Low Loan Growth Got You Down?

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1 FINANCIAL PERFORMANCE Low Loan Growth Got You Down? Uncover Hidden Loan Portfolio Profitability

2 A great deal of attention has been paid in the financial press to the decline in loan growth and the resulting impact on bank financial performance. It is inarguable that lack of loan growth is having an adverse impact on revenue and profitability across the industry. In fact, for community banks in aggregate this harsh economic reality may be even more pronounced. Based on data published by the FDIC, loan growth for all banks (Exhibit I) has been positive during only two of the past eleven quarters. One of those quarters first quarter 2010 can be explained by a change in accounting rules that primarily impacted loan growth reported only by the largest banks. The most recently reported quarter second quarter 2011 reflects an increase of approximately $64 billion (0.9 percent) and is effectively the first time since the second quarter of 2008 where real organic loan growth has been achieved. Two main categories drove the second quarter 2011 increase; C&I loans increased for a fourth consecutive quarter, rising by $34.3 billion (2.8 percent), and loans to depository institutions increased by $27 billion (22.6 percent), but the increase in reported balances consisted of growth in intra-company loans between related institutions. Other notable categories reflecting an increase include auto loans, up by $9.7 billion (3.4 percent), credit card balances, up by $5.2 billion (0.8 percent), and closed-end first lien residential mortgages, up by $2.6 billion (0.2 percent). The most notable decrease in volume came from real estate construction loans which declined for a 13th consecutive quarter, falling by $20.7 billion (7.0 percent). Other major categories showing a decrease in volume include home equity lines of credit, down by $8.5 billion (1.4 percent), closed-end second-lien mortgage loans, down by $8.1 billion (5.8 percent), and commercial real estate loans, down $5.3 billion (0.5 percent). Exhibit I Quarterly Change in Loans at All Banks $300 $200 $ billion $100 $- $(100) $(200) $(300) Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-09 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Source: FDIC Quarterly Banking Profile

3 FINANCIAL PERFORMANCE A glance at these statistics for second quarter 2011 provides some insight into results achieved by community banks during the same period. Several of the growth categories; loans to depository institutions, auto loans, credit card balances and first lien residential mortgages are not typically drivers of portfolio loan volume at most community financial institutions. Digging into the FDIC data in greater detail (Exhibit II) by excluding most banks over $20 billion in assets, bankers banks, and specialty banks like credit card issuers or foreign banking entities, we see that loan growth was actually slightly negative (down $4.3 billion or 0.20%) for the community banking industry. The good news is the decline in this most recent period is significantly lower than the average decrease over the prior nine quarters. The bad news we re still not out of the woods. Lack of new loan volume continues to hamper our ability to grow top line revenue and increase the bottom line. Exhibit II Quarterly Change in Loans at Community Banks $ billion $20 $10 $- $(10) $(20) $(30) $(40) $(50) $(60) $(70) Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-09 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Source: FDIC Quarterly Data So, do we conclude that improvement in profitability is hopeless until loan volume begins to pick up across the industry? Of course not plenty of opportunity still exists to generate profitable new loan volume and improve profitability within our existing loan portfolio. You just have to know where to look! Improved analytics and innovative thinking are key in the current environment where profitable new loan volume is scarce and competition for that volume is fierce. A more thorough analytical approach is also critical to help identify opportunities within the existing portfolio to increase margin and net interest income. Remember, even if new loan volume is scarce we have a significant existing book of business that can be tapped for profit improvement. At ProfitStars we have analyzed the profitability performance and pricing practices of hundreds of community banks. This paper focuses on two primary themes that rise from this extensive analytical work. First, customer profitability is far more concentrated than most of us probably expect and pricing practices represent one of the key culprits driving this outcome. Second, most community banks over-price their largest, most profitable customers and under-price their smallest least profitable customers. The result? We often run significant risk of losing our most coveted existing client relationships or our most attractive new prospects. At the same time, we are often leaving money on the table with the vast majority of our client base.

