Earnings Are High but Bank Stock Prices Are Low

Banks are doing very well, if you look at credit quality and profitability. But tell that to investors.

Last week, the Federal Open Market Committee raised the target federal funds rate by 75 basis points, the third hike of that magnitude in a row, to combat inflation.

The market has punished equities lately in response, but even more so, bank stocks, probably in anticipation of a recession that may have arrived. The S&P 500 fell 21.61% in 2022 as of Friday, Sept. 23, but the S&P U.S. large cap bank index was down 25.19% in that same time frame, according to Mercer Capital using S&P Global Market Intelligence data. By asset size, large banks have seen the biggest declines so far this year.

Going back further in time, the cumulative return for U.S. bank stocks in general, as measured by the S&P U.S. BMI Banks index, was down 5.30% as of Sept. 22 from the start of 2020, compared to a gain of 21.55% for the S&P 500.

Investors’ dim view of bank stocks belies the underlying strengths of many of these banks. Bank net income of $64.4 billion in the second quarter was higher than it had been in the same quarter of 2018 and 2019, according to the Federal Deposit Insurance Corp. Since 2019, in fact, bank profitability has been going gangbusters. Rising interest rates improved net interest margins, a key profitability statistic for many banks. Plus, loan growth has been good.

And credit quality remains high, as measured by the noncurrent loan and quarterly net charge-off rates at banks, important bank metrics tracked by the FDIC. Despite weaknesses in mortgage and wealth management, this combination of variables has made many banks more profitable than they were in 2018 or 2019.

“Earnings are excellent right now, and they’re going to be even better in the third and fourth quarter as these margins expand,” says Jeff Davis, managing director of Mercer Capital’s financial institutions group.

Investors don’t seem to care. “It’s been a real frustration and a real incongruity between stock prices and what’s going on with fundamentals,” says R. Scott Siefers, managing director and senior research analyst at Piper Sandler & Co. “You’ve had a year of really great revenue growth, and really great profitability, and at least for the time being, that should continue. So that’s the good news. The bad news is, of course, that investors aren’t really as concerned with what’s going on today.”

Worries about a possible recession are sending investors away from bank stocks, even as analysts join Davis in his prediction of a pretty good third and fourth quarter for earnings this year. The reason is that investors view banks as sensitive to the broader economy, Siefers says, and think asset quality will deteriorate and the costs of deposits will rise eventually.

The place to see this play out is in two ratios: price to earnings and price to tangible book value. Interestingly, price to tangible book value ratios have remained strong — probably a function of deteriorating bond values in bank securities’ portfolios, which is bringing down tangible book values in line with falling stock prices. As a result, the average price to tangible book value as of Sept. 23 was 1.86x for large regional bank stocks and 1.7x for banks in the $10 billion to $50 billion asset range, according to Mercer Capital.

Meanwhile, price to earnings ratios are falling. The average price to earnings ratio for the last four quarters was 10.3x for large regional banks, and 11.4x for mid-sized bank stocks. (By way of comparison, the 10-year average for large cap bank stocks was 13.4x and 14.6x for mid cap bank stocks, respectively.)

For bank management teams and the boards that oversee them, the industry is entering a difficult time when decisions about capital management will be crucial. Banks still are seeing loan growth, and for the most part, higher earnings are generating a fair amount of capital, says Rick Childs, a partner at the tax and consulting firm Crowe LLP. But what to do with that capital?

This might be the perfect time to buy back stock, when prices are low, but that depletes capital that might be needed in a recession and such action might be viewed poorly by markets, Childs says. Davis agrees. A lot of companies can’t or won’t buy back their own stock when it’s gotten cheap, he says. “If we don’t have a nasty recession next year, a lot of these stocks are probably pretty good or very good purchases,” he says. “If we have a nasty recession, you’ll wish you had the capital.”

It’s tricky to raise dividends for the same reason. Most banks shy away from cutting dividends, because that would hurt investors, and try to manage to keep the dividend rate consistent, Childs says.

