The Bumpy Road Ahead

Banks are in the risk business, and 2023 is shaping up to be a risk-on environment that will keep management teams busy. 

The transformation of last year’s tailwinds into this year’s headwinds is stunning. Slowing economic growth, driven by monetary policy aimed at halting inflation, could translate into weaker loan growth. Piper Sandler & Co. analysts expect net interest margins to peak in the first quarter, before being eroded by higher deposit costs. Credit costs that cannot go any lower may start to rise. Banks may see little boost from fee income and may grapple with controlling expenses. Piper Sandler expects that financial service firms will have a “bumpy” 2023. 

The environment is so novel that Moody’s Analytics Chief Economist Mark Zandi made headlines by describing a new phenomenon: not a recession but a coming “slowcession — growth that comes to a near standstill but that never slips into reverse.” The research firm is baking a slowcession into its baseline economic forecast, citing “generally solid” economic fundamentals and well-capitalized banks, according to a January analysis.

This great uncertainty — and the number of ways banks can respond to it — is on my mind as I get ready for Bank Director’s 2023 Acquire or Be Acquired conference, which will run from Jan. 29-31 in Phoenix. Is growth in the cards this year for banks, and what would it look like? 

Historically, growth has been a necessity for banks. As long as banks can generate growth that outpaces the costs of that growth, they can generate increased earnings. Banks grow their asset base organically, or through mergers and acquisitions, have been two popular ways to generate growth. In a slowdown, some banks may encounter attractive opportunities to buy other franchises at a discount. But growth won’t be in the cards for all — and maybe that’s a blessing in disguise.

“[W]ith the threat of a recession and dramatically increasing cost of funds, there is a solid argument to be made that banks should be shrinking rather than growing,” wrote Chris Nichols in a recent article. Nichols is the director of capital markets at the $45 billion banking company known as SouthState Corp., in Winter Haven, Florida. Growth can exacerbate issues for banks that are operating below their cost of capital, which can push them toward a sale faster. Instead, he’s focused on operational efficiency.

“Financial pressure will be greater, and bank margins will be higher. This combination means that banks will need to focus on the quality of their earnings,” he wrote. Instead of growth, he argued bankers should focus on making their operations efficient, which will direct more profits toward their bottom line.

It makes sense. In a bumpy slowcession, banks aren’t able to control the climb of interest rates and the subsequent changes in economic activity. They may not encounter growth opportunities that set them up for long-term success in this type of environment. But they can control their operational efficiency, innovation and execution — and we’ll talk about that at #AOBA23.

How Banks Can Grab a Slice of the $11 Trillion B2B Pie

A team of economists at the Federal Reserve has tracked noncash payment trends in the U.S. since 2001, including the number and value of transactions across all major payment methods.

Leveraging their December 2021 Payments Study update, Visa’s Business Solutions team estimates there were 2.9 billion B2B checks for an estimated $11.8 trillion. This represents 26% of all checks paid by U.S. depository institutions and 57% of paid check dollar value, based on the Fed’s 2018 Check Sample Survey. Given the ongoing decline in check use by U.S. consumers, we suspect the B2B share is likely even higher today.

Despite decades of decline in check use, check displacement is still a massive growth opportunity for electronic payments, particularly for commercial card. For context, commercial card rails process an estimated $500 billion in business spend — equivalent to just 4% percent of the value of B2B checks, according to McKinsey & Co.’s U.S. Payments Map estimating 2020 U.S. commercial card spend at $485 billion.

Readers are likely familiar with the traditional challenges to commercial card acceptance by suppliers: card processing fees, manual processing of virtual card payments, accounts receivable reconciliation, among others. These challenges are real, but payments innovators are making strides on these daily. For example, let’s consider the inertia by corporate buyers who write all these checks. According to the Fed’s last Check Sample Survey, 82% of B2B checks were for $2,500 or less; 55% were for $500 or less.

These low-value transactions can be paid via a commercial card, right? Unfortunately, too few buyers feel motivated to pursue these opportunities. Often the return on investment feels too low to track down all the data about where these checks are going and then convince suppliers to accept card. Generating a consolidated spend file may require tapping into multiple systems with disparate data structures. In the end, fewer than half of a company’s suppliers are likely to accept commercial cards. It’s no wonder decision makers don’t jump at the chance when bank salespeople ask for a spend file simply to determine if there’s an opportunity worth pursuing.

A New Operating Model
But what if that weren’t the model? What if we took the burden of finding opportunities away from the corporate client entirely? What if a card salesperson showed up at the door with a credible opportunity already in hand? There’s one model that client banks can tap into that does just that.

Each of the 2.9 billion B2B checks paid every year is paid by a financial institution. Most financial institutions (or their processors) use optical character recognition (OCR) in the daily processing of those checks. By repurposing OCR data from checks, banks can identify which suppliers their corporate customers are paying that already accept commercial card, and then pinpointing which business bank customers have the greatest opportunity to shift check spend with those suppliers to card. These banks’ salespeople no longer begin a client conversation by asking for a spend file. Instead, they present a credible analysis, based on the client’s own payments volume processed by the bank.

What used to be a data mining project for the client becomes a simple, data-driven decision about how to move forward. Banks are in a unique position to approach business customers about these opportunities. Without the deposit relationship, commercial card salespeople must use the old model.

If it sounds too good to be true, it’s not. But it does take work. Some could make the argument that the easy growth in commercial card is over; that commercial card issuers are in a race to the bottom. We are more optimistic than that. We believe there is a tremendous, untapped opportunity out there: an $11.8 trillion pie in the form of 2.9 billion B2B checks.

