Unsolicited Advice for Community Bankers

From time to time I like to pitch a business idea that appeals to me since . . . well, it’s my blog and I can.

One area that I've been thinking about recently is community banking. I've come to the conclusion that many local banks (some much smaller than you’d think) could benefit greatly by expanding into the money management business.

Many of the larger banks (regional, super-regional, money center) have long capitalized on cross-selling services and using investment products to boost fee income (look at a bank like BB&T which boasts a fee income ratio near 44%). Yet, when you look at the smaller, more community based banks, they are lacking in this area. I contend that this is a major misstep for those institutions.

Historically, many community banks allowed 3rd party brokers (such as Investment Centers of America, Inc.) to place offices in their branches. In exchange, the bank received a revenue sharing agreement and the ability to tell customers it had a broker in the bank. Unfortunately, due to the inherent conflicts of interest (not a bank employee, not a customer fiduciary, paid on account turnover, 12b1 fees, etc.), this was equivalent to a doctor telling his patients “great news, I’m now sharing offices with a mortician.” (OK, bad analogy, but I’m going with it nonetheless). Like most 3rd party fixes, it left customers confused and alienated when problems arose.

A better fix, in my opinion, would be for a bank (bank holding company technically) to create an SEC Registered Investment Advisor (RIA). This model, although embraced by some of the larger regional banks (often paired with a trust department) is more downward scalable than most community bankers realize. The benefits for community banks are numerous:

• It’s a low capital intensity / overhead business (high margins). Start up costs are minimal (the registration process is cumbersome, but not expensive) and ongoing overhead (employee costs, compliance) are manageable.
• RIAs are fiduciaries for their clients. They charge fees based on account size, not asset turnover. As such, they are (in theory) incentivized to do as well as possible for clients (higher account size = higher fee).
• For family owned community banks, an RIA subsidiary can basically function as a quasi-family office. Instead of the controlling family having to find an outside money manager, why not have your own in-house RIA that can manage family funds, bank holding company excess capital, the bank’s bond portfolio (more on that below), and portfolios for bank customers.
• By funding the RIA with “seed capital” from the banks owners, the investment advisor immediately starts with an asset base (don’t have their backs against the wall), and it creates a nice selling point to potential customers: “the owners of the bank invest their funds with us, you should too".
• Many banks have to hire outside investment consultants to administer their 401k plans. With an RIA sister company, this service can be internalized (leading to cost savings) and a nice cross-sell opportunity (by doing 401k education with bank employees, the RIA is also educating on the services they can provide to external customers).
• There can be overlap / efficiencies between the banks bond portfolio and investment customer accounts. Too many community banks outsource their bond buying to 1 or 2 brokers (i.e. “I bought a new bond – Vining Sparks said it was cheap”). Having a full time investment professional searching for bonds for the bank as well as investment customers can create a nice cost savings / efficiency gain. 
• Having the bankers and portfolio managers be on the same team (owned by the same company) alleviates (some) conflicts of interest – both are paid from the same pool, so if a client is more comfortable in bank CDs, the RIA sends them there (and vice versa). There is no (or minimal) fighting over customers.
• With the low overhead structure, the RIA business could probably be break even with $10 - $15 million AUM (depending on employee compensation structure, fee schedule, etc.).

Bottomline, for the cost of 1-2 employees (with one of those employees possibly being an already underutilized staffer), a bank can create a new fee income source, create internal cost savings (bond portfolio, 401K management), build brand awareness (new services for customers, all under one roof), and have its own “family office,” all with very little cost/overhead.

I remain confused as to why more banks haven’t taken this route (although am in no way so confident that I don't think there must be a good reason). Obvious reasons in my mind would be:

• A lack of qualified employees / candidates to run the RIA.
• The philosophy (which I usually agree with) that a bank should stick to what it knows best – lending and deposit gathering.

However, as the regulatory environment becomes more restrictive (higher capital requirements), compliance costs skyrocket, and bigger banks continue to pressure community banks on loan rates, a little fee income diversification might not be a bad thing, right? As usual, this is just my off the cuff thoughts on the business. I’d be glad to hear the thoughts of others, especially those in the community banking world.



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