Turning Point Advisors

Bank Industry Update June 1, 2010

Introduction
The Banking Industry has been through incredible change over the past three years. Whether an institution is a community bank, regional bank or one of the Big Four, there is no more business as usual. This brief will discuss the economic and regulatory changes affecting the industry, and how this will affect the operational and buying habits of institutions from a marketing perspective. The industry is regulated by the FDIC, the Federal Reserve, and the Comptroller of the Currency. Their business is impacted by employment rates, interest rates, and income and consumer confidence. Industry revenue has contracted by 25% between 2007 and 2009, but is expected to grow again in 2010 as the consumer comes back and credit markets begin to open up.1 From 2010 to 2015, revenue is expected to be less volatile. The TARP banks will grow deposits faster rate than savings institutions. Industry revenue during this time is expected to increase 6.6% annually to $711.5 billion. The four largest too big to fail banks increased their market share from 23% in 2008 to 38.4% in 2010, as the banking sector realized consolidation amidst some bank failures. Over the next five years, government regulation is expected to dramatically change the business model of banks.2

Target Market
The U.S. commercial banking market is in a mature stage of the lifecycle. Banking organizations are spread across the U.S. in approximate levels equal to population. In terms of geographic location, the Southeast region has the largest proportion of establishments, with around 29.7%.3 The Southeast also generates the most banking revenue, around 25% this year. The map below shows the distribution of banks.

1 2

IbisWorld, Commercial Banking in the U.S., Tony Hamilton, February 2010 IbisWorld, Commercial Banking in the U.S., Tony Hamilton, February 2010 3 IbisWorld, Commercial Banking in the U.S., Tony Hamilton, February 2010

Bank Industry Update 2010

The four largest banks own a large and disproportionately growing share of the market. Their market shares are as follows4: Bank of America Wells Fargo J.P. Morgan Chase Citigroup Other 12.7% 12.2% 8.3% 5.2% 61.6%

IbisWorld, Commercial Banking in the U.S., Tony Hamilton, February 2010

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Bank Industry Update 2010

The other category is made up of over 6,400 other commercial banking institutions. All commercial banking institutions combined make up 77,237 establishments (branches). The trend is clear. Whether through FDIC takeover, consolidation or acquisition, the number of banks and credit unions has declined by over 50% in the past 25 years. And a report by consulting group PPC Group believes that banks could shrink by another 33% over the next five years.

Key Statistics
INFLATION ADJUSTED (CONSTANT) PRICES

2006 Industry Revenue Industry Gross Product Number of Establishments Number of Enterprises Employment Total Wages Domestic Demand *640,139.1 *160,035.4 *87,714 *6,885

2007

2008

2009

2010 $Mil $Mil Units Units

*643,020 *542,689.8 *489,045.4 *517,413.3 *160,267 *149,884.7 *133,709.3 *156,511.5 *87,758 *6,888 *86,705 *6,806 *78,175 *6,515 *77,237 *6,410

*1,633,992 *1,634,809 *1,615,191 *1,563,505 *1,544,743 People *99,222.2 NC *99,180.1 NC *98,329.2 NC *98,498 NC *99,078.6 NC $Mil $Mil

Industry Trends
A number of recent studies identify the trends and their impacts on the banking industry. In 2010, the trends most affecting banks are:

The Need for Increased Efficiency The Impact of Regulatory Change Stagnant Budgets Focused IT Projects Loss of Loyalty; Lack of Trust

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Increased Efficiency
A study conducted in February 2010 by Abound Resources shows the top five priorities of Community bank CEOs5:

1. 2. 3. 4. 5.

