Reinvention Gets Real Results at These Three Banks

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Sometimes a bank needs to reinvent itself to reach its full potential.

Take Paragon Commercial Bank in Raleigh, N.C.

Founded in 1999 as a business-focused bank, its model was to keep its branch count to a minimum and fund its loan growth with brokered deposits. The model worked well for a decade, but the torrid growth caught up to the bank when the real estate market crashed. Paragon found itself stuck with scores of problem construction and development loans.

That's when management decided to reposition Paragon as a private bank. It ditched the brokered deposit strategy and brought in teams of private bankers to gather deposits from local firms and well-heeled individuals and to sell products like home-equity lines of credit and money-market accounts.

"We knew that if we wanted to be a true community banking franchise we needed to not only lend locally, but gather deposits locally," said Bob Hatley, Paragon's president and chief executive.

Its commercial lenders began de-emphasizing riskier development loans and focused more on booking commercial and industrial loans and owner-occupied commercial real estate loans.

Those decisions have helped to transform the struggling Paragon — it lost more than $7 million in 2010 — to one of the industry's top-performing community banks. The $1.3 billion-asset bank posted a record profit in 2015 and, in doing so, joined the ranks of American Banker's 200 most profitable community banks, based on a three-year average return on equity. (See the full list of this year's rankings.)

Paragon's return on equity hit double digits for the first time in nearly a decade, and its stock, though thinly traded, is now at an all-time high. The bank debuted at No. 153 on the ranking.

Hatley attributes much of the recent success to a dramatically lower cost of funds. Even as loan yields have steadily dropped in recent years, the bank's net interest margin has increased because funding costs have fallen from above 2% five years ago to less than 0.6% today. "It's been a total attitude change," Hatley said. "As we started gathering more and more core deposits to fund loan growth, we saw our cost of funds drop. That's why our margins have held up."

Other newcomers or big movers in this year's rankings have similar stories of reinvention. Unity Bancorp in Clinton, N.J., aggressively pursued nonqualified mortgages and Small Business Administration lending, while Nicolet Bankshares in Green Bay, Wis., shifted from an organic growth model to one that relies more heavily on acquisitions.

The $1.1 billion-asset Unity debuted at No. 106 in this year's rankings after it too posted a record profit in 2015. SBA lending was a big part of its growth story, as it originated $41.8 million in loans in the federal government's fiscal year that ended Sept. 30, more than any other bank in New Jersey and up nearly 150% from a year earlier.

Unity is also one of the few banks in its markets willing to make loans that don't comply with federal regulators' definition of a "qualified mortgage." Many of the borrowers are small-business owners who cannot show steady income to verify their ability to repay but generally have high credit scores and enough liquid assets that the bank views them as low risk, said Chief Financial Officer Alan Bedner.

"Everybody else has gotten out of that space," Bedner said, explaining Unity's decision to offer non-QM loans and hold them in its portfolio. At Dec. 31, Unity had $264.5 million of residential mortgages on its balance sheet, up nearly 20% from a year earlier.

The $1.2 billion-asset Nicolet vaulted to No. 34 this year, from 109 last year, as acquisitions it completed in 2013 started paying greater dividends.

Nicolet had never made an acquisition until it bought the troubled Mid-Wisconsin Bank in 2013, but its president and CEO, Bob Atwell, said M&A will be a big part of its growth plan. It recently announced a merger with Baylake Bank in Sturgeon Bay, Wis., that will roughly double its size, and Atwell said he envisions Nicolet growing into a $5 billion-asset bank by continuing to roll up smaller rivals in central and northern Wisconsin.

"The reality of the northern two-thirds of Wisconsin is that it's a relatively low-growth place with a lot of community banks," Atwell said. "We believe we can make a real difference" — both for communities and shareholders — "by being a consolidator and creating a larger, local institution that understands what's going on in those towns."

Among the biggest challenges for these banks is keeping expenses in check while continuing to expand their balance sheets. They are holding the line where they can, but top executives also know that, in many cases, banks still have to spend money to make money.

Unity, for example, just started construction on a new branch on which the bank likely won't break even for at least two years. As Bedner put it, branches are still the most effective way to gather deposits, and the bank needs more to keep pace with loan demand. "We have an abundance of loan volume and we need to fund it somehow," he said.

Paragon also opened an office in Cary, N.C., in 2014 in an effort to boost visibility and better serve its high-end clientele. Still, one of Paragon's secrets to success — and the reason its losses weren't even higher during the housing bust, Hatley said — is its low overhead.

Most banks its size might have 20 or 25 branches; Paragon has just three — the Cary office and one each in Raleigh and Charlotte. The bank also has no drive-through bays and, amazingly, no ATMs. Instead, it lets customers use other banks' ATMs and will instantly reimburse them for any fees they may be charged.

"We keep up with what it costs us, and I can tell you it's cheaper than having our own machines," Hatley said.

Hatley, of course, keeps tabs on all of Paragon's key metrics, like ROE, return on assets and earnings per share, but one ratio he's particularly obsessed with is something called overhead to assets. According to FIS FedFis, an Austin, Texas-based provider of bank data, the average for all banks is 2.7%, and for banks with less than $2 billion of assets it's even higher, at 3.25%. Paragon's is right around 2% and Hatley believes it can go even lower if the bank continues to add deposits and loans at double-digit rates.

But don't expect Paragon to sacrifice credit quality even a little to maintain its pace of growth. The bank's ratio of nonperforming loans to total loans is just 0.05%, and Hatley intends to keep it that way by maintaining a strict credit approval process that prohibits lenders from making loan decisions. Lenders, whose compensation is based on the amount of business they bring in, will sometimes complain if a credit officer rejects their deals, but mostly "they know what will fly and what won't," Hatley said.

"If they bring in too much bad stuff, they are going to lose credibility and they won't have a job with us," he said.

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