How to Grow Your Bank’s ROE with Ed Kofman

Caleb Stevens (00:00.098)
Well, Ed, it’s great to have you back on the podcast. How are things out your way in San Francisco?

ed (00:01.271)
Yeah.

ed (00:11.437)
It’s beautiful, it’s sunny, it’s not too hot, but the taxes are high.

Caleb Stevens (00:15.534)
Sounds sounds like San Francisco. Well, you’ve been on the show a number of times and you obviously work here at the bank and you and I have worked closely together for a number of years now. But for folks that don’t know who you are, give us just a quick level set on you and what you do at the bank.

ed (00:33.101)
Sure. So I manage the rate hedging desk here at South State and administered the ARC program for both the bank and community banks throughout the country. It’s not just community banks that use ARC. We have some regional banks and a couple of super regionals that use our program as well.

Caleb Stevens (00:56.728)
So you speak frequently across the country. you we we host a series of lender lunches and listeners, if you ever have the opportunity to attend one of our lender lunches, would encourage you to do so. We’ve done them all over the place from Austin to LA and a lot of places in between. And Ed, one of the things that you note in many of those talks, especially to lenders, but to executives as well, is you give a helpful overview of what the competitive landscape in community banking today looks like.

And for the listener who’s never heard you unpack that, I like how you unpack it. So talk about how should community bankers be thinking about particularly the question, who is my competition?

ed (01:38.401)
Yeah, it’s an important question to be able to answer to maximize performance. So in order to optimize ROA ROE, you need to understand who you’re competing against because your clients and prospects have alternatives. So if you roll the clock back in 1984, we had over 14,000 banks. Today we have 4,300.

And about 3,900, call it 4,000 to make the math easy, are community banks, and those are banks under 10 billion. The other 300 or so banks are over 10 billion, but if you look at the concentration within the industry, the top 10 largest banks by asset size control a little bit over 40% of the domestic loans and deposits.

And the top 20 largest banks control a little bit over half of the loans and deposits in the country. So while your business model is very different than Bank of America’s or Wells Fargo, both of those banks and the largest banks in the country are going after profitable business relationships. And they’re interested in booking clients that have relatively modest credit and deposit needs.

As long as it’s a business that has other cross-cell opportunities, we see Wells and B of A and JP Morgan and other national banks competing for loan sizes down to a million and below. And while a banker may say, Well, I’ve got local community presence, that individual that you hired as your relationship manager.

Can be hired away by JP Morgan and B of A. So we’re all competing in one pool. It is one big bucket. And as a client, you want to do business locally with local decision makers as a borrower, a depositor. But the product offering at a community bank needs to be, it doesn’t have to be best of breed, but it needs to be competitive. So because

ed (04:00.001)
10 banks control over 40% of the assets and liabilities in the country. Those 10 banks naturally tend to set pricing on loans, on deposits, structure, covenants. And while you may be competing for slightly different business, you have a competitive advantage locally, you need to understand what the larger banks are doing.

Caleb Stevens (04:27.307)
Yeah. So even if you don’t feel like you’re competing against Wells, in so many ways you still are. Yeah. And you meant

ed (04:34.848)
Well, you know, we deal with clients that come and say, Well, you know, I lost business to a national bank and it was a good client. So if you want to retain it, what are they doing differently? How can you retain that business?

Caleb Stevens (04:47.157)
And you mentioned, you know, there were however many fourteen, eighteen thousand banks back in the nineteen eighties. Today we’re sitting at just over four thousand. What are some of the forces that you’ve observed that are contributing to the continuing consolidation of the industry? And and and what are some of the some of these factors maybe aren’t as controllable as others, but speak to some of those controllable factors.

ed (05:11.446)
Well, ultimately, it does all ride on return to shareholders. And if a bank cannot earn sufficient ROE to keep shareholders satisfied, then that bank in the long run becomes a target for acquisition. And it may not be that the bank is acquired by a national bank. That’s not the way it works, but it rolls up. And so community bank

Buys a smaller community bank, a small regional buys that community bank, and then the regional buys that small regional, and eventually we’re seeing fewer and fewer community banks competing. The ROE is very important. And when you look at the industry on average, the industry ROE, banks need to be able to earn, in our analysis, somewhere around 11 to an eleven and a half percent roE.

