executive development program bank profitability … 2016/marsico_product_and_custom… · cost of...
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Performance Measurement
StrategicManagement
Profit & ProcessImprovement
Board & Management Advisory Services
Financial Advisory
Executive Development Program
Bank Profitability Module
Product and Customer Profitability
April 8, 2016
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Product and Customer Profitability
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Whole Bank Profitability Measurement
Return On Average Assets
Reflects the institution’s return on the resources
(assets) deployed.
Target - ROAA > 1.00% or 100 Basis Points
Return on Average Assets
(ROAA) =
Net Income
Average Total Assets
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Whole Bank Profitability Measurement
Return On Average Equity
Reflects the institution’s return on the shareholder’s
investment (equity).
Target - ROE > 15.00%
Return on Average Equity
(ROAE) =
Net Income
Average Stockholder’s Equity
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Whole Bank Profitability Measurement
Net Interest Margin
The difference between interest income and interest
expense expressed as a percentage of average earning
assets.
Target - NIM > 4.00% or 400 Basis Points
Now, with a low rate environment…> 3.50% is new norm
Net Interest Margin (NIM) = Net Interest Income
Average Earning Assets
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Whole Bank Profitability Measurement
Yield on Earning Assets
Total interest income expressed as a percentage of
average earning assets.
Target YOEA > 4.00% or 400 Basis Points
Yield on Earning Assets = Interest & Dividend Income
Average Earning Assets
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Whole Bank Profitability Measurement
Cost of Funds
Total interest expense expressed as a percentage of
average interest bearing liabilities & non-interest
bearing deposits.
Target Cost of Funds < 0.75% or 75 Basis Points
Cost of Funds = Interest Expense
Average interest-bearing liabilities
& non-int. bearing deposits
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Whole Bank Profitability Measurement
Efficiency Ratio
Depicts how much in operating expense to generate $1
of revenue. The lower the ratio, the more efficient the
organization.
Target – Efficiency Ratio 50-60%
An efficiency ratio of 55% means it cost 55 cents to earn $1.00
worth of revenue.
Efficiency Ratio = Operating Expense
Net Int. Income + Non-Interest Income
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Whole Bank Profitability Measurement
Net Interest Margin
Depicts operating expense as a percent of average
assets.
Target – Expense Ratio 2.50% - 3.50%
Expense ratio is driven by bank strategy. The lower the ratio, the
more efficient the bank.
Expense Ratio = Operating Expense
Average Assets
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Whole Bank Profitability Measurement
Uniform Bank Performance Report (UBPR) – Summary Ratios Report
Earnings & Profitability (percent of AA)- Interest Income (TE)- Interest Expense- Net Interest Income (TE)- Non Interest Income- Provision- Pretax Net Operating Income- Realized Gain/Loss Secs- Net Operating Income- Net Income
Margin Analysis- Avg. Earning Assets to Avg Assets- Avg Interest Bearing Funds to Avg
Assets- Interest Income (TE) to Avg Earning
Assets- Interest Expense to Avg Earning
Assets- Net Int Inc (TE) to Avg Earning
Assets
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Profitability Information: Why Do You Need It?
Profit Continuum: Whole Bank
Return on: Assets or Equity
Net Interest Margin Fee Income Expense Ratio
YOEA Cost of Funds
Efficiency Ratio
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Profitability Information: Why Do You Need It?
Profit Continuum: Dupont Drill Down
Net Interest Margin (NIM)
Product Spreads
Funds Transfer Pricing (FTP)
Interest Rate RiskOrganizational Unit Spread
Customer Spreads
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Profitability Information: Why Do You Need It?
Product Profitability: Loss Leader Theory
Satisfactory
Profitability * Profitable** Unprofitable
Banks 22.22% 44.44% 33.33%
Thrifts 22.22% 44.44% 33.33%
*Satisfactory Profitability is > 1.00% pretax return on portfolio balances.
**Profitable is 0% - 1.00% pretax return on portfolio balances.
Source: The Kafafian Group 3Q15 Profitability Peer Group.
Portfolio groups include: C&I loans, commercial real estate loans, residential
real estate loans, consumer loans (including home equity), DDA checking,
NOW checking, savings, money market, CD's.
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Profitability Information: Why Do You Need It?
Branch Non-Interest Expense
Source: The Kafafian Group profitability peer database
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Profitability Information: Why Do You Need It?
