How Does Our Bank Make Money? Dissecting the Financial Statements and Operations of a Community Bank

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1 How Does Our Bank Make Money? Dissecting the Financial Statements and Operations of a Community Bank Neil Falken, CPA CliftonLarsonAllen LLP Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.

2 Big Banking Stories for 2018 Bank Prices and Profitability Higher M&A Prices Record Stock Market Pricing Meaningful Regulatory Reform Tax Cut Implications Industry Consolidation End Game has begun Banks are bulking up and partnering up Competition is intensifying Deposits are in demand

3 The State of Banking in 2018 Summary The financial sector is big and broad Since the election, bank stocks have outperformed and valuations remain reasonable Tax reform will accelerate already improving profitability Regulatory reform is gaining momentum The biggest banks are gaining share and profitability Consolidation marches on and Regional Champions 2.0 Bank valuations support an active IPO market Some de novo formations instead of none Deposits are THE issue for 2018 Passive investing matters more When (or will) FinTech disrupt? 61

4 Asset Distribution Among Banks and Thrifts Total Industry Assets = $19.0 Trillion Top 4 Banks: $8.7T inassets 46% of Industry Assets WellsFargo 10.2% Citigroup 10.0% Greater than10b 110 Companies 39.7% Bank of America 12.0% JPMorgan 13.5% 1B-10B 588Companies 8.5% 100MM-1B 3,394Companies 5.8% 0-100M 1,432Companies 0.4% September 30, 2017 Data Consolidated by HC Excludes any bank larger than $1 billion in assets with a deposits to assets ratio of less than20%

5 Number of Banks by Size Group: 2006 vs. 2017

6 ROAA by Size Group: 2006 vs. 2017

7 Bank/Thrift Count by State Q

8 CEO Survey: Size and Profitability How much correlation is there between size and profitability? 92% think size improves profits Based upon survey of 117 CEOs in July of 2017

9 CEO Survey: Bank Values How will the decline in number of banks affect bank value? 50% think banks will become increasingly valuable Based upon survey of 117 CEOs in July of 2017

10 De Novo Activity Since Note: Of the 1,058 De Novos formed since 2000, 548 are still active (52%) # of Bank Openings Note: Currently 2 De Novo applications pending that were filed during 2016 and 8 during As of December 31, 2017

11 CEO Survey: Do We Need More Banks? 72% feel we don t need more banks Based upon survey of CEOs in January of 2018

12 Changing Ecosphere of Community Bank Consolidation 10 Year Drought of De Novo Banks in metro areas: Fewer small metro banks available for purchase Existing metro banks are larger Fewer public banks with interest in acquiring smaller banks Existing public banks looking for targets larger than $500M

13 Bank and Thrift ROA Change since financial crisis 12.0% 10.0% 9/30/2017 Median 0.84% 2006 Median 0.95% The median bank in 2017Q3 earns 0.11% less on average assets % of Total Banks and Thrifts 8.0% 6.0% 4.0% 2.0% 0.0% ROAA (%) LTM 9/30/ % Tax Rate Applied tos-corps

14 Bank and Thrift Equity/Assets Change since crisis 12.0% 10.0% 2006 Median 9.98% 9/30/2017 Median 11.02% The median bank in 2017Q3 holds 1.04% more equity to assets % of Total Banks and Thrifts 8.0% 6.0% 4.0% 2.0% 0.0% Equity / Assets(%) 9/30/ % Tax Rate Applied tos-corps

15 Bank and Thrift ROE - Change since financial crisis % of Total Banks and Thrifts 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 9/30/2017 Median 7.59% 2006 Median 9.24% Assuming the median bank takes 100% of the new tax law savings to the bottom line, ROEs in 2018 will match those recorded in 2006 before the crisis despite higher capital ratios 2.0% 0.0% ROAE (%) LTM 9/30/ % Tax Rate Applied tos-corps

16 CEO Survey: How Much Tax Savings on Bottom Line? Only 41% think more than half of tax savings will hit bottom line Based upon survey of CEOs in January of 2018