When you look back 10 years, banks have there are very few years where the average for the industry has been above that. Now there are banks that earn consistently, those will remain independent, but banks that cannot maintain

11, 11 and a half, depending on the variability of their earnings, maybe 10 and a half percent ROE. Those banks are going to be target. When you look at the industry, the only two years that the community bank in industry has been able to earn above 12% ROE has been during the pandemic when we had PPP loans. And there were a lot of fee income being generated off those loans.

And so we probably are going to talk about fee income, but as an industry, we’re being challenged with below target return on equity.

Caleb Stevens (07:03.649)
Yeah. Yeah. So let’s go a level deeper. Why do you think so many banks are are missing their R ROE targets? are they focused on the wrong things or is it is it a talent issue or leadership issue or where where do you think banks are missing the mark here?

ed (07:22.954)
Well, it’s a little bit of everything you mentioned, but I do want to underscore the importance of measuring return on an instrument and relationship level. So as an example, when we look at a bank, let’s say the average ROE is 10% and management says, I would like to increase that. I would like to drive my ROE up by one or one and a half, two percent.

When we measure each individual relationship contribution to overhead or risk adjusted return on capital for each relationship, we find that the distribution is not evenly split. You have a small percentage, sometimes one or two percent of all clients making up an inordinate percentage of profit for the bank.

So we looked at a bank, a small regional bank, less than 0.6% of the clients made up more than 10% of the profit for the bank. And just seven and a half percent of the clients made up 80% of the profits for the bank. So you have some very profitable relationships. Then you have probably 50% of the relationships that contribute almost no

positive ROE and then the bottom 20-30% that have negative ROE. And the issue the community banks face is that if you don’t measure which clients are earning you positive return on your capital, you don’t know where to allocate resources. So A, you don’t know which region to concentrate on. B you don’t know which category of loans or deposits are profitable.

C, you may not know the proper structure or the variables to drive performance. And so management may say, well, what can we measure? And typically it’s yield on the loans, cost of funding. Cost of funding is very important, but management is only pulling and pushing a couple of levers that it has access to. But there are many others that are under the surface. Management can’t measure it.

ed (09:50.228)
So you can’t affect it and now you can’t optimize performance to get your ROE up. In fact, it’s worse than that. Sometimes the levers that management can pull and push are the exact wrong ones. They’re pulling and pushing in the wrong directions. And you know, I will we’ll I’m sure we can get into examples of you know what those levers are.

Caleb Stevens (10:13.771)
Yeah, so let let’s let’s talk about it. So you mentioned yield and cost of funding, which all ties into your net interest margin. And I’ve heard you say before, net interest margin is an important metric. It’s a perfectly fine metric, all things considered equal. The problem is if you’re not careful, you can get a little too myopic and not see the bigger picture of credit quality, loan size, loan term, some of these other forces cross-sell that play into actually driving ROE. So let’s let’s go there. Where where

Do you see sometimes community banks pushing on the wrong levers or at least only pushing on a couple when they need to be thinking about the broader picture?

ed (10:50.125)
Sure. So I’ll I’ll give you four immediate ones that we see most often. So first I want to mention that everything else being equal, if a bank can expand its net interest margin, it will be more profitable. No question about that. But everything is not equal. And so what we see is when banks are trying to expand net interest margin by getting higher yield on assets.

It leads to lower ROE. Now, if you take a deposit and you can pay less on that same deposit, that’s great. Your NIM expands and your ROE goes up. Deposits don’t attract as much capital. They attract some, but not as much. They’re not credit sensitive. But even within deposits, the they’re better deposits, even though you may pay more.

They may be insensitive, they may last longer, the acquisition cost is lower, etc. But on the asset side, we see that banks that chase higher yield also inadvertently witness four major problems with those assets. And first one is size. So if you tell a lender, go get me higher yielding loans, they’ll do that.

But they will sacrifice first one loan size. So if you look at a $50,000 loan, it has one hundredth of the earning base of a five million dollar loan as an example. But the reality is it takes the bank almost the exact same resources to book both. yeah, it may be a little bit less, but the average loan size at a community bank is 350,000, 450,000. So size matters.