How to Level the Playing Field Through Buy Now, Pay Later

Buy now, pay later (BNPL) has exploded over the last few years and its momentum shows no signs of slowing. In fact, BNPL payments orders grew 85% and revenue increased 88% during Thanksgiving, Black Friday and Cyber Monday compared to the week before, according to Adobe Analytics. Not only is BNPL taking a growing share of lending from many community banks, BNPL platforms are now beginning to move into credit and debit card products too, potentially further eroding banks’ opportunities, and worse, the relationships with their current customers. Fortunately, several white-label solutions are now entering the market, enabling banks to meet the demands for BNPL and to better compete and retain market share of the customer’s wallet.

However, the increased usage and adoption of these solutions has also begun to highlight some of the problems this payment option can pose for both consumers and lenders alike. While it can present an easy way to buy items on credit, every purchase becomes multiple payments to manage and, unsurprisingly, 42% of BNPL users have missed a payment, with 33% of users overdrafting their checking accounts in just one month. As more of today’s borrowers take on an increasing number of BNPL payments, the chance for delinquencies will rise, especially for those customers living paycheck-to-paycheck. Keeping track of BNPL payments in addition to other expenses can get complicated quickly, and for many, one missed loan, credit card or bill payment could mean a long-term hit to their credit scores (and potentially a default for the lending bank).

With BNPL’s popularity and accessibility, it is unlikely to be going away anytime soon, so the question becomes how can banks make BNPL products better and safer for their customers while mitigating their risk? Luckily, banks have several advantages over pure-play fintechs they can leverage to deliver a superior BNPL experience.

  1. If limiting BNPL offerings to current customers, banks can use customer history to make ability-to-pay judgments prior to extending BNPL credit. Not only will this control potential losses, but it will also enable banks to make stronger offerings, whether providing more credit or as a tie-in with other products (e.g., bumped-up deposit account rates, reduced annual credit card fees, free overdraft protection).
  2. While banks can only encourage ACH autopay for BNPL payments, alternatively, they can require repayment through payroll-linked payments. This allows customers to simply “set it and forget it,” avoiding the need to manage multiple payment schedules for various purchases. It could also serve as an incentive to set up direct deposit for customers who are not already doing so (or to move their direct deposit).
  3. Banks can provide tracking tools for their BNPL customers. One key issue with BNPL is that the loans are not typically reported to credit bureaus (although some providers have started). This makes it impossible for lenders to know how many outstanding BNPL loans a customer has (referred to as “stacking” by the CFPB). It is also difficult for customers to track their payments, so banks can add real value by providing visibility, both for themselves as well as for their customers. Additionally, tracking provides greater insights to enhance future ability-to-pay decisions, allowing banks to continue improving their offerings.
  4. Banks should be fully transparent and go the extra mile for their disclosures. Per the Consumer Financial Protection Bureau, loans with four-or-less payments are not required to provide cost-of-credit disclosures, but doing so can be very useful for the customer. Clearly explaining that while BNPL is interest-free for them, the retailer is paying a fee in exchange for a sale, helps ensure customers better understand the process. Banks can even provide broad guidance on BNPL products for their customers, further enabling them to make good decisions about which payment method is best.
  5. Banks can create a big cross-selling opportunity by tying a debit card and, potentially, rewards points to a BNPL offering. This could be particularly effective with millennials and Gen Z customers who tend to be higher users of BNPL (and often lack or do not trust credit cards). While debit cards are not big money-makers for banks, they can act as effective relationship-builders that open the door for traditional deposit accounts and other products over time.

Consumer appetite for BNPL products is growing, as are the number of platforms available to meet that demand. In fact, many national banks are either in the process or have already rolled out their own BNPL offerings. While competition is increasing, the good news is that options like white-label solutions offer community banks the tools to become leaders in this popular market and can help level the playing field.

What’s more, as the CFPB introduces new regulations covering BNPL, banks’ competitive advantage versus pure-play BNPL players will likely increase, as most will be much better positioned to adapt and comply with future regulations. Today’s community banks should consider their options now and develop their BNPL strategies to both retain their existing customer relationships and compete for new ones in the future.

How Bank Compliance Teams Can Champion Micro-Innovation

Despite the compliance group’s reputation as a dream-crushing, idea-stomping wielder of power, they actually do want to help the rest of the bank succeed in delighting customers and clients.

It’s time to approach digital transformation as the new normal for banks. The best way to do that is to get compliance teams on board early — and the best way to accomplish that is by practicing micro-innovation. Micro-innovations are incremental changes that run parallel to proven processes, allowing nimble, modern organizations to try new approaches or strategies without sapping time and attention from what’s known to work.

Jeffery Kendall, the CEO of Nymbus and my colleague, says it best: “Modern organizations know that incremental innovation at a quick pace usually wins, compared to spending years developing a single product.”

The key for banks is to start talking with compliance when the bright idea is forming — not when the work is done. When teams are on the same page from the start, compliance can be an invaluable partner that can help balance risk throughout your micro-innovation strategy.

Align Teams From the Start
Start by including front-line staff and, yes, even compliance, when it’s time to set micro-innovations in motion. Long-tenured employees can be change generators. A recent study showed that the average American customer stays with the institution connected to their primary checking account for 14 years. Chances are, some of them have a relationship with tellers and lobby staff who understand their frustrations better than anyone and can bring these insights to the planning table.

Involving compliance from the outset can uncover what’s possible, rather than just reinforcing what can’t be done. By including compliance early, you can enliven achievable possibilities through micro-innovations. Start with monthly level-setting conversations and a deep dive into what projects and initiatives are on the horizon. Include teams in product development, sales, marketing and compliance so the bank is aligned on opportunities and goals from the start.