17 Efficiency by Size 80.0% Efficiency Ratio 75.0% 75.4% 70.0% 65.0% 60.0% 69.1% 67.4% 65.1% 61.1% 55.0% 50.0% 45.0% 40.0% <$100M $100M to $500M $0.5B to $1.0B $1B - $10B Big 4 Median Data, % of Average Assets, LTM September 30, 2017 Consolidated HC

18 Bank and Thrift ROAAs % of the industry by bank 5% 31% 16% 48% 35% Tax Rate Applied to S-Corps LTM September 30, 2017

19 Percentage of Banks with Loans/Deposits > 90% 33% 30% 17% 21% 25% 28% The declining number of banks and improving economy are creating a demand for deposits especially among banks < $10B in assets Q

20 CEO Survey: What is Most Difficult to Grow? Only 28% think loans will be the greatest challenge Based upon survey of CEOs in January of 2018

21 Loan to Deposits Impact on Net Interest Margin 4.20% 4.00% Loans/Deposits > 80% 3,011 Institutions 3.80% Net Interest Margin 3.60% 3.40% Loans/Deposits 60% - 80% 1,659 Institutions 78bp 3.20% Loans/Deposits < 60% 1,072 Institutions 3.00% 2.80% Q3 L/D < 60% L/D 60% - 80% L/D > 80% Year-to-Date 2017 through September

22 How do Banks Make Money?? Net Interest Income (Interest Income less Interest Expense) Non-Interest Income Provision for Loan Losses Non-Interest Expenses Taxes

23 3-6-3 Rule Pay 3% on deposits Charge 6% on loans On the golf course by 3..

24 Composition of Interest Income Loans Investments Interest-Bearing Deposits at Other Banks Fed Funds Sold Non-Earning Assets Cash Property, Plant and Equipment OREO

25 Composition of Interest Expense Interest Bearing: DDA (Interest Bearing) Money Market Accounts CDs Brokered CDs FHLB and Other Borrowings What do we want?? Free Money.i.e. Non-Interest Bearing DDA!

26 Risks to Interest Margin Inadequate Asset Liability Management Duration Term Liquidity Risk return of our loan interest rates

27 Provision for Loan Losses Expense necessary to recognize the risk identified in the credit quality of our loan portfolio. (Funds the Allowance for Loan and Lease Losses) Requires good risk management processes for identification of problem credits.

28 Non-Interest Income Service Charges on Deposit Accounts Loan Origination Fees Trust Services Insurance Agencies Mortgage Servicing Sale of Investment Securities During the past 30 years NII as a % of Assets has increased approximately 25% for banks less than $1 billion. It has doubled for banks >$1 billion.

29 Non-Interest Expenses Salaries and Employee Benefits Premises and Fixed Assets Other Insurance Professional Fees Data Processing Advertising, Litigation Meals and Entertainment FDIC Premiums

30 Taxes. First question S Corp or C Corp?? S Corp Taxes paid at the shareholder level C Corp Taxes paid at the corporate level

31 Key Ratios Net Interest Income/AA Non-Interest Income/AA Net Income/AA Avg. Earning Assets/AA Avg. Interest Liab./AA ALLL/Total Loans Coverage Ratio Personnel Exp/AA Occupancy Exp/AA Efficiency Ratio Avg. Personnel Expense per Employee ($$) Assets Per Employee Loan Concentrations Past Due Loans Capital Ratios Liquidity Ratios Non Core Funding

32 How Can I Measure All of This? Uniform Bank Performance Reports Customized Reports from FDIC website Vendor purchase software Stress Snapshot

33 Observations Large banks achieve low unit costs through scale economies Traditional community banks Develop close relationships Provide person-to-person contact Operate at high unit costs BUT can typically earn higher margins Earn fee income through service charges on deposit accounts and thus have limited fee income opportunities CAN YOU BE MORE EFFICIENT? ELIMINATE WASTE??

34 Neil Falken, CPA Principal CliftonLarsonAllen LLP CLAconnect.com linkedin.com/company/ cliftonlarsonallen facebook.com/ cliftonlarsonallen twitter.com/claconnect 34