And in terms of lending, banks most certainly will want to continue lending to borrowers with good credit, but may exercise caution when it comes to riskier categories, Davis says. Capital management going forward won’t be easy. “If next year’s nasty, there’s nothing they can do because they’re stuck with what’s on the balance sheet,” he says. The next year or two may prove which bank management teams made the right decisions.

Safeguarding Credit Portfolios in Today’s Uncertain Economic Landscape

Rising interest rates are impacting borrowers across the nation. The Federal Open Market Committee decided to raise the federal funds rate by 75 basis points in its June, July and September meetings, the largest increases in three decades. Additional increases are expected to come later this year in an attempt to slow demand.

These market conditions present significant potential challenges for community institutions and their commercial borrowers. To weather themselves against the looming storm, community bankers should take proactive steps to safeguard their portfolios and support their borrowers before issues arise.

During uncertain market conditions, it’s even more critical for banks to keep a close pulse on borrower relationships. Begin monitoring loans that may be at risk; this includes loans in construction, upcoming renewals, loans without annual caps on rate increases and past due loans. Initiating more frequent check-ins to evaluate each borrower’s unique situation and anticipated trajectory can go a long way.

Increased monitoring and borrower communication can be strenuous on lenders who are already stretched thin; strategically using technology can help ease this burden. Consider leveraging relationship aggregation tools that can provide more transparency into borrower relationships, or workflow tools that can send automatic reminders of which borrower to check in with and when. Banks can also use automated systems to conduct annual reviews of customers whose loans are at risk. Technology can support lenders by organizing borrower information and making it more accessible. This allows lenders to be more proactive and better support borrowers who are struggling.

Technology is also a valuable tool once loans is classified as special assets. Many banks still use manual, paper-based processes to accomplish time consuming tasks like running queries, filling out spreadsheets and writing monthly narratives.

While necessary for managing special assets, these processes can be cumbersome, inefficient and prone to error even during the best of times — let alone during a potential downturn, a period with little room for error. Banks can use technology to implement workflows that leverage reliable data and automate processes based directly on metrics, policies and configurations to help make downgraded loan management more efficient and accurate.

Fluctuating economic conditions can impact a borrower’s ability to maintain solid credit quality. Every institution has their own criteria for determining what classifies a loan as a special asset, like risk ratings, dollar amounts, days past due and accrual versus nonaccrual. Executives should make time to carefully consider evaluating their current criteria and determine if these rules should be modified to catch red flags sooner. Early action can make a world of difference.

Community banks have long been known for their dependability; in today’s uncertain economic landscape, customers will look to them for support more than ever. Through strategically leveraging technology to make processes more accurate and prioritizing the management of special assets, banks can keep a closer pulse on borrowers’ loans and remain resilient during tough times. While bankers can’t stop a recession, they can better insulate themselves and their customers against one.

Growth Milestone Comes With Crucial FDICIA Requirements

Mergers or strong internal growth can quickly send a small financial institution’s assets soaring past the $1 billion mark. But that milestone comes with additional requirements from the Federal Deposit Insurance Corp. that, if not tackled early, can become arduous and time-consuming.

When a bank reaches that benchmark, as measured at the start of its fiscal year, the FDIC requires an annual report that must include:

  • Audited comparative annual financial statements.
  • The independent public accountant’s report on the audited financial statements.
  • A management report that contains:
    • A statement of certain management responsibilities.
    • An assessment of the institution’s compliance with laws pertaining to insider loans and dividend restrictions during the year.
    • An assessment on the effectiveness of the institution’s internal control structure over financial reporting, as of the end of the fiscal year.
    • The independent public accountant’s attestation report concerning the effectiveness of the institution’s internal control structure over financial reporting.

Management Assessment of Internal Controls
Complying with Internal Controls over Financial Reporting (ICFR) requirements can be exhaustive, but a few early steps can help:

  • Identify key business processes around financial reporting/systems in scope.
  • Conduct business process walk-throughs of the key business processes.
  • For each in-scope business process/system, identify related IT general control (ITGC) elements.
  • Create a risk control matrix (RCM) with the key controls and identity gaps in controls.

