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Tackling The Profit Paradox
BY KENNETH CLINE
Kerry Killinger says he won't let short-term earnings pressures deflect Washington Mutual from building its retail bank.
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SYNOPSIS | Washington Mutual Inc. has experienced earnings weakness this year related to a slowdown in the housing market and credit quality problems in subprime mortgages. But WaMu’s chairman and CEO Kerry Killinger says in an interview that he will continue investing in the company’s retail bank, which is experiencing rapid growth in customer accounts. He credits innovative products based on extensive market research with helping WaMu achieve much of this growth. Killinger also explains WaMu’s decision to slow branch expansion in some markets.
2007 has been a difficult year for most U.S. banks as they contended with narrow net interest margins, a slowdown in the housing markets, rising credit quality concerns and increased political and regulatory scrutiny.
Yet even as financial institutions wrestle with these (hopefully) short-term earnings pressures, top executives must still invest for the future and try to anticipate what customers will want five, 10 years down the road. This dilemma, which BAI has termed the “profit paradox,” will be a featured theme of BAI’s Retail Delivery Conference & Expo, to be held in Las Vegas in November. And it’s also much on the mind of one of the keynote speakers at that conference: Kerry Killinger, chairman and CEO of Washington Mutual Inc.
Like its peers, WaMu has been grappling with earnings pressures this year, particularly those contributed by the slowing housing markets and defaults on subprime mortgages. As a thrift, with 36% of its assets in single-family residential mortgages and mortgage-backed securities and another 6% in subprime loans, WaMu remains vulnerable to problems in these markets.
But Killinger, as he explains in the following interview with BAI’s Banking Strategies, intends to keep his focus on future growth, particularly investing in WaMu’s retail bank unit, which has experienced a robust surge in customer accounts in recent years. Much of that growth, Killinger says, derives from WaMu’s strategy of using “edgy” and distinctive marketing to introduce innovative products based on extensive consumer research, including a new style of branch (the “Occasio” design); a revamped free checking account; a paperless online account; and a mortgage product tied to a home equity line of credit.
Such innovation helps Killinger further his stated goal of “re-inventing” WaMu every five years. It also suggests that continual innovation is one of the keys to solving the profit paradox.
Q: One of the themes of BAI’s upcoming Retail Delivery Conference & Expo is the “profit paradox,” the idea that banks need to invest for the future while still maintaining quarterly earnings momentum. How does WaMu handle the profit paradox, particularly in a year that’s been so difficult for banks?
Killinger: We operate from a five-year plan and make all of our short-term practical decisions in the context of that plan. The current plan, 2005 through 2009, has us targeting a high teens return on equity, double-digit earnings growth and reducing our efficiency ratio to below 50%.
We also recognize that, to hit our targets, we are a growth company, so we need to continually drive above-average growth in households and checking accounts and fee income. In times like this, where there are external pressures with the flat yield curve and the negative impact that has on the net interest margin, the focus for us is on those core fundamentals and being sure that our revenues are growing at a faster rate than our expenses. Our business model strives to have revenues grow about twice the level of expenses in our retail banking group.
Now, clearly, you always have trade-off decisions between short-term and long-term profitability. In the retail banking business, I keep our focus predominately on the long term, because it’s a wonderful business. In fact, of all the businesses we’re involved in, I describe the retail banking as the crown jewel for its above-average returns, below-average volatility and terrific franchise value.
If I look at all the businesses I have to invest in, retail banking will always get the first look. It consistently creates enormous value for shareholders.
Q: Expense control is a huge theme in banking this year. How confident are you about reducing your efficiency ratio, which was 56.4% in the second quarter, to 50% or lower by the end of 2009?
Killinger: I think we are in good shape. We aggressively attacked our cost structure over the past year and a half. We reduced our run rate of expenses by about $700 million per year from the fourth quarter of 2005 to the first quarter of 2007.
For WaMu, it’s all about getting the revenue to grow at twice the rate of our expense growth. Said another way, we’re not going to get into the right kind of efficiency ratio from here on just by cutting expenses. Subject to a more normal yield curve and interest rate environment, we’re confident we’ll meet our 50% target by the end of 2009.
Q: In terms of investing for the future, how do you look ahead and try to anticipate what customers will want and then position the company to meet those needs?
Killinger: It’s particularly important in the retail banking business to stay consumer-focused. So we spend an enormous amount of time trying to understand the best thing we can do for the customer. That means coming up with products that will provide better value and convenience. We’re continually adjusting our product mix, continually adjusting how we approach serving the customer.
I have a saying around here that we need to continually reinvent ourselves so that within five years, our bank should look nothing like it did five years before. That keeps a real edginess for us about how we change product offerings, how we change pricing, how we change our physical facilities and how we change getting customers through the Internet.
This whole reinvention of the company is really critical in this retail space.
Q: WaMu is known for innovation. For example, you have your free checking product and the marketing you introduced around that last year, the Occasio branches and the new mortgage product, Mortgage Plus. How do you promote innovation in this company?
Killinger: For us, it’s just a core part of the culture. You have to ingrain it into how people think every day. I don’t think innovation works well if it involves isolated people trying to work on it over in some corner of the organization.
