The Unlimited Potential of Embedded Banking

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With fewer resources and smaller customer bases, community banks often find themselves on the losing end of a tug-of-war game when getting involved in emerging technologies. But that’s where embedded banking is a game-changer.

Embedded banking offers every financial institution — regardless of size — a chance to grab market share of this relatively untapped, billion-dollar opportunity.

Embedding financial services into non-financial applications is a market that could be worth almost $230 billion in revenues by 2025, according to a report from Lightyear Capital. That means forward-thinking community banks could see a big upside if they make the strategic investment — as could their non-bank partners. And those companies that are orchestrating integrations behind the scenes could also reap rewards in the form of subscription or transactional services. And ultimately, end users will benefit from the seamless experience this technology provides. While it’s a winning proposition for all, a successful embedded finance operation involves preparation and strategy. Let’s take a closer look at the four players who stand to benefit with embedded banking.

Community Banks: Building Reach
As community banks retool their strategies to adapt to more digital users, they also face growing challenges from digital-only neobanks and fintechs to retain their existing customers. They will need innovative features on-par with their big-budgeted competitors to thrive in the space.

Embedded banking is a legitimate chance for these banks to stake out a competitive advantage. Embedded banking, a subset of banking as a service (BaaS), allows digital banks and other third parties to connect with banks’ systems directly via application programming interfaces, or APIs. Today, 70% of banks that sponsor BaaS opportunities have less than $10 billion in assets. The cost to compete is low, and the services that non-bank entities are seeking are already available on banking platforms.

To start, institutions work with a technology company that can build APIs that can extend their financial services, then identify partners looking to embed these services on their digital platform. A best-case scenario is finding a digital banking partner that can deliver the API piece and has connections with potential embedded banking partners. Once a bank has an embedded banking strategy in place, expansion opportunities are unlimited. There are numerous non-bank partners across many industry verticals, offering entirely new customers at a lower cost of a typical customer acquisition. And these partnerships will also bring new loans, deposits and payment transactions that the bank wouldn’t otherwise have.

Nonbanks: Retaining Customers, Bolstering Satisfaction
Companies outside of the finance industry are rapidly recognizing how this technology can benefit them. Customer purchases, loans or money transfers can all be facilitated using services from a bank partner via APIs. Companies can offer valuable, in-demand financial services with a seamless user experience for existing customers — and this innovation can fuel organic growth. Additionally, the embedded banking partnership generates vast amounts of customer data, which companies can use to enhance personalization and bolster customer loyalty.

Consumers: Gaining Convenience, Personalization
Making interactions stickier is key to getting consumers to spend more time on a website. Sites should be feature-rich and comprehensive, so users don’t need to leave to perform other functions. Embedding functionality for relevant financial tasks within the platform allows users to both save time and spend more time, while giving them valuable financial products from their trusted brand. They also benefit from data sharing that generates personalized content and offers.

Tech Companies: Growing Partnerships, New Opportunities
Technology providers act as the conduit between the financial institution’s services and the non-bank partner’s experience. These providers — usually API-focused fintech companies — facilitate the open banking technology and connections. By keeping the process running smoothly, they benefit from positive platform growth, the creation of extensible embedded banking tools that they can reuse and revenue generated from subscription or transaction fees.

Everyone’s a Winner
This wide-open embedded banking market has the potential to be a game changer for so many entities. The good news is there is still plenty of room for new participants.

Why Asset Size Does Not Matter To Regulators In ERM

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ERM-1-21-19.pngConventional wisdom in banking has been that asset size matters in terms of regulatory expectations around enterprise risk management (ERM).

But that traditional school of thought might be changing. A new question has emerged: is it the institution’s asset size that matters, or is the complexity of the risk profile more important?

A common question among peer roundtables: what is a bank expected to do for ERM as it approaches the $10 billion asset size threshold of a regional banking organization (RBO)? The Federal Reserve considers an RBO to have total consolidated between $10 billion and $50 billion.

