As Retail Banks' Credit Problems Ease, What Will Drive Growth?

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by: Tom Brown

I was in Orlando earlier this week at the annual “Best Practices in Retail Financial Services” conference SourceMedia puts on every spring. It’s a worthwhile event, now in its 15th year. (Disclosure: For the conference’s first ten years I was its chairman and m.c.)

This year was the first time I’d been to the conference solely as an attendee. I went because, as my confidence grows that the banking industry’s credit problems are about to ebb, I want to start trying to figure out how companies will actually grow once loan loss provisions are back to normal. Talking to people at Best Practices seemed a good place to start.

Don’t get me wrong: credit and credit costs will drive bank earnings for the next two years or more, and credit is still where we’re doing the bulk of our work. But a more normal environment looms just over the horizon—and I want to spend some time before it arrives to figure out just what that environment will look like.

In any event, here, in no particular order, are issues that bankers will likely be thinking about once things get back to normal:

1. Companies aren’t sure how to respond to changes to Regulation E. Come July, most banks will experience a meaningful revenue reduction as a result of the regulatory changes to Reg E, which deals with Nonsufficient Fund (NSF) practices.

At many banks, NSF fees make up around 50% of total service charges, and are (by far) the largest fee income item. But not all customers pay the same number of NSFs—far from it. If you rank a typical bank’s retail customers into five buckets based on deposit balances and look at each bucket’s profitability mix, you’ll find wide variability. In the first (high-balance) quintile, profitability comes from high spread revenues and some NSF fees. At the bottom quintile, meanwhile, NSF charges are the dominant source of profits. Once the revised rules kick in, at most banks these accounts will likely switch from being highly profitable to being meaningfully unprofitable.

Worse, most banks seem to not have decided yet how to respond to the shortfall. Based on what I heard at the conference, all expect a meaningful negative impact during the first year following the changes. But they expressed a surprisingly high (to me, anyway) level of confidence that they’ll be able to offset the negative impact with still-undreamt-up changes and new products. I’m skeptical. Anyway, we’ll be spending a lot of time on this over the next two years.

2. Branch networks will be re-examined, and maybe re-thought. At the end of nearly a decade’s worth of overbuilding, the typical branch network isn’t the untarnished crown jewel of a retail bank that it once was. The number of branches has grown at twice the rate of the U.S. population over the last decade, while, for the last few years, per-branch transaction activity has declined. Low interest rates have cut the value of non-interest bearing deposits in the short term. All this bad news has been partially offset by a reduction in branch operating costs. Still, this situation can’t last. I believe branch-related expenses will receive a lot more management and investor attention over the next few years, and that banks will shutter branches almost as furiously this decade as they opened them in the 2000s. Oddly, no one talked about this much at the conference. And when I brought it up, it seemed clear not many people have given much thought to the issue.

3. Execution still isn’t easy. At most banking organizations, the gap between strategy and execution remains as wide as ever. Much of the discussions at the conference (and every other retail banking conference I have attended over the past 20 years, for that matter) have focused on this gap. Obviously, it’s not easy to get strategy and execution in sync, but it’s (still) painfully obvious that it will never happen without the commitment of senior management. Frankly, I feel sorry for the retail bankers I meet at conferences like this who simply can’t get the dedication (or sometime even attention) of their top leaders.

4. Regulatory reform will put more burdens on banks. Eugene Ludwig, a former Comptroller of the Currency and current CEO of Promontory Financial Group, gave a speech that, while it was in line with what I expected, was depressing nonetheless. He provided a laundry list of areas where banks can expect more attention from bank examiners, along with a slew of new requirements to come from pending legislation.

I respect Gene Ludwig a lot. He said frankly that, while regulatory changes are indeed needed, Congress and regulators, in their haste to “do something,” aren’t likely to adopt the best solutions. The likely result: more costs to banks and, at the margin, less lending to creditworthy borrowers.

Other interesting ideas and presentations: coming changes at Citibank’s (NYSE:C) retail banking platform, success stories of three banking organizations of various sizes in different regions (BB&T (NYSE:BBT), Bancorpsouth (NYSE:BXS), New Alliance (NYSE:NAL)), and the significant erosion in consumers’ trust in banks, particularly large banks.

As I say, credit and credit recovery is the big investment issue in the banking sector now. But as the recovery plays out as I expect, soon investors will be back looking at how banks can generate sustainable growth. It will nice to be able to deal with non-crisis issues again.

What do you think?