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Southwest State Bank
Bank Performance Analysis and Strategic Position
for a Community Bank
OVERVIEW
Boyd Dunkin laughed to himself as he looked out his office window. "What a difference the business cycle makes," he thought. As president and CEO of Southwest State Bank (Southwest), Boyd had watched his bank struggle through serious problems during the mid- to late-1980s when many of the bank's agricultural loan customers had difficulty making their loan payments. He had battled the regulators and even called on stockholders to re-capitalize the bank when it was forced to write off problem loans. Now, years later, Southwest was a high performance bank. Several members of the board of directors were pushing him to expand into new geographic and product markets and to consider buying other community banks.
Southwest is a $53 million community bank located in the small, rural town of Lemars, Arizona, a community of almost 17,000 people. Two other commercial banks and one credit union compete in the area: Sun National Bank is a $101 million bank that has four branches in Lemars and two nearby in the county. People's Bank & Trust is smaller at $45 million but targets affluent consumers with its trust department and retail products. People's operates with a main office downtown and a branch at the local mall. The credit union is affiliated with the state teachers association and boasts almost $29 million in assets. A large national holding company has just announced its intention to acquire Sun National.
Boyd, his daughter, Rebecca Parks, who serves as chief financial officer, and a small group of other investors, including most of the bank's directors, own 100 percent of Southwest, with Boyd's family members controlling 45 percent of the stock. Although Boyd has worked for Southwest for almost 25 years, the family obtained its controlling interest in 1986 when the bank's loan problems peaked. Following the change in the area's farm economy, Southwest had consistently improved its performance, posting record profits in 1993 and 1994. Profits dropped off somewhat but were still very good in 1995 and 1996. Profits reached record levels again in 1997 and 1998 with the help of converting to a Subchapter S Corporation.
STRATEGIC ISSUES
The fundamental problem facing Southwest’s management is to determine the appropriate strategic direction for the bank. With its long history in the community, Southwest is well-known for its agriculture lending, particularly cattle and feedlot loans. One problem is that its loan portfolio is fast becoming even more concentrated in agricultural loans. At a recent board meeting, Rebecca reported that the bank's loan portfolio had shifted from 36 percent agriculture to 78 percent agriculture over the past six years. Although these loans were quite profitable, on average, there was concern about the lack of diversification.
Due to Southwest’s seasonal loan needs, a general lack of demand from good loan customers outside agriculture, and Southwest’s concerns about lack of diversification, the bank has a substantial holding of Fed Funds sold. These short-term overnight investments earn a very low rate of interest and lower the bank’s ROA. The board continues to express concern with this low yielding asset and has put pressure on Dunkin to expand the loan portfolio. Dunkin is concerned that if the bank gets more aggressive in non-agriculture markets where it has less experience or expands the agriculture loan portfolio, it will become too risky and potential loan losses may again put the bank’s entire capital at risk.
Most of the board members believe that Southwest is simply doing what it does very well, which explains the loan concentration. Efforts to diversify within Lemars have failed because Sun National and People's Bank & Trust are strong competitors in the consumer market -- the only other real growth area. Southwest’s consumer loan and deposit base largely reflects its agriculture customers, who conduct all their business with the bank. If Southwest were to increase its consumer loans, they would come primarily from competitors and they would likely be costly to obtain and keep.
To improve its competitive edge, Southwest elected to become a Subchapter S Corporation in 1997. As a direct result, reported taxes almost disappeared by 1998. A Subchapter S Corporation is treated as a pass-through entity, similar to a partnership, for federal income tax purposes. It is generally not subject to any federal income taxes at the corporate level. Its taxable income flows through to shareholders in proportion to their stock ownership, and the shareholders generally pay federal income taxes on their share of this taxable income. This can have the effect of reducing an institution’s reported income tax expense and increasing after-tax earnings.
A vocal group of three directors, also stockholders, recently proposed that Southwest buy another bank. People's Bank & Trust was mentioned as a possibility, as were two commercial banks of the same approximate size in neighboring communities. The group suggested that any acquisition could be financed by omitting Southwest’s dividends. Southwest has paid out over 80 percent of its net income in dividends since 1992, which alternatively could be applied to such an acquisition. People's Bank & Trust or a similarly non-agriculture bank could provide the necessary diversification.