To assess internal controls and procedures for financial reporting, start with control criteria as a baseline. The Committee of Sponsoring Organizations (COSO) of the Treadway Commission provides criteria with a fairly broad outline of internal control components that banks should evaluate at the entity level and activity or process level.

Implementation Phases, Schedule and Events
A FDICIA implementation approach generally includes a four-phase program designed with the understanding that a bank’s external auditors will be required to attest to and report on management’s internal control assessment.

Phase One: Business Risk Assessment and COSO Evaluation
Perform a high-level business risk assessment COSO evaluation of the bank. This evaluation is a top-down approach that allows the bank to effectively identify and address the five major components of COSO. This review includes describing policies and procedures in place, as well as identifying areas of weakness and actions needed to ensure that the bank’s policies and procedures are operating with effective controls.

Phase One action steps are:

  • Educate senior management and audit committee/board of directors on reporting requirements.
  • Establish a task force internally, evaluate resources and communicate.
  • Identify and delegate action steps, including timeline.
  • Identify criteria to be used (COSO).
  • Determine which processes and controls are significant.
  • Determine which locations or business units should be included.
  • Coordinate with external auditor when applicable.
  • Consider adoption of a technology tool to provide data collection, analysis and graphical reporting.

Phase Two: Documenting the Bank’s Control Environment
Once management approves the COSO evaluation and has identified the high-risk business lines and support functions of the bank, it should document the internal control environment and perform a detailed process review of high-risk areas. The primary goals of this phase are intended to identify and document which controls are significant, evaluate their design effectiveness and determine what enhancements, if any, they must make.

Phase Three: Testing and Reporting of the Control Environment
The bank’s internal auditor validates the key internal controls by performing an assessment of the operating effectiveness to determine if they are functioning as designed, intended and expected.  The internal auditor should help management determine which control deficiencies, if any, constitute a significant deficiency or material control weakness. Management and the internal auditor should consult with the external auditor to determine if they have performed any of the tests and if their testing can be leveraged for FDICIA reporting purposes.

Phase Four: Ongoing Monitoring
A primary component of an effective system of internal control is an ongoing monitoring process. The ongoing evaluation process of the system of internal controls will occasionally require modification as the business adjusts. Certain systems may require control enhancements to respond to new products or emerging risks. In other areas, the evaluation may point out redundant controls or other procedures that are no longer necessary. It’s useful to discuss the evaluation process and ongoing monitoring when making such improvement determinations.

3 Ways to Help Businesses Manage Market Uncertainty

Amid mounting regulatory scrutiny, heightened competition and rising interest rates, senior bank executives are increasingly looking to replace income from Paycheck Protection Program loans, overdrafts and ATM fees, and mortgage originations with other sources of revenue. The right capital markets solutions can enable banks of all sizes to better serve their business customers in times of financial uncertainty, while growing noninterest income.

Economic and geopolitical conditions have created significant market volatility. According to Nasdaq Market Link, since the beginning of the year through June 30, the Federal Reserve lifted rates 150 basis points, and the 10-year Treasury yielded between 1.63% and 3.49%. Wholesale gasoline prices traded between $2.26 and $4.28 per gallon during the same time span. Corn prices rose by as much as 39% from the start of the year, and aluminum prices increased 31% from January 1 but finished down 9% by the end of June. Meanwhile, as of June 30, the U.S. dollar index has strengthened 11% against major currencies from the start of the year.

Instead of worrying about interest rate changes, commodity-based input price adjustments or the changing value of the U.S. dollar, your customers want to focus on their core business competencies. By mitigating these risks with capital market solutions, banks can balance their business customers’ needs for certainty with their own desire to grow noninterest income. Here are three examples:

Interest Rate Hedging
With expectations for future rate hikes, many commercial borrowers prefer fixed rate financing for interest rate certainty. Yet many banks prefer floating rate payments that benefit from rising rates. Both can achieve the institution’s goals. A bank can provide a floating rate loan to its borrower, coupled with an interest rate hedge to mitigate risk. The bank can offset the hedge with a swap dealer and potentially book noninterest income.

