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Manage Transition: For Banks 0-5 Years

Balance Sheet Growth

Last update: September 6, 2013


Banking organizations grow in two basic ways: either organically or through mergers and acquisitions (M&A). While the banking industry has grown largely through M&A, de novos and minority-owned institutions grow organically, at least in their early stages. Organic growth is the incremental growth from each new deposit or loan. Although organic growth may take longer and may be more labor-intensive, the underlying customer relationships that develop provide the foundation for future profitability and franchise value. See Mergers and Acquisitions for more information.

Planning for Growth

Banks must grow to foster profitability and satisfy constituents. Shareholder value is tied to growth. Earnings, capital formation, core deposits, retail delivery systems, and geographic footprint are all ingredients of shareholder value and are all tied to growth. Some minority-owned institutions (MOIs), however, are driven by motives other than financial gain, having strategies to enhance and build underserved communities. This can limit the market discipline associated with shareholder expectations and director accountability, resulting in misaligned strategies and undue risk. Nevertheless, growth remains a crucial ingredient for an MOI to successfully serve the financial needs of its customers.

Unplanned growth can result in elevated risk to the institution. Therefore, effectively planning for growth is important and can help avoid unnecessary risk. A critical starting point in this effort is a strategic plan prepared by senior management and the board of directors, which outlines the bank’s growth strategy. The strategic plan should be detailed and clearly convey such things as market niche, risk tolerances, and growth expectations.

An operating budget should be prepared and include projections over a three- to five-year period. Growth requires an investment in staff and infrastructure that must be carefully factored into the budget. In this regard, it is noted that branching is particularly expensive, and care must be taken to ensure that management appropriately weighs the expense of branch expansion against the anticipated growth it generates. If the reasons are not apparent, the assumptions underlying the operating budget may be flawed.

External Factors—Timing Is Everything

In planning for and monitoring growth, it is important to realize that growth is heavily influenced by external factors such as economic trends, business cycles, interest rates, and competition. It is therefore important to constantly monitor such factors and adjust growth expectations accordingly. Some conditions call for slower growth. For instance, aggressive lending to commercial tract developers can be extremely risky in an environment of slower sales and declining values in the real estate market. Also, competition for loans can result in lower underwriting standards and may dictate slower growth. On the funding side, uncontrolled growth can lead to an unhealthy mix of liabilities.

The recent financial crisis has demonstrated the localized nature of certain of these external factors. Some areas of the country experienced rapid and unsustainable growth in some markets, which contributed to some of the recent problems, while other areas grew more modestly and have been less negatively affected. Being in tune with local market conditions is a key factor in managing growth.

MOIs and Growth—Your Difference May Be Your Strength

Although the specialized nature of some minority banks can limit their growth, there may be opportunities to turn some challenges into advantages. For example, some MOIs have developed specialized expertise in providing financial services to churches and church-related customers or remittances services to consumers and businesses, markets often overlooked or misunderstood by other institutions.

In addition, immigration trends in the United States may present opportunities to build customer relationships by bridging language barriers and educating customers in the use of banking services to manage their financial needs safely and conveniently.

Brand recognition is another way to differentiate a bank in order to gain a competitive advantage. Understanding the competition, however, is a key element in differentiating your brand and fostering growth. In many markets where MOIs operate, MOIs are not only competing with the bank down the street but also with credit unions and nonbank financial service companies.

Growth Risks

Credit Risk

While banks face a variety of risks related to rapid growth, the most serious is credit risk, or risk of losses resulting from borrowers that are unable to repay their loans. Sound underwriting and credit risk management can minimize the impact, but prudent practices are often compromised in the heat of credit cycles, economic adversity, and intense competition.

Since most bank failures result from deterioration in the loan portfolio, asset quality is a key factor in determining the bank’s overall financial strength. Loan losses initially affect asset quality, but they can quickly spread to other financial components, such as earnings, capital, and liquidity. Unfortunately, the problem sometimes remains hidden until too late. Credit problems often represent loans underwritten in previous periods.

