42nd Texas Tech School of BankingAugust 9, 2015

Timothy W. KochPresident

Graduate School of Banking at Colorado&

Professor of Finance, University of South Carolina

Community Banking: Then and Now

Fun Facts for 19801. Average price of a new home $68,7002. Price of 1 gallon of gas $1.193. Average price of a new car $7,2004. Price of 1 lb of ground beef $1.39

5. Top new TV show Dallas6. CNN was the only 24 hour news station7. John Lennon was shot in NY

8. Queen released ‘Another One Bites the Dust’9. Popular movies first release:

- Blues Brothers (with Jake and Elwood)- Caddyshack (with Bill Murray and Rodney Dangerfield)

10. Pittsburgh Steelers won their 4th Super Bowl

Fed Funds Rate: 0-0.25%Prime Rate: 3.25%

10-YR Treasury Rate: 2.238%30-YR Fixed-Rate Mortgage: 3.98%Number of FDIC-insured banks:(5,570 Com. Bks; 849 Sav. Bks)-March ‘15

Industry average ROA = 0.98% in 2015 Q1 Almost 200 community banks reported ROAs > 2.1% in 2015 Q1

Number of bank branches:Commercial banks - 82,156

August 2015 August 1979-80Now vs Then

Fed Funds Rate: 0-0.25%Prime Rate: 3.25%

Fed Funds Rate: 11.375%Prime Rate: 12.25%

10-YR Treasury Rate: 2.234%30-YR Fixed-Rate Mortgage: 3.98%Number of FDIC-insured banks:(5,570 Com. Bks; 849 Sav. Bks)-March ‘15

10-YR Treasury Rate: 9.33%30-YR Fixed-Rate Mortgage: 11.09%Number of FDIC-insured banks:(14,364 Com. Bks; 3,418 Sav. Bks)-Dec. ‘84

Industry average ROA = 0.98% in 2015 Q1 Almost 200 community banks reported ROAs > 2.1% in 2015 Q1

Industry average ROA = 0.77% in 1980

Number of bank branches:Commercial banks - 82,156

Number of bank branches:Commercial banks - 34,900

Number of bank branches in Texas:Commercial banks - zero

August 2015 August 1979-80Now vs Then

A Bit of Texas Banking History . . . • Texas did not allow physical branches until 1987

- no drive-up facilities because they were designated branches

• Texas legislature authorized interstate banking and permitted limitedbranch banking effective January 1, 1987- Price of one barrel of West Texas Intermediate crude oil (adj for infl):

$85.70 (Aug. 1979); $25.23 (July 1986); $16.42 (Dec. 1998)- In Feb. 2014, the first Bitcoin ATM in the U.S. opened in Austin, TX

• From 1987 – 1990, 7 of the 10 largest commercial banks in Texas failed- NCNB Texas National Bank absorbed First RepublicBank Corp.

(largest Texas-based bank) with substantial FDIC assistance- Bank One Corp. absorbed 20 MCorp banks (now branches)- In 1988, First City Bancorporation restructured after getting $1 billion

in capital assistance from the FDIC; it failed again in 1992

First City Bancorporation Marketing: 5-month campaign for new accounts in 1985Customer who deposited at least the following amounts for 5 years or more received the following bonus at the time of deposit:

• $100,000 - $499,999 Purebred Arabian colt or Weekend trip to NYC + mink coat orTrip to either China or South America

• $500,000 - $999,999 Steinway grand piano orScuba-diving vacation for two

• $1,000,000 or more Cessna 172 aircraft orPorsche 928S sports car

The campaign raised $280 million

Traditional Community Bank Branch

Today’s Branch (for Millennials)

August 6, 201510-yr = 2.234%30-yr = 2.909%

Reproduced with the permission of Mortgage-X.com

Long-term Trends in Interest Rates

30 Year FRM=3.98% on August 6, 2015

Themes

1. Many Community Banks are High Performers2. Community Banks Must Pursue Strategies to Achieve a

Fortress Balance Sheet3. Bank Managers Should Understand Market-Based

Performance Metrics5. Demographics Mandate the Use of All Delivery Channels and

Changing Technologies6. Bank Managers Should Emphasize Talent Management

General Attributes of a Community Bank

1. Management focuses on ‘high-touch’ relationships with bank customers, employees and stockholders. Decisions are made locally

2. Management pursues core financial strategies:a. Capital adequacyb. Reliance on core depositsc. Originate and hold loansd. Hold sufficient liquid assetse. Net interest income is the primary source of earnings

3. Bank competes in limited geographic markets.

4. There is a strong link between ownership and management.

How Important are Relationships?

• Community banks are the lifeblood of small towns and cities( Compare rural banks with urban banks)

• They are often locally-owned and locally-managed (S Corps, mutuals, etc.)

• Members of the boards of directors are typically small business owners and public figures in the community

• Bank officers and employees often serve on community boards and foundations and contribute time and resources to local schools and non-profit organizations

• Loan officers personally know individual and business customers and have seen the property, etc. the bank is financing

Implications

• Size matters – at some point, the firm becomes too large and focuses on transactions efficiency. This is not ‘bad’; it represents a different business model.

• Business strategy is important – focus on long-term relationships. What is management’s/owner’s strategic objective? Growing quickly in order to sell to a larger organization is inconsistent with a focus on long-term relationships.

• Closely-held organizations likely manage risk differently. Differentiate between S Corp banks, mutual organizations, other closely-held firms and other institutions.

Greatest Threats . . . • Regulatory Burden

- Compliance costs (direct & indirect)- Uncertainty regarding whether bank will be subject to

specific rules- Mortgage Lending (QM vs Non-QM; servicing, appraisal, etc.)- Truth in Lending/RESPA (TRID) – 637 page disclosure rule - HMDA (increased reporting requirements) - UDAAP (Unfair, deceptive, or abusive acts or practices)

• Lack of Strategic Focus

• Lack of Preparation for Rapidly Changing Customer Demographics

• Lack of Attention to Talent Management / Management Succession

Profitability of Community Banks Employing First-Time Attendees at the 2015 GSBC School Session in 2014

ROE = ROA x Equity Multiplier (Assets/Equity)

ROE = 1.06% x 10.1X

= 10.71%

Quarterly Banking Profile, March 2015 at www.fdic.gov

Understand Market-Based Performance Metrics

• Price / Tangible Book Value

• Price / Earnings (Cash) Per Share

• Core Deposit Premium

Economic Growth Varies by State According to Market Orientation

• Business friendly policies toward labor and taxes are associated with higher state GDP growth rates and higher employment- labor policies measured by right-to-work laws and minimum

wage rate below the 50 state average- tax policies measured by state marginal tax rates

Conclusion: GDP grows 1.5X more in right to work states withbelow average tax rates (2000 – 2015 Q1)

Highest growth: Nevada, Utah*, Texas, Arizona & North DakotaSlowest growth: Michigan, West Virginia, Mississippi*, Illinois & Ohio

• States that suffered the most severe recessions measured by employment growth in 2007-2009, experienced the highest employment growth from 2010-2014

*Utah has above avg. marginal tax rates; Mississippi is a right-to-work state with low taxes

Source: Edward Lazear, WSJ, June 23, 2015

The concept of a fortress balance sheet involves having an efficient operating structure and a balance sheet that is shock-proof. In terms of the regulatory and market environment, management must focus on maintaining excellent CAMELS ratings and credit ratings.

To ensure survival and create opportunities to take advantage of market disruptions, do the following:

• Build a strong capital base• Have a strong core deposit base• Have a well-diversified loan portfolio• Hold short-term, unpledged liquid assets• Focus on net interest margin• Manage the investment portfolio, but keep it simple• Find and grow sources of non-interest income

Community Banks Should Build a FortressBalance Sheet

Strategic Checklist for Community Banks• Be able to identify your most profitable customers and the source of profits• Understand your customer demographics• Research how many customers actively use multiple bank products and

services; know how much of a customer’s overall banking business is conducted with your institution

• Deliver services to customers via multiple channels, including physical branch, kiosk, interactive tellers, via online and mobile banking – Use technology to operate on the leading edge

• Develop strategies to retain younger customers before they leave the local community – for they shall inherit

• Have an effective calling program that touches key borrowers frequently• Avoid loan concentrations, loans outside the local trade area and minority

positions in participations to the extent possible• Price loans and deposits to ensure a minimum net interest margin• Hold a meaningful amount of short-term, unpledged high quality securities;

structure pledging programs to provide as much flexibility with unpledged securities (collateral for future borrowing)

• Invest only in securities that you understand

Strategic Checklist continued

• Establish credit lines with the Fed, FHLB and correspondent banks and test them periodically; develop meaningful contingency funding plans

• Diversify the bank’s revenues to focus on increased noninterest income• Consider partnering with other banks or bankers banks to jointly acquire

access to services or specific expertise• Communicate regularly with bank regulators, particularly when key risks

change and when pursuing new strategic initiatives• Have engaged directors who understand the bank’s business model and

effective corporate governance practices• Manage the bank to enhance shareholder value, so understand the key

drivers of:- cash earnings per share- tangible book value of stockholders equity- core deposit premium

• Have a comprehensive and effective enterprise risk management program

Source: Community Banking: From Crisis to Prosperity, Makawk Books, 2014

“The Battle to Bank Millennials,” January 20, 2015

Fry, Richard, “This year, Millennials will overtake Baby Boomers,” Pew Research Center, January 16, 2015

0% 20% 40% 60% 80%

FacebookInstagramSnapchat

TwitterVine

Google+PinterestTumbler

WhatsappLinkedIn

% Use

% Use

Source: 2015 Internet Trends Report, KPBC survey by Mary Meeker; USA Today, May 28, 2015

Social Media Use by U.S. population, aged 12 - 24

How Many Times Per Day Do You Check/Use Your Smartphone?

Consider checking time, messaging, voice call, music, gaming, social media, camera, alarm, news & alerts, calendar, web search, etc.

1. 0 – 75

2. 76 – 150

3. 151 – 225

4. > 225

Update on Mobile Banking ServicesSource: “Consumers and Mobile Financial Services 2014,” by the Board of Governors of theFederal Reserve System, March 2014

• Number of Times the typical user checks his/her phone per day- messaging (23); voice call (22), check time (18), music (13), gaming (12), social media (9),

camera (8), alarm (8), news & alerts (6), calendar (5), web (3), search (3) and other (14)- total exceeds 150 (United States, March 2014)

- total: 221 (United Kingdom, Oct. 2014; Source: betanews.com)

• Mobile commerce will account for an estimated 24.4% of overall ecommerce revenues by 2017

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Text Messaging Social Media Instant Messaging Blogging

Millennials Generation X Baby Boomers

Fraction of Category Active with the Associated Media

Source: La Roche, Julia, “Goldman: Here’s how millennials will completely change the economy,” www.businessinsider.com; Feb. 27, 2015

Millennials . . .

• 50+% actively play video games• 30% live at home• Are delaying marriage; thus waiting longer to have children• Are reluctant to buy homes• Are active participants in the sharing economy (cars, hotels, …)• Want maximum convenience at the lowest cost• Buy lots of stuff online• Exercise more, eat better and smoke less

Source: La Roche, Julia, “Goldman: Here’s how millennials will completely change the economy,” www.businessinsider.com; Feb. 27, 2015

What Do Millennials Look for in an Employer?• Millennials want to work where they can grow with their employer

- Offer the technology, accessibility and transparency the today’s ‘connected’ customer wants

- Open environment where lower-ranked employees can walk into the officeof a higher-ranked employee to ask a question

- Define a clear path where a teller can become an officer

• The intangibles offered by the employer- Entrepreneurial spirit- Willingness to be flexible and collaborative (flexible work hours, PTO)- Ability to change jobs within the organization

• Opportunity to make an impact- Work should have a purpose - Give them ownership of a project (branch of the future)

• Constant recognitionSiya Vansia, “What Millennials Want in an Employer,” American Banker, April 30, 2015

Watch: Millennials in the Workplace Training Video – YouTubeMillennials: We Suck and We’re Sorry - YouTube

Brownstone, Sydney, “Millennials Will Become The Majority in the Workforce in 2015. Is Your Company Ready?” www.fastcoexist.com; The 2015 Millennial Majority Workforce, study by Elance-oDesk & Millennial Branding

What Do Customers Want?*• If they were to change banks, more than 25% of customers

would consider a branchless bank.

• Just under 75% of U.S. bank customers view their banking relationship as transactional.

• A majority of customers want their institution to proactively recommend new products and services

• Almost 50% of customers would like assistance with budgeting analytics.

* The Digital Disruption in Banking, Accenture, 2014

How Will You Compete with . . . ?• Square: accept debit and credit card payments via smartphones

or tablets via a ‘reader’ that plugs into an audio jack- in early 2014, sellers could accept payment in Bitcoin- in 2014 introduced Square Capital (small bus. lending)

• Dwolla: transfers $ instantaneously via FiSync (federally approved) via member institutions at no cost to user

• PayPal: digital wallet allowing payments/money transfers

• Apple Pay / Google Wallet: mobile payment services (tied to credit/debit card accounts;

• Bitcoin: a new type of money and a payment system with instantpeer-to-peer transactions and low processing fees; it is open-source so no one owns it (Treasury labels it a virtual currency)

Christopher Mims, “Money Isn’t Free, but Moving it is Now Cheaper,” WSJ, June 8, 2015

• B Crowd-funding via Bitcoin

• VENIMO: the Snapchat of money – peer-to-peer paymentsystem; $2.4 billion (2014) & $1.2 billion (Q1- 2015)

• Facebook Messenger: peer-to-peer payments

• TransferWise: international peer-to-peer payments

Almost instantaneous transfers; most are at no cost

Most use banks; what happens when most customers actively use only mobile devices?