Commodity Price Hedging
Many commercial customers — including manufacturers, distributors and retailers — have exposure to various price risks related to energy, agriculture or metals. These companies may work with a commodities futures broker to hedge these risks but could be subject to minimum contract sizes and inflexible contract maturity dates. Today, there are swap dealers willing to provide customized, over-the-counter commodity hedges to banks that they can pass down to their customers. The business mitigates its specific commodity price risk, while the bank generates noninterest income on the offsetting transaction.

International Payments and Foreign Exchange Hedging
Since 76% of companies that conduct business overseas have fewer than 20 employees, according to the U.S. Census Bureau, there is a good chance your business customers engage in international trade. While some choose to hedge the risk of adverse foreign exchange movements, all have international payment needs. Banks can better serve these companies by offering access to competitive exchange rates along with foreign exchange hedging tools. In turn, banks can potentially book noninterest income by leveraging a swap dealer for offsetting trades.

Successful banks meet the needs of their customers in any market environment. During periods of significant market volatility, businesses often prefer interest rate, commodity price or foreign exchange rate certainty. Banks of all sizes can offer these capital markets solutions to their clients, offset risks with swap dealers and potentially generate additional income.

How Technology Fosters Economic Opportunity and Success

Is your bank promoting financial literacy and wellness within the communities you serve?

The answer to that question may be the key to your bank’s future. For many community financial institutions, promoting financial wellness among historically underserved populations is directly linked to fostering resilience for individuals, institutions and communities.

Consider this: 7 million households in the United States didn’t have a bank account in 2019, according to the Federal Deposit Insurance Corp.; and up to 20 million others are underserved by the current financial system. Inequities persist along racial, geographical and urban lines, indicating an opportunity for local institutions to make an impact.

Many have already stepped up. According to the Banking Impact Report, which was conducted by Wakefield Research and commissioned by MANTL, 55% of consumers said that community financial institutions are more adept at providing access to underrepresented communities than neobanks, regional banks or megabanks. In the same study, nearly all executives at community institutions reported providing a loan to a small business owner who had been denied by a larger bank. And 90% said that their institution either implemented or planned to implement a formal program for financial inclusion of underserved groups.

Technology like online account origination can play a critical role in bringing these initiatives to life. Many forward-thinking institutions are actively creating tools and programs to turn access into opportunity — helping even their most vulnerable customers participate more meaningfully in the local economy.

One institution, 115-year-old Midwest BankCentre based in St. Louis, is all-in when it comes to inclusion. The bank partnered with MANTL to launch online deposit origination and provide customers with convenient access to market-leading financial products at competitive rates.

Midwest BankCentre has also committed $200 million to fostering community and economic development through 2025, with a focus on nonprofits, faith-based institutions, community development projects and small businesses for the benefit ofr historically disinvested communities. The bank offers free online financial education to teach customers about money basics, loans and payments, buying a home and paying for college, among others.

Midwest BankCentre executives estimate that $95 out of every $100 deposited locally stays in the St. Louis region; these dollars circulate six times throughout the regional economy.

In a study conducted in partnership with Washington University in St. Louis, researchers found that Midwest Bank Centre’s financial education classes created an additional $7.1 million in accumulated wealth in local communities while providing critical knowledge for household financial stability.

“When you work with a community banker, you are working with a neighbor, friend, or the person sitting next to you at your place of worship,” says Danielle Bateman Girondo, executive vice president of marketing at Midwest BankCentre. “Our customers often become our friends, and there’s a genuine sense of trust and mutual respect. Put simply, it’s difficult to have that type of relationship, flexibility, or vested interest at a big national bank.”

What about first-time entrepreneurs? According to the U.S. Bureau of Labor Statistics, approximately 33% of small businesses fail within 2 years. By year 10, 66.3% have failed.

Helping first-time entrepreneurs benefits everyone. Banks would gather more deposits and make more loans. Communities would flourish as more dollars circulate in the local economy. And individuals with more paths to economic independence would prosper.