The next question typically is if regulatory expectations have lessened around comprehensive capital analysis and review (CCAR) or Dodd-Frank Act Stress Test (DFAST) requirements because of recent reforms in Congress?

These are hot topics especially for banks below the $10 billion asset size bubble, known as community bank organizations (CBO) by the Fed, because the cost of ERM implementation remains high.

Specific to CBOs between $2 billion and $5 billion in assets, regulatory agencies have been providing more prescriptive guidance and recommendations to upgrade and enhance ERM and model risk management frameworks consistent with existing regulatory guidance aimed at RBOs.

Examinations are more detailed, covering policies and procedures, personnel, risk appetite, risk assessment activities and board reporting. Examiners are pushing smaller banks to recognize the ERM value proposition because a keen risk awareness will inspire more informed decisions.

An effective ERM program starts with the risk culture necessary for appropriate governance of policies and procedures, risk awareness training, tone from the top and credible challenge. The culture should start with the CEO and the board establishing a proactive risk strategy and aligning the risk appetite of the bank with strategic planning.

Implementing an effective risk management program is understanding your bank’s risk profile and addressing matters proactively, having the discipline to identify emerging risks and mitigating those risks before a risk event or loss.

As banks approach $10 billion in assets, they are expected to increase the rigor around risk identification and assess risks for their likelihood and impact before identifying risk-mitigating controls.

A CBO should have a champion to effect change strategically throughout the organization, rather than a regulatory or audit check-the-box exercise. The risk management champion can be compared to an orchestra conductor who does not need to do everyone else’s job but should be able to hear someone is out of tune. Breaking down silos is key because risk management should be a continuous, collaborative process involving all stakeholders.

Regulatory expectations are converging as examiners push smaller banks to show a safe and sound risk management framework. This should encompass a separate board risk committee, or, at a minimum, a subcommittee responsible for ERM.

All banks have traditionally been expected to maintain appropriate risk management processes commensurate with their size and complexity and operate in a safe and sound manner.

The formality and documentation required is a new, evolving trend. Board and senior management oversight is important, as is risk monitoring and information system reporting. Board support is critical to understand risk areas, develop training programs and establish accountability among leadership and risk management team members.

Regulatory scrutiny for banks below $10 billion of assets has increased for ERM sub-processes, including model risk management, new products and services and third-party risk management.

We live in a post-CCAR world trending toward deregulation; however, the regulatory burden of risk management expectations for the smaller CBOs is increasing. Essentially, asset size does not matter anymore.

Breaking Down Deregulation Based On Asset Size

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deregulation-9-5-18.pngIn May, President Donald Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act into law, clearing the last hurdle for an expansive roll-back of U.S. banking regulations. The bill will relieve many of the nation’s banks from compliance and regulatory obligations imposed by the 2010 Dodd-Frank Act, adopted in the aftermath of the 2008 financial crisis.

The legislation benefitted from significant support from the banking industry, and in particular from the Independent Community Bankers of America and other representatives of community banks. Proponents of the bill assert that the oversight and compliance obligations imposed by Dodd-Frank disproportionately burdened community banks with the costs and organizational challenges associated with compliance, even though these institutions do not pose the same level of risk to the domestic or global financial systems as their larger national bank counterparts.

To address these concerns, the new law adjusts existing regulatory requirements to create a more tiered regulatory framework based on institution asset size, primarily by (i) removing certain compliance obligations to which community banks are subject, and (ii) increasing the threshold triggering application of some of the most stringent oversight and compliance requirements.

The most significant regulatory changes for community and regional banks resulting from the law include:

Under $3 Billion:
Raises the qualification threshold from $1 billion in assets to $3 billion in assets for: (i) an 18-month exam cycle for well-managed, well-capitalized banks, and (ii) the Federal Reserve’s Small Bank Holding Company Policy Statement.

Under $10 Billion:
No longer subject to the Volcker Rule enacted as part of Dodd-Frank. The Volker Rule restricts proprietary trading by FDIC-insured institutions, and imposes related reporting and compliance obligations on these institutions as a result. These reporting and compliance obligations reflected regulators’ belief that proprietary trading poses high systemic risk. But because it is typically only large national institutions that engage in proprietary trading, the community banking industry argued that smaller banks should not be subject to the Volcker Rule.

