West Bancorporation: Conservative Risk Management Practices And Community Focused Banking

West Bancorporation, Inc. (WTBA) is an Iowa-based community commercial bank. As discussed below, WTBA’s focus on community banking has contributed to a strong track record of profitability and credible risk management that is hinged on excellence in customer relations. It has also pursued operational efficiency to boost income in the face of declining fee income and historically low interest environment. The COVID-19 pandemic has had minimal impact on these factors (profitability, operational efficiency, and risk management) and WTBA continues to stand on a strong financial foundation of prudent risk taking, built on customer understanding, and one that extends shareholder returns. The sustainability and extension of these factors make a buy investment reasonable.

Annual Performance

Like other commercial entities, profitability is a core aspect of assessing management’s ability to generate shareholder returns by utilizing scarce resources. In this regard, ROE (return on equity) and ROA (return on assets) are standard metrics. ROE is the result of dividing net income by shareholders’ equity, while ROA is the outcome of dividing net income by average total assets. Figures 1 and 2 show two developments at WTBA and the industry. Firstly, WTBA has outperformed its peers on both ROE and ROA, especially over the last two years ending 2019. Secondly, WTBA and industry profitability has been shaky and seen a decline between 2018 and 2019. Consequently, it is necessary to interrogate factors leading to these outcomes.

Figure 1: ROE trends

Source: (WTBA Annual Report: FRED)

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Figure 2: ROA trends

Source: (WTBA Annual Report: FRED)

Since banks derive a significant portion of profits from interest, NIM (net interest margin) is a major contributor to these trends. Figure 3 shows WTBA’s NIM has both been on a consistent decline over the four years ending 2019 and has also underperformed the industry. One potential cause includes an unswerving decline in major interest rates used by the bank in loan pricing. Moreover, WTBA prides itself as a community bank. It also satisfies the Federal Deposit Insurance Corporation (FDIC) definition of a community bank. Specifically, these are financial institutions that are emphatic on layering personal relationships with their customers. These relationships provide lenders with better soft information regarding a borrower’s financial position compared to non-community banks. Consequently, community banks tend to have more and current information regarding a borrower than is provided by financial metrics. For instance, knowing a borrower’s lifestyle changes is much better than waiting for him/her to provide financial statements every quarter. Additionally, a bank’s interest rate on loans has a direct relationship to a borrower’s risk profile. Therefore, it is likely that WTBA could be charging lower interest rates compared to its rivals on account of its customer relationships aiding in reducing the risk exposure of its assets. Moreover, as a community bank, WTBA may not be willing to charge its customers the same rates found in other institutions owing to customer relations. This factor is hinted at by the decline in fee income, the other source of bank profitability, over the four years ending 2019. This is illustrated in Figure 4.

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Figure 3: NIM trends

Source: (WTBA Annual Report: FRED)

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Figure 4: Fee income trends

Source: (WTBA Annual Report)

Despite these declines in NIM and fee income, WTBA still outperformed the market with regard to profitability as mentioned earlier in Figures 1 and 2. This can be attributed to the bank’s commitment to operational efficiency. One of the indicators of this strategy’s payoff is found in the cost to income ratio, which assesses the amount of revenues that go towards meeting non-interest expenses. Figure 5 shows a steep decline in this ratio since 2016. The implication is that WTBA is increasingly efficient in its operations as fewer revenues go towards paying expenses that are not entirely related to its core business. It is necessary to note that salaries are conventionally a bank’s largest expense factor after interest. Therefore, enhancing employee output is critical to enhancing profitability. From this perspective, WTBA has significantly improved revenue and profit earned per employee as exemplified in Figure 6.

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Figure 5: Cost to income ratio trend

Source: (WTBA Annual Report)

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Figure 6: Employee efficiency trends

Source: (WTBA Annual Report)

Half-Year Results and Risk Management

Apart from seeking to earn more profit per dollar deployed in assets and equity, banks also have to maintain sound risk-management strategies. This factor becomes more apparent with every banking and/or economic crisis experienced. The onset of the COVID-19 pandemic has also highlighted the importance of risk management owing to the loss of income for millions of households in the United States. The knock-on effect is that the pandemic threatens repayments from mortgages and commercial loans that form the core of WTBA’s loan book as shown in Figure 7.

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Figure 7: WTBA half-year loan book composition

Source: (WTBA Annual Report)

Despite the grim outlook occasioned by COVID-19 on WTBA’s loan book, the bank has consistently showed commendable risk management practices as exemplified in two key measures. One, the ratio of nonperforming assets (NPAs) to total assets was significantly lower than that of the industry before the pandemic occurred. The implication here is that WTBA’s loan book shows lower risk of default compared to its rivals. Consequently, the bank recognized lower loan loss provisions and reserves than those reported by its peers. Figures 8, 9, and 10 illustrate these trends. It is then apparent that leveraging on personal relationships has a positive impact on WTBA risk management strategies, though it depresses its profits. This is not entirely surprising as community banks have been shown to have lower NPAs compared to non-community financial institutions. This is achieved by leveraging on personal relationships to derive soft nonfinancial information about a borrower that is not found in financial data that is primarily used by non-community banks.

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Figure 8: NPA/Total Loans trend

Source: (WTBA Annual Report: FRED)

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Figure 9: Loan charge-offs trend

Source: (WTBA Annual Report: FRED)

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Figure 10: Loan reserves trend

Source: (WTBA Annual Report: FRED)

Notably, COVID-19 appears to have had no negative impact on WTBA’s asset risk exposure. On the contrary, the bank’s portfolio of NPAs declined from $538,000 at the end of 2019 to $390,000 in June 2020. While this is partly attributable to the risk management strategies mentioned previously, it is also necessary to note that recently implemented accounting policies forbid the recognition of loans whose delinquency is due to COVID-19. Instead, financial institutions were required to restructure such loans and not include them under troubled debt. WTBA indicated that it held $553,000 such loans on its books. Assuming that these loans were included in troubled debt, this would raise WTBA’s NPAs to $943,000 or 0.04% of total assets as at June 2020. This ratio is still significantly lower than the industry average of 1% over the same period. Additionally, COVID-19 does not appear to have had an impact on WTBA’s profitability with net income growing by $2.5 million (18.4%) for the six months ended June 2020 compared to a similar period in 2019.

Conclusion and Investment Recommendation

WTBA’s asset and equity returns have been robust over the four years ending 2019 despite the bank appearing to charge lower interest rates on its loans compared to its rivals. A study of the financial reports suggests that WTBA relies on operational efficiency to deliver superior value to both its customers and shareholders. Additionally, the adequacy and vigor of WTBA’s risk management strategies has been exemplified during the ongoing COVID-19 pandemic. Specifically, the epidemic does not appear to have significantly increased WTBA’s risk exposure and it remains below the industry average at 2020’s half-year mark. It also does not appear to have hurt WTBA’s revenues and profits. Consequently, a buy investment decision is recommended based on the bank’s strong risk management, continued profitability, and operational efficiency.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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