Strategy 101: Part II

By Cass Bettinger, Cass Bettinger & Associates

All bank strategies, in the final analysis, will be directed at  achieving the specific financial performance objectives needed to satisfy the bank’s owners/shareholders. These strategies fall into two broad categories; those that impact directly specific financial objectives under the shareholder commitment and those whose impact is indirect, supporting objectives under the employee, customer, and/or community commitments.

Financial performance objectives will likewise fall into two broad categories; those which relate to ROA (and its six drivers) and those that relate to the management of the capital ratio and its reciprocal, the equity multiplier. This relationship is expressed by what I call “the shareholder value equation”.

The strategic relevance of the shareholder value equation is that there are only two drivers of ROE, and they must be managed in tandem. For example, there are numerous combinations of ROA and equity multiplier (100 ÷ capital ratio) to produce a target ROE, as shown below:

One of the fundamental responsibilities of boards and executive leadership teams, and an absolute prerequisite for effective strategy, is to reach consensus regarding the target ROE and the preferred combination of ROA and capital ratio/equity multiplier to achieve the target ROE.

The next strategic imperative relates to building the optimum portfolio of compatible strategies for each of the two drivers. In this and the following column we will focus on ROA strategies. The subsequent column will focus on strategies for managing the equity multiplier.

ROA has six drivers, each of which is expressed as a percentage of average assets; 1) interest income, 2) interest expense, 3) non interest income, 4) overhead expense, 5) loan loss provision, and 6) taxes. Each of these, in turn has drivers that must be mastered. For example, interest income, the most powerful driver in most community banks, has three drivers, 1) the earning assets/total assets ratio, 2) earning asset mix, and 3) pricing. Every strategy for managing interest income/avg. assts, for example, will be directed at one or more of these three drivers.

These strategies might involve 1) the operations area, e.g., reducing cash and due from in order to increase the earning assets/total assets ratio; 2) marketing, e.g., strengthening the bank’s brand in the minds of target borrowing audiences (the stronger your brand the less you have to compete on price; the weaker your brand the more you have to compete on price) and/or redirecting marketing resources in order to change earning asset mix; 3) finance, e.g., designing systems to track loan portfolio yield by loan officer (differences of 50 to 75 basis points are not uncommon); and 4) HR, e.g., designing compensation systems that link incentives to portfolio yield and/or relationship profitability and/or which provide training in negotiation skills and/or which provide training in understanding and managing personality profile (which influences significantly, and unconsciously,  how lenders price loans).

When developing ROA strategies it is important to remember that “every basis point counts.” For example, consider the impact on ROE of 15 basis points in a bank with a 7 percent capital ratio (14.28 equity multiplier). 

It is entirely conceivable, for example, that the owners of a bank earning close to 15 percent might be quite satisfied - but would seriously consider selling if the return were consistently less than 13 percent. In other words, the difference between selling and remaining independent might come down to a mere 15 basis points!

Consistent high-performing banks do not rely on a single 50 basis point strategy, but rather on multiple strategies, each producing just a few basis points above the peer group average.

In the next column we will focus on strategies for managing the other five drivers of ROA.

  <back to June 2006 Directors Digest>