Branch Indirect Expense
Source: The Kafafian Group, Inc.
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Profitability Information: Why Do You Need It?
Case Study: Commercial Loan Product
(All % are annualized)
1 Gross Funds Provided (Used) (120,761) 100.00% (102,828) 100.00% (95,866) 100.00% (98,406) 100.00% (97,166) 100.00%
2
3 P & L:
4 Interest Income 2,063 6.85% 1,541 6.08% 1,491 6.19% 1,322 5.34% 1,257 5.20%
5 Cost of Funds 1,182 3.93% 951 3.75% 825 3.42% 762 3.08% 680 2.81%
6 Total Interest Spread 881 2.93% 590 2.33% 666 2.76% 560 2.26% 577 2.39%
Q2 Q1 Q4 Q3 Q2
Note: Q1 Interest Income includes a significant reversal of interest income from a non-performing loan.
Source: The Kafafian Group, Inc.
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Profitability Information: Why Do You Need It?
Case Study: Mortgage Lending Department
(All % are annualized)
1 Interest Income 5,631 7.20 % 5,908 7.31 % 6,189 7.40 % 6,353 7.60 % 5,956 7.61 %
2 Cost of Funds 4,742 6.06 % 4,930 6.10 % 5,168 6.18 % 5,243 6.27 % 5,061 6.46 %
3 Net Asset Spread 889 1.14 % 978 1.21 % 1,021 1.22 % 1,110 1.33 % 895 1.14 %
4 Credit for Funds 54 0.07 % 37 0.05 % 37 0.04 % 72 0.09 % 50 0.06 %
5 Interest Expense 23 0.03 % 14 0.02 % 29 0.03 % 27 0.03 % 7 0.01 %
6 Net Liability Spread 31 0.04 % 23 0.03 % 8 0.01 % 45 0.05 % 43 0.05 %
7 Total Interest Spread 920 1.18 % 1,001 1.24 % 1,029 1.23 % 1,155 1.38 % 938 1.20 %
8 Funds Credit Allocated Equity 204 0.26 % 211 0.26 % 222 0.27 % 227 0.27 % 213 0.27 %
9 Net Interest Spread 1,124 1.44 % 1,212 1.50 % 1,251 1.49 % 1,382 1.65 % 1,151 1.47 %
10 Provision for Credit Loss 20 0.03 % - 0.00 % 60 0.07 % 60 0.07 % 60 0.08 %
11 Marginal Inc (Loss) After Prov. 1,104 1.41 % 1,212 1.50 % 1,191 1.42 % 1,322 1.58 % 1,091 1.39 %
12 Non-Interest Income 206 0.26 % 122 0.15 % 89 0.11 % 533 0.64 % 244 0.31 %
13 Total Income 1,310 1.67 % 1,334 1.65 % 1,280 1.53 % 1,855 2.22 % 1,335 1.70 %
14 Direct Expense 201 0.26 % 226 0.28 % 581 0.69 % 840 1.00 % 848 1.08 %
15 Indirect Expense 90 0.12 % 113 0.14 % 296 0.35 % 437 0.52 % 417 0.53 %
16 Total Non-Interest Expense 291 0.37 % 339 0.42 % 877 1.05 % 1,277 1.53 % 1,265 1.62 %
17 Pretax Profit (Loss) 1,019 1.30 % 995 1.23 % 403 0.48 % 578 0.69 % 70 0.09 %
Q2 Q1 Q4 Q3 Q2
Source: The Kafafian Group, Inc.
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Profitability Information: Why Do You Need It?
Case Study: Trust Department
1 Non-Interest Income 424 100.00 % 447 100.00 % 366 100.00 % 375 100.00 % 346 100.00 %
2 Total Income 424 100.00 % 447 100.00 % 366 100.00 % 375 100.00 % 346 100.00 %
3 Direct Expense 370 87.26 % 380 85.01 % 457 124.86 % 429 114.40 % 435 125.72 %
4 Indirect Expense 71 16.75 % 73 16.33 % 73 19.95 % 67 17.87 % 71 20.52 %
5 Allocated Overhead 125 29.48 % 131 29.31 % 136 37.16 % 119 31.73 % 110 31.79 %
6 Total Non-Interest Expense 566 133.49 % 584 130.65 % 666 181.97 % 615 164.00 % 616 178.03 %
7 Pretax Profit (Loss) (142) (33.49)% (137) (30.65)% (300) (81.97)% (240) (64.00)% (270) (78.03)%
Q4Q2 Q1 Q3 Q2
Source: The Kafafian Group, Inc.