Q: No “innovation czar” at WaMu?
Killinger: Right. It really has to be core to whatever the business unit is trying to do.
As a CEO, I take it as one of my most important responsibilities to nurture and encourage innovation and make it part of the expectation for everybody. And the innovation needs to stay centered on helping the customer with better products at better prices with more convenience.
The Mortgage Plus product, for example, was designed with the idea of putting more control into customers’ hands. They can simply call us once a year and re-set the interest rate on their mortgage so they don’t have to go through a re-financing. That’s a huge breakthrough, I think, in the mortgage business. We also designed that product without closing costs, which is another obstacle for a lot of people getting into home loans.
We also developed an instant online checking product that is paperless. Why should a customer have to go into a bank branch to open a checking account and take 20 or 30 minutes to get that done when they can come online and do it in five minutes or less with no paperwork? This product makes it easy not only to sign up for the account but also to then sign up for a savings account and other things associated with it.
We have now catapulted ourselves into the leading bank in the nation in terms of opening online checking accounts. So, I think that’s a good reflection of innovation being alive and well here.
Q: How do you research customer needs or preferences?
Killinger: We have always valued market research very highly in this organization. For many years, I had that area reporting directly to me. We have never come out with a new product or service that wasn’t backed by very extensive market research. We research both our customer base and the customer bases of our competitors. We use research to figure out which features customers value most, which ones they would perceive as providing additional value and so forth.
Both Mortgage Plus and the online checking product, as well as the updated version of free checking, all received extensive market research that accurately predicted what the volumes and the customer demand would be.
Q: You said earlier this year at a conference that the Occasio branch design may be modified in the future, perhaps to include more drive-ups. What was market research telling you in that case?
Killinger: When we first came up with the Occasio concept, about seven years ago, we did a lot of market research. We found that consumers wanted to be greeted by a concierge when they walked into the store. They wanted us to take down barriers that hindered comfortable interaction with banking personnel. They wanted an open, welcoming design. Research also told us that they would like a children’s play area and some new technologies such as the Internet. We tried to respond to all those preferences.
Overall, that program has been enormously successful. We added over 1,000 branches utilizing the Ocassio concept.
Now, as we go to the next evolution, customers are telling us that they want to have a seamless online banking experience with their in-store experience. That’s why we’re doing a lot of work on how to make it seamless for a customer to open accounts online and come into the branches to get service.
We’re also seeing that, in many markets, drive-ups are very important and in some of our newer markets we need to put in more drive-ups than we had in the past. The drive-ups are a market-by-market issue—important in metro Chicago, for example, but not New York City.
We’ve also developed technology that makes it easy for our store employees to avoid handling cash. We found customers very willing to use the automated cash dispensing machines as a way to get the cash, rather than having tellers counting out bills to them. That has proven to be very positive for us.
We’re still working on all of the elements of our next generation of stores and can’t release any more details at this time.
Q: Speaking of branches, you have reduced the number of branches you’re building and actually closing some in markets like Chicago and Atlanta. Have you decided that de novo branch expansion is less important strategically?
Killinger: Branches are very important; they’re the cornerstone of delivering retail banking services.
However, when we first developed Occasio and then ramped up the openings, we had relatively little competition from other banks. We were opening stores while most banks around the country were closing stores. Then, the rest of the industry started accelerating their new branch openings. It became much more competitive in terms of finding retail space and some markets got over-branched.
Beginning a couple of years ago, we started to open fewer stores and to open those stores predominately in our existing major markets of California, Texas, Florida and New York. We were seeing a higher payback on those stores than we experienced in newer markets such as Chicago, Atlanta and Denver, where we hadn’t done an acquisition before starting de novo branches. So we’re focusing new store openings in areas where we have the highest likelihood of excellent paybacks.
The other thing that’s important is we now have a significant number of our new accounts being opened directly through the Internet. This year, we expect to open between 100 to 125 stores compared to the peak, when we were opening about 250 new stores a year. And yet, we’re growing our customer base at a faster rate today than we were at that time. So, I think these multiple channels of distribution are really allowing us to grow without opening as many new branches.
Having said that, we’ll continue to aggressively open new bank branches. And depending on market conditions, we could easily increase the level of annual openings.
Q: But just to clarify, you essentially discovered that new branches require critical mass to succeed in a new market, which usually means an existing network provided by an acquisition?
Killinger: Yes. Our experience has been that we’re most successful when we entered a market with an acquisition and then added de novo branching on top of that. A good example of that would be the greater New York area, which has been highly successful for us. We’ve exceeded all of the targets we set when we acquired Dime Savings a few years ago and de novo branching has worked very well in that market.
By contrast, in Chicago, where we entered the market totally de novo, we did not have that critical mass. It’s been much more difficult getting to our targeted levels of profitability.
Q: Some analysts have pointed out that WaMu has done a good job increasing new account openings, but has been less successful increasing deposit balances, particularly in the newer markets like Chicago and Atlanta. What are you doing to improve that situation?
