KBRG Research - 2017 Excess Costs in US Community Banks

NEW RESEARCH BY KBRG: US Banks have more than $3BN in Excess Cost SUMMARY OF FINDINGS Banking regulations are complex and continuously evolving. Today’s financial institutions must adapt to stay in compliance, but at what cost? Costs to be compliant continue to grow inefficiently due to the reactive nature of regulatory feedback and enforcement. The finance and compliance functions in today’s banks are struggling to maintain operational efficiency while ensuring regulatory expectations are met. KBRG performed an assessment of its proprietary metric – “SET” (Total Salary cost as a % of Total Non-Interest Expense) on all 829 US Banks and Credit Unions with assets from $1 – $10BN (as of FY’16). The research of the SET metric showed the following:  Approx. 585, or 70% of the total, have an excess of $3.11BN in cost within their current organizations.  Excess cost increased by more than $300MM over fiscal year 2015.  The SET Metric, a relative measure of salary expense, continued to outpace the increase in total non-interest expense by ~3% annually.  On the other hand, non-interest expense has been steadily growing greater than 7% annually.  Total assets in the meantime have grown by ~10%, while excess cost grew by more than 11% in 2016, outpacing asset growth.  Total number of full-time employees (where data is available) has been steadily increasing over the last three years, with over 300,000 employed at the end of 2016.  The average employee was making more than $86,000/yr. in salary in 2016, an increase of roughly 3% over 2015.  The average bank; held total assets of $2.77BN, had ~364 full-time employees with an average annual salary of $86.7K, total non-interest expense of $83.4MM, a SET metric of 53.6% and $3.8MM in excess cost.

Karlo A. Bustos

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All proprietary information and analysis held within this document is the absolute property of KBRG, LLC. No part of this document may be produced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, nor may it be used outside the scope of the engagement for which it was supplied or disseminated, without the prior written permission of KBRG, LLC. www.kbrg.co

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RESEARCH & ANALYSIS METHODOLOGY: KBRG’s research and analysis was a compilation of public data available on SNL along with previous research and data compiled by KBRG. KBRG uses the most recent publicly available data for the companies involved. For this research, the analysis performed was focused on US banks with assets of $1$10 billion for the fiscal year 2016.

The main metric used is SET (Salary Expense Transformation) Metric - Salary Expense as a % of Total Non-Interest Expense (NIE) is used to identify excess cost. It is an external view of a company’s performance as compared to its peer group in terms of salary expense within total non-interest expense.

Adjustments may have been made to the data to provide true, consistent and comparable figures. It necessarily requires disaggregation to determine regional performance.

Each company is compared against a peer group from its own region as identified through their primary supervisory body region. The resulting excess cost opportunity range is the difference of SET metric when compared to the Upper Quartile of its peer group multiplied by the annual total non-interest expense.

REGIONAL PERFORMANCE BREAKDOWN: Our research looked at banks within their respective regions as determined by their main regulatory oversight body. This allows for fair comparison of supporting compliance to regional regulatory expectations as well as average cost of having sufficient staff in these regions.

Below is a table that breaks each of the regional make up of banks along with average assets: # of Banks 216 131 123 191 168

Regional Breakdown Northeast Southeast Central Midwest West

Average Assets $3.0BN $2.7BN $2.3BN $2.7BN $3.0BN

Average Northeast Region bank profile: The average bank in the Northeast region held total assets of $3BN, had ~363 full-time employees with an average annual salary of $95.7K, total non-interest expense of $75.4MM, a SET metric of 54.3% and $3.4MM in excess cost. As can be seen in the graph below, the gap between the average bank vs the top performer in the region has continued to expand, by over 390bps in 2016, from 270bps in 2015.

Northeast Region - SET Metric Performance 55.0% 54.0% 53.0%

54.3% 53.5%

52.8%

52.0% 51.0% 50.0%

50.8% 50.0%

50.4%

49.0% 48.0% 47.0% FY 2014

FY 2015 Average

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FY2016

Top Performer

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Average Southeast Region bank profile: The average bank in the Southeast region held total assets of $2.7BN, had ~313 full-time employees with an average annual salary of $78.2K, total non-interest expense of $75.8MM, a SET metric of 52.6% and $3.3MM in excess cost. As can be seen in the graph below, the gap between the average bank vs the top performer in the region compressed in 2016, to 270bps from 330bps in 2015.

Southeast Region - SET Metric Performance 53.0% 52.0%

52.6%

52.2% 51.6%

51.0% 49.9%

50.0%

49.0%

49.0%

48.9%

48.0% 47.0% FY 2014

FY 2015 Average

FY2016

Top Performer

Average Central Region bank profile: The average bank in the Central region held total assets of $2.3BN, had ~305 full-time employees with an average annual salary of $79.7K, total non-interest expense of $62.8MM, a SET metric of 53.6% and $3.6MM in excess cost. As can be seen in the graph below, the gap between the average bank vs the top performer in the region has continued to expand, by over 380bps in 2016, from 320bps in 2015.

Central Region - SET Metric Performance 54.0% 53.0%

53.6%

53.4% 52.7%

52.0% 51.0%

50.2%

50.1%

50.0%

49.8%

49.0% 48.0% 47.0% FY 2014

FY 2015 Average

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FY2016

Top Performer

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Average Midwest Region bank profile: The average bank in the Midwest region held total assets of $2.7BN, had ~363 full-time employees with an average annual salary of $81.3K, total non-interest expense of $82.3MM, a SET metric of 54.1% and $4.4MM in excess cost. As can be seen in the graph below, the gap between the average bank vs the top performer in the region has improved, residing at ~380bps in 2016, down from 470bps in 2015.

Midwest Region - SET Metric Performance 55.0% 54.0% 53.0% 52.0% 51.0% 50.0% 49.0% 48.0% 47.0% 46.0%

54.1%

54.0%

53.5%

50.3% 49.3%

49.0%

FY 2014

FY 2015 Average

FY2016

Top Performer

Average West Region bank: The average bank in the West region held total assets of $3BN, had ~361 full-time employees with an average annual salary of $93.2K, total non-interest expense of $116.2MM, a SET metric of 53% and $3.9MM in excess cost. As can be seen in the graph below, the gap between the average bank vs the top performer in the region has compressed, sitting at ~210bps in 2016, down from 290bps in 2015.

West Region - SET Metric Performance 53.5% 53.0% 52.5% 52.0% 51.5% 51.0% 50.5% 50.0% 49.5% 49.0% 48.5%

53.0%

52.9%

52.7%

50.9% 50.1%

50.0%

FY 2014

FY 2015 Average

FY2016

Top Performer

When reviewing the trends across all five regions, it should be noted that the Midwest was flat regarding excess cost, but remains with the highest average excess cost at $4.4MM. The region that experienced the highest increase in excess cost was the Northeast, with an average excess cost of $3.4MM up from $2.7MM in 2015, roughly a 27% increase. The other regions that took #2, 3 and 4 respectively were; Central – up ~23%, from $2.9MM in 2015 to $3.6MM in 2016, Southeast – up 7.2%, from $3.1MM in 2015 to $3.3MM in 2016, and the West – up 6.7%, from $3.6MM in 2015 to $3.9MM in 2016.

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IN CONCLUSION – US BANKS HAVE AN OPPORTUNITY TO IMPROVE PROFITABILITY AND RETURNS In order to avoid this excess cost trap, executives of these fundamental institutions should adopt best practices used by their top performing peers: 1. Tools and Systems - Ensure your organization has a central repository of all compliance related documentation as well as regulatory feedback and audit findings. A system should be in place (technology or not) to then report on progress and identify areas of concern and roadblocks.

Management should use this reporting to support the remediation efforts to meet the objective and ensure a successful and sustainable delivery of change.

2. Awareness and Ownership - Implement mandatory training for all key personnel in compliance, risk and finance function as well as all dependent internal constituents. This will ensure all are aware of their specific roles and responsibilities in implementing the change required, while ensuring all on-going monitoring and support of implemented and/or updated processes are rightfully followed and owned.

3. Execution and Prioritization - Align regulatory feedback and audit findings to prioritize remediation efforts with areas of top financial and reputation risk to your organization. This requires a holistic view of all items requiring time, support and investment to be reviewed monthly by management along with key personnel from impacted functions to ensure the basis of #2.

In conclusion, to best understand the excess cost opportunity, the average bank in our research; held total assets of $2.77BN, had ~364 full-time employees with an average annual salary of $86.7K, total non-interest expense of $83.4MM, a SET metric of 53.6% and $3.8MM in excess cost. The average net income was $20.4MM, giving the average bank a ROAA (Return on Average Assets) of 0.75%. If the average bank improved their operational efficiency to maintain compliance with today’s regulatory expectations and reduced cost by the $3.8MM in excess cost, the adjusted ROAA would improve by 14bps to 0.89%.

As excess cost continues to grow, banks will need to re-assess their cost structure and assure their cost of being compliant is not growing larger than they are able to generate in profits. Bank executives will need to determine which process, people and technology should be revamped to wind down costly legacy processes and implement more efficient and effective ones.

ABOUT KBRG AND THE AUTHOR: KBRG’s mission is to deliver actionable results to best align financial institution’s goals and objectives with the most cost-effective manner of achieving compliance in today’s regulatory environment.

Bring it back to the basics, a philosophy that serves as a foundation for our company and informs all our work. We fully believe that simplicity is better, and that relationships are the key to success.

KBRG helps companies clearly plan and effectively execute their strategic objectives. We are a multifaceted company providing solutions via: • • •

Regulatory Cost Assessment – Independent validation of processes and cost to be compliant Management Consulting – Strategic advisement and planning focused on execution Content Development – Custom and relevant content around best practices Karlo A. Bustos, CEO & Chief Analyst at KBRG, LLC Karlo Bustos, the founder and CEO of KBRG, is a proven strategy and finance professional with strong analytical and diverse industry knowledge. With expertise in leading benchmarking and financial analysis along with market/competitive analysis skills, he personally ensures the right result for organizations is always delivered.

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