Deems certain mortgages originated and retained in portfolio as Qualified Mortgages if: (i) they comply with requirements regarding prepayment penalties, (ii) they do not have negative amortization or interest-only features, and (iii) the financial institution considers and documents the debt, income and financial resources of the customer. Qualified Mortgages are legally presumed to comply with Dodd-Frank’s Ability to Repay requirements.

Truth In Lending Act escrow requirement exemption for depository institutions that originated no more than 1,000 first lien mortgages on principal dwellings in the previous year.

Directs federal banking regulators to develop a Community Bank Leverage Ratio (equity capital to consolidated assets) between 8 and 10 percent. Banks exceeding this ratio will be deemed well capitalized and in compliance with risk-based capital and leverage requirements. Federal banking agencies may consider a bank’s risk profile when evaluating whether it qualifies as a community bank for purposes of the ratio requirement.

$10 Billion – $50 Billion:
No longer subject to mandatory stress testing or required to maintain risk management committees.

$50 Billion – $250 Billion:
No longer designated as “Systemically Important Financial Institutions” under Dodd-Frank. This designation triggers application of “enhanced prudential standards” under existing law, such as stress-testing and maintenance of risk management committees.

Institutions holding between $50 billion and $100 billion in assets will are exempt as of May 24, 2018, and institutions holding between $100 billion and $250 billion in assets will become exempt as of November 24, 2019.

Under $250 Billion:
Changes the application of High Volatility Commercial Real Estate (HVCRE) rules, which will now only apply to the 12 largest domestic institutions. Existing HVCRE rules apply broadly to loans made for the acquisition or construction of commercial real estate, unless one of a few exemptions applies. Loans categorized as HVCRE receive a higher risk-weighting under capital adequacy regulations, requiring the bank to hold more capital than for non-HVCRE loans. The banking industry argued the HVCRE definition was unnecessarily broad and the related guidance was redundant.

All Banks:
Exempts certain rural real estate transactions of less than $400,000 from appraisal requirements if no certified appraiser is available. Community banks argued that finding appraisers in rural areas can be difficult or expensive.

Depository institutions that originate fewer than 500 closed-end mortgages or open-end lines of credit will be exempt from certain disclosures under the Home Mortgage Disclosure Act.

The expansiveness of these reforms means a significant easing of U.S. bank regulations applicable to community and regional banks. Legislators have indicated that the Act may soon be followed by further regulatory changes. Regardless of future congressional action, the newly modified regulatory landscape will be new and very different for many banking institutions, especially those far from Wall Street and doing business on Main Street.

Now Is The Time to Use Data The Right Way

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data-6-29-18.pngMost bankers are aware of the changes that are forthcoming in accounting standards and financial reporting for institutions of all sizes, but few are fully prepared for the complete implementation of all of the details in the new current expected credit loss (CECL) models that will take effect over the next few years.

Banks that act now to effectively and strategically collect, manage and utilize data for the benefit of the institution will be better positioned to handle the new accounting requirements under CECL and evolving regulations with state and federal agencies.

Here are three articles that cover key areas where your board should focus its attention before the rules take effect.

credit-data-6-29-18.pngCredit Data Management
Under Dodd-Frank, the law passed in the wake of the financial crisis, banks of all sizes and those especially in the midsize range of $10 billion to $50 billion in assets were required to do additional reporting and stress testing. Those laws have recently been changed, but many institutions in that asset category are opting to continue some form of stress testing as a measure of sound governance. Managing credit data is a key component of those processes.

management-6-29-18.pngCentralizing Your Data
Bank operations are known to be siloed in many cases as a matter of habit, but your data management can be done in a much more centralized manner. Doing so can benefit your institution, and ease its compliance with regulations.

CECL-6-29-18.pngGet Ready for CECL Now
The upcoming implementation of new CECL standards has many banks in a flurry to determine how those calculations will be developed and reported. Few are fully ready, but it is understood that current and historical loan level data attributes will be integral to those calculations.

