OUTLOOK FOR 2006

2005 is coming to a close, and your budgets are in their final stages as well. As you contemplate 2006, consider my predictions below. They give me one more opportunity to put my foot in my mouth before year-end... I'd also appreciate, as always, your thoughts and reactions to the content below.

Also, be sure to check out a list of my 2005 favorites (books, movies, music, chocolate etc.).

Wishing all of you a healthy, happy and successful holiday season and year, full of joy, solid profits and great chocolate,

As I do every year, I dusted off my crystal ball to take a look at the upcoming year and what it might bring to our industry. Here are my observations

• The ever shrinking margin

• The flat yield curve is taking its toll. The unpredictable yield curve will continue to defy ALM models. However, 2006 will be less eventful than 2006. The yield curve will become steeper and rate hikes will not be as frequent as in 2005.

• Many deposit markets will remain highly competitive. Concentrated and fragmented deposit markets nationwide will continue to present kamikaze pricing. Competition from the mega-banks will intensify as they improve their retail execution in the absence of major acquisitions.

• Loan demand is robust but pricing isn't. Pricing and covenants will experience further erosion during the year, but some credit during the second half of 2006 might result in some tightening toward year-end.

• More banks yield to rate plays, which further threaten the margin. Even disciplined banks find it difficult to stick to their principles when others in the market reduce loan pricing and compromise covenants. The intense competition for quality, experienced loan officers make resistance to market rates and terms risky, since dissatisfied loan officers can defect with greater ease than in the past. As a result, some banks compromise on loan pricing or loan types (such as accepting more commercial real estate lending).

• Asset/liability management systems aren't delivering: models and reality don't mesh. Asset/Liability management has not been a front-of-mind item for several years, and the technology at many banks is now behind the times. The models fail to predict margin and economic value behavior in uncharted times such as we have experienced in recent years. Consequently, margin shrinkage has not matched model predictions in many institutions and presents a greater risk in the future than in the past.

• Balance sheet leverage strategies are costly and difficult to unwind. Leverage strategies come and go, but they never pay off through the lifecycle. Many banks that have engaged in them in recent years have been compelled to unwind since their margins could not recover from the drag that the funding costs of the leverage strategies placed on their performance. The costs of unwinding have been steep, and many exceeded one year's earnings. The lesson is: what goes around comes around, and such timing-sensitive strategies are extremely risky in the long run.

• The year of the deposit

• De novo branching is only a partial answer. De novo branching has become a ubiquitous element in most banks' deposit gathering strategies. Some have found that such plans aren't always the answer, since execution is a key part of success. Consequently, the Chicago branch blitz predicted by several mega-banks hasn't panned out, as several entrants found the market unwilling to accept their branches or their pricing. In other situation de novo branches have been most successful, and certain banks, such as TCF, Flagstar and Commerce, have perfected the branch opening and staffing process. De novo branching will continue in 2006, but the bloom is off the rose among the banks who failed to execute the strategy effectively in 2005.

• Banks need better articulated deposit gathering and pricing strategies. Some banks have clearly articulated their desired position in the pricing markets. Mega-banks have internally specified their desired market positions clearly and stick to that pricing discipline with mixed results. The pressure on deposit gathering puts greater emphasis on the role of consistent pricing in the overall deposit gathering strategy.

• Low revenue credit for core deposits from 2000-2003 is coming home to roost as core funding regains its glory. During the early 2006 deposits lost their luster as alternative funding sources became significantly cheaper than core deposits. Retail franchises of many SuperCommunity banks showed losses year after year when credited with swap-curve transfer pricing. The value of interest free checking accounts has been downplayed. Today, these franchises are deposit starved yet the mechanism for gathering them is rusty. Renewed emphasis in 2006 will help sharpen the skills again, but the real lesson is, core deposits should always be in vogue.

• Acquisition will remain expensive as buyers vie for coveted deposit-rich sellers; the market is unlikely to rationalize in 2006. Between foreign buyers and deposit-poor banks, the market will continue to be a seller's market this year. Aggregation at all levels is another factor that will keep prices up, especially among banks under $1 billion. Last, "hot" markets pricing is out of sight as so many banks are seeking presence in high growth markets to balance their franchise.

• Many markets experience solid deposits growth, but not all banks are getting their share of the market. 2005 was a good deposit growth year, with several major markets growing at a double digit clip. However, banks as a sector of the financial institutions industry are not getting their fair share of the growth, and experience continued share decline. The issue isn't deposit growth; it is how and whether banks capture that growth.

• Niche plays and two-base runs are effective solutions. Some banks have devised interesting strategies to improve their deposit gathering performance, ranging from focus on the church business to prime based CDs, small business money market accounts, cross selling investment customers etc. Niche plays are an effective way to penetrate both deposit and loan markets, and I believe we'll see more of those in 2006, with special concentration on small business.

• So many loans, not enough funding

• Loan growth in commercial real estate outstrips growth in other lending sectors, resulting in further pressure on liquidity. The trend will continue in 2006 until real estate markets start rationalizing toward the second half of 2006.

