Copyright © January 2011 BankNews Media