Dunkin is unsure as to what strategy is best. To a large extent, he is satisfied with the profits the bank is currently generating and doesn't want to spend the energy to enter a new market or retool with new products, such as consumer and trust services. Southwest’s strength is its small size and strong community focus. Customers know tellers and loan officers by name and are treated as family members. This atmosphere would likely disappear with any substantive growth. Alternatively, Dunkin knows that at least one large banking organization will enter Lemars soon and others may follow, either by buying an existing bank or opening a new branch. To compete, Southwest will have to decide to offer a broader array of services. It might also need to diversify its asset base.
Dunkin has indicated that Southwest’s Internet banking services are non-existent. Dunkin indicated that the bank’s client base “currently does not want or demand Internet banking services and hence there is no reason to be a leader in this area.” Dunkin also knows that the trend toward business banking on the Internet is approaching rapidly and that business customers are beginning to understand the advantages of Internet Cash Management. Internet Cash management allows business customers can move excess funds on a daily basis to an interest bearing account (not FDIC-insured). The ability to offer cash management accounts to Southwest’s customers could make a big difference in retaining some of their best customers.
The issue facing Southwest State Bank is not unusual in today’s rapidly changing financial services industry. The bank is currently enjoying record profits in a low interest rate environment doing what it has always done well, serving the small niche agricultural market. The real question facing Southwest is how does it continue to profit by doing what has been successful while investing in new ventures? Spending millions of dollars on Internet banking is one approach, but will all customers do business this way and if so, when? Southwest’s profitability and expense control are good and the board of directors is struggling with decisions regarding additional investment (purchasing another bank or branch) or investing into new technology, delivery systems and products their existing customer base does not appear to demand at this time.
ECONOMIC ENVIRONMENT
The Southwest economy has been strong during the past five years. Southwest has performed above average relative to peers with acceptable amounts of risk. Forecasts for the year 1999 and beyond are more uncertain. Interest rates are expected to remain steady, and most indicators suggest that business and consumer spending is good. Inflation, while currently low, will likely accelerate.
Economic reports indicate that the Southwest has experienced robust economic conditions during the most recent survey period. Sales were brisk for retailers and service-providers to consumers and businesses. Manufacturing activity proceeded at a moderate pace, and contacts reported a mild pickup in export demand. Conditions in the agricultural sector were somewhat weak. Activity in real estate and construction markets remained at high levels in most areas, and financial institutions reported strong demand for credit. Wages and prices exhibited limited movement overall, although increases were noted for some types of workers and some products.
Retail sales were rapid overall, although reports of slight slowing appeared in a few surrounding states. Automobiles and light trucks sold at a good clip in most areas of Arizona. Agricultural producers faced somewhat weak demand and lower sales prices. Reports from California, Washington, and Oregon indicated that farmers were hampered by weak export demand so that sales prices have remained low. Planting and growing conditions were mixed
Economic reports on banks and other financial institutions, such as venture capital firms, reported strong demand for credit and relatively good supply conditions.
QUESTIONS
Assume that you are a consultant who has been charged with analyzing Southwest State Bank's profitability and risk profile. The bank's balance sheet and income statement data for 1996 through 1998 and corresponding data from the bank's Uniform Bank Performance Report are shown in the following Exhibits. Also, a complete set of profitability and risk ratios for Southwest for the years 1996 – 1998 are provided in the template. Use this information to conduct analyses regarding the bank's current profitability, risk exposure, and optimal strategic direction. Specifically:
- Perform a ratio analysis using the ROE model to evaluate Southwest’s profitability relative to peers for 1998. In what significant ways does Southwest’s profitability differ from peers?
- Specifically identify the reasons for higher (lower) interest income and non-interest income. Do you see these trends continuing?
- Perform a ratio analysis to evaluate Southwest’s risk position compared to peers' for the period 1996 through 1998. In what significant ways does Southwest’s risk differ from peer banks'?
- Examine Southwest’s liquidity position. What recommendations would you have for improvement? Discuss both asset and liability liquidity.
Subchapter S Corporations
The Small Business Job Protection Act of 1996 changed the Internal Revenue Code to allow financial institutions to elect Subchapter S corporation status, beginning in 1997. Banks are required to indicate on the Call Report whether there is currently in effect an election to file under Subchapter S. Thrifts have a similar requirement as of March 1998.