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Profitability Information: Why Do You Need It?
Product Profitability Decision Tree
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Profitability Measurement
Organizational Profitability
• Management tool to assist in improving organization
performance by measuring the results of organizational units
that reflect how the institution is managed
• Assist in strategic decision making and the budget process
• Assist in the measurement of performance (i.e., units/people)
• Assist in the determining of performance rewards, i.e.
compensation, bonuses, incentives
• Provide the detail to understand and evaluate complex issues
and problems
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Profitability Measurement
Organizational Profitability – Typical Structure
Board
President/CEO
Senior Lender
Commercial
Consumer
Residential
Loan Ops/Servicing
Credit Branch Admin
Branches
Operations
IT
Deposit Ops
Facilities/Security
Marketing HR
Payroll
Training
Compliance Finance
Audit Officer
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Profitability Measurement
Product Profitability
• Marketing tool to determine organizational resources required to
deliver products to customers versus the revenue per product
• Assist in strategic decision making
• Assist in product development
• Assist in the measurement of the success of certain marketing initiatives (ROI analysis, etc.)
• Provide the detail to understand and evaluate complex issues and
problems
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Profitability Measurement
Product Profitability
Fund Providing:
• Demand Deposits
• Savings Deposits
• Time Deposits
• Other Borrowings
Fund Using:
• Investments
• Short-Term Assets
• Loans
Non-Fund/Fee-Based:
• Safe Deposit Boxes
• Mortgage Servicing
• Trust, Insurance, Brokerage, etc.
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Profitability Measurement
Customer Profitability
• Marketing tool to determine organizational resources required to
serve customers versus the revenue per customer
• Assist in strategic decision making to determine the most
profitable customers to keep and prospective customers to
pursue
• Critical input into determining service levels (i.e. platinum, gold,
silver service, etc.)
• Can roll up into relationship manager profitability to measure
individual RM performance
• Provide the detail to understand and evaluate complex issues and problems
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Profitability Components
Funds Transfer Pricing - FTP
The “Art/Science” of crediting fund providers
(deposits, borrowings, capital) for generating
funds, while at the same time charging fund users
(loans and investments) for using funds…..at a
market rate which considers various product risks
and maturity characteristics.
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Profitability Components
Funds Transfer Pricing - FTP
• Single Rate/Pool (sometimes actual cost of funds)
• Specific Matching (both sides of balance sheet)
• Multiple Pools
• Matched Maturity - Coterminous
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Profitability Components
Funds Transfer Pricing - FTP
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Profitability Components
Funds Transfer Pricing – Actual Spread Versus FTP
CQ PQ Difference
Interest Income 5.95% 5.70% 0.25%
Interest Expense 1.95% 1.85% 0.10%
Net Spread 4.00% 3.85% 0.15%
Fund Using Prods. CQ PQ Difference
Interest Income 5.95% 5.70% 0.25%
FTP-Cost of Funds 3.81% 3.65% 0.16%
Net Spread 2.14% 2.05% 0.09%
Fund Providing Prods. CQ PQ Difference
FTP-Credit for Funds 3.89% 3.73% 0.16%
Interest Expense 1.95% 1.85% 0.10%
Net Spread 1.94% 1.88% 0.06%
Mismatch Spread -0.08% -0.08% 0.00%
Cost Basis
Market Basis
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Profitability Components
Capital Assignment – Risk Adjusted Return on Capital (RAROC)
• RAROC is considered to be a “best practice” tool for measuring
risk vs. return in the financial services industry. It provides a
framework for measuring risk-adjusted financial performance of
organizational units, products, and customers.