Killinger: First, we are seeing some excellent improvement in all those new markets. But I must point out that our primary business strategy is not to simply grow deposits in our retail stores. It’s all about maximizing revenue growth. And for us, revenues come predominately from opening checking accounts and garnering all the fee income that comes from those accounts. Then, we cross-sell the average customer seven products and services.
When we come into a new market, we lead with a checking account and the fee income that comes with that. Then the focus is on home equity loans, credit cards, a certain amount of home lending, a certain amount of investments and, yes, a certain amount of deposits. Deposits will grow but with a lag effect vis-á-vis everything else going on in our model. We really manage ourselves to the bottom line of that model, much more than trying to get to a particular deposit level.
The other factor is that we manage our deposits to a certain point in the business cycle. And at this point in the cycle, we’ve not been trying to grow deposits at a significant rate. We have been more inclined to manage our deposit costs in order to minimize the challenges on the net interest margin that you have at this point in the cycle. There will be other times when we will decide to become much more aggressive in deposit pricing and you’ll see a different growth trajectory for deposits.
Q: In essence, there’s no reason to grow deposits when you’re not growing loans as well, right?
Killinger: That’s right. In fact, we have decreased the overall size of our balance sheet slightly in the last few quarters and have been extraordinarily aggressive in re-purchasing our common stock. We decided that was a smarter play than taking on a lot of new assets at what we thought were not particularly attractive spreads.
Q: Let’s look at mortgages then, which constitute the largest share of your assets. The housing market is in a slump right now, with particular stress in subprime mortgages. From where you sit, how bad do you think it can get?
Killinger: Over two years ago, I was saying publicly that housing prices were becoming extended and that we had a high risk of a slowdown in housing with price declines in some parts of the country. So, we started to take defensive actions at that time, including selling off the 2004 and 2005 subprime residuals. We began selling the majority of our Option ARM originations and basically have reduced the prime residential loans that we had on our balance sheet. Additionally, we consciously decreased our market shares in both the subprime business and in the prime correspondent business, which we subsequently decided to exit.
We also tightened our underwriting. As a result, I think we will be very well positioned for a more challenging housing market.
Now clearly, this year, we have seen some softness in housing in many parts of the country. That has led to an increase in non-performing assets and credit costs for the industry. But in our case, I think the performance has been right in line with what I had expected.
In terms of how much longer the softness may continue, it’s very difficult to make that kind of a forecast. I will say that the housing downturn has been minimized by continued strong employment. The current unemployment rate is only 4.6% and interest rates are relatively low as well. Trying to assess the future of housing needs to be done in the context of what’s going to happen with the overall economy and interest rates. Right now, both of those are having a moderating influence on the downturn in housing.
Q: Your stated goal, for many years, has been to convince investors to value WaMu more like a bank andless like a thrift. Do you get frustrated in periods suchas this, when a negative environment in the mortgage business causes people to overlook what you’redoing on the retail side?
Killinger: No, certainly not frustrated.
I am sensing a significant shift in how investors are now viewing WaMu. I was recently out visiting a number of large shareholders and found that they are now seeing the real value that we are building in our retail franchise. Most of the questions I’m now getting pertain to the growth of our retail business.
Q: You still have a thrift charter, however. Any plans to switch to a bank charter?
Killinger: Well, we consider all of our alternatives. Right now, we think that the charters that we have are very flexible and serve us well. The valuations of the company are going to depend more on the numbers we produce and whether we do a good job of communicating our progress to investors. Those are far more important than a specific charter we might have.
Q: One advantage of the thrift charter is it has few restrictions on where you can expand or what kinds of companies you can buy. Are there any new geographic regions you’d like to enter?
Killinger: I really like the geographies we have now. We’re in all of the high-growth areas of the country, from California right across to Florida and New York. Then we have the newer markets in Chicago, Atlanta and Denver. I think, over the next five years, we can achieve all of our financial objectives by concentrating on filling out all of those markets. We will be open to moving into additional markets but I don’t feel we need that to hit our financial targets.
We have been, periodically, a very active acquirer over the years and we will continue to look opportunistically for ways to leverage our franchise if the economics make sense for us. We’d be interested in either banks or thrifts that gave us good branching networks. We’d also be interested in deals that help us diversify away from just residential assets and provide product categories that could be sold through our retail stores. Providian Financial Corp., which we bought in 2005, is a good example of an acquisition that gave us both.
Q: Front-line employees are the key to customer service. What kind of culture are you trying to instill at WaMu?
Killinger: We try to create a culture that is different from most of our major competitors. I think the culture in most banks is not particularly conducive to being a good retail banking organization. Traditionally, bankers have gotten caught up in a stuffy, institutional feel. We’ve had success over the years by being a bit outside of that—being a little quirky, a little hip and cool here and there.
Our brand has generated a good response, especially in the Internet channel. The younger folks particularly identify with our brand, which bodes really well for the company. In fact, one of our recent studies shows that we have the fastest growth rate of households among our major competitors. And we’re getting just as attractive a customer as everyone else so there’s an attractive profitability curve to the growth.
Based on all this data I’m seeing, it’s very encouraging at this point.
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