Lessons Gleaned From Bank Failures

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The postmortem regulatory reports on the failures of $209 billion Silicon Valley Bank and $110 billion Signature Bank are an emphatic reminder of the consequences of poor risk management.

Among the specific circumstances that contributed to their closures in spring 2023 is how their boards and management teams failed to effectively manage several core banking risks, including interest rate, liquidity and growth, according to reports from the Federal Reserve and the Federal Deposit Insurance Corp. The official reports confirm recent media reporting that indicated surprisingly lax risk management practices at the banks, both of which were some of the largest in the country. Community banks that may see themselves as having little in common with these large institutions can still glean insights from the reports — and perhaps, avoid their fates.

Santa Clara, California-based Silicon Valley Bank’s “rapid failure can be linked directly to its governance, liquidity, and interest rate risk-management deficiencies,” the Fed wrote. And the FDIC found that New York-based Signature Bank had weaknesses in “liquidity contingency planning, liquidity stress testing, and internal controls” that figured “prominently” in its failure.

Interest Rate Risk
“While interest rate risk is a core risk of banking that is not new to banks …, SVB did not appropriately manage its interest rate risk,” the Fed wrote. 

The bank’s interest rate risk (IRR) policy — which detailed how the bank would manage and measure interest rate risk — was vague. It didn’t specify which scenarios to run, how to analyze assumptions, how to conduct sensitivity analysis and it didn’t define back-testing requirements. The bank used “the most basic” IRR measurement available, despite its size.

Still, its models indicated the bank had a structural mismatch between repricing assets and deposit liabilities; as early as 2017, it identified breaches in its long-term IRR limits, the Fed wrote. But instead of addressing the “structural mismatch” between longer duration bonds and demand deposits, the bank adjusted its model to get better results.

“I lose count of the number of cognitive biases that got activated in their process — from confirmation bias and optimism bias to so much else,” says Peter Conti-Brown, an associate professor of financial regulation at The Wharton School at the University of Pennsylvania. “It is the most common story ever told: When you make big goals, you then try to rough up the ref so that you can get the outcomes you’re seeking. The ref in this case is basic bank accounting.” 

Additionally, Silicon Valley executives also removed interest rate hedges that would’ve protected it from rising rates, a move the Fed attributes to maintaining short-term profits instead of managing the balance sheet. 

“That’s more casino behavior than it is prudential behavior,” says Joe Brusuelas, chief economist at RSM US LLP. “It’s throwing the dice at a casino.”

Liquidity Risk
Both banks had an unusually large percentage of accounts that were over the $250,000 deposit insurance threshold, the withdrawals of which acutely contributed to their failures. 

“Uninsured deposits are considered higher risk as they are more prone to rapid runoff during reputational or financial stress than insured deposits,” the FDIC wrote. But Signature’s management didn’t develop a funds management policy or a contingency plan, in part because they didn’t believe those customer deposits would become volatile. 

“[Signature’s p]resident rejected examiner concerns about the stability of uninsured deposits as late as noon EST on March 10, 2023,” the FDIC wrote. New York regulators closed the bank on March 12. “[M]anagement’s lack of a well-documented and thoroughly tested liquidity contingency plan and its lack of preparedness for an unanticipated liquidity event were the root cause of the bank’s failure.”

Both management teams had assumptions around their deposit base that “just weren’t true” Brusuelas says. He adds that bank management teams now should reexamine their analytical framework around their liquidity risk management and strengthen governance policies and limits around their deposit mix.

The FDIC wrote that funds management practices should lay out how a bank will maintain sufficient liquidity levels, how it will manage unplanned or unanticipated changes in funding sources — like a number of large accounts withdrawing and how it will react and withstand changes in market conditions. The practices should also incorporate the costs of the backup liquidity or source of the liquidity, both of which may change under market stress.

Backup liquidity is crucial in times of stress. Silicon Valley Bank didn’t test its capacity to borrow at the Federal Reserve’s discount window in 2022; when the run started, it didn’t have appropriate collateral and operational arrangements in place to meet its obligations. 

Growth
“The fundamental risk of too much growth too fast is a failure of diversification,” Conti-Brown says. “Rapid growth comes [from] a sudden influx of funding … that goes into a small number of asset classes.” 