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Profitability Components
Capital Assignment – FRB Risk Categories
• Credit
• Market (Interest Rate)
• Liquidity
• Reputation
• Legal
• Operational
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Profitability Components
Capital Assignment – RAROC Sample
Low Medium High
Risk Rating Scale 1 2 3 4 5
Capital Assignment 0% 4% 8% 12% 16%
Assigned Capital
Risk Categories Credit Interest Rate Liquidity Composite Capital ($000)
Risk Weights 55% 35% 10% 100%
Balance
Loans: ($000)
Commercial & Industrial 100,000 4 2 2 3.10 8.40% 8,400
Commercial Real Estate 200,000 2 4 4 2.90 7.60% 15,200
Construction 40,000 5 2 2 3.65 10.60% 4,240
Consumer 50,000 3 3 3 3.00 8.00% 4,000
Residential Real Estate 100,000 2 4 4 2.90 7.60% 7,600
Total Loans 490,000 8.05% 39,440
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Profitability Components
Capital Assignment – RAROC Customer Example
Low Medium High
Risk Rating Scale 1 2 3 4 5
Capital Assignment 0% 4% 8% 12% 16%
Assigned Capital
Risk Categories Credit Interest Rate Liquidity Composite Capital ($000)
Risk Weights 55% 35% 10% 100%
Loans: Balance
Loan on building(CRE) 250,000 2 4 4 2.90 7.60% 19,000
Home equity loan 50,000 3 3 3 3.00 8.00% 4,000
Deposits/funding:
Business checking 30,000 1 2 2 1.45 1.80% 540
Funding gap 270,000 1 2 2 1.45 1.80% 4,860
Total Capital for Customer 28,400
Capital Ratio 9.47%
Pre-tax ROE Hurdle Rate 15.00%
Pre-tax Profit Requirement $4,260
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Profitability Components
Capital Assignment – What’s Your “Well Capitalized”Capital Capital
Current Well Risk Required Required
Period Capitalized Buffer (% ) $
(Dollars in Thousands)
1 Total Cash & Bals Due $28,428 5.00% 0.15% 5.15% $1,464
2 Investment Securities 339,217 5.00% 1.25% 6.25% 21,201
3 Net Loans & Leases 2,203,532 5.00% 2.35% 7.35% 161,960
4 Other Assets 82,441 5.00% 0.50% 5.50% 4,534
5 Total Assets $2,653,618 5.00% 2.13% 7.13% $189,159
6 Total Deposits $2,229,590 0.90% 0.90% $20,066
7 Fed Funds & Repos 24,104 0.20% 0.20% 48
8 Borrowings 144,424 0.25% 0.25% 361
9 Other Liabilities 13,221 0.00% 0.00% 0
10 Total Liabilities 2,411,339 20,476
11 Total Equity 242,279 Required Equity ---- > $209,635
12 Total Liabilities + Equity $2,653,618
13 Total Equity (actual) $242,279
14 Total Equity (required) 209,635
15 Buffer (deficit) 32,644
16 Your Well Capitalized 7.90%
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Profitability Components
Cost Assignment
Activity-based-costing
Full absorption versus standard costing
Variable/fixed-direct/indirect costs
Isolating efficiencies/inefficiencies
Capacity utilization
Allocations methodologies:
• Average balances
• Fixed percentages
• Statistical databases
• Weighted statistics
• Direct Dollar Assignment
• Rate X Volume (ABC)
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Profitability Components
Cost Assignment
Daily
Time Salary
Name Activities (mins) Data
Jane Doe Deposit Servicing Rep II $25,189
20% NSF (comml & retail dda) 10 96 $5,038
30% Processing outgoing returns (all checking) 10 144 $7,557
30% Verification of new checking acct (all checking) 10 144 $7,557
10% Processing outgoing mail (bank ovhd) 98 48 $2,519
5% Posting data input (customer change requests/all deposits) 1 24 $1,259
5% Phone calls, etc. (dept ovhd) 99 24 $1,259
$0
Totals: 480 $25,189
Product
Group
Number
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Profitability Components
Cost Assignment
Product
Group Allocated Allocated
Number Product Group Name $'s %'s
1 All deposits 13,790 10.10%
2 CDs/ Savings/ DDA/ MMDA 7,912 5.80%
3 CDs 7,912 5.80%
4 All retail deposits 989 0.72%
5 IRAs & CDs 2,024 1.48%
6 Internet Banking 4,243 3.11%
7 All retail checking 6,365 4.66%
8 All retail checking & savings 10,608 7.77%
9 All checking/ savings / MMDA 10,348 7.58%
10 All checking 33,062 24.23%
11 All savings 1,863 1.36%
12 IRAs & MSAs 15,985 11.71%
13 Misc branch fees 5,460 4.00%
14 MSAs 9,161 6.71%
15 IRAs 4,228 3.10%
0 0.00%
98 General Bank Overhead 2,519 1.87%
136,469 100.00%
99 Local Department Overhead 47,828
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36
Profitability Components
Cost Assignment – Step Variable Cost
A step-variable cost is a resource that is obtainable
only in large chunks (such as ops workers) and
whose costs change only in response to fairly wide
changes in activity.