4 Customer Profitability Distribution The old 80/20 Rule is dead. Today in the community banking industry that rule has become the 230/20 Rule a pretty startling prospect. Based on ProfitStars relationship profitability work with community banks, we have found that 230% of the typical bank s profit is generated by the top 20% of customers worse, approximately 210% relates to the top decile (Exhibit III). Looked at from the opposite end of the profitability spectrum, approximately 70% of community bank clients lose money. Exhibit III Community Bank Customer Profitability Distribution 250% 200% 150% 100% 50% 0% Profit -50% -100% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Source: ProfitStars RPM Even if we have historically accepted the old 80/20 notion and acknowledge that a large share of profit is generated by only 20% of clients, it is still likely we have not recognized the severity of our situation. The degree of concentration is critical in terms of the strategy employed to drive profit improvement. Knowing that the top decile of the client base yields 2X the bottom line underscores the importance of protecting these crucial relationships and identifies the need for focus when sourcing new opportunities. Finding more top 10 percentile clients will have a geometric impact on bottom line results. Possibly just as important, strategy also must reflect the fact that up to 70% of clients are not just less profitable than the top deciles, these customers actually lose money. In most cases, substantial change in strategy is needed to grow these relationships in a way that increases profitability. The $64K question is: what strategic changes are needed and how do we quickly and efficiently implement those changes across the organization? One important way to accomplish this goal is to address the profit distribution dynamic by effecting change through more strategic loan pricing.

5 FINANCIAL PERFORMANCE Pricing Impact on Portfolio Profitability Looking at current community bank pricing practices provides insight into one main reason why customer profitability has become so concentrated. ProfitStars compiles commercial loan portfolio data on client community banks of all sizes. These analyses include key statistics on portfolio size, total count of loan activity, average loan balance, average yield, average term, as well as distribution of loan volume based on size. Custom client analyses are detailed by product and tiered by various size bands. Aggregate summary data from these studies is presented in Exhibit IV. This information is based on the combination of statistics compiled for client banks over the past 24 months. This data reflects community banking industry pricing practices over that period and the findings are consistent with the relationships we see in our work with clients over any interest rate period. We have selected three asset size ranges that are representative of over 90% of all community banking institutions. Exhibit IV Select Commercial Loan Statistics by Asset Size Range All Loans <$150MM - $350MM <$150MM <$350MM - $1B Avg. Bal. Avg. Rate Avg. Term Mo. $149, % 49 $26, % 56 $222, % 45 Loans < $50K Avg. Bal. Avg. Rate Avg. Term Mo. % of Count % of Bal. $23, % % 8.5% $23, % 34 44% 3.8% $25, % % 4.7% Loans > $150K - $750K Avg. Bal. Avg. Rate Avg. Term Mo. % of Count % of Bal. $333, % % 43.5% $346, % % 33.2% $312, % % 35.5%

6 There are three very important strategic priorities to highlight from this study that have a major impact on bank profitability. Strategic Priority #1: implement tactics to increase volume of large commercial loans The average loan balance of all commercial loans at community banks range from a low of $149 thousand for banks with total assets less than $150 million to over $220 thousand for larger banks. Regardless of asset size, average commercial loan sizes across the community banking industry reflect the fact that larger commercial loans loans in excess of $1 million represent a very small proportion of the overall loan portfolio. In fact, for all three asset ranges shown in the table above, less than 7% of loans are larger than $1 million for the less than $150 million group, the proportion is less than 3%, partly a result of legal lending limit for the smallest banks in this category. Not only are these loans highly profitable from an ROE perspective, they are also important in terms of the gross volume of net interest income dollars they bring to the table. Customers with loans in this size range are typically top 10 percentile clients. Strategic Priority #2: implement tactics to increase volume of bread and butter loans Loans referred to as bread and butter are loans that fall in the $150 thousand to $750 thousand size range. These are loans that offer two key advantages: 1) they are typically very profitable, and 2) there are many more opportunities in this size range vs. the larger loan category. Most every community bank commercial lender has the experience and relationship contacts to source loans like these. However, our statistics show that only 19.5% to 25.8% of commercial loans depending on asset size fall in this size range. Bread and Butter commercial loan customers are also typically in the top two deciles of a bank s customer profitability distribution. Strategic Priority #3: implement tactics to price up small commercial loans Pricing for size is a key concept that is often overlooked or ignored altogether by many community banks. Small commercial loans loans smaller than $50 thousand represent anywhere from 40% to 53% of community bank commercial loan portfolios depending on asset size of the bank. All of these loans are marginally profitable or lose money. Although these loans typically represent less than 10% of the overall commercial loan portfolio in dollars, because of the sheer number still have a material impact on bank profit. Some loans in this size range belong to customers that also maintain larger loans at the bank. However, if 40-50% of all commercial loans are of this size, they all are not part of a larger, more profitable relationship. Many customers that fall in this size category are those among the 70% that lose money for the bank. Pricing plays a pivotal role when implementing strategies to achieve these strategic priorities. As one example, the pricing differential between the average size loan and the small loan category is not nearly large enough to account for the differential in size of loan, even considering other factors like term and lower cost. For banks smaller than $150 million, the average yield on all commercial loans is 6.11% and for loans smaller than $50 thousand the average rate is 7.13%. The resulting differential is only 1.02%. On the surface, you might conclude that the 1% higher yield coupled with a lower average term of only 22 months on the smaller loan is sufficient to achieve an acceptable profit. However, if we were to apply analytical pricing methods to the average vs. small loan scenario we would find the differential is far too slim in fact, up to 300 basis points too slim to achieve equivalent profitability in terms of ROE. The actual differentials reflected in Exhibit IV for the $150 million to $350 million and $350 million to $1 billion size tiers are even narrower, coupled with smaller differences in average term. For banks in those tiers, the need to price up is even greater. On the surface, the three strategic priorities sound simple, right? In fact, putting these three strategic priorities into action is simple if your lending team is armed with the right analytical tools and process to achieve implementation success.

