George Martinez took a couple of clients to lunch last month and ordered the chef’s special, mahi-mahi. When he asked for some vegetables other than potatoes, the waiter said he couldn’t substitute side dishes with the special.

“I ended up having the red snapper, and I probably won’t go back to that restaurant again,” said Mr. Martinez, chairman of $2 billion-asset Sterling Bancshares in Houston. The moral, he said: Customers do not like hearing “no” for an answer, so avoid saying it. Of course, Mr. Martinez must pay more than lip service to that philosophy to keep his own customers satisfied. Sterling’s 24 branches are full of senior-level employees who are there to give customers quick, consistent responses to their loan applications.

It is an expensive way to operate, but it has let Sterling keep close tabs on the risky market segment — small, owner-operated businesses — that makes up its core customer base. And by targeting borrowers that many large banks have turned away, Sterling has generated record annual profits for 13 years running.

“Our strength is in the field,” Mr. Martinez said. “That’s where our customer relationships are. Putting key people in the field is different. You just don’t see many banks do that.”

Chuck Talley, a Sterling customer and president of Valves Unlimited of Houston, which supplies equipment to energy producers, said he “wouldn’t think” of switching banks, though he routinely gets cold calls urging him to do so.

“At all the other banks I’ve ever been with, they beat the hell out of me whenever I asked for anything,” said Mr. Talley, a Sterling customer for the past 10 years. “Everything they talk about doing, they do, and they’re real people, not slot machines.”

Sterling is a bank that “gets it,” said consultant Paul Pustorino. He is national line-of-business leader for depository institutions at the consulting firm Grant Thornton in Chicago. Delivering superior customer service is expensive, but it produces big profits, Mr. Pustorino said, and “most community banks are just starting to realize that.”

Last year Sterling, the holding company for Sterling Bank, paid salaries and benefits totaling $47.12 million, 18.5% more than the average for commercial banks with assets of $1 billion to $10 billion, according to data compiled by the Federal Deposit Insurance Corp.

Yet these extra costs hardly seemed a drag on Sterling’s bottom line. The company’s net income was $26.6 million last year, a 19.3% increase from 1999 and enough to extend a streak of record profits that began in 1988, according to Mr. Martinez.

Moreover, J. Downey Bridgewater, Sterling’s president, said he expects to meet analysts’ consensus first-quarter earnings estimate of 26 cents per share and their estimate for the year of $1.14, which would be a 14% increase from 2000.

In fact, analysts say Sterling may be in a position to extend its string of record annual earnings for several years to come.

“That is entirely conceivable,” said Kenneth Puglisi, an analyst at Sandler O’Neill & Partners in Chicago. “I wouldn’t bet against them.”

Sterling has several things working in its favor. For one, Houston, the company’s primary market, has one of the strongest economies in the country right now. Sterling also is entering two other rapidly expanding markets, Dallas, where it opened a branch in 1999, and San Antonio, where its pending $51.8 million purchase of CaminoReal Bank is expected to close this quarter.

“Sterling is very focused on small business, and they’ve had a great deal of success taking business away from bigger banks,” said Mr. Puglisi. “They are trying to take the same formula that’s worked in Houston and replicate it in Dallas and San Antonio.”

The formula Mr. Puglisi referred to is simple: Focus on companies the big Houston banks ignore, monitor the loan portfolio very closely, and aggressively seek deposits from borrowers. Dozens of community banks use the same strategy, but few execute it as well as Sterling, said Daniel Cardenas, an analyst at Howe Barnes Investments Inc. in Chicago.

Sterling primarily serves owner-operated businesses, companies whose annual revenues are less than $25 million and whose average loan size is $100,000, said Sterling’s Mr. Bridgewater. Mr. Cardenas said bigger banks tend to ignore these borrowers because they require what he termed “extra handling.”

Not that the “extra handling” — or the cost of providing it — bothers Mr. Martinez any more than the company’s high salaries do. In fact, it furnishes the rationale for the higher-than-average interest rates that Sterling charges.

Sterling said it expects to achieve a net interest margin of 5.75% to 6% in 2001. Its margin in the fourth quarter was 5.77%.

“To be able to get this kind of a rate, you have to provide good service,” Mr. Martinez said. “These are companies that don’t have a lot of advisers or a chief financial officer. They really depend on their bankers for a lot.”

Mr. Bridgewater is even more emphatic.

“Margins are the key,” he said. “Once your margins start to shrink, the game is over.”

Sterling relies on more than interest income to keep its margins wide. Deposits play a major role in its strategy, and loan officers routinely ask new borrowers to move their accounts, as well as those of their employees, into the bank.

“We try to get all of our borrowing customers’ deposits,” Mr. Bridgewater said.

This approach is not unique. Cincinnati-based Fifth Third Bancorp, with assets of $44 billion, also puts a premium on acquiring borrowers’ deposit accounts, Mr. Puglisi said. So does $7 billion-asset Commerce Bancorp in Cherry Hill, N.J.

Sterling is especially eager to win borrowers’ checking accounts, on which it pays no interest. At the end of 2000, its demand deposits neared $506 million, or 35.6% of its total deposits. Nationally, at commercial banks with assets of $1 billion to $10 billion, demand deposits made up 11.46% of total deposits, according to the FDIC.

Sterling’s checking accounts serve two purposes, Mr. Martinez said. They shed light on the health of client relationships, and they are a source of cheap financing for Sterling’s loan portfolio, helping to bolster its all-important net interest margin.

The downside to Sterling’s business model, according to Mr. Martinez, lies in the volatility of its borrowers’ finances.

The small companies Sterling serves frequently have a smaller cushion against downturns than bigger companies do. As a result Sterling’s balance sheet shows a relatively high share of nonperforming and “problem” loans.

At Dec. 31, it reported nonperforming assets of $11.88 million, or 0.87% of total assets. Chargeoffs totaled $6.6 million, or 0.53%.

To accommodate this, Sterling maintains a healthy allowance for loan losses — $15.7 million at the end of 2000 — and takes a “proactive” approach to managing its portfolio, said Mr. Martinez.

In addition to loans classified as nonperforming, it keeps an internal list of problem loans that totaled $34.6 million at Sept. 30, as well as a special department that does nothing but manage loans in the problem category.

“It’s not that those credits won’t work out just fine,” Mr. Martinez said. “It’s just something we’re careful about.”

Mr. Martinez said Sterling expects to charge off about 0.5% of its loans.

“If we tighten on credit and get chargeoffs down to 0.25%, we won’t be able to grow,” he said.

Though Sterling’s total of nonperforming and problem assets approaches $50 million, Howe Barnes’ Mr. Cardenas said he is not unduly worried about asset quality.

“They do a good job of managing that,” he said. “They are aggressive about staying on top of their loans.”

Sterling’s success has helped keep takeover speculation to a bare minimum even as nearly 30 Houston banks were being sold from 1998 to 2000.

“There’s no reason to sell unless you can find someone who is doing a better job, and I can’t think of many who do a better job than Downey and George,” Mr. Cardenas said.

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