Both reports discuss how already-weak risk management was further exacerbated when the banks experienced rapid growth; risk management and control policies failed to increase in sophistication as deposits and assets grew. And neither bank seemed to revisit the appropriateness of risk management, governance and internal audit policies nor whether their boards had experience levels commensurate with the institutions’ new sizes as they grew.

Silicon Valley Bank’s growth “far outpaced the abilities of its board of directors and senior management,” the Fed wrote. “They failed to establish a risk-management and control infrastructure suitable for the size and complexity of [the bank] when it was a $50 billion firm, let alone when it grew to be a $200 billion firm.”

The reports make a compelling argument that active and constant risk management plays an important role in the long-term financial solvency, success and continued operations of banks. Boards and executives at institutions of all sizes can learn from the risk management failures at these banks and revisit the appropriateness of their risk management principals, policies and models as the economy continues to shift. 

“The goal of risk management is not to eliminate risk,” the Fed wrote. “but to understand risks and to control them within well-defined and appropriate risk tolerances and risk appetites.”

Risk issues like these will be covered during Bank Director’s Bank Audit & Risk Conference in Chicago June 12-14, 2023.

Keys to Serving ‘Risky’ Businesses

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Most banks focus on taking deposits, making loans and providing many other services for their retail and commercial customer channels. Recently, some institutions have opened their doors to riskier businesses — in particular, cannabis businesses. Banks that navigate those spaces successfully can offer lessons to other banks.

Failing to Prepare Is Preparing to Fail
The first and most important theme is extreme preparation. Before actually providing services to risky businesses of any kind, banks need to consider and prepare for the enhanced expectations of regulators and shareholders. Banks also need to appreciate where they may stand with the regulators, addressing any outstanding issues before going further.

Ahead of any conversation with regulators, bank executives should develop plans that cover the institution’s staffing, existing and future expertise, development of policies and procedures, compliance considerations, use of third parties, regulatory notices or approvals, market dynamics, growth expectations and ongoing risk management.

Regulators will want to understand how serving risky businesses fits into the bank’s strategic plans and will expect the board to have robust discussions that are especially focused on risk management. Regulators are particularly skeptical of new business lines that increase risk to the bank, its customers and ultimately, the deposit insurance fund. Bank executives should anticipate receiving heightened scrutiny of their plans for serving risky businesses.

Talk to Your Regulators
Talking to regulators about servicing risky businesses is really a bank’s second step. First, the bank needs to prepare to talk to them.

Executives and the board will need to do their homework to support their reasoning and analysis; they will need to demonstrate to regulators what the institution has already done and plans to do from a compliance, risk management and operational perspective.

Regulators will want to see details fleshed out in as much specificity as possible. Due to the increased risk and expectations in these areas, they may take the position that expanding into these business lines represents a change in the general character of the bank’s business, which may require specific filings or approvals from regulators. In any event, it is critical that executives have discussions with regulators before going to market.

Robust, Ongoing Risk Management
The third theme is robust and ongoing risk management. Risk management is a key element of bank examinations, often hammered home by examiners who want to provide a clear signal of their expectations. This is especially true with any bank seeking to provide services in riskier business areas.

It’s not enough to dust off old policies and add in the applicable key words for the new business. Banks need to tailor their policies and procedures to the specific businesses they’re looking to serve, including the flexibility for growth.

What many banks already understand is that regulators want to see a risk management framework that is tailored not only for the existing business, but more importantly, a framework developed to address the growth plans of the business lines. The framework needs to be robust in its current state and from a forward-looking standpoint: Is your bank’s risk management framework appropriate for today and tomorrow?

Patience
The final theme should come as no surprise: Patience is paramount for banks as they plan to engage with risky businesses. There is an extended timeline to work through; it will probably take longer than expected to work through details with regulators and seek necessary approvals. And it will certainly take time to develop and exercise the appropriate risk management framework that is flexible enough to address not only the current business, but also what the line of business might look like in the future.

These four themes are critical for any bank board and management team to consider and appreciate if they’re interested in working with risky businesses. Given the heightened risk, these conversations need to start in the boardroom, but there are many opportunities for those banks willing to put in the time and effort. These business lines are clearly not for every institution, but these themes apply to almost any new line of business — whether or not it might be considered risky.

This piece was originally published in the second quarter 2023 issue of Bank Director magazine.