Here’s What Bankers Are Asking About Risk Committees

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committee-6-13-18.pngOne of the central topics of conversation at this week’s Bank Audit & Risk Committees Conference hosted by Bank Director in Chicago is whether a bank’s board of directors should have a risk committee separate from its audit committee. And for banks that have already established a risk committee, the question is what responsibilities should be delegated to it.

In one respect, the question of whether a bank should establish a risk committee seems easy to answer because it’s clearly delineated in the regulations. Under the original Dodd-Frank Act of 2010, banks with more than $10 billion in assets are required by law to have one, though that threshold was raised to $50 billion in legislation enacted last month designed to ease the burden of the post-financial crisis regulatory regime on smaller banks.

There is a general consensus among attendees at this year’s conference that a bank shouldn’t base its decision to establish a risk committee solely on a size threshold. “Now that we have a risk committee, I don’t know how we did it without one,” said Tom Richovsky, chairman of the audit committee at United Community Banks, a $12.3-billion bank based in Blairsville, Georgia.

Rob Azarow, a partner at Arnold & Porter, says the decision should be informed by two factors in addition to size. The first is the complexity of a bank, with the presumption being that a bank with a more complex business model should establish a risk committee sooner than a bank with a less complex model. The second factor is dollars and cents—namely, whether a bank has the internal resources at its disposal to essentially split its existing audit committee into two.

It’s worth noting as well, as Azarow points out, that even under the new legislation, the Federal Reserve retains the authority to require a bank to implement a risk committee, irrespective of size. Another point to keep in mind is that even for banks not required as a result of their size to establish a risk committee, once established, it is subject to regulatory oversight.

Approximately half the banks at this year’s Bank Audit & Risk Committees Conference have both types of committees—audit and risk—with many of the others still weighing the pros and cons of establishing both.

Deciding whether to have a risk committee is only half the battle; the other half involves deciding exactly what that committee should do. Should it be vested with all risk-related questions, thereby usurping the authority over those questions from other committees? Or should the other committees retain their authority of relevant risks, while the risk committee then plays the role of overseeing an aggregated view of those risks?

This distinction is clearest in the context of the credit committee, for example. One of the fundamental purposes of a credit committee is to gauge credit risk. It isn’t uncommon, for instance, for a bank to require its credit committee to approve especially large loans. Would the risk committee now handle this?

Generally, the answer is no. The role of the risk committee when it comes to credit risk is broader, focused on concentration risk as opposed to the risk associated with individual credits.

Another place this comes up is in the context of technology and information security. While the audit committee would retain the authority to ensure that current laws, regulations and best practices are being abided by, the risk committee would be more focused on looming threats.

Deciding which responsibilities fall under the risk committee as opposed to, say, the audit and credit committees seems to boil down to the question of whether the issue is backward-looking or forward-looking, tactical or strategic. Issues that are forward-looking and strategic should go to the risk committee, with the rest remaining under the jurisdiction of their home committees.

To be clear, conclusions on when and how to charter a risk committee are far from settled. There are rough best practices, but no overarching consensus in terms of bright lines. Even banks that have established separate risk committees with clearly delineated duties are still in a process of adjustment. They’re happy with their decision to do so, but they recognize that this is more of an evolution than a revolution.

Blockchain is Coming, but It’s None of Your Business…Yet

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blockchain-5-18-18.pngFor most banks under the $20 billion asset threshold, blockchain technology—the distributed ledger—will be a tool like every other technology tool. Banks under that size will be provided that tool by established providers or very large institutions and the tool itself will enable typical banking businesses like extending credit, payments and wealth management.

While there is a ton of argument about the validity of the distributed ledger as a tool that enables currency that is untethered to a government or regulation, there is widespread belief that the technology behind the currency itself can carry value and be a boon for banks. It is useful because blockchain technology is enables faster, cheaper and fully transparent transactions in near real time.