And if you chase yield, you’ll get that, but you will sacrifice that volume. now I’m not advocating that as you get larger in loan size, you continue to get higher ROE. Because at some point, if you have a hundred million dollar loan, it’s not like you can be profitable at zero margin. There is a law of diminishing returns, and around three million, we see that the ROE kind of

ed (13:15.271)
becomes asymptotic. It it goes straight, so it’s level. But definitely between three hundred and fifty and thousand and three million, there’s a lot to be gained in profitability and ROE in larger loan sizes. If you can’t measure that in a model, you’re gonna lose sight and you’re gonna gravitate to smaller loans that have higher margin. The second one is term. And so it takes the same amount of effort to bring in

A one-year loan as a 10-year loan, but the 10-year loan has a lot of advantages. you have more revenue, you also have more cross-sell opportunities. That’s very important. So when banks don’t have the ability to measure ROE on a year loan, two-year loan, three-year loan, ten-year loan, the term of that relationship, if you can’t measure it, you’re missing out on a lot of profitable business.

So if you have to replace your whole portfolio in the extreme every year, it’s not what happens in reality, but if you think of it, if all your loans are one year loans, your lenders running in place, just trying to replace what’s coming off. Being able to book steady long term relationship business is very important on ROE basis.

The other one is credit quality, and it doesn’t just mean default, poor performance detracts management’s attention. Higher credit quality loans do come at a lower margin, but they’re more profitable in the long term. And especially in the downturn, and I want to make this very clear: none of us can predict a downturn.

We don’t know when the next one’s going to happen. So the right way to price credit sensitive products like loans is with the intention and the understanding that we can’t we can’t predict the next downturn. So assume that it’s going to happen within the commitment term of your loan. Better credit quality leads to higher profitability in the long run. You can get more margin.

Caleb Stevens (15:02.413)
Right.

ed (15:31.15)
Playing on the edge of credit acceptable quality, but in the long run, banks are more profitable with better credit quality loans. And finally, cross-sell and upsell opportunities. Every community banker talks about relationships, but being able to measure it is very important. And so what we find is that if you can add fee income, cross-sell deposits to an obligore. So someone who has a million-dollar loan.

And still keeps 200,000 in deposits with you. That 200,000 self-funding is very important in driving up profitability. And if you have treasury management, fee-based service, if you can cross-sell wealth management, investor service, hedging opportunity, foreign exchange, all of those can add up very quickly. And so the margin misses all of those things that we talked about.

Caleb Stevens (16:29.397)
Okay. So going back to loan term, you said it takes the same amount of effort for a lender, you know, to wine and dine and book a one year loan versus a ten year loan. And obviously it’s more profitable to clip coupons for ten years versus for one year. But what would you say to the skeptic who’s listening that says, Well, Ed, ten year fixed rate on balance sheet? That sounds that sounds too risky. I mean, maybe it’s more profitable to have that loan for for a long time, but if my cost of funding goes up

And rates go up and that loan goes underwater, that that that’s not helping me at all. Why would I want to go out ten years? What would you say to the to a banker who pushes on you there?

ed (17:06.465)
Yeah, perfect lead-in here. good setup. So remember we’re talking about RayRock, risk-adjusted return on capital. So we don’t advocate that bankers take uncompensated risk. And 10-year fixed rate on balance sheet is interest rate risk that banks do not get compensated for. And it it’s beyond the scope of this podcast to explain why.

In thorough terms, but I’m just going to say that there are hundreds of community banks across the country that use our ARC program, which eliminates interest rate risk and actually adds fee income to the bank. So it’s not that hard to be able to eliminate it. Top 10 banks in the country, all of them use a hedging program. They control 40%, a little bit over of the loans in the country. Top 20 banks, over 50% of the loans.

All of those are using hedging programs as well. They can eliminate the interest rate risk, generate fee income, increase the expected life of the loan, which means more cross-sell, more upsell. All of that leads to more profitability. So we’re not advocates of taking risk without getting compensation. It’s very easy to eliminate that interest rate risk. And

If there’s a way of doing it, then I’ve yet to see it. But if a bank can have a prepayment provision on a ten year floater, that’s just as good as a hedge loan, as long as you can maintain with some kind of contractual prepayment provision the extended life of that contractual commitment. That’s what counts.

