Banks with “cost save leap” potential

Centerstate Bank’s correspondent group recently published a recommendation that banks who wanted to confirm their independence should be running 50% efficiency ratios with a goal to reach 40% in the years to come, in part by cutting branches:

Taking this to heart, and joining the list of banks closing in aggregate 50-100 branches a month across the US, Northwest Bank in Pennsylvania last Friday announced a reduction of 20% (!) of its branch network: As you can see below they are joining a party that’s been going on for some time:

Branch closures are generally boring to investors because they are incremental – the stock of Northwest’s parent rose about 3% post event and the cost saves should run $13 million on a bank earning a bit over $100 million annually. They are boring but they are essential, because low cost wins over time if doing the commodity banking that so many banks do. It’s also a waste of money to run a $30-$40 million deposit branch when wholesale funding may be 25bp or less for the next 2-3 years. Finally, branch traffic tends to decline 1-3%+ each year (per FMSI and S&P) with that number accelerating dramatically now that Covid lockdowns forced millions to figure out how to work online technology.

The issue is some banks can close branches more easily and profitably than others. Beyond standard roadblocks such as lease terms, location and local demographics, the biggest variable is technology. While banks like PNC spend heavily to develop solutions in house, most smaller banks are dependent on the core processor oligopoly. (FIS, Jack Henry and Fiserv). These processors know they have the banks under contract and a 30% EBITDA margin to uphold so with this unfortunate incentive set, banks are notoriously frustrated with their responsiveness to technology initiatives. This podcast: provides more detail.

So how to get to 40% efficiency with a legacy network? Increasingly, providers will move to startup cloud-based processors or other means to get to “open API”, meaning the ability to easily bolt on software solutions to offset the “inconvenience” of a closed branch.

For example, Live Oak Bank likes to point out that they ran 1/3 more PPP loans than they would have otherwise because of the flexibility of a cloud platform. Live Oak only has one branch, but increasingly other banks are making the same conclusion. This is why we tend to focus on technology right behind credit and capital management when speaking to banks to determine long-term return potential.

Perhaps this is also why Live Oak, part owner of one such cloud processor, has outperformed its peer group by 50% this year:

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