Are De Novos All They're NOT Cracked Out To Be?

De novo branching is in, and the consensus is: they’re a bad idea. To the extent that our business has been known for its colossal lemming-like mistakes, the doom-sayers are right. The LILO principal that has been the landmark of our industry (Last-in-last-out) never worked. Early entrants would reap all the profit, and then the margins would shrink considerably as they were followed by hundreds of others, eager to share in this newly found panacea. Some of those were left holding the bag, and the losses. Examples are abound, ranging from highly leveraged transactions to the Japanese equity warrant market.

However, the negative reaction to de novo branching is all too sweeping. Much like in other situations, early entrants and those who developed core competencies relating to new branches have been extremely successful in creating wealth and shareholder value that did not exist before through the creation and growth of de novos. There is no reason this will change in the near future; at least not until the market gets over-saturated with new branches and a correction takes place.

Consider MidFirst, an $8+ billion Oklahoma-based bank. Half of the Company's branches have been de novos, and almost all have exceeded expectations. Break evens of 18 months or less were achieved, and the growth of core deposits has been impressive.

Consider Sterling Bank of Houston. The Company has been building new branches for years, and organic growth has been amazing, including a 34%+ of total deposits in non-interest bearing accounts.

Consider Capitol Bancorp, a $2+ billion collection of new banks, typically one-to-two branches, located in markets with no geographic leverage, yet highly profitable where others have failed.

These three companies, and others, may not achieved the notoriety that others with high-profile de novo strategies have experienced, but their shareholders benefited greatly from their success. The growth rates have been impressive and consistent, the break even points earlier, and the core deposits stronger.

These companies demonstrated that de novo branching is a valid option to non-acquisitive banks if effectively executed. All three companies employed dramatically different strategies to reach their goals. One involved the community in the investment and business development process well before the branch opened, and provided equity incentives to the branch founders and community leaders to ensure early breakeven and success. Another developed the core competency of establishing de novo banks, with in-house expertise to execute filings, capital raising and other related activities more quickly and cheaply than through investment bankers and lawyers, and developed a method to attract the right leaders and players to capture share in each market they have entered. The third company used de novo branching to rationalize its franchise in a long-term low-cost way. Through careful targeting they placed the branches in the right locations, staffed them well and created a network effect that wasn't there before.

These companies and others like them did not view de novo branching as the flavor of the year. Instead, this is a core strategy to their shareholder value creation and growth. They approached this activity like a major strategic initiative, while putting in place unique financial discipline and other specific tools to enhance the likelihood of success. It is no accident that their efforts paid off; for these three, de novo branching is a core competency, not a fad.

The critics of de novo branching rightly point out that it is becoming a widespread fad, following the change in the acquisition accounting rules. They explain how this anticipated over capacity will build costs and shrink margins, and they are right. For those who use this strategy as today’s answer to long-term core issues, the result will likely be painful. But let’s not paint everyone with the same brush. There is room for de novo branching if the focus is right and the execution effective, if the infrastructure to ensure success is there and the expectations include big, hairy and audacious goals rather than 3 year minimum breakeven points. Those who will continue to execute an existing strategy or perfect it will reap the rewards of this approach for years to come. It is the Johnny-come-lateley's of our business that will discover yet one more time that Last-in-last-out doesn't work.