Blockchain has potential to carry property deeds, stocks or insurance. Many banks have been skeptical about the technology because of the speculative nature of the cryptocurrency market and the dubious ethics of some of the folks running that market. But now many banks are starting to see it as a solution for quicker, cheaper transaction options.

JPMorgan Chase and the National Bank of Canada announced a debt insurance blockchain test. They believe that they can move debt insurance cheaper, faster and more securely on the distributed ledger, and they are doing a year-long test to find out. If that test works, the platform will have faced many challenges and presumably overcome them. It will have to get multiple regulators to sign off on it, it will have to integrate old systems’ data with the new platform, and it will have to prove that this new technology is actually superior to old systems.

Many banks under $20 billion can and will use it when it is rolled out by a reputable provider. So don’t worry too much about blockchain for now—you will be using it when it has been developed by a much larger institution with the capacity to invest in its trials. One important part of that process will be creating shared protocols. Right now, there is no one blockchain, and there is no one common language where one chain can talk to another. That will probably need to change if it is to become ubiquitous.

There are exceptions for banks below $20 billion
When you are a bank that is a specialist in a particular line of business, you should watch the enablers of that specialty with keen interest. If a bank makes 80 percent of its profit through commercial real estate lending, for instance, that bank should be looking at anything that enables better, quicker, easier service, better pricing, or cheaper production. Adopting the technology that gets the bank in front of most competitors will eventually increase potential for growth, profitability and market share.

It doesn’t matter if that technology is Statistical Analysis System (SAS), or on a distributed ledger, someone in the bank should be trying hard to be the second adopter of the technology that will make the bank so much better at what it does well. That is when a bank should care about blockchain—when it is proven enough to not to be a nightmare to your bottom line or your employees, and provides a competitive advantage in an area that really counts.

Well Conceived and Executed Bank Acquisitions Drive Shareholder Value

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acquisition-2-21-18.pngRecent takeovers among U.S.-based banks generally have resulted in above-market returns for acquiring banks, compared to their non-acquiring peers, according to KPMG research. This finding held true for all banks analyzed except those with greater than $10 billion in assets, for which findings were not statistically significant.

Our analysis focused on 394 U.S.-domiciled bank transactions announced between January 2012 and October 2016. Our study focused on whole-bank acquisitions and excluded thrifts, acquisitions of failed banks and government-assisted transactions. The analysis yielded the following conclusions:

  • The market rewards banks for conducting successful acquisitions, as evidenced by higher market valuations post-announcement.
  • Acquiring banks’ outperformance, where observable, increased linearly throughout our measurement period, from 90 days post-announcement to two years post-announcement.
  • The positive effect was experienced throughout the date range examined.
  • Banks with less than $10 billion in assets experienced a positive market reaction.
  • Among banks with more than $10 billion in assets, acquirers did not demonstrate statistically significant differences in market returns when compared to banks that did not conduct an acquisition.

Factors Driving Value

Bank size. Acquiring banks with total assets of between $5 billion and $10 billion at the time of announcement performed the strongest in comparison with their peers during the period observed. Acquiring banks in this asset range outperformed their non-acquiring peers by 15 percentage points at two years after the transaction announcement date, representing the best improvement when compared to peers of any asset grouping and at any of the timeframes measured post-announcement.

Performance-chart.png 

Acquisitions by banks in the $5 billion to $10 billion asset range tend to result in customer expansion within the acquirer’s market or a contiguous market, without significant increases in operational costs.

We believe this finding is a significant factor driving the value of these acquisitions. Furthermore, banks that acquire and remain in the $10 billion or less asset category do not bear the expense burden associated with Dodd-Frank Act stress testing (DFAST) compliance.

Conversely, banks with nearly $10 billion in assets may decide to exceed the regulatory threshold “with a bang” in anticipation that the increased scale of a larger acquisition may serve to partially offset the higher DFAST compliance costs.

The smaller acquiring banks in our study—less than $1 billion in assets and $1 billion to $5 billion in assets—also outperformed their peers in all periods post-transaction (where statistically meaningful). Banks in these asset ranges benefited from some of the same advantages mentioned above, although they may not have received the benefits of scale and product diversification of larger banks.