Caleb Stevens (18:47.949)
So you mentioned the word hedging and how all the large national banks use it. talk to the banker who says, Well hedging that sounds like a big bank term, that sounds kinda scary. That doesn’t sound like a community bank product or offering. Talk about how ARC really does simplify it and make it easy for a bank to administer and for a borrower to understand.

ed (19:07.489)
Well, in in my career I have worked both in the traditional ISDA swap world where borrowers need to hire a lawyer to be able to decipher a sixty five page is the agreement. That’s the International Swap Derivative Association.

That documentation is dense, and borrowers most would not be able to understand the mechanics of the ISDA agreement. Even some legal experts get lost through the documentation. But what we’ve done through the ARC program is created three very important distinctions. The first one is the documentation is simple, it’s a four and a half page agreement, straightforward.

It even defines what the premium provision is. Number two, it is one billing statement. So borrowers are not dealing with a loan and a swap. It really looks like a fixed rate loan to the borrower. So that eliminates a lot of confusion and questions from the borrower. And number three, there’s no derivative for the bank, and there’s no derivative accounting for the borrower either.

And so when you add all of that together, it becomes a product that community banks can offer proactively. Instead of some community banks have tried to offer back-to-back swaps using is this. Now, some have succeeded, they’ve hired teams, accounting, legal, sales to be able to accomplish that. But most have not. And so they have a program that languishes. It’s reserved for borrowers who come in and ask for.

an interest rate derivative. And by the way, most borrowers don’t come in asking for that. So we’ve created a democratized product that is easily adopted at a community bank.

Caleb Stevens (21:07.903)
And what would you say to the banker who says, Okay, I understand this, it sounds sounds like no sounds relatively simple, but but I Ed I think rates are gonna continue, say, to go down. And if I have a variable rate note on my books and my customer has fixed and rates go down, well that suppresses my my yield because I’ve got a variable rate loan. it’s talk to the banker who’s trying to time the market or thinks they’ve missed the window where it might be appropriate to to hedge.

ed (21:34.254)
Sure. So interest rate risk is unpredictable. We don’t know where rates are going. despite clamoring over the last year that rates are going to go down. Now the market expects them to go up. Now it’s still unknown what rates are going to do. And what I’d like to point out is that some people take a view of where the market is going, interest rate market is going.

But they take that view for three, four, six months, up to a year. And we’re dealing with five, 10, and in some cases, 30-year loans. We’ve done 30-year hedge loans. that’s not common, but certainly five, seven, ten, fifteen, that’s very common. Who knows where rates are going to be over that length of time? Rates are gonna go up and down multiple times during that period.

And so bankers that say, I know where rates are going, need to talk to those at Silicon Valley Bank, First Republic, and I’m saying it tongue in cheek, but those banks failed because they some people there, and I spoke to them, thought they knew where rates are going. Rates went the opposite way. We’re talking multiple administrations, different business cycles, even a five-year fix. Now, not every loan at a bank should be an adjustable rate loan.

And so every bank will have its mix fixed rate for the larger loan. So we talked about the four things that you know banks aren’t measuring correctly, community banks, you know, many of them. So for the right size loan, so loan that’s we started our program 250,000, but let’s say it’s a million dollar loan that the bank would like to target and up for the right term. So whether it’s three years, five, seven, depending on the bank.

So minimum size, minimum term. If it’s the right credit quality, we talked about that as the third prong. And finally, if it’s the right cross-sell upsell opportunity. So an example of that is you have a 75-year-old doctor, dentist, construction work, whatever they they’re doing, widget manufacturer says, well, I’ve got two years left and I want to retire and I have no succession planning. Well, that’s not a cross-sell upsell opportunity as an example.

ed (24:01.931)
Now you bring in a million-dollar loan where the bar says, I want a relationship for the next 10 years with your bank, good credit quality, and now it’s a 35-year-old-year-old business owner that has a view of growing their business. A million-dollar loan becomes two, a hundred thousand deposits becomes three hundred thousand, and you can sell treasury management.

And the fee that you can generate off the hedging business, and they need treasury management. All of a sudden, that looks a lot like a relationship. And by the way, Caleb, that’s exactly when we talked about the top-tier client. Those are the profitable accounts. Those are the accounts you want to target. Those are the accounts you want to keep. And those are the accounts that hedges allow you to retain for longer periods.