7 FINANCIAL PERFORMANCE Over-Pricing the Most Profitable, Under-Pricing the Least Profitable To explore the strategic priorities outlined in the previous section in a little more detail, three practical pricing scenarios based on the rate environment on October 17, 2011 have been developed. Exhibit V below shows the profitability results of the 230/20 Rule loan. This is a $2 million commercial real estate loan, priced at 4.53% for a fixed term of 5 years and a 20 year amortization. The loan also had a 0.50% loan fee and was risk rated as a 2 better than average credit risk. This loan is an example of a Strategic Priority #1 loan. Winning our fair share of large loans like this one is critical to maximize profitability a top 10 percentile relationship. Knowing how aggressive we can be in terms of price while also achieving reasonable ROE targets is the key to success. This loan example shows a strong ROE of 20%...priced at 4.53%. Is your bank s pricing strategy aggressive enough to win these strategically important relationships? Are we currently pricing existing clients at rates well above the rate in this scenario? If so, some of our top 10 percentile clients may be at risk. Exhibit V

8 Exhibit VI presents a Bread and Butter loan example to further explore the profit opportunity of this segment. This is a $250,000 commercial real estate loan priced at 5.34% for a fixed term of 5 years and a 20 year amortization. The loan also has a 0.50% loan fee and is an average rated credit. With the exception of the risk grade, the terms of this loan are essentially the same as the large loan presented in Exhibit V. Yet, the rate required to achieve the same 20% ROE is higher driven partially by risk grade but also by the size of loan. There are three important takeaways from this example. First, size is a driver of profitability in our industry it s an inescapable fact. Second, risk is another key driver of profitability which also should be reflected explicitly in every pricing decision we make. And finally, Bread and Butter loans are also highly profitable for your institution. It s critically important to place more emphasis on driving up the proportion of these loans in the commercial portfolio. Exhibit VI

9 FINANCIAL PERFORMANCE Our final example relates to Strategic Priority #3 price up small commercial loans. In Exhibit VII a typical commercial installment loan from the <$50 thousand size tier is presented. The loan size is $23,500 priced at 6.5% for a fully amortizing fixed term of 3 years. The loan has a $150 fee and is graded as an average credit risk. The ROE result on this loan is a disappointing (4.69%) it generates an annual loss of $47 after tax on average over the three year life. That loss might be small on a per loan basis, but when 40% to 54% of loans fall in this category the losses add up. More importantly, this represents a low hanging fruit opportunity to implement strategic pricing practices that will drive increased net interest income straight to the bottom line. Exhibit VII Conclusion Loan growth is still lagging and many analysts predict no significant change in the near term. However, substantial industry-wide loan growth is not the only path to improved profitability. The distribution of bank customer profitability provides insight into strategic pricing practices that can be implemented to uncover hidden profitability in your existing book of business. Opportunities also exist in every market to selectively target larger client relationships by implementing more aggressive pricing strategies that will drive increased net interest income and at the same time achieve target profitability. To accomplish these results, community bankers need to arm their lenders with the tools and process they need to effectively compete in an increasingly competitive environment. Additional information is available at or by calling Jack Henry & Associates, Inc. ProfitStars is a registered trademark of Jack Henry & Associates, Inc.