Community Bank CEOs Clean up the balance sheet (70%) Improve efficiency ratios; become more efficient (63%) Grow commercial loans (52%) Get more value from existing technology (52%) Use technology for better efficiencies (52%)

According to this study, CEOs feel the worst is behind them. While their top priority is to clean up the balance sheet, three of their top five priorities revolve around gaining efficiencies. While CEOs are firmly focused on efficiency, the study found their COOs, CIOs, and CFOs top three priorities are mobile banking, CRM and online account opening systems. Perhaps this misalignment is representative of the changes and stresses on the industry. It also shows vendors the need to understand the banks from every angle and be able to present solutions in a way that meets the need of the decision makers differing roles. As a result of banks seeking to improve efficiencies, reduce costs and free up capital they are increasingly turning to outsourcing. Those areas most often outsourced are treasury management, wholesale lockbox, remote capture, disbursements, check processing and image exchange, according to reports. But todays outsourcing is usually a domestic venture; only 4 percent of North American bank CIOs are considering moving operations overseas in the next two years, Aite notes.6 In a global roundtable and study, Celent Researchs Banking group found that across all geographies, banks shared a common set of priorities. Bob Meara, Senior Analyst with Celent's Banking group found, "Risk, cost reduction, and multichannel delivery efficiency appear to be consistent filters applied to all prospective projects over the last year."7 Consistently, these priorities continue to show up the highest in 2010.

Abound Resources Survey Finds Efficiency is the Common Denominator in Community Bank and Credit Union's 2010 Plans 6 2010 IT Spending in Banking, Aite Group, September 2009 7 Top Technology Trends in Retail Banking for 2010, Report Published by Celent

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Bank Industry Update 2010

Changes in Regulations
Financial reforms, including the establishment of a stronger consumer protection agency, will require banks to also change practices. According to the Aite Group, further regulatory changes could take the form of payday lending restrictions, pressure against alternative forms of financial services, and merchants' lobbying for interchange regulation.8 In any case, there is no doubt that new regulations will profoundly affect the business models of banks. For instance, stricter overdraft regulations recently implemented to Reg E, affect the amount of fee income banks are able to generate. Alarmingly 45% of banks and credit unions would not have been profitable in 2008 without overdraft fees.9 Another survey by consulting group PPC estimates that the majority of bankers think the overdraft change will affect their OD/NSF income somewhere between 10% and 30%. Changes such as this, just like the changes to the Credit Card Act that became effective in February, will cause banks to revamp their offerings seeking new revenue channels. Redesigning products will not only help meet regulations, but simplifying the ways products are presented and fees are charged, but they should improve customer satisfaction, and be able to better deliver profitability. Banks will have to improve their targeting and segmentation of customers with more tailored products. According to Accenture, products will be simpler for the customer to understand and easier for relationship managers to sell. Another reason banks are focusing on efficiency is that they are required to raise capital ratios. This change in regulation drastically affects the amount of free cash banks have to invest in projects.

No Increases in Budgets
Seventy-two percent of North American bank technology executives expect their budgets to stay the same or decrease in 2010, according to an Aite Group report published last September. Aites research director had prophetic words for vendors in this report:
"Vendors need to rapidly adjust their sales process to account for the rising number of stakeholders involved in IT decisions. They should train their sales force to build momentum more effectively

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9

Top 10 Banking Trends for 2010, Aite Group, February 2010 Mercator Advisory Group, VP Bob Landry, Bank Systems & Technology/Fiserv webcast

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Bank Industry Update 2010

through IT decision influencers with distinct agendas. It is not enough to target only the business side beyond IT; functions like risk and compliance, operations and finance must also be targeted."10

Bezard is suggesting that sales forces must target the needs of individual roles within the bank, and involve them simultaneously, as new IT decisions are taking on more importance and becoming increasingly complex to bring to a close.