Find the Compliance Sweet Spot
Banks face a challenging operating environment; for compliance and risk, it’s also an opportunity to innovate. To support innovation in this landscape, compliance officers can ask themselves “How can we get where we want to go?” and “Where are the boundaries?”

In reality, most of a bank’s biggest processes, procedures and inefficiencies route through the risk compliance organizations at some point. This makes compliance staff natural advocates for change. Because they own the processes, empowered compliance officers are well positioned to understand nuance and identify opportunities for improvement and change.

Siya Vansia, chief brand and innovation officer at ConnectOne Bancorp in Englewood Cliffs, New Jersey, notes that when she stepped into her role, she “stopped hiring for innovation” and “started building internal advocates.” By working with compliance and others throughout the organization, Vansia creates a culture of innovation that looks for opportunities instead of tallying roadblocks.

With 70% of banks saying the Great Resignation has challenged their ability to carry out compliance requirements, some are considering unconventional hiring to fill jobs. As your institution prepares for 2023, prioritize retention and employee satisfaction to retain the talent you have on hand.

Digitize Progress, Not Inefficiencies
It can be tempting for banks to build an app and migrate longstanding inefficiencies onto a new digital platform. That’s a missed opportunity for positive change and customer loyalty.

“The future is about making banking better and connected, not simply having a cool app with a lot of features,” says Corey LeBlanc, cofounder and chief operating and chief technology officer of Fort Lauderdale, Florida-based Locality Bank.

As your institution identifies targets for micro-innovations, examine existing processes to ensure they still fit what your customers need and want. Look for opportunities to remove inefficient and cumbersome practices and simplify the customer experience. Even one or two steps in a process can add up over a customer journey; incremental improvements can have a significant impact on satisfaction. Compliance here can be a tool to identify inefficient processes. Leverage these same techniques to assess your people, resources and strategies. Start now with small changes that can have an innovative impact right away.

Your bank’s compliance office doesn’t have to be a “no” factory. Compliance teams can help banks build delightful experiences that matter to their customers — especially when they’re aligned on solving the problem from the start.

It can be daunting to assemble a 2023 strategic plan that hits the key performance indicators, solves the issues and makes digital a reality — all at once. So don’t. Instead, divide and conquer with micro-innovations that allow your institution to take small and mighty steps toward growth and change without delay.

Venture Capital Funds Remain Hungry for Fintechs

Fintech investment isn’t drying up, so much as resetting from rabid to rational. That’s the assessment of several bank-backed fintech investment funds, where interest in striking deals remains high.

“Given the reset in valuations, more disciplined cash burn in the companies we are looking at and record deal flow, it’s a great environment for us and I expect us to step up our pace of investments in 2023,” says Adam Aspes, general partner at JAM Special Opportunity Ventures.

Over the past two years, its JAM FINTOP joint venture has raised about $312 million from a network of more than 90 bank investors to put into promising fintech and blockchain technology. It has two funds with a five-year investment period, “so we are still in the very early days of deploying capital,” Aspes says.

Regulators have signaled that they’ll be scrutinizing bank-fintech partnerships more closely and reviewing how well compliance issues are addressed. That might have unsettled some venture capitalists, especially those from outside the industry who are sometimes referred to as fintech “tourists.” But Aspes is unphased.

“We have always had a thesis [that] there would be greater emphasis on fintechs being compliant with a bank’s regulated rails,” he says. “So, I don’t think our investment thesis has changed, but I think the market is definitely moving in our direction,” especially in the areas of blockchain technology and banking as a service, or BaaS.

Activity at the venture capital divisions of the largest U.S. banks has not cooled off significantly either, says Grant Easterbrook, a fintech consultant.

“While the total dollars involved may be down relative to 2021 — as firms retrench in a down market and valuations fall — I am not seeing any signs of a major pullback from fintech,” Easterbook says. “Banks know that technology continues to be both a weakness and an opportunity, and they are looking for deals.”

Carey Ransom, managing director of the BankTech Ventures fund, is on the hunt for “real solutions to real problems,” and thinks the fintech shakeout will benefit investors like him. His goal is to find fintechs that can be of value to the more than 100 community banks in his fund by advancing their digital transformation efforts in some way. So the fund isn’t just injecting capital, but helping the fintechs grow.

“We have increasing relevance in a market shift like this,” Ransom says. “We have a very clear value proposition.”

In his view, the market had gotten out of whack with all the free-flowing money over the last year. Now the focus is on more sensible valuation metrics. “Some of it is just returning back to the right valuations and fundamentals,” he says.

David Francione, managing director and head of fintech at Capstone Partners in Boston, has a similar take, pointing out that 2021 skewed perceptions in more ways than one. With the pent-up demand following the Covid-19 pandemic, “2021 was a record year by anybody’s imagination for any metric.”

He notes that investment in fintechs for this year is up compared to the years prior to 2021, so he thinks the dramatic drop-off needs to be put into perspective. “If you strip out 2021, and you look at the prior three or so years before that, this year is still a record year, relatively speaking,” Francione says.

Still, he would not be surprised if there is a lull in activity, given factors like the geopolitical environment and the threat of a recession.

“I think this year is sort of a transition year. Things are probably taking a little bit longer to finance. At least that’s what we’re seeing in some of the transactions that we’re in,” says Francione, whose firm was recently acquired by the $179 billion Huntington Bancshares in Columbus, Ohio. “I would call it more of a pause than anything.”

Like Ransom, Francione thinks the pause could benefit banks that want to partner with fintechs. Francione’s advice to fintechs is to reflect on what they can do to solve a problem that banks — or more importantly, the bank’s customers — have.