For Midwest BankCentre, one part of the solution was to launch a Small Business Academy in March 2021, which provides practical education to help small businesses access capital to grow and scale.

The program was initially launched with 19 small businesses participating in the bank’s partnership with Ameren Corp., the region’s energy utility, with a particular focus on the utility’s diverse suppliers. And 14 small business owners and influencers participated in the bank’s partnership with the Hispanic Chamber of Commerce of Metro St. Louis. Midwest BankCentre teaches small businesses how to “think like a banker” to gain easier access to capital by understanding their financial statements and the key ratios.

Efforts like these might explain why, according to the Banking Impact Report, 69% of Hispanic small business owners and 77% of non-white small business owners believe it’s important that their bank supports underserved communities. Accordingly, non-white small businesses are significantly more likely to open a new account at a community bank or credit union: 70%, compared to 47% of white small businesses.

This can be a clear differentiator for a community bank: a competitive advantage in a crowded marketplace.

For today’s community banks, economic empowerment isn’t a zero-sum game; it’s a force multiplier. With the right strategies in place, it can be a winning proposition for the communities and markets within your institution’s sphere of influence.

What to Look for in New Cash and Check Automation Technology

Today’s financial institutions are tasked with providing quality customer experiences across a myriad of banking channels. With the increased focus on digital and mobile banking, bankers are looking for ways to automate branch processes for greater cost and time savings.

This need should lead financial institution leaders exploring and implementing cash and check automation solutions. These solutions can improve accuracy, reduce handling time and labor, lower cost, deliver better forecasting and offer better visibility, establish enhanced control with custom reporting and provide greater security and compliance across all locations, making transactions seamless and streamlining the branch experience. However, as bank leaders begin to implement a cash and check automation solution, they must remember how a well-done integration should operate and support the bank in its reporting and measurement functions.

Ask Yourself: Is This the Right Solution?
When a bank installs a new cash or check automation solution, the question that should immediately come to mind for a savvy operations manager is: “How well is this integrated with my current teller software?” Regardless of what the solution is designed to do, the one thing that will make or break its effectiveness is whether it was programmed to leverage all the available functionality and to work seamlessly with the banks’ existing systems.

For some financial institutions, the question might be as simple as: “Is this device and its functionality supported by my software provider?” If not, the bank might be left to choose from a predetermined selection of similar products, which may or may not have the same capabilities and feature sets that they had in mind.

The Difference Between True Automation and Not
A well-supported and properly integrated cash automation solution communicates directly with the teller system. For example, consider a typical $100 request from a teller transaction to a cash recycler, a device responsible for accepting and dispensing cash. Perhaps the default is for the recycler to fulfill that request by dispensing five $20 notes. However, this particular transaction needs $50 bills instead. If your cash automation solution does not directly integrate with the teller system, the teller might have to re-enter the whole transaction manually, including all the different denominations. With a direct integration, the teller system and the recycler can communicate with each other and adjust the rest of the transaction dynamically. If the automation software is performing correctly, there is no separate keying process alongside the teller system into a module; the process is part of the normal routine workflow within the teller environment. This is a subtle improvement emblematic of the countless other things that can be done better when communication is a two-way street.

Automation Fueling Better Reporting and Monitoring
A proper and robust solution must be comprehensive: not just controlling equipment but having the ability to deliver on-demand auditing, from any level of the organization. Whether it is a branch manager checking on a particular teller workstation, or an operations manager looking for macro insights at the regional or enterprise level, that functionality needs to be easily accessible in real time.

The auditing and general visibility requirements denote why a true automation solution adds value. Without seamless native support for different types of recyclers, it’s not uncommon to have to close and relaunch the program any time you need to access a different set of machines. A less polished interface tends to lead to more manual interactions to bridge the gaps, which in turn causes delays or even mistakes.

Cash and check automation are key to streamlining operations in the branch environment. As more resources are expanding to digital and mobile channels, keeping the branch operating more efficiently so that resources can focus on the customer experience, upselling premium services, or so that resources can be moved elsewhere is vital. Thankfully, with the proper cash and check automation solutions, bank leaders can execute on this ideal and continue to improve both the customer experience and employee satisfaction.

