Revenue generation has long been a challenge for banks of all sizes, and the last eight years have only compounded the problem, with interest rates at all-time lows. The pain has been most severe for community banks, as they lack the scale and efficiencies that larger institutions often rely upon to help weather the pressures of revenue compression.
Looking at performance trends
FDIC data indicates that, as of September 2015, community banks experienced year-over-year revenue growth that was 50% lower than their larger counterparts.
Why is that? Community banks possess fewer revenue “levers” to pull than their larger counterparts, as interest income has long been their primary source of revenue generation. Making quality loans is the cornerstone of this revenue stream.
There is some good news. Over the last several years, community banks have outperformed mid-size and large peers in generating and—most importantly—protecting relatively higher margins on loan activities.
COMPARATIVE BANK PERFORMANCE*
(By asset size. For 12 months ending 9/30/15)
• Median Revenue Growth:
Community Banks: +3.73%**
Midsize Banks: +7.68%
Large Banks: +7.30 %
• Revenue Diversification:
Fee Income/Total Revenues:
Community Banks: 10%
Midsize Banks: 22%
Large Banks: 27%
Non-interest Income/Avg. Assets:
Community Banks: 0.51%
Midsize Banks: 0.84%
Large Banks: 1.O4% .
• Loan and Deposit Growth:
Median Net Loan Growth:
Community Banks: 5.85%
Midsize Banks: 10.21%
Large Banks: 8.15%
Median Core Deposit Growth:
Community Banks: 5.89%
Midsize Banks: 10.11%
Large Banks: 12.93%
• Net Interest Margins (NIM):
Community Banks: 3.62%
Midsize Banks: 3.42%
Large Banks: 3.28%
• Yield On Earning Assets:
Community Banks: 4.07%
Midsize Banks: 3.85%
Large Banks: 3.73%
While these figures illustrate the stellar job community banks have done at generating and preserving strong margins, they also reveal a severe lack of revenue stream diversity and a sub-optimal mix within community bank loan and deposit portfolios.
The challenge for the community banks, therefore, is, revenue diversification.
Revenues need to come from multiple sources and be generated from businesses that are aligned with your mission statement and risk tolerances.
As evidenced by the ongoing uncertainty surrounding the Fed’s rate-setting agenda, a financial institution’s ability to sustain revenue momentum in all interest rate environments is more relevant than ever before. Furthermore, given the regulatory and expense pressures on community banks, it is essential that revenues always exceed expense levels and that customer profitability is very clearly understood.
So, how can community banks enhance and diversify their revenue streams while strengthening their value propositions?
Path to enhancing revenue streams
Based on my experience as the CEO of two community banks, there are several things community banks can do to foster sustainable revenue momentum and increase the number of levers available to generate quality revenue streams.
When determining whether or not these approaches are appropriate for their respective institutions, bank boards and management teams should evaluate against the broader backdrop of the company’s:
• Mission Statement: “Is this consistent with our institutional identity?”
• Risk tolerance: “Is this going to enhance our risk profile, and do we have the appetite?”
• Operational strengths: “Is this achievable with our current personnel, technological infrastructure, and operational controls?”
1. Exert greater pricing discipline.
It’s important to set the right tone from the top—profitability does matter! While it might seem easy, designing and implementing an effective pricing structure requires a formalized approach with careful calculations.
Steps to take:
• Form a Pricing Committee that meets weekly to review deposit and loan pricing, competitive positioning, and sales trends. The committee should include the heads of the lending units, the retail sales manager, and financial staff.
The CEO should head this key committee.
• Establish monthly pricing parameters within which the lenders should operate. Particularly on the business side, the lenders must have a weighted loan yield they can produce on a monthly basis. This will allow some pricing discretion and enable the lenders to provide better financial terms to the more-qualified borrowers.
• Tie loan and deposit profitability to lender bonus plans. This move is not always popular. Annual business plans are driven by when loans get booked and interest income is generated, so while banks often reward sales staff for volumes generated and credit quality, they also need to hold them accountable for the revenues generated.
In short, the lenders need to generate the loans when they said they would!
2. Reward customers for their quality relationships. Segment your pricing.
Community banks have built their reputations on providing greater value than their larger counterparts. Unfortunately this can be code for aggressive pricing and fee-free banking. This is compounded by the fact that every customer gets the same great deal regardless of the depth/breadth of their relationship.
This is where a relationship pricing strategy can do great things to lower your cost of deposits and boost deposit service charge income.
Executing on this needs to be carefully orchestrated as customers don't like change, so they need to feel this is in their best interest. When branding the tiered pricing plan, the focus needs to be on the bank’s appreciation of customer loyalty.