“A lot of these fintechs that we’re talking to, they think, ‘Oh, this bank could be interesting.’ But sometimes they don’t really understand why and what they can really do for them. So they really have to peel back the onion and figure out: Who are their customers? Is it a similar target market? What are some of their needs? Does our technology solution address those needs? Can they integrate easily? What is the real value that they’re going to bring to this potential bank partnership, whether the partnership is in the form of an investment or is strictly a partnership to resell some of its products?”

Ransom says he has been in meetings where fintech executives come in saying they are out to disrupt banks. Then they find out that Ransom works with banks and because they need to raise money, “mid-conversation they shift their tone to, ‘Maybe I can help banks,’” he says.

His top recommendation to fintech executives that want to work with BankTech Ventures is to understand the value their technology can provide to community banks. “If we have to explain it, they’ll lack credibility,” Ransom says.

The fintech founders who tend to be a fit for his fund — which is backed by banks ranging in size from $200 million to $20 billion in assets — are less flashy and more pragmatic. The ideal founders also have taken care to capitalize the fintech properly.

“Don’t raise $100 million for a business that’ll sell for $200 million,” Ransom says. “That’s a change we have seen — which I see as healthy.”

Those that take on too much money create a situation where the risk is no longer worth the potential return for investors. But the total amount raised is not the only concern; the types of investments can also be an issue.

He believes some fintechs take on too much “preference capital,” the outside money that gets priority for returns over common shares, which the founding executives tend to own. If the executives think they are unlikely to get paid, it misaligns incentives and creates a risk that they could decide to leave the fintech, Ransom says.

If some fintechs are in a sudden scramble to cut expenses, slow the cash burn and move from growth to profitability faster, fintech analyst Alex Johnson suggests that it is to be expected after the heady cash free-for-all that prevailed last year.

“Between 2019 and 2021, money was just too readily available. A lot of tourists — founders looking to get rich quickly and generalist VC firms sitting on massive piles of cash — wandered into fintech and screwed stuff up,” Johnson writes in a recent edition of his Fintech Takes newsletter.

A growth-over-everything mindset prevailed and a lot of bad behavior got overlooked. “One example: the alarming amount of first-party fraud that has been tolerated by neobanks in recent years,” he writes. “And now we are all suffering through the hangover.”

Leveraging Innovations to Double Down Where Fintechs Can’t Compete

For years, financial technology companies, or fintechs, have largely threatened the domain of big banks. But for community banks — perhaps for the first time — it’s getting personal. As some fintechs enter the lending domain, traditional financial institutions of all sizes can expect to feel the competitive impact of fintechs in new ways they cannot afford to ignore.

The good news is that fintechs can’t replicate the things that make local community banks special and enduring: the relational and personal interactions and variables that build confidence, trust and loyalty among customers. What’s even better is that local financial institutions can replicate some of the fintechs playbook — and that’s where the magic happens.

It’s likely you, the board and bank management understand the threat of fintech. Your bank lives it every day; it’s probably a key topic of conversation among the executive team. But what might be less clear is what to do about it. As your institution navigates the changing landscape of the banking industry, there are a few topics to consider in creating your bank’s game plan:

  • Threat or opportunity? Fintechs give consumers a number of desirable and attractive options and features in easy-to-navigate ways. Your bank can view this as a threat — or you can level up and find a way to do it better. Your bank should start by identifying its key differentiators and then elevating and leveraging them to increase interest, engagement and drive growth.
  • It’s time for a culture shift. Relationships are not built through transactions. Banks must move from transactional to consultative by investing time, talent and resources into the relational aspects of banking that are best done in-person. They also need to find ways to meet the transactional needs of consumers in low friction, efficient ways.
  • It’s not about you … yet. Step outside of the services your bank directly provides. Think of your institution instead as a connector, a resource and trusted advisor for current and prospective consumers. If your bank doesn’t provide a certain service, have a go-to referral list. That prospect will continue to come back to you for guidance and counsel and one day soon, it will be for the service you provide.
  • What’s in your toolbox? What is the highest and best use of your team’s time? What are your team members currently spending time on that could be accomplished more efficiently through an investment in new, different or even fintech-driven tools? By leveraging technology to streamline operations, your bank can benefit from efficiencies that create space and time for staff to focus on relationship-building beyond the transaction.
  • Stop guessing. You could guess, but wouldn’t you rather know? Banks have access to an incredible amount of data. Right now, many financial institutions are sitting on a treasure trove of data that, when activated appropriately, can help target and maximize growth efforts. Unlocking the power of this data is key to your financial institution’s growth and evolution; data drives action, offering valuable insight into consumer behaviors, preferences and needs.

Your bank can adopt a view that fintechs are the enemy. Or it can recognize that fintechs’ growth stems from an unmet consumer need — and consider what it means for your bank and its products and services. The key is doubling down on the who, what and why that is unique to your brand identity, and capitalizing on the opportunity to highlight and celebrate what makes your bank stand out, while simultaneously evolving how your institution determines and delivers against your consumers’ needs.

Banking During a Time of Uncertainty

The following feature appeared in the fourth quarter 2022 edition of Bank Director magazine. It and other stories are available to magazine subscribers and members of Bank Director’s Bank Services Membership Program. Learn more about subscribing here.

For John Asbury, CEO at Atlantic Union Bankshares Corp., a $19.7 billion bank headquartered in Richmond, Virginia, concerns about the direction of the U.S. economy have a familiar feel to them. It was just two years ago that Asbury and the rest of the banking industry were staring into the abyss of an economic catastrophe caused by the Covid-19 pandemic.