While sound loan underwriting standards are important, effectively managing credit risk is also critical in situations where loans, though prudently underwritten, may be stressed by external factors. This is why portfolio segmentation and concentration monitoring are also important considerations in managing credit portfolios. Too much exposure to any one industry or economic sector significantly increases risk. The recent financial crisis was caused, in part, by a gradual deterioration in underwriting standards, which fueled growth and concentrations in high-risk assets. Financial institutions that maintained sound credit underwriting and accepted slower growth weathered the financial storm, while others failed or suffered significant losses. Also, since credit risk cannot be entirely eliminated, it is also important to maintain additional protection in the form of a sufficient allowance for loan losses and a sound capital position.

Another factor that should be considered in managing credit risk is lender incentives. While it is reasonable to compensate lending personnel based on production, parameters should be set to ensure that they also have a clear stake in the quality of the loans. Also, loans obtained through loan brokers are a red flag for regulators. These loans present greater risk to the bank because the bank does not interact with the customer directly and may be misled regarding both the character and the financial capacity of the borrower.

Review Credit Risk for more information.

Funding Risk

Banks can grow only to the extent that they have the funds to extend loans, buy investments, and expand through branching. In other words, asset growth must correlate with the funding side of the bank’s balance sheet. The bank’s initial capital infusion provides a foundation for growth and affords protection from financial adversity. Sustainable long-term growth relies predominantly on building a core deposit base and developing alternative funding sources. Similar to brokered loans, brokered deposits are a red flag for regulators because they do not arise through a local customer relationship. As a result, they are likely to be withdrawn if the bank does not pay a very competitive rate.

Finally, banks should be cautious in implementing leverage programs to foster growth. These programs are designed to match borrowings against assets to produce a predictable spread. They can substantially increase the size of a bank in a short period of time but can also devastate a bank’s earnings if they are miscalculated or are dependent on specific interest-rate scenarios. Refer to Asset Liability for additional information.

Fraud Risk

Banks are "where the money is" and have always been vulnerable to fraud, particularly in a rapid growth environment where internal controls may be compromised. Therefore, it is particularly important to consider the impact of growth on fundamental controls such as segregation and rotation of duties, vacation policy, passwords, and dual control over valuables. With the advent of the Internet and electronic banking, banks must provide a secure environment for customers. Reputational risk can occur if a bank is lax in this area.

Regulatory Constraints on Growth

Capital Guidelines

Banks are subject to specific capital requirements (see Capital for more information). These requirements are designed to protect the viability of the bank but they limit growth. As a result, they must be carefully factored into growth projections, taking into consideration both the amount of growth, as well as the risk of the underlying activity. Failure to meet capital requirements can cause regulators to disallow expansionary proposals. Also, regulatory sanctions that limit growth are required under the FDIC Improvement Act if capital falls below specific thresholds. These sanctions become increasingly severe as the level of capital declines.

The importance of a capital cushion to support growth should not be underestimated or taken for granted, since we have recently learned how quickly capital levels can erode and sources for new capital disappear overnight.


Dodd-Frank and the Basel rules will likely increase capital requirements, making expansion more challenging. The perception during the financial crisis was that capital levels were not sufficient to absorb losses, because capital ratios were too low, especially at the holding company level. Institutions relied too much on forms of capital other than common equity, and risk-based capital requirements did not fully capture many of the risks incurred by banking organizations.1

Increased capital standards will include the exclusion of certain debt and equity instruments (such as trust preferred securities) as regulatory capital for large bank holding companies; and annual capital plans, dividend and share buyback limitations, and stress testing for certain bank holding companies.

Investment Securities

When loan demand is soft, a bank’s investment portfolio can absorb deposit growth and provide a safe return. Bank regulations limit the amount of certain types of securities and are designed to promote high credit quality and diversification. The investment selection process should adhere to regulations and factor in the bank’s liquidity and interest-rate sensitivity. Derivative securities present special risks, since their interest-rate sensitivity and credit quality are difficult to assess.

Adhering to regulatory limits is just the first step toward achieving proper investment portfolio diversification. Of all the lessons learned during the recent financial crisis, perhaps the most surprising was the level of unforeseen credit risk in investments. In the past, investors relied on credit rating agencies and developed a false sense of security toward complex derivative investment products. Recent events have taught us that neither the rating agencies nor the financial institutions fully understood the credit risk inherent in many securitized loan pools. Concentrations in seemingly low-risk securities resulted in large credit losses, which negatively affected earnings, liquidity, and capital. One important lesson that has emerged from the financial crisis is that a diversified investment portfolio is an integral part of an effective growth strategy.


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