Driving Efficiency in Banking’s Middle-Market

Polling the AQN office reveals a strong consensus of our ideal midsize bank or large Credit Union: high margins driven by low cost deposits and high yielding assets. That’s right, lots of profit driven by low costs and high revenues! But if it’s so obvious why aren’t more mid-size firms doing this? A quick look at how banks build these assets and liabilities demonstrates the inherent difficulty in acquiring these accounts.

Deposits

Low cost deposits are driven primarily by checking accounts, which usually pay no interest and are therefore about the cheapest funding source there is.  These accounts can be tremendously difficult to capture, with the average American holding the same primary checking account for an average of 16 years (BankRate). Direct deposits and automated payments further strengthen customers’ assumptions that it is difficult to change checking accounts.

Traditionally, banks captured deposits by building branches.  But branches are expensive to build and operate.  And the serious decline in branch visits has limited banks’ ability to drive revenue through the branch channel.  So, people are increasingly trying other options to increase their deposit base. 

A lot of players are trying to avoid the expensive and messy branch route through less messy but expensive alternatives.  A quick look at currently available promotional offers on Nerd Wallet shows many banks with direct or branch light models are willing to pay up to $700 for large deposit balances. This can work, but does substantially increase the cost base.  And players like Marcus and Etrade have shown that if you offer good enough rates on Savings and CDs, you can quickly build balances.  But that also erodes the cost advantages of the traditional checking account.

Seamless digital experiences are becoming table stakes, especially outside of the established branch footprint. Moreover, deposits require a strong brand as customers are unlikely to let a firm they don’t know hold their cash. Whether the approach is building branches or building a brand backed by digital experiences, ample capital is necessary to grow a deposit base with any speed.  And the required funding can be hard for smaller banks to manage.  Digital and brand investments cost the same for them in terms of absolute dollars, but represent a much higher share of their overall budget than for bigger banks. In 2018 Chase, Wells, and Bank of America each invested around $10B in technology, though this represented less 0.5% of their total assets.

Assets

On the asset side the highest yields remain in unsecured products and in non-prime assets. Almost all of us at AQN have some card experience and we tend to like them as assets.  They have strong yields and don’t necessarily require going subprime to get them which appeals to midsize banks. 

Card assets are incredibly easy to book. Unfortunately, good card assets are incredibly difficult to book. Card acquisitions is a very brand driven game and tends to be dominated by the top players making it difficult for smaller institutions.  Increasingly it is a digital game, through channels like Credit Karma, which requires specialized knowledge to play and win without being adversely selected.  

Cards are also complicated products with a lot of dimensions like line management, rewards structures, direct mail optimization, and fraud prevention. This means an advanced analytics team is necessary to ensure firms are adequately compensated for risk and can compete intelligently.  Today’s card customers also expect a broad set of digital capabilities, reaching beyond payments and account management to rewards redemption and credit tracking.  On the whole, pairing a capable analytics team with heavy marketing and tech investments is a high-priced endeavor. As with deposits, the absolute cost can be the same as a big firm, but the impact to returns is larger the smaller you are.

Pulling it All Together

So, the road to the bank we all want (remember the one with the cheap deposits and high yield loans?) turns out to be an expensive thing to build.  If I want to avoid just paying for deposits with high rates I need great digital experiences and a brand.  And if I want a high yielding card business, I need digital, a brand, and a high quality analytic function.  And in fact, it’s not just about growth.  Banks need to invest in all of these at a threshold level just to keep up and avoid losing customers.

The need to build investment capital is apparent, but the path to do that is unclear. The key for small to midsize firms is focusing on growing return on assets (ROA), not just net-income or asset volume alone. Money center banks can generate billions in capital with massive books of marginally profitable assets, but most firms don’t have that luxury. Instead, mid-size firms must identify the highest margin opportunities and pursue them relentlessly. This means applying the best talent and the lion’s share of capital to winning in these places, even if it means neglecting other more marginal areas of the business.

Targeting the highest yielding assets is a strong start but targeting the highest yielding prospects can deliver results even more quickly. Most firms track ROA at the asset class or line of business model, but at AQN we take a more granular approach and look at the product/segment level. More granular segmentation identifies the groups worth investing more to acquire, and those which warrant less focus.

If midsize firms continue trying to be all things to all people, they are destined to deliver a collection of lackluster experiences.  Trying to beat the competition everywhere is nearly impossible but winning in strategically selected assets and liabilities is achievable.  Pivoting to an intense focus on high yield opportunities generates the necessary capital for reinvestment, creating a virtuous cycle towards a destination balance sheet.