OVERVIEW

Boyd Dunkin laughed to himself as he looked out his office window. "What a difference the business cycle makes,"

he thought. As president and CEO of Southwest State Bank (Southwest), Boyd had watched his bank struggle

through serious problems during the mid- to late-1980s when many of the bank's agricultural loan customers had

difficulty making their loan payments. He had battled the regulators and even called on stockholders to re-capitalize

the bank when it was forced to write off problem loans. Now, years later, Southwest was a high performance bank.

Several members of the board of directors were pushing him to expand into new geographic and product markets

and to consider buying other community banks.

Southwest is a $53 million community bank located in the small, rural town of Lemars, Arizona, a community of

almost 17,000 people. Two other commercial banks and one credit union compete in the area: Sun National Bank is

a $101 million bank that has four branches in Lemars and two nearby in the county. People's Bank & Trust is

smaller at $45 million but targets affluent consumers with its trust department and retail products. People's operates

with a main office downtown and a branch at the local mall. The credit union is affiliated with the state teachers

association and boasts almost $29 million in assets. A large national holding company has just announced its

intention to acquire Sun National.

Boyd, his daughter, Rebecca Parks, who serves as chief financial officer, and a small group of other investors,

including most of the bank's directors, own 100 percent of Southwest, with Boyd's family members controlling 45

percent of the stock. Although Boyd has worked for Southwest for almost 30 years, the family obtained its

controlling interest in 1986 when the bank's loan problems peaked. Following the change in the area's farm

economy, Southwest had consistently improved its performance, posting record profits in 2006 and 2007. Profits

dropped off somewhat but were still very good in 2012 and 2013. Profits reached record levels again in 2018 and

2019 with the help of converting to a Subchapter S Corporation.

STRATEGIC ISSUES

The fundamental problem facing Southwests management is to determine the appropriate strategic direction for the

bank. With its long history in the community, Southwest is well-known for its agriculture lending, particularly

cattle and feedlot loans. One problem is that its loan portfolio is fast becoming even more concentrated in

agricultural loans. At a recent board meeting, Rebecca reported that the bank's loan portfolio had shifted from 36

percent agriculture to 78 percent agriculture over the past six years. Although these loans were quite profitable, on

average, there was concern about the lack of diversification.

Due to Southwests seasonal loan needs, a general lack of demand from good loan customers outside agriculture,

and Southwests concerns about lack of diversification, the bank has a substantial holding of Fed Funds sold. These

short-term overnight investments earn a very low rate of interest and lower the banks ROA. The board continues to

express concern with this low yielding asset and has put pressure on Dunkin to expand the loan portfolio. Dunkin is

concerned that if the bank gets more aggressive in non-agriculture markets where it has less experience or expands

the agriculture loan portfolio, it will become too risky and potential loan losses may again put the banks entire

capital at risk.

Most of the board members believe that Southwest is simply doing what it does very well, which explains the loan

concentration. Efforts to diversify within Lemars have failed because Sun National and People's Bank & Trust are

strong competitors in the consumer market -- the only other real growth area. Southwests consumer loan and

deposit base largely reflects its agriculture customers, who conduct all their business with the bank. If Southwest

were to increase its consumer loans, they would come primarily from competitors and they would likely be costly to

obtain and keep.To improve its competitive edge, Southwest elected to become a Subchapter S Corporation in 2018. As a direct

result, reported taxes almost disappeared by 2019. A Subchapter S Corporation is treated as a pass-through entity,

similar to a partnership, for federal income tax purposes. It is generally not subject to any federal income taxes at

the corporate level. Its taxable income flows through to shareholders in proportion to their stock ownership, and the

shareholders generally pay federal income taxes on their share of this taxable income. This can have the effect of

reducing an institutions reported income tax expense and increasing after-tax earnings.

A vocal group of three directors, also stockholders, recently proposed that Southwest buy another bank. People's

Bank & Trust was mentioned as a possibility, as were two commercial banks of the same approximate size in

neighboring communities. The group suggested that any acquisition could be financed by omitting Southwests

dividends. Southwest has paid out over 80 percent of its net income in dividends since 1992, which alternatively

could be applied to such an acquisition. People's Bank & Trust or a similarly non-agriculture bank could provide the

necessary diversification.