The U.S. economy shrank 31.2% in the second quarter of 2020 when the country was put into lockdown mode to fight the pandemic. And while the economy made a dramatic recovery, growing 38% the following quarter, it was a time of great uncertainty for the nation’s banks as they dealt with an unprecedented set of economic and operational challenges.

For bankers like Asbury, it’s déjà vu in 2022.

“Once again we find ourselves in a period of great uncertainty — which is a familiar place to be,” says Asbury. This time the economic challenges come from a sharp rise in inflation, which came in at 8.5% in July — well above the Federal Reserve’s target rate of just 2%. The Fed clearly misread this sudden increase in inflation, thinking it was driven primarily by supply chain disruptions coming out of the pandemic, and now is trying to catch up with a fast-moving train.

Year to date through September, the Fed’s rate setting body — the Federal Open Market Committee — raised the federal funds rate five times, including three successive rate increases of 75 basis points each, bringing the upper limit of the target rate to 3.25%. It’s been a long time since the Fed raised interest rates by such a substantial margin in so short a time. The FOMC was scheduled to meet again in November and December, and Federal Reserve officials indicated in September that rates could reach 4.4% by year-end.

During the early days of the pandemic, the Federal Reserve also pumped money into the economy through a policy tool called quantitative easing, where it bought long-term securities from its member banks. Earlier this year, the Fed began to reverse that policy to reduce liquidity in the economy, which should help boost interest rates.

The result has been a dual economic outlook, with the immediate future looking more promising than it has in years — but with the longer-term prospects clouded by the threat of inflation and the Federal Reserve’s determination to bring it to heel. Rising interest rates are generally a boon to most banks, but there is a threshold point at which higher rates can lead to a prolonged economic downturn — which is not good for banks or most other companies.

“It remains to be seen what [the Fed] will do when push comes to shove but at least for now, it looks like they’re more concerned about reining in inflation than any of the effects — like a slowdown — that such actions could cause,” says R. Scott Siefers, managing director and senior research analyst at the investment bank Piper Sandler & Co.

The challenge for banks is plotting a course through such a confusing landscape. Do they push for loan growth at the beginning of an economic slowdown of unknown depth and duration, or adopt a more conservative posture toward credit? Should they compete for deposits as funding costs inevitably go up, or be content to let some of their excess funding run off? And lurking in the background is the risk that the Federal Reserve ends up tipping the economy into a deep recession as it seeks to choke off inflation.

By a traditional definition, the U.S. economy has already entered a shallow recession. The country’s gross domestic product, which is the monetary value of all goods and services produced in a specific time period, was -1.4% in the first quarter and -0.9% in the second quarter. Recessions are generally thought of as two quarters of economic contraction, but a variety of factors and data are part of that consideration. The Business Cycle Dating Committee, which is part of the National Bureau of Economic Research, is the group that declares when the U.S. is in recession and has yet to declare this current cycle one.

By other measures, however, the economy is doing surprisingly well. The country’s unemployment rate in August was just 3.7% — down from a peak of 13.2% in May 2020 — and the economy added over 500,000 new jobs in July and another 315,000 in August. In another piece of good news, August’s inflation rate was 8.3%, down from 8.5% in July and 9.1% in June, offering a glimmer of hope that the Fed’s rate hikes are beginning to work.

And in many respects, the experience of bankers on the ground is also at odds with the economic data. “What I’ve found myself saying as I speak to our clients and to our teams is that I feel better than I do when I simply read the financial press,” says Asbury. “Despite all the uncertainty, we’re actually in a pretty good place at the moment. Asset quality remains very benign. We see no end in sight to that, which is one of the more astonishing aspects of the whole pandemic, continuing even to now. Liquidity is still very good. We would have expected to see more deposit runoff than we have. It’s really all about business and consumer sentiment, which seems to be going up and down … The reality is that we’re in a pretty good spot.”

Ira Robbins, chairman and CEO at Valley National Bancorp, a $54.4 billion regional bank headquartered in Wayne, New Jersey, offers a similar assessment. In addition to New Jersey, the bank also does business in New York, Alabama and Florida. And a bank’s experience during an economic downturn may depend on its geographic location, because not all regions of the country are affected equally. “I’m sitting in Florida today, and it doesn’t feel like a recession here at all,” says Robbins in a recent interview. The economy might fit the traditional definition of a mild recession, but that doesn’t seem to bother him very much.

“I really don’t think it’s all that relevant to be honest with you,” he says. “When I look at the behavior of our consumers and commercial customers, we would say we’re not in a recession based on activity, based on spending habits, based on the desire to still have capital investments. When it comes to commercial endeavors, the economy still feels very, very strong.”

Valley National is a large residential lender, and Robbins says that the rise in interest rates has chilled the mortgage refinancing market and made it more difficult for first-time home buyers looking for an entry-level home. “But general activity in the purchase market is still very strong,” he says. “The Florida market is still on fire for us. Prices really haven’t abated yet. And the demand is still very strong in the market from a residential perspective.” Commercial real estate activity, including multi-family housing, is also booming in Florida thanks to the continued influx of people from out of state, according to Robbins. “We still have many of our borrowers — developers — looking to this footprint to grow,” he says. “And the rise in interest rates really hasn’t impacted their desire to be in this market.”

Valley National is also seeing a lot of multi-family development in the Jersey City, New Jersey market, where the bank is an active lender. “We have an environment where the supply hasn’t kept up with demand for a long time,” Robbins says. “Irrespective of what’s going on in the interest rate environment, there’s still a lot of people demanding newer product that just isn’t available to them today.”

