“Ducks in a Row: An American expression meaning to have one's arrangements completed, to have things organized or lined up; or, literally, to have one's skittles set up. In an American bowling alley the skittles, or pins, are called ducks.” – Brewer's Dictionary of Phrase and Fable, ISBN 0-06-270133-9

As the year draws to a close, are you feeling like you have your strategic ducks in a row? As you take stock of your situation, consider these third-quarter returns for the bank and thrift industry:

• For the first time in 18 months, the FDIC reported that institutions with assets greater than $100 million saw a quarter-to-quarter increase in net interest margins: one basis point.
• Non-performing loans, at 0.74% of total loans, are at their second-lowest level in 22 years. Still, caution reigns as, for the first time in three years, loan-loss provisions were added to loan-loss reserves at a faster rate than amounts taken in net charge-offs.
• Deposits continued to grow: 2.2% during the third quarter. Nonetheless, the growth rate still did not keep up with the pace of 2.7% loan growth, and non-interest-bearing deposits (those long-duration, low-cost sources of funds) actually declined.
• The industry seems to recognize that in order to preserve, protect, and defend returns on equity, balance sheets must grow. They are increasingly growing by way of loans, which now constitute 60.7% of assets. Recent growth has largely been generated by construction and commercial real estate loans. Conversely, C&I and home equity loan growth have been noticeably stagnant.

The world of financial services faces well-known and formidable challenges: escalating technology and labor costs (some institutions report year-over-year loan-officer compensation rates growing by nearly 40%), competition from organizations and products that didn’t even exist several years ago, increased regulatory oversight, and funding and asset growth challenges. It is an understatement to claim that change represents the only constant.

How can you be ready for the change—and challenges ahead? We offer the following thoughts for your consideration as you prepare for a New Year:

1. Banking is a declining margin business. It’s always been that way in retailing. Get used to it and sell like a retailer. But, remember: your expertise and ability to execute remains in banking!
   How are you measuring the success of your sales and marketing efforts? Are you gauging success by growth in revenues or balances? Most successful retailers measure performance on the basis of sales-per-square foot, or better yet, profit-per-salesperson. Revenues or balances are always easier to measure than product or customer profitability. Measuring performance based on information that may be the easiest, rather than the most relevant to attain, is analogous to driving in the fog. Measuring profitability, preferably on a risk-adjusted basis, requires systems and analytical tools that allow you to assess profitability throughout your customer and employee base and product line.

   As is the case in retailing, there’s reason to be concerned about physical overcapacity. Over the last 12 years, the nation’s population-to-branch ratio has declined by 15%. While there may be less potential for additional breadth of market, there’s always room for more depth. That means hiring and retaining bankers with expertise and the ability to execute. You cannot succeed in developing a sales-driven culture without these fundamental abilities. In his famous treatise, The Effective Executive, the late Peter Drucker frequently cautioned that organizations will not succeed if they attempt to sell a product before it has been developed or made capable of successful execution. As a retailing pioneer, James Cash (J.C.) Penney was on the same wavelength: “We can serve our customers well only if our buying jobs are right. You cannot sell if you haven't ordered wanted goods into your store.” Those goods in the store are analogous to having a team of state-of-the-art bankers!

2. Niche guys don’t finish last.
   In the late 19th century, Italian economist Vilfredo Pareto deduced that 20% of the peapods in his garden produced 80% of the harvest. While the ratio may not be exactly the same in the case of your customer base, the theory is relevant: 20% of your products, customers, and/or employees are likely to be producing 80% of the results. The time and money that you spend on these variables should roughly the same.

   Highly focused banks are migrating to business models that target specialized segments. Institutions that develop a deep expertise and are capable of delivering a premium product will avoid the invariable price wars and reap the benefits of growing ROEs.

   The good news is that there are more ways to differentiate your mission than ever before. Chances are that you won’t need to seek new niches to develop. Rather, you might simply need to define the specific areas of expertise and knowledge that you already are providing to your customers. Just as an upstart entrepreneur must be able to articulate the unique value proposition that a competitor would find difficult to copy, so must you. How does your financial institution truly stand out from the rest of the pack?

