Market Expansion

Sections in this Topic

Overview
Growth Distribution
Rapid Growth Risk
Managing Growth Risk
Can Specialization Limit Growth?
Regulatory Constraints on Growth
Branching
Regulatory Applications—Branches
Branch Opening
Branch Closing
Key Drivers for Mergers and Acquisitions (M&A)
Business Considerations/Risks
Key Steps for M&A
Regulatory Considerations
New Product Considerations
Resources
Main Page for Manage Transition

Chart

Growth-GAO Study 2006

Last update: July 22, 2014

Overview

For a bank to be successful in the long term, planning and managing growth is very important. A successful bank does not grow by coincidence, but rather by executing a well-planned strategy related to selling products or offering services. Naturally, total asset growth occurs as more products or services are offered to customers. This growth should be safe and sound.

Growth Distribution

The accompanying charts indicate that most MOIs have less than $300 million in assets, which is similar to the composition of other banks in the industry. As a group, MOIs are structured similarly to the industry as a whole. It is interesting to note that MOIs and the banking industry in general follow similar growth distribution patterns. More than 61 percent of banks in both categories have an asset size of under $300 million. Approximately 39 percent of MOIs have more than $300 million in assets, and approximately 12.8 percent of MOIs are over $1 billion in assets.

Rapid Growth Risk

Fast growth that creates negative operating results can generally be traced back to asset quality problems. However, because of the interrelationship of asset quality, earnings, liquidity, and capital, the problems do not stop at asset quality. Asset quality directly affects earnings due to increased provisions for loan losses. Reduced earnings hurt a bank's capital, and loans that are not repaid can cause a liquidity crunch.

Before loan growth is considered, management must determine how new loans will be funded. Common red flags to keep in mind when planning a growth strategy include unbudgeted growth, growth not comparable to that of peers (even if budgeted), and growth not in sync with external factors. Brokered deposits are more common in today's environment, but their stability and pricing still must be evaluated.

Managing Growth Risk

Before embarking on a growth strategy, management and the board should have a strategic plan to guide them. The plan should be a living document that is adjusted as economic or environmental circumstances change. Any lender incentives should be based on results favorable to the bank's bottom line. Credit standards should be in writing, and all lenders should know them.

Controlling overhead while the bank is in a growth phase is important. Opening a branch without a measurable goal for that branch generally leads to an unprofitable branch. Measurable goals include the number of loans, number of customers, dollar amount of deposits, and other measures. Every branch adds to overhead, and management should consider the timing of the branch opening in conjunction with current market conditions. The local competition and interest rates being paid for deposits should also be considered in making decisions regarding a branch.

Can Specialization Limit Growth?

Although an MOI or de novo may choose to focus on an underserved population, banks that also serve the broader population tend to outperform those that have an underserved focus, due to increased and other operational adjustments to meet the needs of the community. Specialization in banking may limit growth opportunities that could improve efficiencies, especially if the customer needs specialized service and communication. Also, banks that are highly specialized cannot use generic policies, handouts, or advertisements.

If the bank's customers are mostly immigrants or underserved or low-income clientele, the bank may need to fill more of an educator role than usual. This may mean spending more time with customers to explain available products, conducting customized workshops or helping to complete forms. Additionally, management many need to hire knowledgeable lenders, sales reps, and managers who have experience with the banking services offered and the clientele.

Regulatory Constraints on Growth

Banking is a regulated business, and as a result, banks must comply with many laws and regulations. For example, banks must meet the Capital Adequacy Guidelines. The Federal Deposit Insurance Corporation Improvement Act (FDICIA) establishes certain minimum capital standards. Review the topic on Capital Requirements for more information on these regulations.

Also, there are laws that limit what banks can invest in. For example, although there are exceptions, a bank generally cannot invest in equity securities. Additionally, regulators issue concentration guidelines that provide guidance on sound risk management practices, an example of which is SR07-1, Interagency Guidance on Concentrations in Commercial Real Estate.

Branching

A key consideration in branching is to make sure that the organization is "ready" for growth. Specifically, has management developed the proper infrastructure to manage additional staff or operate the facilities? Has a product delivery system been established for the new location? For the computer system, has connectivity been established? Also, management should ensure that internal controls and compliance monitoring activities are in place at all locations.

Regulatory Applications—Branches

A key consideration when you file any application is the bank's financial and managerial strength. Therefore, your bank's CAMELS rating is an important factor in expansion. However, regardless of regulatory considerations, prior to filing, management should have already prepared a written analysis of the costs/benefits of opening the branch and its expected break-even point. Additionally, the board should discuss and document reasons for opening a branch. When filing a branch application, remember that automated teller machines (ATMs) are not considered branches and do not require prior approval.

Branch Opening

If certain criteria are met, a branch application can be as simple as submitting a copy of the newspaper notice(s) and the affidavit(s) of publication. To qualify for the simplified application process, the applicant bank must meet the following criteria:

The bank must be in satisfactory financial condition, as evidenced by a CAMELS composite rating of 1 or 2.
The bank must be well capitalized.
The bank must have a satisfactory record of performance under the Community Reinvestment Act.
The bank must have satisfactory compliance with laws and regulations.
The bank must be in compliance with any supervisory directives.
The proposal must not cause the bank's aggregate investment in fixed assets to exceed the limitations under Section 24A of the Federal Reserve Act. Review Capital Requirements for more information about investments.

If the applicant does not meet the criteria above the application process is more complex. Also, for applicants with supervisory issues to address, SR 13-7 may allow branching if certain additional requirements are satisfied.