If Asbury and Robbins see the current economic situation from a glass-half-full perspective, Tim Spence, CEO at $207 billion Fifth Third Bancorp in Cincinnati, Ohio, sees it as half empty. Spence has chosen to position the bank more conservatively given the economy’s uncertain outlook going into 2023. “We’ve elected to be more cautious as it relates to the outlook than many others have been,” he says. That caution has manifested itself in tougher expense control, “paring around the margins in terms of the lending activity” and using swaps to protect the bank’s net interest margin should the Fed end up cutting interest rates in the future, Spence explains.

While the U.S. economy may be slowing down, there are other factors that should buoy the industry’s profitability through the remainder of 2022. Most banks benefit from a rising rate environment because they can reprice their commercial loans faster than market competition forces them to reprice their deposits.

Deposit costs have yet to increase upward even as interest rates have shot up dramatically, and there is still a lot of liquidity in the country’s banking system. Siefers points to Fed data that deposits grew 0.6% in the first half of the year and remarks in an email exchange that he’s “been surprised at how resilient the deposit balances were. The conventional wisdom is that commercial balances have been looking for other homes, while consumer [deposits] have [gone] higher. Net/net, very little movement in total balances.”

One of the dichotomies in the economy is the industry’s strong loan growth despite the evidence of a slowdown. Citing Federal Reserve data, Siefers points out that loans excluding Paycheck Protection Program loans grew 5.5% in the first half of the year. While it might seem counter-intuitive that loans would grow while the economy is cooling off, Tom Michaud, CEO of investment bank Keefe, Bruyette & Woods, says that many commercial borrowers have been returning to the loan market after staying out during the early days of the pandemic. “The government took much of the role of lending out of the industry’s hands with the Paycheck Protection Program and other support elements,” he says. “And then after Covid started, most middle market corporations didn’t see any reason to increase borrowing a lot until they had a better feeling about the economy.”

The industry’s asset quality has also remained at historically low levels and along with the Fed’s interest rate hikes, has created what Siefers calls a “Goldilocks environment” with rising margins, strong loan growth and benign credit trends.

This will likely lead to higher profitability in the latter half of the year. “You’re going to see a significant expansion in bank net interest margins in the third and fourth quarters — the likes of which we’ve probably not seen in a couple of decades, because you’re going to have the cumulative impact of the May, June and July rate hikes flowing into the third and fourth quarters,” says Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities.

The dichotomy between low deposit costs and higher rates won’t last forever, of course. David Fanger, a senior vice president at Moody’s Investors Service, says that deposit rates typically move very little during the first 100 basis points in rate hikes when the Federal Reserve begins to tighten its monetary policy. And even when they do begin to move upward, it’s never on a one-to-one basis. “Even at the end of the [last] rate hike cycle, deposit rates increased only 30% of the increase in [the federal funds rate],” says Fanger. Once deposit rates do begin to rise — certainly in 2023 if not later this year as the Fed continues its tight monetary policy — that will probably cut into the expanding net interest margin that most banks are currently enjoying, although Fanger does not expect the industry’s margin to contract unless loan growth drops significantly.

What probably will change, however, is a decline in the industry’s liquidity level as banks decide not to compete for excess funds that seek out higher rates than they are willing to pay. Through a combination of federal stimulus legislation like the CARES Act, passed in March 2020 during the Trump administration, and the American Rescue Plan Act, passed in March 2021 during the Biden administration, along with $800 billion in PPP loans that banks originated and the Fed’s quantitative easing policy, trillions of dollars were pumped into the economy during the pandemic. Much of this money ended up on banks’ balance sheets at historically low interest rates. (The federal funds rate in May 2020 was 0.05%.) As rates rise, some of the money will start looking for a higher return.

“I don’t think banks are going to manage their companies just for the absolute level of deposits,” says Michaud. “I believe they’re going to manage their deposits as the market becomes more competitive for deposits relative to the size of their loan portfolio or what they believe is the size of their core bank. Some banks even started doing that in the second quarter. They were happy to let deposits run out of the bank, and they were more willing to focus on their core deposits.”

While it’s possible that the inflation rate peaked in June, Michaud doesn’t expect the central bank to begin lowering the fed funds rate anytime soon. “I think, if anything, the Fed is going to wait to see the outcome from their policy actions to ensure that inflation has gone back down to the level that they wish to see,” he says.

Asbury is of the same mind. “There have been lots of studies that suggest that if the Fed backs off too quickly, that will be a bad thing,” he says. “So, I don’t think rates are coming down anytime too soon.”

In fact, in late summer, there was a disconnect between the fed funds futures market and information coming out of the Federal Reserve. Activity in the futures market implied that the Fed would cut rates next year, even though messaging coming out of the central bank strongly suggested otherwise. The Fed’s summary of economic projections, which includes its dot plot chart that reflects each Fed official’s estimate of where the fed funds rate will be at the end of each calendar year three years into the future, suggests that the median rate will be 4.4% at the end of this year and 4.6% at the end of 2023.

And in a speech at the Federal Reserve Bank of Kansas City’s annual policy symposium in Jackson Hole, Wyoming, in late August, Federal Reserve Chairman Jerome Powell warned that “[r]educing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth and softer labor conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.”

Translation: If it takes a recession to bring the inflation rate back down to 2%, so be it.

Inflation has several direct effects on bank profitability. Like most other industry sectors, banks have seen their employment costs rise in a tight job market. “We’ve had to make adjustments, and we continue to look at what needs to be done to remain competitive for front line, client-facing teammates,” says Asbury. “The war for talent is raging.” Valley National also gave raises that went into effect in June, 5% to those making less than $65,000 a year, and 3.5% for those earning between $65,000 and $75,000 a year. “Those are permanent raises,” says Robbins. “It’s going to cost us almost $5 million a year in increased salary expense. So, we have to do a much better job on the revenue side to make sure we’re generating enough to support those expenses.”