3. Know and exploit your unfair advantage.
   In his most recent book, The Power of Unfair Advantage: How to Create It, Build It, and Use It to the Maximum Effect, Silicon Valley management consultant John Nesheim urges organizations to direct time and effort toward the services that stand out as distinctive competencies that are difficult to replicate. Unfair advantage can take on a number of forms, ranging from a service-oriented staff with little turnover, to having the ability to service complex and unique industries.

   On the surface, distinctive competencies may seem tough to find in financial services, but here are some examples:

   • Going beyond a Customer Relationship Management (CRM) system to a CRM culture. Certain banks might segment customers not only based on the size of account balance, but also by other factors, including length of relationship and probability of increasing “share of wallet.”
   • Consider the benefits of a “keep-it-simple” strategy. Netherlands-based ING Direct did just that in attracting a quarter-of-a-million U.S. depositors into basic online CD and loan products. ING eschews checking accounts and offers only three types of mortgages—that’s it. Simplicity can sometimes be perceived as a distinctive competency.
   • With$1 billion in assets, Los Alamos National Bank in New Mexico sees its unfair advantage as being a low-fee, high-value community bank. Los Alamos has the distinction of being the only banking recipient of the Malcolm Baldridge National Quality Award to date. By offering low fees on loans and credit cards, the bank has been able to continuously grow its net interest margin. More importantly, being located within a region with a highly educated workforce, the bank supports a vigorous executive and leadership training effort for its employees. To date, over two-thirds of the bank’s staff has been provided external training. A highly educated bank staff within a highly educated community—now that’s an unfair advantage!

   What’s your unfair advantage?

   • The ability to process loan applications faster than anyone else in your market area due to your investment in a state-of-the-art, automated, decision-support system?
   • The ability to comprehensively and professionally service a unique industry or market sector?
   • Unique trust and wealth management services and the historical performance record to prove it?
     
     
4. Define and develop an organizational culture that invests in employees, rewards performance, spurns complacency, and is comfortable with change.
   With mediocre performance hardly a vanishing commodity, it sometimes appears that the primary charter of some organizations is to serve as a warning for others! One of our favorite reads is Patrick Lencioni’s The Five Dysfunctions of a Team. In this short parable, a 57-year-old executive from the automotive sector is unexpectedly selected to lead Decision Tech, a young company that had been missing development deadlines and recently been hurt by key executive departures. Within months, the company was on the rebound, having recognized and addressed the following dysfunctions:
   • Absence of trust
   • Fear of conflict
   • Lack of commitment
   • Avoidance of accountability
   • Inattention to results

   In short, Lencioni defines a successful culture as one that: fosters an open flow of communications, questions which issues are important, solves critical problems quickly, learns from mistakes, has a bias toward action, exerts constant pressure to improve, discourages individual “superstar” behavior, and celebrates success. It’s interesting to think about the finalists in the past year’s World Series contenders. Both appeared to have exemplified these qualities.

   How do you obtain the necessary ingredients for developing such an organizational culture? It’s often said that a democracy cannot be imported or imposed from outside a country. The same philosophy would apply to the culture of an organization.

5. Link your strategies with performance benchmarks and action steps.
   Suppose that your institution agreed to forge ahead with five key strategic initiatives after your annual management retreat. You might consider backing these strategies with specific performance objectives. Here are some examples:

   Strategic Initiative Performance Objective Action Steps To become the financial services employer of choice in the tri-city area. Limit personnel attrition to 10% annually. Attain summary employee satisfaction survey results of “8” or better. Construct an intranet employee communications module. Implement a new incentive plan that rewards individual and team performance. To deepen customer relationships and maximize “share of wallet.”  Reach an initial goal of having each customer using six different products and services by the end of 2006. Sell a new property management escrow deposit product to at least 25% of property managers in our market area. Upgrade your CRM software. Add deposit sales goals to your bank-wide incentive plan. Execute new breakpoint deposit pricing plan that is scaled with customer product usage. Increase sources of liquidity and develop more cost-effective funding mechanisms. Increase your core deposit ratio to 70%. Increase your availability of funds from the Seattle Bank. Apply for expanded collateral with the Seattle Bank. Develop an enhanced sources-and-uses-of-funds model. Include a marginal-cost-of-funds model within your deposit pricing process. To become the preferred source of innovative mortgage products. Grow your reverse equity mortgage product to 25% of market share in the region. Accelerate your HELOC response times to one business day. Hire one underwriter and one originator with reverse-equity mortgage product expertise. Reallocate staff in order to add two additional FTEs into the mortgage underwriting function. Deliver loan growth and support the region’s highest credit standards. Support a ratio of non-performing assets-to-total assets in the lowest quartile of competing institutions. Originate commercial loans-per-employee by more than at least 80% by the end of 2006. Redesign your loan pricing model. Design a new quantitative credit scoring model for your commercial real estate loan portfolio. Identify, train, and develop top branch personnel for commercial loan origination.