The most important IRS requirements to elect and maintain Subchapter S status are:
· There can be no more than 75 eligible shareholders and no more than one class of stock. (In general, shareholders can only be individuals, estates, and certain types of trusts. Certain retirement plans and charitable organizations will be eligible in 1998.)
· All shareholders must consent.
· Banks and thrifts converting to Subchapter S status must use the specific charge-off method for tax purposes rather than the reserve method of accounting for bad debts and recapture tax bad debt reserves over a period of six years, if the reserve method had been used prior to conversion. (Note: even though the specific charge-off method is required for tax purposes, an adequate allowance for loan and lease losses must still be maintained on the financial statements and Call Reports.) Banks and thrifts are subject to a built-in gains (BIG) tax, if the aggregate fair market value of assets is greater than their aggregate adjusted bases on the date of conversion to Subchapter S status.
[Banks are required to indicate separately on the Call Report in December of each year, the deferred portion of income taxes reported in net income. For Subchapter S banks, some or all of their deferred tax assets and liabilities may be eliminated upon conversion to Subchapter S status; however, deferred taxes related to the BIG tax and the recapture of bad debt reserves must be recognized.].
A Subchapter S Corporation is treated as a pass-through entity, similar to a partnership, for federal income tax purposes. It is generally not subject to any federal income taxes at the corporate level. Its taxable income flows through to its shareholders in proportion to their stock ownership, and the shareholders generally pay federal income taxes on their share of this taxable income. This can have the effect of reducing institutions' reported income tax expense and increasing their after-tax earnings.
The election of Subchapter S status may result in an increase in shareholders' personal tax liabilities. Therefore, S corporations typically increase the amount of earnings distributed as dividends to compensate for higher personal taxes.
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CERT# 123781 DIST/RSSD: 11/ 505756 Southwest State Bank LEAMERS, AZ
CHARTER # NA COUNTY: Leamers SUMMARY RATIOS PAGE 01
12/31/1998 12/31/1997 12/31/1996 12/31/1995 12/31/1994
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AVERAGE ASSETS ($000) 48896 43558 39394 37943 39212
NET INCOME ($000) 876 783 494 486 613
NUMBER OF BANKS IN PEER GROUP 865 855 866 867 907
EARNINGS AND PROFITABILITY BANK PEER 014 PCT BANK PEER 018 PCT BANK PEER 018 PCT BANK PEER 018 BANK PEER 018
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PERCENT OF AVERAGE ASSETS:
INTEREST INCOME (TE) 7.22 7.67 19 7.77 7.78 50 8.02 7.74 68 8.11 7.76 7.29 7.10
- INTEREST EXPENSE 3.32 3.56 30 3.36 3.55 40 3.31 3.53 38 3.22 3.49 2.34 2.81
NET INTEREST INCOME (TE) 3.90 4.11 36 4.41 4.23 60 4.71 4.20 79 4.90 4.26 4.95 4.29
+ NONINTEREST INCOME 0.54 0.67 48 0.37 0.66 28 0.38 0.64 29 0.43 0.60 0.46 0.60
MEMO: FEE INCOME 0.08 0.23 32 0.03 0.21 14 0.07 0.19 39 0.07 0.16 0.07 0.17
- NON-INTEREST EXPENSE 2.59 2.74 46 2.76 2.70 50 2.91 2.66 61 3.16 2.73 3.20 2.79
- PROVISION: LOAN&LEASE LOSSES 0.04 0.21 27 0.09 0.19 51 0.24 0.16 76 0.20 0.14 -0.32 0.10
= PRETAX OPERATING INCOME (TE) 1.80 1.84 45 1.93 2.00 52 1.94 2.02 53 1.97 1.99 2.53 2.00
+ REALIZED GAINS/LOSSES SECS 0.00 0.02 66 0.00 0.01 80 0.00 0.00 77 -0.01 0.00 -0.10 -0.02
= PRETAX NET OPERATING INC(TE) 1.80 1.86 44 1.93 2.01 51 1.94 2.03 53 1.96 1.99 2.43 1.98
NET OPERATING INCOME 1.79 1.27 88 1.80 1.33 89 1.25 1.30 54 1.28 1.27 1.56 1.27
ADJUSTED NET OPERATING INCOME 1.79 1.32 85 1.77 1.39 86 1.25 1.35 51 1.23 1.31 1.56 1.30