The sharp rise in interest rates has also led to an increase in bond yields, which has impacted those banks that over the last two years used their excess deposits to invest in lower yielding securities. This has resulted in unrealized losses in their accumulated other comphrensive income — or AOCI — line. While these losses are not charged against a bank’s net income or its regulatory capital if the securities are being held for investment rather than trading purposes, they still impact its tangible common equity capital ratios “and industry observers watch that,” says Michaud.

But the biggest impact of inflation is how it drives the Federal Reserve’s monetary policy. Rising interest rates help fatten the industry’s net interest margin, but they also hike the debt service costs for corporate borrowers as their loans reprice higher. And some of those companies may end up defaulting on their loans in a longer, deeper recession.

As bankers look at the uncertainty hanging over the economy going into 2023, it’s important to give increased attention to customer communication and credit risk analysis. “Banks that have underwriting processes that have survived through multiple economic cycles and that are extremely client-centric will do better,” predicts Poonawala at Bank of America Securities.

“This is an appropriate time to step up communication with the client base, and we are doing that,” says Asbury. “You also have to run sensitivity analyses in terms of the impact of higher borrowing costs. We do this in the normal course of underwriting. Even when rates were at absolute historic lows, we still made credit decisions [by] running scenarios of higher rates and their capacity to service debt and repay in a higher rate environment. That’s just good banking.”

For his part, Robbins sees no need to pull Valley National back from its core commercial borrowers, even with the economy cooling off. “Seventy percent of our commercial origination comes from recurring customers,” he says. “Many of them have been through interest rate environments that have historically been much higher. Their ability to operate in this type of environment isn’t something that really concerns us.” Interest rates would have to go much higher before many of the bank’s core borrowers, particularly in an asset class like multi-family housing, where the demand for new product is high, would pull back from the market, Robbins says.

The larger risk occurs when banks stray beyond their comfort zone in search of yield or volume.

“Because we’ve been in a declining net interest margin environment, banks have been stretching to get into new geographies or asset classes they don’t have any real experience with,” Robbins says. And in an economic downturn, “banks that have done that but haven’t done it in the proper way are going to have real challenges,” he adds.

The difference in perspective may be more nuanced than truly material, but Spence at Fifth Third takes a more cautious view of the future beyond 2022. “From our point of view, it is a challenging environment to understand because the Fed has never had to move at the pace it has,” he says. “We’re coming off 15 years of zero or near-zero interest rates, and an environment where central banks were the largest bond buyers in the world. Now all of a sudden, they’re bond sellers.” Factor in the continued supply chain challenges that were initially driven by the pandemic but are now being accentuated by the war in Ukraine, along with a tight labor market, and it’s a very uncertain time.

Spence outlines three steps that Fifth Third has taken to address this uncertainty. First, the bank is spending even more time thinking about concentration risk. “Are we lending to sectors of the economy … that are going to be more resilient in any environment?” he says. On the consumer side, that has meant more emphasis on super prime customers and homeowners, and less on subprime borrowers even though they pay higher rates. And on the commercial side, that translates into greater focus on commercial and industrial loans to provide inventory financing, equipment purchases and working capital, and less emphasis on commercial real estate and leveraged lending.

Second, Fifth Third has used various hedging strategies to protect its balance sheet for a time when the Fed eventually loosens its monetary policy and begins to lower rates. Spence says the bank has added $10 billion in fixed-rate swaps to build a floor under its net interest margin for the next 10 years.

And finally, the bank is prepared for a scenario in which the Fed has to drive interest rates much higher to finally curb inflation. “In that case, nothing is more important than the quality of your deposit book,” says Spence, who believes that Fifth Third has a strong core deposit franchise.

Spence worries much less about the consequences of being too conservative than being too reckless. “In a business like ours that’s susceptible to economic cycles, the single most important thing that you can do is ask yourself what happens if I’m wrong,” he says. “From my point of view, if we are wrong, then we gave up a couple of points of loan growth in a given year that we can just get back later.”

Becoming a CEO

The chief executive officer is usually the single most important person in any organization, but it’s a job that most individuals grow into over time. The transition is often filled with challenges and difficult learning experiences.

Such was the case for Ira Robbins, the chairman and CEO at Valley National Bancorp, a $54 billion regional bank headquartered in Wayne, New Jersey. The 48-year-old Robbins was just 43 when he succeeded long-time CEO Gerald Lipkin in 2018. Lipkin, on the other hand, was closing in on his 77th birthday when he passed the baton to Robbins after running the bank for 42 years.

Robbins is deeply respectful of Lipkin but shares that one immediate challenge he faced was changing a culture that hadn’t kept pace with the bank’s growth over the years. He said Valley National was a $20 billion bank that operated as if it was still a $5 billion bank. Changing that culture was not easy, and he had to make some very difficult personnel decisions along the way.

Robbins is thoughtful, introspective and candid about his growth into the CEO role at Valley National. His reflections should be of great interest to any banker who hopes to someday become a CEO.

This episode, and all past episodes of The Slant Podcast, are available on Bank DirectorSpotify and Apple Music.

Giving Customers Choice, Access With Investments

It’s time for community financial institutions to significantly upgrade their investment resources to service their clients. Retail investors want to be more educated about investing opportunities and have greater access to investment tools; in response, investment-as-a-service companies are building platforms so banks can give their clients more of what they want.

