The Best Business Models in Community Banking

1. The Best Business Models in Community Banking 2014 NDBA/SDBA Annual Convention

2. Where We’ve Been • Roaring 20’s • Great Recession • “New Normal”

3. Where We’re at Now • Weak loan growth; shifting customer needs • Reduced earning levels • Increasing costs • Increasing regulations • Intense competition

4. Where We’re Going • Compressed margins • Less profits & shareholder return • Higher capital requirements • Earnings unable to exceed cost of capital (60% now) • Fewer banks

5. How to Get Out of the New Normal Malaise? • Cost cutting • Shifting LOBs • Stealing business from others • Remaining relevant? • Other solutions? Magical formulas? • No good answers readily apparent!

6. Hold it! – There are exceptions • Some banks have & continue to do well! • How are they doing it? What about their business model? • Lessons for the rest of us?

7. The Top of Mind Issue for C-level & BODs Today • KPMG study: 90% of banks are re-evaluating their business models (BM) • Next question: What constitutes an effective BM in today’s environment?

8. What is a Business Model & Why is it Important? • Defined: How a bank creates, delivers & retains value • Importance: Determines the way and how much money you make • Components: • LOB segments & structure • Customer acquisition methods • Customer interactions • Internal structure & performance • Delivery channels

9. The Best Business Models: Unique Study Aims • Examine those top banks that have continued to succeed, despite tough climate & peers failing • ID effective BMs in today’s environment: commonalities & differences • Structure, alignment, or execution? • Can the best be emulated? Lessons for your bank

10. Studying the Best Banks • Business and/or retail/consumer banks • Three size categories • $50M – 999M (top 1%) • $1B – 24B • $25B+ • Consistent ROAA performance over three distinct periods in past six years • 2006-2007 (good times winding down) • 2008-2009 (Great Recession) • 2010-2011 (“New Normal”) • Statistical & reputational leaders (studied 59 banks thus far)

11. High ROA, but Excluded…. • Specialty commercial banks • Trust*, credit card*, nat’l mortgage, investment, private • Economic/geographic biased areas • Excluded top 25 states w/ lowest unemployment rate • Oil & ag states • Demographic biased communities (personal income levels) • <$50 million in assets (size bias, unique components outside norm) • Inconsistent profitability (2 or more years w/ losses, or extraordinary gain year(s))

12. How the Top 1% of CBs Perform (mean assets = $196M)

13. Best of Breed Have Their Issues Too • Low LTD ratios – Not enough loans • NPAs • Regulatory demands

14. Our Local “Best” (top 1%) • Sargent County Bank (Forman, ND) • Assets = $110M (3 branch) • LOBs = Business & retail • 6 year ROAA = 1.97 • 31.85 efficiency ratio; 4.60 NIM • SNL: ND most Top 100 banks < $500 M • Farmers & Merchants St. Bank (Plankinton, SD) • Assets = $85M (2 branch) • LOBs = Business & retail • 6 year ROAA = 2.31 (3.13) • 40.08 efficiency ratio; 4.69 NIM

15. Key Findings: One or Many Business Models? • Traditional community banking is alive & well! (80%) • Business & retail operations • Serving local communities; rural & some urban; many 100+ years old • Standard products & services • Strong referral networks • Niche players in urban areas also prosper (20%) • Niches include CRE, mortgage, ag, & asset based lending • Local, regional, & national focus

16. Lending LOB Breadth

17. For Niche Focused (20%) , Describe Type of Niche 50%

18. Primary Value Proposition (check up to two)

19. Structure & Pursuit of Credits (adj. to pricing, LTV, underwriting)

20. Typical Sales Orientation

21. Internal Core Competencies (check all that apply)

22. Most Valuable BM Elements (forced ranking; 1-3)

23. BM Changes with Recession & New Normal

24. Degree of Competition

25. Case Study: #1 Bank Nationally • Merchants Bank of Indiana (Indianapolis, IN) • Assets = $608M • LOBs = Primarily business bank w/ niche focuses (private, ag, & mortgage) • 6 year ROAA = 4.51 • BM/USP = Custom products; personal bankers; responsiveness; come to your office; experience; rapid growth/acquisitions; efficiency (35.80%)

26. Case Study: Role & Importance of Execution • #1 most valuable BM element (per Top 50 survey) • Key question: Can your ability to execute model exceptionally well, with seemingly disadvantaged architecture, result in top of peer performance? • Examples: • Bank of Hemet (- CRE monoline –national geographic presence = 2.31 ROAA + 45.97 efficiency ratio [$439M assets]) • USAA (- low end retail –highly limited delivery systems & convenience = above peer ROA [1.32 for 2011] + highest customer satisfaction)

27. Case Study: Role & Importance of Structure • Close #2 most valuable BM element (per Top 50 survey) • Key question: Can you replicate successful model architecture elsewhere, and achieve similar results? • Example: • 1st Business Bank, LA (patient LT investors; target healthy prospect companies; deep advice/relationships; effective sales/training; emphasize core deposits). Since successfully replicated at: • American Business Bank (consistent 6 year profitability) • 1st Enterprise Bank (.38 NPA; rapid growth) • Regents Bank (Bauer 5 star; 3% Texas ratio)

28. Case Study: Role & Importance of Alignment • Key question: Can you align certain BM components into a powerful combination; left separately they offer no particular advantage? • Examples: • US Bank (limited geo scope + focus on simpler & better, not bigger + decentralized underwriting & advisory boards = considered among best of the biggest banks) • Southwest Airlines (low fare/compete on price + low costs + frequency of service = consistent top performer)

29. Need for Structure, Alignment, &/or Execution? • Opposing question: Can you succeed with the wrong structure, poor alignment, or weak execution? • Yes! • Bank of Hemet (“wrong” structure & alignment for the times) • Possibly get away with weaker execution? (tougher) • Not required to have all three or even two components in place, but you must be able to excel in at least one BM area to prosper

30. Case Study: Now that’s a Business Model! • Oakwood State Bank (Oakwood, TX) • Assets = $5M (smallest bank in US) • BM/USP = No computers; types deposit slips by hand; manual general ledger; no voicemail; 2 employees with average age of 78 • Recent results = 2.37 ROA; 10.22 ROE; 64% efficiency ratio; 596 total loans

31. What’s Important for Being the Best • Customer closeness; going the extra mile (key performance driver) • Highly efficient & productive (key performance driver) • Best at your niche • Strong leadership; passion • Avoid intense competition • Control asset quality • Strong margins • Strong referral network

32. What’s Not So Important • Lowest loan rates & best terms (price leader) [Deloitte study] • Aggressive structure & pursuit of credits • Most convenient • M & A; external growth • Retail/consumer bank in urban areas • Custom products & services; multiple/bundled • Extensive staff training & development • Employee stock ownership • Frequent, significant shifts to business model

33. Final Considerations • Not final word on business models • Must tailor solutions (e.g., relationships or niche focus) • No magical solutions or reinvention • Instead: BM execution, structure, and/or alignment (need 1) • Easy work now done (cost cutting, LOB shifts) • Tough work now ahead: Being a more effective competitor • Benefits of being the best; and costs of being ordinary • Which path for your bank?

34. For More Information… Joseph Cady CS Consulting Group LLC (858) 530-8250 jcady@csconsultinggroup.com www.CSConsultingGroup.com