   
   
6. Keep your eyes on the risk meter. Know what can hurt you the most, and buy the insurance before you need it.
   By now, you know that your best defense against interest rate risk is good intelligence. That good intelligence comes from a thorough and dynamic modeling of your balance sheet under a variety of interest rate assumptions. While interest rate risk can be mitigated by specific actions, including extending or shortening assets or liabilities, credit risk can be equally, if not more disruptive to your best laid plans. Let’s face it; in many markets, rising loan demand and favorable economies have prompted slippage in underwriting standards.

   Much of the increase in loan demand has come from commercial real estate activities. Commercial real estate lending now constitutes more than 30% of total community bank assets, the highest level since the early 1990s. As we know, in the early 1990s, the industry sustained large write-downs when the overbuilt commercial real estate market went bust. While we can hope that at the next low point in the cycle will spur fewer casualties, there are some steps that you can now take to reduce your risk, including funding and holding shorter and smaller commercial real estate loans and smaller construction loans. Before approving commercial real estate loans, gain comfort in modeling the debt service coverage of the asset against a variety of economic and interest rate conditions. It’s smart to favor cash flow-based credit analysis above and beyond projected market value, or collateral analysis. Read the November 2005 issue of What Counts for some credit scoring techniques that provide you with objective parameters that can increase your chances of stocking your balance sheet with “A” credits.

   You might be among the many asset-sensitive institutions that have profited by 325 basis points in successive rate increases. If you believe the implied forward yield curve, you have 50 – 75 basis points of additional good times ahead. After the Fed ceases its tightening campaign, what will the effect of declining rates be on your floating-rate portfolio relative to your long-duration sources of funding? Have you thought about hedging your downside in the event rates decline? Now might be the time to consider such tactical options as:

   • Purchasing interest rate floors in the capital markets
   • Shortening your liability durations by pricing your shorter-term deposits more aggressively than your longer-term deposits
   • Obtaining variable rate funding with embedded interest rate caps from the Seattle Bank
   • Structuring your variable rate loan portfolio with floors
   • Adding longer duration investments to your portfolio with less-frequent calls, or no calls at all

   The odds are high that the cost of implementing these solutions will be less than they will be when—and if—rates start declining.

Port Out, Starboard Home
In the 19th century, the European traveler’s equivalent of a 21st century first-class upgrade involved avoiding the sun’s direct heat by booking eastbound passage from to India on a ship’s port side and westbound passage on the starboard side. During 2006, it may prove challenging to avoid the heat of declining margins and confirm your bank’s passage in the most desirable accommodations. The sailing will be smoother to the extent that you know your strategic mission and distinctive competencies, develop a conviction to them throughout your organization, and link them with specific performance objectives and action steps.

John Biestman is assistant vice president, senior bank analyst at the Federal Home Loan Bank of Seattle.

IMPORTANT DISCLAIMER, PLEASE READ: The Federal Home Loan Bank of Seattle ("Seattle Bank") publishes What Counts for educational and promotional purposes only. The data and analysis presented are based upon information obtained from sources that we consider reliable. The opinions expressed represent the current opinions of our staff and are subject to change without notice. We make no warranties, express or implied, regarding the accuracy or completeness of any information, analysis, or opinions presented. No part of this newsletter may be reproduced in any manner without the written permission of the Seattle Bank. The Seattle Bank, its employees, agents, and contractors are not registered investment advisors, financial advisors, or broker dealers, and they are not acting in a fiduciary capacity. The information contained in this newsletter does not constitute a recommendation, offer to sell, or solicitation of an offer to purchase any particular investments or products, including without limitation securities of any companies discussed, and it should not be construed as such. It is the reader’s responsibility to evaluate the suitability, risks, and merits of any investment, funding strategy, or business proposal presented in this newsletter. Newsletter content is for our readers' informational purposes only. Please refer to our Terms of Use for details.