• Deposit pricing wars abound. Some banks have placed themselves at the top of the market, garnering rate-surfer deposits in mega-sized branches. They substitute brick-and-mortar costs with rate premiums, which is a viable strategy for some. Most banks, however, still need to find a way to fight off the convenience of the mega-banks and the rate wars of the high payers, credit unions and the de novo banks. A focus on differentiated strategy will be helpful in 2006.

• Free checking ride is over in many markets. While some highly focused banks are still growing their free checking base, combined with a courtesy overdraft strategy, the boon of this product offering is ebbing. 2006 will see additional product innovation in the deposit business by those who find new avenues for both deposit and fee income growth beyond the George Foreman grill.

• Regulators don't like loan-to-deposit ratios >100%. Regulatory pressure on high LTD banks will intensify in 2006, forcing some banks into acquisitions of deposit-rich banks and bidding up the price of deposits in some markets.

• Credit cannot get any better

• Yet reserves are under pressure from the SEC and the accountants

• Credit will worsen as the cycle turns. I don't see much relief in 2006, but as credit quality starts deteriorating, the battle for adequate reserves, including non-specific reserve allocations, will come to a head.

• Conflict between the SEC and the regulators regarding reserves remains unsolved, and the SEC is winning. No change expected in this coming year, and further push for total reserve elimination and pure cash flow transparency is possible.

• Easing on covenants, more than pricing, will start taking its toll toward the end of 2006. Credit quality will start fraying toward the end of the year as the sins of 2005 will unfold. While a credit crisis isn't in the offing, current loss levels are unlikely to continue throughout 2006 for many banks.

• Retail (including small business) is the answer

• Mega-banks are busy leveraging existing networks, customers and technology investments; they are tougher competitors, especially in Retail Banking. The mega-banks have consistently recognized the value of retail banking, and have made significant investments in infrastructure to support that business. While they cannot out-service SuperCommunity Banks, no matter how hard they try, they can certainly offer better on-line banking capabilities than their smaller brethren, and have better propensity-to-buy systems to support their branch sales force. They will continue to improve in 2006, as they are paying more attention as a group to customer attrition, on-boarding processes and service levels. SuperCommunity Banks need to better define and execute their competitive position in Retail Banking.

• Highly commercial banks discover that they are in Retail Banking anyway as their branch networks expand. In 2005 many banks that pride themselves on being purely commercial realized that, want it or not, they are in the retail banking business. They further awakened to the importance of retail banking as a funding and fee income source. The result: many SuperCommunity Banks are looking for ways to improve their retail banking operations and product offering. 2006 will see some winners and some losers in this arena, as so many work toward leveraging better their branch fixed and variable investment.

• Sales process isn't panning out for many banks. Too many banks, both large and small, have discovered that the sales process in retail banking isn't the silver bullet they hoped for. Instead, it is a basic training system that doesn't produce results on its own. Success of sales management depends on much more than training, and hinges, more than anything else, on the tight execution of the people in the field. It is the branch managers and the loan officer managers that ultimately control how effective the bank's sales process is. Our industry has not executed well against this challenge, and I do not foresee much change in the coming year.

• Customer migration and defection patterns remain unchanged. We continue to find that customers leave banks because of their practices and their people more than any other factor. While price and convenience are important, they often aren't the final straw. The final decision is made at the branch or while interacting with the phone banks, and is often associated with poor problem resolution or being placed in the wrong product in the first place (often the result of an over-simplified sales process). That pattern will not change in 2006, but some banks are going to find key drivers to improve their customer retention by focusing more than ever on dealing with this all-important issue.

• If you have a strong brand, Retail is a great place to leverage its promise. Unfortunately, most banks do not have sufficient brand equity to effectively build on. Better focus on the meaning of the brand will help create a leverage point for solid-brand banks.

• What's on the regulators' mind?

• BSA/AML are here to stay for 2006. Regulatory scrutiny of customers' sources of funds and suspicious activity documentation will persist through 2006, ebbing toward year-end.

• Business continuity is back on the map. Thanks to Katrina, Wilma, Rita and other women, Business Continuity is on the front burner. Special emphasis on scenario planning will be placed in 2006, including less likely but catastrophic events. The usual Disaster Recovery process will need augmentation by scenario building as well as implementation of lessons learned from the recent 2005 disasters, including the failure of cell phones as communication devices; the need for second back-up sites further than 30 miles away; planning for the unreliability for vendors, including delivery services, armored car services etc.; and the planning for a central communication site for all employees to connect to.

• Don't forget your asset/liability management

• Current model results do not build confidence in the information output. An mentioned above, interest rate risk is rising, if for no other reason due to the unprecedented and unpredictable rate environment. 2006 might be a simpler year when it comes to interest rate moves, but the risks are still embedded in banks' balance sheets. Even sophisticated models often miss yield curve slope shifts like the ones we've experienced in 2005, and the price of such misses is heavy. Uncharted interest rate environment calls for more attention to ALM, and 2006 should be a good year to get a better handle on the topic.

Overall, I believe 2006 will be another excellent year for banking. This wasn't a popular prediction in 2005, yet it panned out. I count on similar success in 2006.