Survive and Thrive (Part I)

By Greg Madsen
Senior Consultant

 

As we learned in graduate school, the primary goal of any organization—above profitability and customer satisfaction—is survival. Over the past three years, 304 banks have failed. This number is especially stunning when compared to the previous eight years, when only 27 banks failed. In proportional numbers, these last three years resulted in more than 100 failures per year versus fewer than four per year in the previous eight years—a 25-fold increase in the failure rate. These numbers exclude the large banks that were bailed out by TARP. Clearly, this recent trend is a threatening storm cloud for many of the remaining banks. Breaking the recent failures down by asset size, we see the following:
 

I’ll leave it up to others to dissect the exact causes, but the most common underlying root causes for the failures have been bad loans and significant missteps by bank management.
Some questions that begin to arise from this stark reality are: “How many more banks are on the failure bubble, and what actions can bank management take to survive?” To answer the first question, one can analyze the $1 to $10 billion asset segment. Currently, there are 558 active banks and savings associations in this category; whereas three years ago, there were approximately 608. Two telling statistics of the failed banks in this asset category are the changes to their net charge-offs (NCO) and efficiency ratio (ER) over the few years preceding their demise. These changes are especially revealing when the banks are compared to their peer group. Looking at year-end data two years prior to a bank failing, the NCO and ER numbers tend to resemble those of healthy banks. However, the year-end data one year back begins to show a large gap between the ailing banks and their healthy peers. What this tells us is that a bank can look healthy one year but slide downhill quickly the next. Loans are charged off in growing numbers, and the ratio between income and expenses deteriorates rapidly.
 

Recent history also shows that the vast majority of banks in this $1 to $10 billion asset category that have continued to survive have maintained an ER at or below 62% (note that the ER of the top quartile of banks is 51%). Obviously, the lower the ER, the better shape a bank will be in, but any bank with an ER over 70% is beginning to slip into an unhealthy situation.
 

Using June 2010 data, more than 180 organizations—35% of banks, thrifts, and savings associations in the $1 to $10 billion asset class—have an ER ratio of 70% and are in the survival danger zone. This provides some insight into our first question about how many banks are on the failure bubble. Having this many banks in the survival danger zone is a risky situation for both the banks and the financial industry.
 

So, what are some survival strategies for these banks? Clearly, an aggressive work-out plan to minimize the effect of bad loans is a top priority. Fortifying the collection department and being flexible with repayment terms is one strategy. Improving the ER is a companion strategy that also should be addressed. For an $8 to $9 billion bank to drop its ER from 70% to 60% requires some combination of increasing income and reducing expenses. Because increasing income traditionally requires a longer timeline than reducing expenses, expense reduction is the most reasonable option if organizational survival is at stake when time is of the essence.
 

When organizations get into the survival mode and choose the expense reduction route, they usually focus on across-the-board actions, such as cutting everything by 15%. In the short run, that action is harmful to everyone—employees, customers, and taxpayers (through the loss of jobs). It punishes those managers and employees who have tried to keep expenses in line with work needs and rewards almost no one.
 

Surgical cost cutting, on the other hand, requires strategic information about where the best opportunities lie for reducing expenses without placing undue hardship on employee workload. With high-quality information, some parts of an organization can be cut by 20%, while other parts can keep their current cost structure. This strategic information can be obtained by using comparative peer data, such as that in the Bank Performance Study that Nolan does each year. (Find out more at www.bankbenchmarks.com.)
 

Survival is the primary goal of every organization, and surviving means having a chance to be profitable again. Surviving also provides management with the opportunity to resolve to never again get in the same financial bind and to take actions to do a much better job running the company.
 

Look for Part II - "Thriving" in next quarter's Nolan newsletter.