The Easiest Way to Launch a Digital Bank

New fintechs are forcing traditional financial institutions to acclimatize to a modern banking environment. Some banks are gearing up to allow these fintechs to hitchhike on their existing bank charters by providing application programming interfaces (APIs) for payments, deposits, compliance and more. Others are launching their own digital brands using their existing licenses.

Either way, the determining factor of the ultimate digital experience for users and consumers is the underlying technology infrastructure. While banks can spawn digital editions from their legacy cores through limited APIs and cobbled-up middleware, the key questions for their future relevance and resilience remain unanswered:

  1. Can traditional banks offer the programmability needed to launch bespoke products and services?
  2. Can they compose products on the fly and offer the speed to market?
  3. Can they remove friction and offer a sleek end-to-end experience?
  4. Can they meet the modern API requirements that developers and fintechs demand from banks?

If the core providers and middleware can’t help, what can banks use to launch a digital bank? The perfect springboard for launching a digital bank may lie in the operating system.

Removing friction at every touchpoint is the overarching theme around most innovation. So when it comes to innovation, why do banks start with the core, which is often the point in their system with the least amount of flexibility and the most friction?

When it comes to launching a digital bank, the perfect place for an institution to start is an operating system that is exclusively designed for composability — that they can build configurable components to create products and services — and the rapid launch of banking products. Built-in engines, or engines that can take care of workflows based on business rules, in the operating system can expedite the launch of financial services products, while APIs and software development kits open up the possibility for custom development and embedded banking.

That means banks can create products designed for the next generation of consumers or for niche communities through the “composability” or “programmability” offered by these operating systems. This can include teen accounts, instant payments for small and medium-sized business customers that can improve their cash flow, foreign exchange for corporate customers with international presence, domestic and international payments to business customers, tailored digital banking experiences; whatever the product, banks can easily compose and create on the fly. What’s more, they also have granular control to customize and control the underlying processes using powerful workflow engines. The operating system also provides access to centralized services like compliance, audit, notifications and reporting that different departments across the bank can access, improving operational efficiency.

Menu-based innovation through operating systems
The rich assortment of microservices apps offered in operating systems can help banks to launch different applications and features like FedNow, RTP and banking as a service(BaaS) on the fly. The process is simple.

The bank fills up a form with basic information and exercises its choice from a menu of microapps compiled for bankers and customers. The menu includes the payment rails and networks the bank needs — ACH, Fedwire, RTP, Swift — along with additional options like foreign exchange, compliance, onboarding and customer experiences like bulk and international payments, to name a few.

The bank submits the form and receives notification that its digital bank has been set up on a modern, scalable and robust cloud infrastructure. The institution also benefits from an array of in-built features like audit, workflows, customer relationship management, administration, dashboards, fees and much more.

Setting up the payment infrastructure for a digital bank can be as easy as ordering a pizza:

  1. Pick from the menu of apps.
  2. Get your new digital brand setup in 10 minutes.
  3. Train employees to use the apps.
  4. Launch banking products to customers.
  5. Onboard fintech partners through For-Benefit-Of Accounts (FBO)/virtual accounts.
  6. Offer APIs to provide banking as a service without the need for middleware.

The pandemic has given new shape and form to financial services; banks need the programmability to play with modular elements offered on powerful operating systems that serve as the bedrock of innovation.

The Opposite of Blissfully Unaware

There’s been an increasingly common refrain from bank executives as the United States moves into the second half of 2022: Risk and uncertainty are increasing.

For now, things are good: Credit quality is strong, consumer spending is robust and loan pipelines are healthy. But all that could change.

The president and chief operating officer of The Goldman Sachs Group, John Waldron, called it “among — if not the most —complex, dynamic environments” he’s seen in his career. And Jamie Dimon, chair and CEO of JPMorgan Chase & Co., changed his economic forecast from “big storm clouds” on the horizon to “a hurricane” in remarks he gave on June 1. While he doesn’t know if the impact will be a “minor one or Superstorm Sandy,” the bank is “bracing” itself and planning to be “very conservative” with its balance sheet.