One problem with financial and investment innovation today is that there is either too much focus on gimmicks or not enough focus on innovation. Crypto-only investment companies indiscriminately pitch every token as the latest and greatest get-rich-quick scheme. Gamified investment apps promote risky options trades to retail investors, turning investing into a lottery or casino and distracting users from what investing should be: a powerful tool to maintain, protect and build wealth. Further, legacy investment institutions often make the bulk of their revenue from customers who are already wealthy via older products, with little incentive to experiment with creative new offerings.

In this unhappy mix, it is investors with the most to gain from a long-term investing strategy — younger less affluent or not yet rich investors — who lose the most. Unable to access wealth management and investing services from their trusted financial institution, they seek out third-party investment apps that don’t prioritize their long-term success and happy retirement. For community financial institutions, this interrupts the chain of familial wealth transfer and risks their next generation of customers.

Investors desire a unified platform that offers access to a growing list of investments, ranging from physical metals to AI-driven investment models to crypto-assets to collectibles. A self-directed platform is key: Investors should be given a choice to pursue the investment strategy they feel fits best for their unique investment interests and risk profile. The platform should include all the tools they need to effortlessly pursue the “Get rich slowly” strategy: passive investing and dollar-cost averaging into a low-cost, highly diversified portfolio.

Cloud computing innovations and numerous rounds of fintech venture capital have made it possible for companies to build curated investment platforms that traditional banks can easily add and implement. Investment tools driven by application program interfaces, or APIs, allow financial services to embrace change in collaborative ways that don’t conflict with existing business, yet still appeal to the ever-changing preferences of investors.

Investing is not one-size-fits-all. Wine fans may want to invest in a portfolio of wine assets to hold or eventually redeem. Investors who collected baseball cards as a kid may now have the capital to buy collectibles with significance to them as culturally relevant assets. Individuals also may want to invest in thematic categories, like semiconductors — the foundation for all computing, from electric vehicles to computers to smartphones. These investments are not optimal for everyone, but they don’t have to be for everyone. What matters most is access.

Too many banking platforms do not take full advantage of the full range of investment tools available in the marketplace, even though their clients are looking for these. Lack of access leads to painful experiences for the average investor who wants to be both intelligent with their money and allowed to experiment and explore the ever-changing world of digitally available investment categories. Give customers a choice to pursue wealth-building strategies based on their unique insights and instincts, and made available through their existing bank.

Optimize Fintech Spending With 3 Key ROI Drivers

Bankers are evaluating their innovation investments more closely as customer expectations continue to skyrocket and margins shrink. Technology spending shows no sign of slowing any time soon. In fact, Insider Intelligence forecasts that U.S. banks’ overall technology spending will grow to an estimated $113.71 billion in 2025, up from $79.49 billion in 2021.

The evolution of the fintech marketplace is challenging banks to strategically choose their next fintech project and calculate the return on those investments. How do they ensure that they’re spending the money in the right places, and with the right providers? How can they know if the dollars dedicated toward their tech stack are actually impacting the bottom line? They can answer these key questions by evaluating three key ROI drivers that correlate with different stages of the customer journey: acquire, serve and deepen or broaden.

The first ROI driver, acquire, relates to investments focused on customer acquisition that are often the main focus of new technology initiatives — for good reason. Technology that supports customer acquisition, such as account opening or loan origination, makes bold claims about reducing abandonment and driving higher conversion rates. However, these systems can also lead to a disjointed user experience when prospects move between different systems, each with their own layout and aesthetic.

When bankers search for solutions that improve customer acquisition, they should ensure the solution provides the level of flexibility required to meet and exceed customer expectations. A proof of concept as part of the procurement process can help the bank validate the claims made by the fintechs under consideration. Remember: A tool that is more configurable on the front-end likely requires more up-front work to launch, but should pay dividends with a higher conversion rate. A style guide that describes the bank’s design principles can help implementation go smoother by ensuring new customers enjoy a visually consistent, trustworthy onboarding experience that reinforces their decision to open the account or apply for the loan.

The next ROI driver, serve, is about critically evaluating customer service costs, whether that’s achieved through streamlining internal processes, integrating disparate systems or empowering customers with self-service interfaces. While these investments are usually aimed at increasing profitability, they often contribute to higher customer satisfaction.

An often-overlooked opportunity is to delegate and crowdsource content through nonbank messaging channels, like YouTube or Reddit. A Gartner study found that millennials and Gen Z customers prefer third-party customer service channels; some customers even reported higher satisfaction after resolving their issue via outside channels. A majority of financial services leaders say they are challenged to provide enough self-service options for customers; those looking to address that vulnerability and improve profitability and customer satisfaction may want to explore self-service as a compelling way to differentiate.

The final ROI driver is about unlocking growth by pursuing strategies that deepen or broaden your bank’s relationships with existing customers while expanding the strategic core of the company. A study by Bain & Co. evaluated the effectiveness of different growth moves performed by 1,850 companies over a five-year period. Researchers found six types of growth strategies that outperformed: expand along the value chain, grow new products and services, use new distribution channels, enter new geographies, address new customer segments and finally, move into the “white space” with a new business built around a strong capability.

The key to any successful innovation initiative is to view it not as a one-time event, but rather a discipline that becomes central to your institution’s strategic planning. Bain found that the average companies successfully launches a new growth initiatives only 25% of the time. However, that rate more than doubles when organizations embrace innovation as a cyclical process that they practice with rigor and discipline.

As your bank seeks to better prioritize, optimize and evaluate its fintech investments, carefully consider these three key ROI drivers to identifying where the greatest need stands can help. This will ensure your institution’s valuable technology dollars and employee efforts are spent wisely for both the benefit of the customer and growth of the bottom line.