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Manage Transition: For Banks 0-5 Years

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Branching

Last update: November 3, 2009

Overview

Branching is critical to the success of most banks. This is because a bank's primary competitive advantage lies in its ability to attract low-cost (core) deposits based on the protection afforded its customers by FDIC insurance. Despite the advent of electronic banking, branches remain the most significant component of a bank's retail delivery system and are key in attracting and retaining deposits. Although many banking transactions are conducted electronically, most new customers are obtained through personal interactions at branch locations. The selection of branch sites and the staffing and delivery of branch services are important to achieving long-term growth and sustained profitability.

Regulatory Considerations

Applications Process

Each branch expansion requires an application with federal and/or state bank supervisors. Regulators expect a banking organization to expand from a position of strength. This generally means that a bank should have satisfactory examination ratings for both safety and soundness and consumer compliance. Individual component ratings of less than satisfactory, particularly in the earnings category, may not be a barrier to approval but will likely get a very close look by regulators.

De novo banks rarely do well with a single location. Branch expansion, however, is expensive and can be a drag on earnings in a bank's initial growth years. Regulators understand this and tend to focus on management's ability to meet projections rather than standard earnings benchmarks. For this reason, de novo banks are wise to budget for branch expansion at anticipated intervals in their de novo bank application, and advanced banks should budget appropriately for future growth. Overly aggressive expansion plans seldom work and should be avoided, as they do not give management time to fully evaluate incremental success. It is difficult to compensate for poorly performing branches with additional expansion.

A bank's consumer compliance and CRA ratings can affect its ability to expand. Banks are special in that they are allowed to solicit public deposits. Under the law, this privilege requires banks to support the communities from which they acquire deposits. Regulatory applications, such as branch proposals, must be published in a newspaper of local jurisdiction, which provides the public the opportunity to formally protest the application. A protest of this nature will, at a minimum, slow down the application process and may potentially result in a denial. For these reasons, the bank's compliance and CRA profile and its relationship with the community are very important.

Interstate Branches

De novo branching into another state can present legal obstacles, since some states have restrictive statutes. For this reason, it is important to consult with legal counsel when considering interstate branching.

Limits on Bank Premises

Branches can be a drag on earnings because the premises that support them are a nonearning asset. As a result, bank regulators typically impose a limit on the level of bank premises based on the bank's total investment in premises in relation to its capital. It should be noted that regulators have approved investment beyond the statutory thresholds based on the strength of the bank's earnings and capital.

It should also be noted that regulators frown on banks using branches as a conduit for real estate investment. While each regulator has different standards, as a general rule, any real estate purchased should be used at least 50 percent for bank premises within five years of being purchased. Real estate, including land, cannot be warehoused indefinitely for some vague banking purpose in the future. Bankers should consult with their regulators in regard to marginal situations.

Location and Accessibility

The selection of a branch location is an important decision, particularly for a de novo bank, where that first location can spell the difference between success and failure.

Banks can fall prey to false economy in trying to take advantage of a good deal or pursue the easiest or least expensive alternative. Some minority and de novo banks have acquired a branch location that another bank is willing to sell or donate to the bank. This can sometimes provide false economies (i.e., there may be issues with a location that make it less than desirable). A marginal branch for a larger institution can be absorbed by its overall expense structure but can spell disaster when it is the only location for a newly formed bank or a smaller institution with modest performance.

Accessibility is often overlooked. As with anything having to do with real estate, the old adage, "Location, Location, Location," is the primary consideration. A good location for a banking institution is one that is in proximity to and readily accessible by its customers. Since bank customers want convenience, a branch should be easy to locate and access. Traffic patterns can play a large role in this regard, with divided highways and on/off ramps having a major impact on accessibility. If you are building a branch from the ground up, make sure zoning ordinances don't impose restrictions on signage or other factors that will impede your ability to attract and accommodate customers.

Profitability Analysis

The value of a bank branch lies largely in its ability to generate deposits. It takes time to gather deposits, and the assumptions underlying deposit growth are critical in predicting the impact the branch will have on the bank's earnings. Clearly, there will be a period during which the branch will have a negative impact on earnings.

Since deposit growth may be difficult to predict, it is important that management use conservative assumptions. Performing a best-case, worst-case, and most likely case calculation is advisable to ensure that the bank can handle the downside. Management should consider the competitive environment for the areas as well as the impact of nonbank financial service companies that may offer lower-cost products to the community.

It is also important for management to carefully consider the extra cost related to branch expansion, such as salaries for additional staff, fixed assets, and associated infrastructure expenses. Management should be precise here, particularly for de novo banks, where the first few branch expansions can largely determine the ultimate success of the bank.

Readiness/Infrastructure

Branch expansion requires more than brick and mortar. The difficulty of managing additional facilities, staff, and infrastructure can expand geometrically as branch locations begin to multiply. Issues surrounding system connectivity and maintaining communication channels can compromise product delivery and service levels. It is also important to ensure that internal controls and compliance processes protect against fraud and adhere to regulatory requirements. For all these reasons, it is important to carefully anticipate the impact of a new branch on a bank's infrastructure.

Be Creative and Consider Alternatives

Branches and their employees provide the primary connection with bank customers. This makes them critical to establishing brand and attracting business. The appearance of the branch and the service levels provided by employees are keys to differentiating the bank from its competition. Theme, consistency, and convenience must be carefully considered and are opportunities for creativity. Branches have gradually gotten smaller as construction costs have risen, and greater attention has been paid to overall appearance and efficiency. Drive-through tellers, kiosks, and expedited deposit drop-off have become popular ways to reduce teller lines. Alternative specialized locations, such as supermarket branches, are also gaining popularity and represent a low-cost way to provide convenience to customers.

Branch Closings

It should be noted that closing a branch requires specific notices to both regulators and customers. This process may be easier and even avoided if the branch is being relocated or consolidated with another branch and meets specific parameters. Please refer to the Interagency Policy Statement on Branch Closings External Link PDF for more information.