Caleb Stevens (24:57.919)
All the four factors that drive ROE, the head are the arc hedging program helps you improve upon all of those things and accomplish those goals. That’s great. Ed, you recently published a research report on this. So for folks that want to go deeper, give us just a preview of that ebook that we promoted. We’ll put a link in the show notes of this episode so folks can go get it, but give us just a flavor for what that ebook covered and some of the things that we found.

ed (25:07.511)
Exactly.

ed (25:24.641)
Yes, so there were some surprising and unsurprising results, things that we expected and some things we didn’t expect. but we looked at our own banks use of the ARC program. we looked at other banks that have been using the ARC program, and what we find is that exactly what we expected that the ARC loans are more profitable when measured on a risk adjusted return on capital.

They’re larger on average. They’re definitely longer term. They’re made on better credit quality, and that’s self-selecting. So banks recognize that when you use a hedge, it has to be a relationship account. The credit quality should be higher. But there were c there was one thing that we didn’t expect to such an extent, and that is the prepayment speed. And it speaks to point number four, and that’s the cross-sell and upsell. But the

Prepayment speeds on ARC loans, everything else being equal, is two and a half times slower. So we expect an ARC loan to last much longer at a bank. They don’t prepay. And there are a bunch of reasons for that. Some of them are because of who you select as a client, but some of them are because of the prepayment provision and the portability that we have with the ARC program. But that longer expected life on the loan.

has a few benefits. You can cross sell more, you can upsell more.

And there’s this opportunity to keep making fee income. So you earn a fee going into that ARC loan. And then when the borrower has an opportunity to do a blend and extend 1031 exchange, substitute collateral, their opportunities to earn more fee income. And that boosts ROE because as you recall, there’s no additional assets allocated.

ed (27:28.053)
if you generate more fee off the exact same capital base. So that that that’s some of what we saw in our studies.

Caleb Stevens (27:35.511)
Banks are in the business of keeping loans, not just making loans, as you are famous for saying around here.

ed (27:41.249)
Yes, exactly.

Caleb Stevens (27:42.646)
That’s good. Ed, any final thoughts or words of encouragement to the bankers out there? It’s been quite a roller coaster of rates, you know, since since COVID really rates went down, rates shot back up. Now there’s a lot of uncertainty about where they’re gonna go in the future. and as you say, there were eighteen thousand banks or so a long time ago, and here we are at 4,200. Here at the correspondent division, we believe in these community banks. We think they’re important to their communities, we think they’re important to the country, and we want to see their ROE.

be above, you know, we we want that ROE to be as high as it can be so that their shareholders are are happy, getting a good return, and so that they can stay independent. And so that’s what we do here at the correspondent division. But any final words of encouragement to the banks out there?

ed (28:25.975)
Yeah. Yeah. So when you look at the the world and the banking industry around the world, we have a unique model in the United States. I started my banking career in Canada, but I’m familiar with the European banking system. We have a large number number of financial institutions that are willing to provide capital for the entire stack that

a company needs, whether it’s seed capital, private equity, mezzanine, unsecured debt, senior secured community banks play a vital role in the business vitality of this country. They provide the senior secured stack, but if you’re a business owner in Germany, in France, in Canada, you don’t have access to capital like you do in this country.

And so community banks create a stronger, more vibrant, and more risk-taking economy, and it pays dividends for our industries. I also believe that community banks have a competitive advantage. People do want to deal locally with a decision maker they can meet face to face. So that’s a competitive advantage. What bankers should do is focus on what they can control.

They can’t control interest rate risk, they can’t control business cycles, so they need to prepare for them and manage the risks there, but not try to predict them. However, community bankers can and should measure the return on an instrument level basis.

And say which relationships and what regions and which lenders and what lending category is profitable and what is not profitable for me. And say, well, if it’s profitable, I want to defend it. I don’t want to lose that business. And if it’s unprofitable, can I make it profitable? Or equally good, how do I shed?

ed (30:36.011)
that business and free up capital so that my return for my shareholders can keep me independent.

Caleb Stevens (30:44.693)
It’s a great place to end it. folks, if you want to get our latest ebook, it’s called the Community Bank Performance Engine. You can click on the link in the show notes of this episode. And if you want to book a call with Ed and time more with Ed about how to implement these ideas at your bank, we’ll include a link to Ed’s scheduling calendar link as well. Ed, thanks for coming on. Always a pleasure.

ed (31:03.778)
Thank you, Caleb. Great time.