Steps to take:
• Begin with an in-depth understanding of your existing customer base.
Utilizing a marketing database, stratify your customers into sub-groups based on balances maintained, transactions performed, and the scope of services held with you. Taking this information and downloading it into a profitability model will reveal where the revenues are being generated—and where they are not.
• Develop a set of relationship packages, which allow you to offer your customers a bundle of products, services, and benefits depending on sub-group. These packages are linked to existing core checking accounts, and rates and fee structures will be based on the balances maintained.
The result is that customers feel rewarded and incented to increase their banking activity with you, while your deposit costs go down and fee income goes up.
3. Avoid balance sheet concentrations.
Too often, community banks become overly focused on a narrow set of businesses, typically on the lending side. Often, this can be attributed to the bank's founding focus on residential mortgages or commercial real estate.
Not only does this limited perspective contribute to the lack of revenue diversity, the concentration of business poses a credit risk.
I recommend the following:
• Try my “pizza test.” Using a food analogy, conduct this simple pie chart analysis. Take four pizzas, with two reserved for deposits and two for loans. Cut the pizzas into slices based on the percentage of dollars they represent by product type. Then, do the same for the revenues each portfolio generates by product type.
You'll be amazed at what you find.
• On the deposit side, I'd venture there is an under-penetration of DDA. Demand deposits should represent 30% of total deposits as they are rich in spread and fees. Core deposits (defined as DDA, savings, and MMA) should represent at least 70% of total deposits.
• On the lending side, no one portfolio should represent more than 40% of balances or revenues. Given community banks' geographic concentrations, this is both a credit risk and a handcuff on revenue generation if the portfolios are too concentrated.
4. Invest in new business lines.
There are some business lines that fit nicely with the high-touch, customer-focused business model offered by community banks. They deserve consideration as you look to enhance your value proposition and boost revenue streams.
On the lending side:
• Commercial and Industrial lending (C&I) is a highly profitable business, generating yields in the 5-6% range. They are an excellent cross-sell to your small business deposit customers and new C&I customers tend to bring deposits and fees with them.
• Loans held for sale on the residential and commercial segments are an effective way to get low-yielding loans off your books, reduce portfolio concentrations, and generate healthy premiums in the form of fees.
This needs to be a regularly recurring program—quarterly—as opposed to conducting the sales on a random basis. Done sporadically, the income won't be considered core income or an integral part of your business model.
On the deposit side:
• Wealth management is an excellent way to provide an investment alternative to clients, particularly when interest rates are low and clients are looking for higher returns on their savings. In addition to providing an excellent source of fee income, it's a powerful customer retention vehicle. In absence of a program, these customers could otherwise be flight risks.
• Insurance is also a great fee-based business, which is an easy cross-sell to the existing client base. Fixed-rate annuities are a tempting proposition to sticker-shocked CD customers looking for higher yields and little risk.
• Invest in your DDA offerings.
On the retail side, that means offering clients a way to utilize your mobile and online banking offerings. As debit card utilization tends to be low at community banks, marketing these to customers can only increase your fee income.
On the business front, cash management is a win-win. While it requires talented employees who are comfortable with the sales process, it's a perfect fit for community banks. Launching a program will bring you high-balance checking and significant fee revenue.
5. Acquire new revenue sources via acquisition.
If M&A is an established element of your business model and your capital levels permit, acquiring another community bank can be an effective means of boosting revenue streams and creating greater efficiencies within the combined organization.
Access to new customers, broader geographies, and potentially new business lines can get you where you want to go, faster. I caution, however, that M&A requires extensive due diligence, and its success ultimately depends on whether or not the integration strategy can transform two separate organizations into one well-oiled machine.
Despite not having all of the resources and tools that larger banks have at their disposal, community banks can solve the revenue diversity challenge. It requires careful attention to greater pricing discipline, rewarding customer loyalty, balance sheet management, and investment in fee-based businesses.
* Source of financial information is Capital Performance Group: Banking Industry Financial Performance (9/30/15)
** Definition of bank asset size categories:
Community Banks (less than $1 billion)
Midsize Banks ($1 to $10 billion)
Large Banks ($10 to $50 billion)
About the author
Former banker Peyton Patterson, subject of a “7 Questions” interview in late 2015—"Don't give away your bottom line"—heads Peyton R. Patterson Consulting. She has been in banking for over three decades, most recently at the top of two community banks—Bankwell Financial Group and NewAlliance Bancshares, both of Connecticut. Her career also includes posts with much larger institutions.