As mentioned earlier, acquirers with greater than $10 billion in assets did not yield statistically meaningful results in terms of performance against peers. We believe acquisitions by larger banks were less accretive due to the relatively smaller target size, resulting in a less significant impact.

Additionally, we find that larger bank transactions can be complicated by a number of other factors. Larger banks typically have a more diverse product set, client base and geography than their smaller peers, requiring greater sophistication during due diligence. There is no substitute for thorough planning, detailed due diligence and an early and organized integration approach to mitigate the risks of a transaction. Furthermore, alignment of overall business strategy with a bank’s M&A strategy is a critical first step to executing a successful acquisition (or divestiture, for that matter).

Time since acquisition. All three acquirer groups that yielded statistically significant results demonstrated a trend of increasing returns as time elapsed from transaction announcement date. The increase in acquirers’ values compared to their peers, from the deal announcement date until two years after announcement, suggests that increases in profitability from income uplift, cost reduction and market expansion become even more accretive with time.

Positive performance pre-deal may preclude future success. Our research revealed a positive correlation between the acquirer’s history of profitability and excess performance against peers post-acquisition. We noted this trend in banks with assets of less than $1 billion, and between $1 billion and $5 billion, at the time of announcement.

This correlation suggests that banks that were more profitable before a deal were increasingly likely to achieve incremental shareholder value through an acquisition.

Bank executives should feel comfortable pursuing deals knowing that the current marketplace rewards M&A in this sector. However, our experience indicates that in order to be successful, acquirers should approach transactions with a thoughtful alignment of M&A strategy with business strategy, an organized and vigilant approach to due diligence and integration, and trusted advisers to complement internal teams and ensure seamless transaction execution.

A Modest Yet Welcome Thaw for Banking M&A and Financial Stability

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mergers-4-18-17.pngAs part of approving the merger of $40.6 billion asset People’s United Financial Inc., with $2 billion asset Suffolk Bancorp, the Federal Reserve stated that, “[t]he [Federal Reserve] Board’s experience has shown that proposals involving an acquisition of less than $10 billion in assets, or that result in a firm with less than $100 billion in total assets, are generally not likely to create institutions that pose systemic risks” and that the Federal Reserve Board now presumes that such a proposal does not create material financial stability concerns, “absent evidence that the transaction would result in a significant increase in interconnectedness, complexity, cross-border activities, or other risk factors.”

Before the recent action, the Federal Reserve had since 2012 imposed very low thresholds under which it would presume no financial stability concerns exist. It only exempted acquisitions of less than $2 billion in assets or where the resulting firm would have less than $25 billion in total assets. Only a small number of transactions met these thresholds. The Federal Reserve reiterated its position, however, that it maintains the authority to review the financial stability implications of any proposal, specifically noting any acquisition regardless of size involving a global systemically important bank.

Through this action, the Federal Reserve has not only liberalized the key asset thresholds it previously established in 2012 for its evaluation of the financial stability factor in banking M&A, but also delegated authority to approve applications and notices that meet the newly revised thresholds to the Federal Reserve Banks. This revision has obvious parallels to recent statements from Chair Janet Yellen, Governor Tarullo and other Federal Reserve officials over the past few years (including as recently as December 2016) that the current $50 billion threshold for designation of a financial company as a systemically important financial institution (SIFI) may be too low. We believe that the delegation of authority to the Federal Reserve Banks could be at least as important, if not more important, as revisions to the financial stability thresholds because delegation should increase the chance that M&A transactions would proceed without the long delays that have recently been the norm in Federal Reserve Board reviews. Of course, all of the other requirements for delegation would also have to be met.

In support of this liberalization, the Federal Reserve cited its approval of a number of transactions over the past two years, including several transactions where the acquirer and/or resulting firm were over $100 billion or where the firm being acquired was over $10 billion and thus exceeded the newly revised financial stability thresholds. The increased thresholds and the delegation of authority to Federal Reserve Banks to process filings are welcome developments, especially for regional and community banking organizations that may be looking to acquire or be acquired. We would not, however, read the Federal Reserve’s actions as a strong signal that it expects or desires increased financial industry acquisitions or consolidation. The financial stability factor is only one of many that must be evaluated and questions will persist over how Community Reinvestment Act or fair lending concerns, anti-money laundering compliance, competition, general supervisory issues or public comment may affect a particular transaction. This action may, however, represent more formal support from the Federal Reserve for efforts to raise the $50 billion thresholds for SIFI designation and other purposes with a financial stability component under the Dodd-Frank Act.

Note: Another version of this article was initially published as a blog post on the Davis Polk FinRegReform blog on March 18, 2017.

Compliance Costs: How Does Your Bank Compare?

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compliance-9-8-16.pngBanks across the country are complaining about the costs of compliance, especially community banks, which have fewer resources.

Now, the Federal Reserve has done a detailed analysis of what those costs actually are. Taking a look at responses from more than 400 financial institutions surveyed in 2015 by the Conference of State Bank Supervisors, researchers Drew Dahl, Andrew Meyer and Michelle Clark Neely at the Federal Reserve Bank of St. Louis recently published findings that banks with less than $100 million in assets are spending roughly three times more relative to their expenses than banks from $1 billion to $10 billion in assets.

Those super-small banks spend roughly 8.7 percent of their noninterest expenses on compliance; while banks from $1 billion to $10 billion in assets spend 2.9 percent on average, the study found.

2014 Mean Compliance Expenses

  Asset Size Categories
<$100M $100M to $250M $250M to $500M $500M to $1B $1B to $10B
Data Processing Expense $27.6
1.5%		 $36.8
0.9%		 $82.0
0.9%		 $108.7
0.6%		 $188.3
0.4%
Legal Expense $4.6
0.2%		 $5.9
0.1%		 $20.0
0.2%		 $47.4
0.2%		 $134.9
0.2%
Accounting Expense $19.9
1.1%		 $31.6
0.7%		 $45.6
0.5%		 $57.7
0.3%		 $188.2
0.3%
Consulting Expense $11.7
0.6%		 $18.2
0.4%		 $24.0
0.3%		 $43.4
0.2%		 $129.1
0.2%
Personnel Expense $100
5.3%		 $176
3.9%		 $312
3.4%		 $507
2.8%		 $1,203
1.8%
Total Expense $163.8
8.7%		 $268.5
5.9%		 $483.6
5.3%		 $764.2
4.2%		 $1,843.5
2.9%
Number of Banks 113 154 121 45 36

Source: Federal Reserve.
NOTES: The sample consists of 469 commercial banks with assets under $10 billion that responded to the Conference of State Bank Supervisors’ survey in 2015 on operations in 2014 and for which complete data are available. Dollar amounts, expressed in thousands, represent means for banks in varying categories. Percentages are means within a category of the ratios of dollar amounts to overall noninterest expenses.

Arthur Johnson, chairman of United Bank in Grand Rapids, Michigan, says the notion that regulations are scalable based on the size of the institution “just isn’t true.” His bank, which has $560 million in assets, is contending with new mortgage disclosures and regulations put forth by the Consumer Financial Protection Bureau as part of the Dodd-Frank Act. People getting a residential mortgage these days have to look at paperwork that’s a quarter of an inch thick. Mortgage is a big part of the bank’s business model, so giving up on it is not an option, he says. Households want a checking account and they want a residential mortgage. “If we can have those two relationships we can feel we will be the primary institution for that household,’’ he says.

For the most part, mortgage activity has not been curtailed. A recent GAO report found that while banks say new regulations coming out of the Dodd-Frank Act have negatively impacted their banks, and their ability to offer some products such as nonqualified mortgages, the level of mortgage lending is actually on the increase.

“The results of surveys we reviewed suggest that there have been moderate to minimal initial reductions in the availability of credit among those responding to the various surveys and regulatory data to date have not confirmed a negative impact on mortgage lending,” the report said.

Paul Schaus, president and CEO of CCG Catalyst, a consulting group, says banks tell him frequently that they are spending more money on compliance than years past. Ten years ago, a community bank might have one compliance officer and a $200,000 budget for compliance. Now, it has five to six employees and a $1 million budget, even though nothing else has changed about the bank.

Some of the biggest compliance headaches involve the Bank Secrecy Act, he says. Even though the law is the same as it has been for many years, enforcement has become tougher, he says. Banks are buying monitoring systems to track transactions, which when first installed, trigger an avalanche of activity that must be analyzed by employees.

He thinks the costs of compliance are among several issues leading to more consolidation among banks. A bank with $400 million in assets can merge with another bank and become one with $800 million in assets that combines its compliance functions.

Another solution short of merging is to narrow the bank’s focus and cut costs that way. A lot of small, community banks still are trying to be everything to everyone, and that’s not going to cut it, Schaus says. “You need to differentiate yourself,’’ he says.

Johnson says his bank is looking at its options to grow to become more efficient, which might mean buying another bank. With five full-time employees working on compliance, two of them lawyers, the cost of compliance has become quite high. “I’ve been here for 45 years and I never thought we’d be big enough to hire our own in-house lawyer,’’ he says.

Julie Stackhouse, the executive vice president for banking supervision at the St. Louis Fed, says she hears all the time that community banks are struggling under the weight of compliance, but they have other problems too, including low interest rates and slow growth in many of the small communities where they do business.

“The costs clearly are being attributed to consumer compliance laws and regulations, and there have been several new ones; and the ongoing costs of BSA and anti-money laundering legislation, which has been here for some time,” she says. She says banks are spending more on computer systems to help with compliance and BSA.

Highly Rated Banks Don’t Spend More
Further, researchers analyzed whether banks who spend more on compliance have better management ratings on regulatory exams than banks who spend less. Apparently, that wasn’t the case. Other factors, such as the ability of management, the audit committee and auditors to work together to properly focus oversight attention, may better determine management ratings than the sheer number of dollars you spend on compliance, the researchers found.

In fact, for very highly rated banks under $100 million in assets, which received a “1” rating on their management score, the spend was about 6.8 percent of noninterest expenses, compared to 9.1 percent on average for everybody else in their size category.

There are obviously problems comparing your banks with others in your asset class. Some banks may have relatively high expenses because they do business in expensive cities such as San Francisco, or because they have expensive but highly profitable business models, so it doesn’t always make sense to compare your bank with an average.

Overall, though, Stackhouse thinks the study will be very useful. “Having research that supports analysis of the issues is going to be very useful for us going forward,’’ she says.

What Does the $10 Billion Asset Barrier Mean For Banks?

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ThePurposefulBanker.jpgCrossing the $10 billion asset threshold has a big impact on a growing bank, due to enhanced regulations mandated by the Dodd-Frank Act. In March, Bank Director President & CEO Al Dominick sat down with Dallas Wells of PrecisionLender for “The Purposeful Banker” podcast, to explain the implications of crossing the $10 billion mark, and what banks should do to prepare for it.

  • Implications of Being a $10 Billion Asset Bank
  • M&A and Scale
  • Infrastructure and Talent
  • Technology

Transcript excerpt:

Dallas Wells: Welcome to another episode of “The Purposeful Banker,” a podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today’s best bankers. I’m Dallas Wells, and thank you for joining us.

Today, we’re talking about the $10 billion asset threshold and why it has become so critically important for banks. To help us with this conversation, I’m joined by one of the industry’s foremost experts on bank strategy, Al Dominick. Al is the president and CEO at Bank Director and has lots of commentary out there about how banks are handling this exact issue. Al, welcome and thank you so much for taking the time to do this.

Al Dominick: Yeah, my pleasure. Great to be a part of this.

Dallas Wells: Al, for anyone who might not be familiar, tell us a little bit about yourself and what you all do at Bank Director…

For a complete transcript of this “The Purposeful Banker” podcast, please view here.