How Will You Compete with . . . ?• Lending Tree

www.ispot.tv/ad/7Zpc/lending-tree-bank-speak

• Earnest – an online lender that markets to millennials- the traditional credit industry “functions as an investment tool for organizations that lend” rather than a system to help individuals achieve financial mobility

Earnest uses “merit-based interest rates” that incorporatethe individual’s credit score plus information regardingeducation, employment, personal income, . . . LinkedIn profile

• OnDeck – makes small business term loans online with loans from $5,000 - $250,000 and maturities from 3 – 24 months; offers lines of credit up to $20,000; Over $2 billion in loans

• Peer-to-Peer LendersProsper.comIndividuals can invest (lend) or borrow; rates are fixed ranging from 6.73% - 35.36% APR; amount available rangesfrom $2,000 to $35,000; claims to have originated $1.6 billion in loans in 2014

LendingClub.com – Same format; can borrow up to $35,000Returns to investors range from 4.74% - 7.98%Borrowers get fixed-rate loans with no prepayment penaltiesand no ‘hidden fees;’ quick access to credit ($4.4 billion in 2014)

Affirm – targets the financing of online purchases; it alsoconsiders an individual’s Facebook account, cell phone activity,etc. (non-traditional information); buy from approved retailers(100+ signed up in 2014); plans to enter education and small business lending

Wack, Kevin & Bailey Reutzel, “How P-to-P Lending Evolved into Different Animals in the U.S., U.K.,” WSJ, June 8, 2015

• LendUp (payday lender – founder was a senior executive atZynga, which created ‘Farmville’ )

- Qualifying customers can get access to credit in 15 minutes- Borrowers readily see their APR under different loan

scenarios; in CA a 15-day $250 loan requires interest of $38.60 for an APR of 375%.

- Loans cannot be rolled over; if unpaid, the firm puts in placea payment plan with payments allocated first to principal

- Borrowers that repay their loans qualify for ‘rewards’ thatinclude lower rates and higher credit amounts.

- To encourage repeat business, it has a Lender Ladder program that allows borrowers to move from Silver to Goldto Platinum to Prime status, at successively lower rates . . . Prime status applies rates between 19% - 29% and will report successful repayments to credit bureaus.

You Can Count on it . . .• Financial innovation will produce more affordable ways for

consumers to access small loans (consumer and business)

• Financial innovation will remove or at least reduce existing frictions that constrain the movement of money throughout the globe – and will do so at a lower cost to consumers

VCs Invest $23.5 Billion in Fintech

Crosman, Penny, “Three Technologies That Could Keep Banks Relevant, Per Santander,” American Banker,June 29, 2015

0 10 20 30 40 50 60 70 80 90 100

Bank Branch

ATM

Telephone

Online Banking

Mobile Banking

% Accessing Banking Services by Source

2014 2013 2012

How Do Customers Access Banking Services?

Consumer and Mobile Financial Services 2015, Board of Governors of the Federal Reserve System, March 2015 at www.federalreserve.gov

Banks and Bank Branches Will Not Disappear . . . Soon

Carney, John, “Mobile Finance Won’t Bring a Bank Ice Age,” WSJ, Jan. 5, 2015

Trends in the Number of Branches

“Where Branch Closures are Concentrated,” American Banker online, January 13, 2015

Management Succession Opportunities• “I’m tired of battling with regulators, and I’m not having fun

anymore.”

• “If I could get 2X book and liquidity, I would sell . . . .”

• Is it that the bank hasn’t been proactive in addressing competitive and regulatory concerns? And hasn’t adequately planned for management succession?

• What does it cost to hire a senior executive for a community bank and use an executive search firm?

• Would you be better served to develop known internal talent for the C-level positions?

CEO School for Community Banks

Key Features of the Executive Development Institute (EDI) for Community Bankers

• Emphasis on strategic thinking

• Focus on personal development

• Use of own-institution information

• Development of initiatives to improve the bank’s bottom line

• Enhance personal network of peers

Program is 19 months in length; 4 on site sessions (Denver, CO) beginning in April and ending in October 19 months later

• Each participant receives 10+ hours of executive coaching

• Each participants works with a CEO mentor from a similar organization outside the participant bank’s trade area

• Extensive use of leadership, coaching, communication diagnostic tools

• Completes three research projects using own-bank information:- comprehensive internal risk assessment- talent management assessment- initiatives to increase non-interest income and/or reduce

non-interest expense

Specific Program Features

References

Banking Compliance Index, BankingComplianceIndex.com, info.continuity.net/bci

Hall, Phil, “Community Banks Struggle Against Regulatory Burdens,” National Mortgage Professional, October 15, 2014

Lux, Marshall and Robert Greene, “The State and Fate of Community Banking,” working paper No. 37, Mossavar-Rahmani Center, Harvard Kennedy School, February 2015

Peirce, Hester, Robinson, Ian and Thomas Stratmann, “How Are Small Banks Faring Under Dodd-Frank?” working paper, Mercatus Center, February 2014

Contact Information

Timothy Kochtimothywko@gmail.com803-777-6748