Bankers are also pulling forward their expectations of when the next recession will come, according to a sentiment survey conducted at the end of May by the investment bank Hovde Group. In the first survey, conducted at the end of March, about 9% of executives expected a recession by the end of 2022 and 26.6% expected a recession by the end of June 2023. Sixty days later, nearly 23% of expect a recession by the end of 2022 and almost 51% expect one by the end of June 2023.

“More than 75% of the [regional and community bank management teams] we surveyed [believe] we will be in a recession in the next 12 months,” wrote lead analyst Brett Rabatin.

“[B]anks face downside risks from inflation or slower-than-expected economic growth,” the Federal Deposit Insurance Corp. wrote in its 2022 Risk Review. Higher inflation could squeeze borrowers and compromise credit quality; it could also increase interest rate risk in bank security portfolios.

Risk is everywhere, and it is rising. This only adds to the urgency surrounding the topics that we’ll discuss at Bank Director’s Bank Audit & Risk Committees Conference, taking place June 13 through 15 at the Marriott Magnificent Mile in Chicago. We’ll explore issues such as the top risks facing banks over the next 18 months, how institutions can take advantage of opportunities while leveraging an environmental, social and governance framework, and how executives can balance loan growth and credit quality. We’ll also look at strategic and operational risk and opportunities for boards.

In that way, the uncertainty we are experiencing now is really a gift of foresight. Already, there are signs that executives are responding to the darkening outlook. Despite improved credit quality across the industry, provision expenses in the first quarter of 2022 swung more than $19.7 billion year over year, from a negative $14.5 billion during last year’s first quarter to a positive $5.2 billion this quarter, according to the Federal Deposit Insurance Corp.’s quarterly banking profile. It is impossible to know if, and when, the economy will tip into a recession, but it is possible to prepare for a bad outcome by increasing provisions and allowances.

“It’s the opposite of ‘blissfully unaware,’” writes Morgan Housel, a partner at the investment firm The Collaborative Fund, in a May 25 essay. “Uncertainty hasn’t gone up this year; complacency has come down. People are more aware that the future could go [in any direction], that what’s prosperous today can evaporate tomorrow, and that predictions that seemed assured a few months ago can look crazy today. That’s always been the case. But now we’re keenly aware of it.”

3 Reasons to Add SBA Lending

There were nearly 32 million small businesses in the United States at the end of the third quarter in 2020, according to the Small Business Administration.

That means 99% of all businesses in this country are small businesses, which is defined by the agency as 500 employees or fewer. They employ nearly 50% of all private sector employees and account for 65% of net new jobs between 2000 and 2019.

Many of the nation’s newest businesses are concentrated in industries like food and restaurant, retail, business services, healthy, beauty and fitness, and resident and commercial services. This is a potentially huge opportunity for your bank, if it’s ready and equipped for when these entrepreneurs come to you for financing. But if your bank is not prepared, it may be leaving serious money on the table that could otherwise provide a steady stream of valuable loan income.

That’s because these are the ideal customers for a SBA loan. If that’s not something your bank offers yet, here are three reasons to consider adding SBA lending to the loan portfolio this year.

1. New Avenue for Long-Term Customers
Small business customers often provide the longest-term value to their banks, both in terms of fee income generated and in dollars deposited. But not having the right loan solution to help new businesses launch or scale means missing out on a significant and lucrative wave of entrepreneurial activity. That’s where SBA lending comes in.

SBA loans provide the right solution to small businesses, at the right time. It’s an ideal conversation starter and tool for your bank team to turn to again and again and a way to kick off relationships with businesses that, in the long run, could bring your bank big returns. It’s also a great option to provide to current small business customers who may only have a deposit relationship.

2. Fee Income With Little Hassle
In addition to deeper relationships with your customers, SBA lending is an avenue to grow fee income through the opportunity for businesses to refinance their existing SBA loans with your bank. It broadens your portfolio with very little hassle.