Branch Closing

Under Section 228 of the Federal Deposit Insurance Corporation Improvement Act of 1991, depository institutions must give notice to the appropriate federal banking agency at least 90 days prior to closing a branch office.

Notice requirements:

Identification of the branch to be closed.
The proposed date of the closing.
A detailed explanation of the reasons for the closing.
Statistical or other information that supports the decision to close the branch consistent with the bank's written policy for branch closings.
A copy of the notice sent to branch customers advising them of the branch closing, dated at least 90 days prior to the date of the closing.
A statement that the branch intends to post a notice of the closing in a conspicuous manner on its premises for at least 30 days prior to the closing.

Remember that insured institutions are mandated to adopt policies for closure of branches under Section 228. Please note that items required in the closing notice are not required for branch relocations. Interstate banks should refer to the Interagency Policy Statement on Branch Closings for additional guidelines with respect to branches located in low- to moderate-income areas.

Key Drivers for Mergers and Acquisitions (M&A)

As banks grow, they have the opportunity to spread their fixed costs over a larger asset base, commonly referred to as increased economies of scale. This, in effect, reduces the unit costs of the institution and supports an increased return on assets. Additionally, as the asset base expands, the opportunity to increase revenue or market share grows. Geographic diversification may allow the bank to offer new products not currently in demand. But banks should keep in mind that there is often increased pressure for performance as assets increase. The pressure for performance must be balanced with sound lending decisions.

Business Considerations/Risks

Because of changes in the economy and other factors, sometimes even well-planned mergers do not yield the desired results. The greatest risk to consider in merger discussions is the risk of overpaying for the target. Management should realize that the anticipated cost savings may fail to materialize. Goodwill represents the amount an acquirer pays in excess of the fair value of the net assets acquired. This recorded goodwill is not amortized, but must be tested annually for impairment. This falls under the area of accounting rather than business.

Retaining core deposits is another important acquisition consideration. Core deposits are considered the cheaper funding source. To mitigate risks, bank management must perform thorough due diligence on the target. Some banks form merger integration teams early in the process, and others hire an outside company to perform the due diligence. In any event, once the merger is completed, management must establish and maintain a strong management information system (MIS) and integrate the best practices and infrastructure from both organizations.

Key Steps for M&A

Before acquiring an entity, the bank's management team and board should assess their strategic objectives and opportunities. Once a potential target is identified, management should hire an M&A advisor or approach the target directly. When one bank indicates interest in a target bank, it should also be prepared to show the benefits to the target's shareholders. Preliminary due diligence should be performed based on publicly available information. Then, if interest is still there, the interested bank should sign a letter of intent and get permission to perform final due diligence, reviewing inside books and records. Only after the final due diligence is completed should a bank sign a definitive agreement establishing the terms of the deal.

Regulatory Considerations

An application with the Federal Reserve must be filed if a holding company is used to effect an acquisition or if a state member bank is the survivor in a bank-to-bank merger. All Federal Reserve applications and application information can be found on the Federal Reserve's Application Filing Information website. The website contains general information about the types of filings required by the Federal Reserve and how they are processed. Banking organizations are generally required to notify the Federal Reserve or seek its approval before acquiring banks or companies or engaging in new activities. Also, keep in mind that the public has the right to comment on banking mergers. So, before filing, a bank should consider its record under the Community Reinvestment Act and its compliance with consumer laws. State-chartered banks will also have to consider any filings or approvals required by the respective state banking department. Certain mergers are subject to consideration by the Justice Department, the Federal Trade Commission, or the SEC.

In Summary, M&A best practices include performing due diligence, effectively communicating the proposed merger/acquisition and the organizational changes that will result, and continually assessing the accuracy and integrity of MIS throughout the process.

When a potential application for a merger, acquisition, branch or other transaction raises questions the MOI desires to resolve, it is important to seek input from the supervisory agency. The Federal Reserve also encourages the “pre-filing” process to help address questions, as necessary. (See SR 12-12)

New Product Considerations

Just as in the acquisition of a company, management should perform due diligence when offering new products. The first question should be: "Is the product consistent with the bank's mission?" Banks should always consider whether a product offers a competitive advantage and then identify who will benefit (e.g., potential customers) from the product. An advanced marketing strategy should be in place, determining whether there is potential for the product to negatively affect other current business lines.

Important steps to take when considering a new product include the following:

Identify the cost to implement this new product and how much revenue it will generate.
Consider the risks the product presents to the organization and how the organization will mitigate those risks.
Analyze any impact on liquidity this product could have, and consider how the product will affect the asset/liability mix at the organization.
Always consult an attorney and get advice on whether the product's implementation is in compliance with applicable laws and regulations.
Have an attorney review all contracts to determine their reasonableness.
Do not overlook compliance considerations when implementing a new product.
Determine how the product will be marketed and make sure all communications/marketing efforts comply with laws and regulations. In particular, consider accommodation loans, which are individually structured to meet the specific needs of a particular customer and often pose unique compliance risk.

As in any business venture, the financial projections and risk analyses should support a new product launch. See Market Competition/Feasibility Study for more details.

Resources

Listed below are links on specific topics that may be helpful when considering growth and market expansion.

Banking Information:

Branch Information:

Community Development Bank Information:

Minority-Focused Banks:

"Keeping the Faith: Connecting with Church Groups to Spread the Financial Literacy Word," article

Regulatory Constraints: