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FIGHTING THE YIELD CURVE
BY KENNETH CLINE
Commerce Bancorp's Vernon Hill says his company will continue to outperform the industry in core deposit growth, despite a recent slowdown.
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SYNOPSIS |Vernon Hill, chairman and CEO of Commerce Bancorp, says an inverted yield curve has slowed Commerce's deposit growth, adding to pressure to cut costs this year. But he says Commerce's business model will continue to show faster growth than major competitors. He also asserts that Commerce, despite the expense controls, will do nothing to change or degrade its strategy to provide lavish customer service to attract depositors and that the company's branch-building program will continue despite recent regulatory issues.
You know it's a tough environment when even New Jersey’s Commerce Bancorp has trouble maintaining its core deposit growth. Cherry Hill-based Commerce, the banking industry’s star deposit gatherer, recently reduced its projections for annual deposit growth to 20%, from a previous range of between 24% and 26%.
Is the Commerce business model showing signs of stress in an interest rate environment characterized since early 2006 by an inverted yield curve? “We’re challenged a little bit more with this inverted rate environment,” says chairman and CEO Vernon W. Hill II, in an interview with BAI’s Banking Strategies. “But the model is just as sound now as when the yield curve was much steeper. And we can never do anything stupid to degrade the brand and the model that we’ve built.”
The Commerce model has always been controversial in the industry. Fans hail its unparalleled core deposit growth as transformational while detractors say the company spends too lavishly on its branches to maintain that growth. The difficulties Commerce has encountered in the current interest rate environment clearly heighten the intensity of that debate. And it comes at a time when the company is facing pressure on other fronts.
In January, Commerce revealed it was being investigated by the Office of the Comptroller of the Currency and the Federal Reserve Board for certain related-party transactions involving bank premises.
Hill declines to discuss the regulatory issues. But regarding the business environment, he points out that the entire industry is under stress right now. He asserts that his model, built on a nearly unprecedented level of customer service, will continue to generate faster deposit growth than any of the competition.
Q: Your deposit growth has been unprecedented in the industry, ranging from about 24% to 30% a year. Then, in January, you reduced your guidance to 20% a year over the next five years. What’s behind the slowdown in growth?
Hill: First of all, it’s the law of big numbers. As you get bigger, you have a larger base. And also, with this yield curve inversion, you have to ask yourself whether you want to pay the higher rate for the extra marginal deposits, something we didn’t have to deal with in earlier years.
But the magic of Commerce is not only our continued, very rapid growth in deposits, but also our ability to grow deposits at a lower cost of money than the competition. There’s no magic to growing deposits. If you want to pay the highest rate, you can always grow deposits. The trick is to grow them with cheaper rates. And we have a 75 basis point cost advantage over time. So the magic is: high growth with low-cost deposits.
Q: And you’ve been letting some of the higher rate deposits leave the bank ...
Hill: Oh, yes, absolutely. In the last quarter of 2006, we probably ran off $400 million to $500 million of, let’s call it “marginal rate money.” It’s a choice we have to make now.
Q: Obviously you don’t have a crystal ball, but how long do you think this flat yield curve-currently more than a year old-will last?
Hill: Well, it’s never lasted this long in my lifetime, so I think that’s the magic question. Nobody really knows the answer.
We’ve all seen the curve invert before, but never for this long and it’s hard to figure out what’s going to make it change. Somebody said to me, “Vern, if you believe the yield curve is always going to be inverted, you have to believe the laws of economics have been repealed.” So hopefully soon, it’s going to normalize.
Q: But if this continues on a long-term basis, does it put your business model under particular stress? Does your business model work as well in this sort of rate environment?
Hill: First of all, all banking models are built on the idea that we borrow short at lower cost than we lend long. That’s banking. So I would say everyone’s model is more stressed in this environment. We grew our income 11% last year, and we grew our revenue 17%, fighting the yield curve all the way.
I would put it somewhat differently. If you’re a bank that has little or no growth, you’re getting killed by the yield curve. At Commerce, the growth is offsetting a lot of the yield curve effect. But certainly we’re not growing our income as much as we have historically.
In 2004, we grew income 41% and historically we’ve been growing 20% to 25%, so it’s a tough environment. But we cannot let this environment cheapen our model or delivery system.
Q: But you are focusing more on expense control this year, aren’t you?
Hill: Because we have no choice. Before this yield curve inverted, income was growing 25% a year and we could over-invest in the future. So now we have to be more careful about how we over-invest.
Fortunately, we did over-invest in those earlier years, 2002 to 2004, which allows us to control our expense growth somewhat going forward.
Q: But you won’t cut back on branch expense?
Hill: We are not going to do anything to cheapen our model, whether it’s branch, online, call center, or whatever. One of the things we’re proud of is, we were rated by Greenwich Associates in 2006 and 2005 as the best call center in America of all companies, certainly all banks, because we have a human being answer the call every time. In America, that’s something that hardly exists any more.
Q: You don’t use Voice Response Units (VRUs)?
Hill: We have a VRU but that’s just for account balance information. You call our main call center number and you don’t get a computer prompt, you get a human being and the customers really love that.
Q: So, I guess the expense cuts have to come in administrative support ...
Hill: Well, it’s partially that. But when we’re growing at our rates, you want to have the ability to over-invest because one of the risks of this model is, if your infrastructure doesn’t keep up with your growth, service degrades over time. So, it’s this balance of controlling expense growth and not allowing your infrastructure to degrade. In fact, that infrastructure has to get better.
Q: What’s the strategy behind spending so much on branches and customer service?
Hill: Our philosophy is: the real value in a bank is core deposits-not loans, but core deposits. Second, customers will give us more low-cost deposits if we give them a great retail experience. And great businesses, whether they’re Starbucks or Home Depot or McDonald’s, create fans, fans who buy into the model and then reinforce the brand.
Q: By fans you mean loyal customers?
Hill: Loyalists is another way to say it. Customers will give us more low-cost deposits for a differentiated retail experience and this creates fans, who reinforce the model.
Q: But a lot of analysts are now questioning whether it’s possible to maintain those expenditures on the customer experience in this difficult interest rate environment ...
Hill: The typical big bank model is relatively high cost of money, relatively low cost to run, with no growth. Our model is relatively low cost of money, relatively high cost to run and high growth.
So, yes, we’re challenged a little bit more with this inverted rate environment. But the model is just as sound now as when the yield curve was much steeper and we can never do anything stupid to degrade the brand and the model that we’ve built.
You should look at Commerce not as a bank, but more like Starbucks for this reason: why are you paying $5 for a cup of coffee at Starbucks when the guy outside is selling coffee for $1? You’re obviously getting something else.
The same is true with Commerce. Customers are giving us more of their low-cost money for the retail experience.
Q: Now in regards to this retail experience, what are the important things that really make a difference to customers?
Hill: It’s no one thing. When bankers and reporters write about banking and retailing, they always focus on the parts. But the parts are almost immaterial. It’s the way you integrate the experience together.
When J.D. Powers reports that we’re number one in customer satisfaction, as well as Consumer Reports, it’s not any one thing that we do. It’s the way we integrate all the parts together. It’s the seven-days-a-week hours, the facilities, the look, the people, the pricing, the call center, the computer system, etc.
I don’t believe any great retailer has ever been built by doing deals. I don’t believe you can find me one in America. We’ve all been built the same way. We learn to build a model over a long period of time, we refine the model and we expand the model.
We talk about all these things: hours, buildings, facilities, free checking, pricing, friendly people, training—all that stuff counts, it’s all very important. But when the other banks attempt to pick out parts of it, and don’t change the rest, because they can’t change the rest, they don’t get the results.
For example, 5.6 million people used our coin-counting machines last year. Now, there are other banks in the country that tried to put these machines in. But they’re not integrating the whole thing. It’s not part of the experience.
We say that great companies have these three parts: differentiated models, where the customer sees clear value; a culture that matches the model, is unique to the model and is pervasive; and fanatical execution. We mystery shop ourselves 100,000 times a year and that means every branch on average gets shopped every other day. When you get to this level, you create fans.
You can go to McDonald’s in the early days, or Home Depot, or Starbucks-we all fit in the same group. The coin change machines are a great example. What bank do you know would spend $50,000 a branch to get zero direct return? Our coin change machines are free, customers don’t even have to bank with us to use them. Who’s going to spend $50,000 a machine to get zero return? The answer is no one.
Q: Can you think of any banks that emulate your model? Do you have any disciples?
Hill: I don’t really believe you can copy this model. That’s how hard it is.
They tinker with it, they change a few things, they play around, but no one has really built a model this way from scratch. Our company is built around copying or imitating retailers that have unique values.
Q: Do you have trouble trying to explain your model to bank analysts, who are trained to focus on bank-like rather than retail-like metrics?
Hill: I’ve been doing this for a long time, so it’s one of those things that you never get to where you want to get.
Yes, we’d like to be valued as a retailer, yet our multiple has always been, if not the highest of the banks, one of the highest, so we’re always half way there. As a retailer, if you produced the results we have over time, our stock multiple would be 40 instead of 20. The typical bank is 12. So you could say we’re sort of half way there.
If you believe you’re a retailer, you run your business from the store level up. That’s whether you’re Starbucks, Home Depot or whatever. What happens at the stores is what counts. If you’re a bank, you run it from the top down.
It sounds like a simple phrase, but it dramatically changes everything that you do. The branch-we call it the store-becomes the center of everything. They get all the deposit credit, everything we do revolves around them. It’s a different way of looking at life.
Q: But you still have an administrative layer on top ...
Hill: Yes, but it’s the way you run an administration and I’ll give you a couple of examples.
In a typical big bank, if you went to Wharton, or Harvard or Yale, you’d go into the commercial loan side of the business. But if you went to a community college, they would send you out to the branches. Now we can pretend it’s not true, but we all know it’s true. So, first of all, the glamour and the focus at the big banks are not at their retail level.
Also, our big competitors run their business by lines of business. I’m totally opposed to that. We run what’s called a “market manager” system.
Let’s take New York City, where we have $6 billion in deposits. I have one executive, Greg Braca, who’s in charge of retail, commercial, big-ticket commercial, government and community. In other words, he’s running the Commerce Bank model in New York City. That is a completely different model from the Chase model, where they may have a branch administrator who doesn’t have lending authority and small business lending is done in a loan center someplace else.
Everything we do is to bring it down to the local level. In fact, this all started when we were very, very small. I said to myself, “How do we keep a local bank feel when we get big?” Because the customers don’t want you to be big. What they want is this local, small town bank feel, backed by the big bank capability.
Our whole management system is designed to deliver the small bank feel with the large bank capabilities. This has been a rare management model.
Q: Isn’t that how banking used to be in the 1950s and 1960s, when institutions were smaller and geographically based?
Hill: Quite true. But today, the reason the competition all goes the other way is because their compensation systems are based on the profitability in their lines of business. So it’s not how well the company does, it’s how well their unit does. They’re tremendously conflicted as they deliver.
We follow the policy that every deposit dollar is assigned to the appropriate branch. Well, here’s what the typical big bank does: corporate deposits don’t go to the branch, government deposits don’t go to the branch and private bankers suck money out of the branches. So the branch banker hates the corporate guys, the government guys and the private banker.
In our model, every deposit dollar goes to the appropriate branch. So, now, my managers love the corporate guys etc. because they’re helping them make their numbers.
It goes back to my earlier comment. If you’re retail, you’re focused on store results, as opposed to a big bank, which is focused on lines-of-business results.
Our model allows us to replicate our Commerce model in New York, Philadelphia, Florida or Washington D.C.
Q: How do you keep your corporate culture intact as you expand?
Hill: First of all, you have to have a very clearly defined model. We recruit people whose personalities match our culture and model. We hired 6,000 people last year. We need to recruit them, train them and put them in the field. These two things together, model and culture, have to be united; they have to be on the same page.
We have an industry-leading training operation called “Commerce U.” It is the state of the art for training in America, not just for banks. We get people from all over the country coming to see this training operation. It goes with what you just asked me, how can we keep the culture, how can we keep delivering? We’ve got to be fanatic about the way we train.
It’s not so much the skill, except at the very high skill levels. The competitive advantage at the retail level is really about how you deliver it. Do you smile? Do you ask customers for their name? You can go on and on like that.
Going back to your question about diluting the culture, I used to be scared to death that, as our store manager base grew by attracting people from outside Commerce, it would get weaker. Actually, the reverse has happened. When we hire from Chase, Bank of New York, Wachovia or Bank of America, those people have seen the dark side. Our job is to recruit great people trapped in a broken model.
Q: What’s your take on customer segmentation strategies, or the idea that you should focus your attention, and best service on the most profitable customers?
Hill: You can’t tell who’s your high-profit customer because they’re moving all the time on you. The old 80/20 rule-that 20% of your customers contribute 80% of the profit-has died, but it has taken a lot of banks with it. To me, that was one of the most influential theories in degrading bank service in the 1990s.
Another destructive theory going around in the ‘90s was that banks with the largest market share in each metro area won: buy everybody, get the largest market share, raise fees and degrade service. Well, all they did was leave themselves open to attack.
Q: Commerce’s method of increasing market share, of course, is to build new branches. In the fourth quarter of 2006 you talked about slowing that down a bit ...
Hill: Well, our growth rate for new branches has been in the range of 15% to 20%. We’re at the low end of that right now. I think it’s fair to say that’s a reaction to the earnings pressure with the yield curve. But we’re still going to open 65 stores this year, with 200 in development.
Remember, we only build free-standing, except in downtown areas. So it’s a much more difficult and lengthy process to go free-standing than to put something in the middle of a strip center. Free-standing sites are much harder to do and they take more time but the results are much, much better.
Think about CVS and Walgreen’s. Walgreen’s will pay almost any amount to get the right corner because the building is the customer’s first impression of the brand.
So while we spend much more to build a branch than all the competition, we get much higher results. The ability to find the best site, to have a special building and to get it through the approval process is a definite advantage. Development is a Commerce competitive advantage.
The competition for sites in our markets is CVS, Walgreen’s and us. Great retailers believe that the site is always important, and if your results are much higher, you can afford to pay a lot more. When you can afford to buy the best branch site, you get better results because you have the best corner. If you can only afford inferior sites, you have an inferior model.
Q: What geographic areas are you looking to mostly for expansion?
Hill: Our two new markets are Washington D.C. and Southeast Florida. In a couple of years, we hope to expand in other metro areas in Florida and then Boston. We believe we can build 1,400 stores on the East Coast.
Q: So you’re going to stick then to those areas ...
Hill: Well, for a while. Remember, great retailers don’t put five stores in New York, 10 in Chicago and 13 in Atlanta. Nobody does that except the guys who want to fail. The idea is to cover your market as much as you can. In metro Philadelphia, it’s a 200-store market for us and we have about 150. In metro New York, it’s a 400-store market and we’re at 250.
The more stores you put into a market, the better they all do, up to a point.
Q: Commerce currently faces an investigation by the Office of the Comptroller of the Currency. Could this possibly interrupt your growth plans?
Hill: We’ve been growing our stores 15% to 20% a year and I’m sure we will continue.
Q: Nothing of a regulatory nature preventing you from building more branches?
Hill: Correct.
Q: What about you personally? You’re 61 now. Do you plan to retire anytime soon?
Hill: No. But we have a great management team, great depth. A lot of our people have been with me 15 years plus. Our model breeds stars.
Q: Do you still see yourself at Commerce, say, five years from now?
Hill: I do.
Q: And what will Commerce look like at that point? What’s your best guess?
Hill: I don’t have to guess. We expect to be $100 billion plus in assets with 800 stores. And that assumes no deals, it assumes we grow our store base 15% to 20% a year and we grow our stores $20 million a year in deposits.
If you look at our model, we’re growing somewhere between five to 19 times better than the competition. Who wins? Also, our average branch size is $120 million. I think the average in America is about $49 million.
Q: Some analyst critics, however, point out that your return on assets (ROA) is lower than most of your peers ...
Hill: And nobody cares about the ROA except them. What Wall Street cares about is predictable growth.
Obviously, you have to be within a range; you can’t be crazy. But what Wall Street pays for, whether you’re selling banks or shoes or anything else, is predictable growth. Remember, your multiple is a predictor of growth, so when you have no growth, you talk about ROAs and efficiency ratios instead.
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