Volume
Cost
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37
ROI Exercise
Money Market Campaign
Personal
MMDA
Business
MMDA
1 Credit for Funds 3.84% 3.84%
2 Interest Expense 1.79% 2.13%
3 Total Interest Spread 1.97% 1.65%
4 Funds Credit Allocated Equity 0.10% 0.10%
5 Net Interest Spread 2.05% 1.75%
6 Non-Interest Income 0.07% 0.04%
7 Total Income 2.11% 1.79%
8 Non-Interest Expense 1.11% 0.78%
9 Pretax Profit (Loss) 0.98% 1.01%
10 Number of Accounts 1,835 363
11 Average Balance per Account $44,156 $139,199
12 Non-Interest Income per Account $5.79 $6.78
13 Annualized Cost per Account $524.28 $1,027.80
14 Annualized Net Income per Account $428.08 $1,575.55
Percent of Average Balance
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ROI Exercise
Credit Card vs. HELOC
(dollars in thousands) Credit Card HELOC
1 New Balances $10,000 $10,000
2 Interest Income $1,000 $400
3 Cost of Funds (FTP) 150 150
4 Spread 850 250
5 Fee Income 200 50
6 Total Revenue $1,050 $300
7 Estimated net charge-offs 400 25
8 Incremental Operating Expenses 200 15
9 Net Revenue $450 $260
10 Campaign Cost $50 $50
11 Return on Investment (ROI) 900% 520%
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ROI vs. ROE
Credit Card vs. HELOC
(dollars in thousands) Credit Card HELOC
1 New Balances $10,000 $10,000
2 Net Revenue $450 $260
3 Campaign Cost $50 $50
4 Return on Investment (ROI) 900% 520%
5 Capital Allocation $1,000 $500
6 Risk Adjusted Return on Capital (RAROC) 45% 52%
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Customer Profitability Exercise
RAROC
Business Commercial Home Eq.
DDA Mortgage Loans
1 Credit for Funds 3.45% Interest Income 6.27% 6.32%
2 Interest Expense 0.00% Cost of Funds 3.95% 4.57%
3 Total Interest Spread 3.44% Total Interest Spread 2.25% 1.72%
4 Funds Credit Allocated Equity 0.15% Funds Credit Allocated Equity 0.39% 0.24%
5 Net Interest Spread 3.58% Net Interest Spread 2.62% 1.93%
6 Non-Interest Income 0.72% Provision for Credit Loss 0.69% 0.21%
7 Total Income 4.35% Marginal Inc (Loss) After Prov. 2.07% 1.76%
8 Non-Interest Expense 3.76% Non-Interest Income 0.10% 0.10%
9 Pretax Profit (Loss) 0.39% Total Income 2.15% 1.83%
10 Non-Interest Expense 0.66% 1.29%
11 Number of Accounts 2,525 Pretax Profit (Loss) 1.16% 0.61%
12 Average Balance per Account $18,432
13 Non-Interest Income per Account $36.88 Number of Accounts 405 1,185
14 Annualized Cost per Account $719.87 Average Balance per Account $505,002 $58,427
15 Annualized Net Income per Account $76.28 Non-Interest Income per Account $71.09 $9.82
16 Annualized Cost per Account $3,535.46 $781.60
17 Annualized Net Income per Account $6,762.85 $670.03
Customer Balances from RAROC Sample: Profits
18 Commercial Mortgage $250,000 $2,900 Capital Allocation to Customer 9.47%
19 Home Equity Loan 50,000 305
20 Business DDA 30,000 117 Profit Hurdle for 15% ROE $4,260
Total Profit $3,322 ------------------------------------->>>>>> $3,322
Customer profit over (short) of hurdle ($938)
Percent of Average Balances
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Performance Measurement
StrategicManagement
Profit & ProcessImprovement
Board & Management Advisory Services
Financial Advisory
Jeffrey P. Marsico
Executive Vice President
Ph: 973.299.0300 x120
Email: [email protected]
www.kafafiangroup.com
www.jeff-for-banks.blogspot.com