Dunkin is unsure as to what strategy is best. To a large extent, he is satisfied with the profits the bank is currently

generating and doesn't want to spend the energy to enter a new market or retool with new products, such as

consumer and trust services. Southwests strength is its small size and strong community focus. Customers know

tellers and loan officers by name and are treated as family members. This atmosphere would likely disappear with

any substantive growth. Alternatively, Dunkin knows that at least one large banking organization will enter Lemars

soon and others may follow, either by buying an existing bank or opening a new branch. To compete, Southwest

will have to decide to offer a broader array of services. It might also need to diversify its asset base.

Dunkin has indicated that Southwests Internet banking services are non-existent. Dunkin indicated that the banks

client base currently does not want or demand Internet banking services and hence there is no reason to be a leader

in this area. Dunkin also knows that the trend toward business banking on the Internet is approaching rapidly and

that business customers are beginning to understand the advantages of Internet Cash Management. Internet Cash

management allows business customers can move excess funds on a daily basis to an interest bearing account (not

FDIC-insured). The ability to offer cash management accounts to Southwests customers could make a big

difference in retaining some of their best customers.

The issue facing Southwest State Bank is not unusual in todays rapidly changing financial services industry. The

bank is currently enjoying record profits in a low interest rate environment doing what it has always done well,

serving the small niche agricultural market. The real question facing Southwest is how does it continue to profit by

doing what has been successful while investing in new ventures? Spending millions of dollars on Internet banking

is one approach, but will all customers do business this way and if so, when? Southwests profitability and expense

control are good and the board of directors is struggling with decisions regarding additional investment (purchasing

another bank or branch) or investing into new technology, delivery systems and products their existing customer

base does not appear to demand at this time.

ECONOMIC ENVIRONMENT

The Southwest economy has been strong during the past few years. Southwest has performed above average

relative to peers with acceptable amounts of risk. Forecasts for the year 2020 and beyond are more uncertain.

Interest rates are expected to remain steady, and most indicators suggest that business and consumer spending is

good. Inflation, while currently low, will likely accelerate.

Economic reports indicate that the Southwest has experienced robust economic conditions during the most recent

survey period. Sales were brisk for retailers and service-providers to consumers and businesses. Manufacturing

activity proceeded at a moderate pace, and contacts reported a mild pickup in export demand. Conditions in the

agricultural sector were somewhat weak. Activity in real estate and construction markets remained at high levels in

most areas, and financial institutions reported strong demand for credit. Wages and prices exhibited limited

movement overall, although increases were noted for some types of workers and some products.

Retail sales were rapid overall, although reports of slight slowing appeared in a few surrounding states. Automobiles

and light trucks sold at a good clip in most areas of Arizona. Agricultural producers faced somewhat weak demand and lower sales prices. Reports from California, Washington, and Oregon indicated that farmers were hampered by

weak export demand so that sales prices have remained low. Planting and growing conditions were mixed

Economic reports on banks and other financial institutions, such as venture capital firms, reported strong demand for

credit and relatively good supply conditions.

QUESTIONS

Assume that you are a consultant who has been charged with analyzing Southwest State Bank's profitability and risk

profile. The bank's balance sheet and income statement data for 2017 through 2019 and corresponding data from the

bank's Uniform Bank Performance Report are shown in attached data template. Also, a complete set of profitability

and risk ratios for Southwest for the years 2017 2019 are provided in the template. Use this information to conduct

analyses regarding the bank's current profitability, risk exposure, and optimal strategic direction. Specifically:

1. Perform a ratio analysis using the ROE model to evaluate Southwests profitability relative to peers for

2019. In what significant ways does Southwests profitability differ from peers?

2. Specifically identify the reasons for higher (lower) interest income and non-interest income. Do you see

these trends continuing?

3. Perform a ratio analysis to evaluate Southwests risk position compared to peers' for the period 2017

through 2019. In what significant ways does Southwests risk differ from peer banks'?