IT Expenditures Narrowly Focused

Banks are making intentional moves in 2010 to demonstrate their commitment to small business lending. This should increase interest in risk modeling and analytic tools. In the consumer lending space, Katherine Burger predicts, "Financial services institutions will increase IT investment for integrated credit risk management, improved regulatory compliance management, and new loan collections and portfolio risk management solutions."11 There is continued fascination and investment into the mobile banking space. S1 and FIS are partnered with PayPal to offer banks mobile or online P2P solutions. Fiserv has started to offer a new P2P personal payments service to the 3,000 financial institutions in its online payment network.12 In 2009 there was increased focus on personal financial management tools for individuals and small business. 2010 should offer an even greater opportunity in this area, however Bank Systems & Technology points out that it could be either an opportunity or a threat to bankers, as many non-banks and direct banks are also offering these tools and could pull customers away from traditional banks. In either case, PFM tools can provide a key to increased satisfaction and loyalty that banks are lacking. Consulting firm Accenture predicts that the most successful banks will decrease vulnerability in their business by embedding new capabilities into their operations, such as risk analytics, customer analytics, pricing optimization and industrialized management of nonperforming loans.

Loss of Loyalty, Loss of Trust

With the machinations in the market over the past few years, banks have suffered huge losses in customer good will, customer satisfaction, trust and loyalty. It will not be easy to earn this back, but it may present an opportunity for community banks to pick up some lost market share from the Big 4, or even the regional institutions. A 2009 study by J.D. Power and Associates found consumer satisfaction had declined for the third consecutive year and only 35% of customers were "highly committed to their retail bank."13 According
10 11

Gwenn Bezard, Aite Group, September 2009 Consumer Lending Forecast 2010, by Katherine Burger, TowerGroup 12 10 in 2010: Banking Trends for the New Year, Bank Systems & Technology, January 4, 2010 13 Frustrated Investors Move from Big Banks, Dow Jones, copyright 2010

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Bank Industry Update 2010

to an Accenture Global Customer Satisfaction Survey in 2009, banking had the second highest defection rate among ten industries surveyed. Over Twenty-five percent of customers had switched banks because of poor service, while only 38% of customers were very satisfied 14 with the level of service. Similarly, despite the focus by banks on the small business customer over recent years, their level of satisfaction with their primary institutions decreased between 2007 and 2009.15 The most significant declines in satisfaction were seen in customer ratings of service, online banking application ease-of-use, and financial institutions' ability to understand the specific needs of their customers. Larger banks were rated much more poorly than community institutions. Among small businesses that are "disappointed" with their financial institutions, 31% stated they "definitely" or "probably will" switch to a new financial institution over the next two years. Thirty-eight percent of disappointed customers bank with Big Four banks, while 41% bank primarily with regional banks.

The opportunity to increase their customer bases has not been lost on community banks. In a recent article in the Oregonian, they found that community banks are hoping to capitalize on a backlash against big banks, they're pulling out all the stops to seem safer, local and more personable than the bailed-out behemoths. 16

Summary
Altogether, 2010 should be the year that the bank industry begins to heal, but it will not be without significant changes that affect operations, profitability and long-term outlook. The industry will continue to consolidate. Regulatory changes and the need for greater transparency and simplification will result in changes to products and pricing. There is a tremendous need for institutions to increase their service to customers, as well as enhancing product sets and adding tools that customers find more

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Tech Upgrade Needed for U.S. Retail Banks, Steve Reiter and Fiaz Sindhu, Accenture, appeared on website of ABA Banking Journal, April 9, 2010 15 Declining Satisfaction Levels Among Small-Business Customers, Aite Group, February 1, 2010
16

Capitalizing on Big Bank Backlash; Small Banks Bigger on Service, Risks, Brent Hunsberger, The Oregonian, March 27, 2010.

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attractive. Customer satisfaction and loyalty has been on the decline and high performing banks will be the ones to figure out how to reverse the trend. Initiatives that enhance efficiency will be the most likely to be funded. Those IT initiatives that are targeted will cut costs, offer new capabilities in high demand by customers and small business, or reduce risk. The IT decisions will be weighed more carefully and involve more influencers across the areas of compliance, marketing, risk, and finance. Vendors selling into the bank space should carefully target their messages for better appeal. For those that perform well, 2010-2015 should be a period that sees moderate returns to growth.

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