And when banks choose to outsource their SBA lending, they not only get the benefit of fee income, but incur no overhead, start up or staffing costs. The SBA lender service provider acts as the go-between for the bank and the SBA, and they handle closing and servicing.

3. Add Value, Subtract Risk
SBA loans can add value to any bank, both in income and in relationship building. In addition, the SBA guarantees 75% to 85% of each loan, which can then be sold on the secondary market for additional revenue.

As with any product addition, your bank is probably conscientious of the risks. But when you offer the option to refinance SBA loans, your bank quickly reduces exposure to any one borrower. With the government’s guarantee of a significant portion, banks have lots to gain but little to lose.

Unlocking Banking as a Service for Business Customers

Banking as a service, or BaaS, has become one of the most important strategic imperatives for chief executives across all industries, including banking, technology, manufacturing and retail.

Retail and business customers want integrated experiences in their daily lives, including seamlessly embedded financial experiences into everyday experiences. Paying for a rideshare from an app, financing home improvements when accepting a contractor quote, funding supplier invoices via an accounting package and offering cash management services to fintechs — these are just some examples of how BaaS enables any business to develop new and exciting propositions to customers, with the relevant financial services embedded into the process. The market for embedded finance is expected to reach $7 trillion by 2030, according to the Next-Gen Commercial Banking Tracker, a PYMNTS and FISPAN collaboration. Banks that act fast and secure priority customer context will experience the greatest upside.

Both banks and potential BaaS distributors, such as technology companies, should be looking for ways to capitalize on BaaS opportunities for small and medium-sized enterprises and businesses (SMEs). According to research from Accenture, 25% of all SME banking revenue is projected to shift to embedded channels by 2025. SME customers are looking for integrated financial experiences within relevant points of context.

SMEs need a more convenient, transparent method to apply for a loan, given that business owners are often discouraged from exploring financing opportunities. In 2021, 35% of SMEs in the United States needed financing but did not apply for a loan according to the 2022 Report on Employer Firms Based on the Small Business Credit Survey. According to the Fed, SMEs shied away from traditional lending due to the difficult application process, long waits for credit decisions, high interest rates and unfavorable repayment terms, and instead used personal funds, cut staff, reduced hours, and downsized operations.

And while there is unmet demand from SMEs, there is also excess supply. Over the last few years, the loan-to-deposit ratio at U.S. banks fell from 80% to 63%, the Federal Reserve wrote in August 2021. Banks need loan growth to drive profits. Embedding financial services for SME lending is not only important for retaining and growing customer relationships, but also critical to growing and diversifying loan portfolios. The time for banks to act is now, given the current inflection point: BaaS for SMEs is projected to see four-times growth compared to retail and corporate BaaS, according to Finastra’s Banking as a Service: Global Outlook 2022 report.

How to Succeed in Banking as a Service for SMEs
There are three key steps that any institution must take to succeed in BaaS: Understand what use cases will deliver the most value to their customers, select monetization models that deliver capabilities and enable profits and be clear on what is required to take a BaaS solution to market, including partnerships that accelerate delivery.

BaaS providers and distributors should focus on the right use case in their market. Banks and technology companies can drive customer value by embedding loan and credit offers on business management platforms. Customers will benefit from the increased convenience, better terms and shorter application times because the digitized process automates data entry. Banks can acquire customers outside their traditional footprint and reduce both operational costs and risks by accessing financial data. And technology companies can gain a competitive advantage by adding new features valued by their customers.

To enable the right use case, both distributors and providers must also select the right partners — those with the best capabilities that drive value to their customers. For example, a recent collaboration between Finastra and Microsoft allows businesses that use Microsoft Dynamics to access financing offers on the platform.

Banks will also want to focus on white labeling front‑to-back customer journeys and securing access to a marketplace. In BaaS, a marketplace model increases competition and benefits for all providers. Providers should focus on sector‑specific products and services, enhancing data and analytics to enable better risk decisions and specialized digital solutions.

But one thing is clear: Going forward, embedded finance will be a significant opportunity for banks that embrace it.