3 Principles to Promote a Bank Culture of Innovation

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Many bank leaders I talk to are very aware of the importance of innovation in the face of a fast-paced, changing environment. Yet, they have trouble promoting change and adopting more modern and efficient processes and technology — contributing to the struggle of making their bank more innovative. While every institution is slightly different, I wanted to share a few practical approaches to achieve internally led innovation that were very effective during my 12 years at Alphabet’s Google and another six working with the most innovative community and regional banks.

A recent survey from McKinsey & Co. found that 84% of CEOs understand innovation is imperative to achieve growth, yet a mere 6% are satisfied with the level of innovation within their organizations. These numbers reinforce that executives have the desire to promote innovation, but continue to struggle with execution and strategy.

One of the main problems I see institutions having in their typical approaches to innovation is the reliance on external paid consultants instead of activating an existing resource within their bank: their own employees. Employees already have a deep understanding of issues that both they and customers experience with the existing services and technology stack and are in a unique position to generate ideas for improvements. Not to mention they are also highly motivated to drive these innovations to a successful completion.

Embracing this approach of where the innovation most likely comes will enable bank leadership to focus on creating an environment that is conducive for innovation. Here are three practical suggestions executives and boards should consider:

1. Make it “Safe” to Fail
The foundation of a successful bank business model includes managing risk, such as balancing the downside of defaulting loans with the benefit of interest income on performing loans. And just like it is impossible to benefit from interest income without risking the principle, it is not possible to innovate without trying some things that, in retrospect, do not work out as originally planned.

The key here is to make sure everyone in the organization knows it’s OK to try things and sometimes fail. Without trial and error, there is no reward. Organizations that minimize the negativity around failure and view it as an opportunity to become better are often the ones that are able to move forward and innovate.

2. Encourage “Bottom-Up” Ideation
Most are familiar with “top-down” change that stems from leadership teams and management. However, this approach makes it harder to innovate; in many cases, it ignores the unique context that front line employees have gleaned. These employees use the bank software and speak with customers, giving them a unique and very valuable perspective. They know what is causing pain and what modifications and improvements would make customers happier. The key to promoting innovation is to extend the opportunity for ideation to all employees in a “bottom-up” approach, allowing their voices to be heard while embracing and appreciating their creativity and insight.

Giving employees a safe space to voice their ideas and an opportunity to provide feedback is at the core of innovation. Executives can achieve this by shifting the organizational process from a one-pass, top-down approach to a two or more-pass approach. This is front line employees can propose ideas that management reviews and vice versa: management proposals are reviewed by the same front line employees for feedback. Management proposals’ are then refined to reflect the employee feedback. This allows management to incorporate all relevant context and makes everyone feels part of the process.

3. Enable an Agile Approach
While planning everything down to the smallest detail may seem like the safer option, it is important that boards and management teams accept that the unexpected is inevitable. Rather than trying to foresee every aspect, it is important to incorporate an agile mindset. An agile approach starts small and observes, adjusts course based on those observations and continues to course correct through repeated observation/adjustment steps. This allows the organization to absorb the unforeseen while still continually making progress. Over time, the pressure to be correct all the time will dissipate; the bank will feel more in control and enabled to make appropriate adjustments to increase the chances of the best possible outcome.

The rate of change around us and within financial services is steadily increasing; it is impossible to predict and plan for what will happen in the next few years. Instead, it is crucial that bank boards and management teams embrace adaptability as a critical element of corporate survival.

Student Loans Come Due

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Just as the Federal Reserve raises rates and inflation hits a 40-year high, Americans with federal student loan debt will start making payments on the debt after a two-year pause. On Aug. 31, the Department of Education will require 41 million people with student loans to begin paying again. 

According to the Federal Reserve, about one in five Americans have federal student loan debt and they saved $5 billion per month from the forbearance. It’s safe to say that a lot of people are going to struggle to restart those payments again and some of them work for banks.

The good news is that there are new employee programs that can help. One CARES Act provision allowed companies to pay up to $5,250 toward an employee’s student loans without a negative tax hit for the employee. Ally Financial, Fidelity Investments, SoFi Technologies, and First Republic Bank are a few of the many financial companies offering this benefit to employees. First Republic launched its program in 2016, after its purchase of the fintech Gradifi, which helps employers repay their employees’ loans. These programs typically pay between $100 and $200 a month on an employee’s loans, and usually have a cap.

The 2020 Bank Director Compensation Survey shows that 29% of financial institutions offered student loan repayment assistance to some or all employees. Many of those programs discontinued when the student forgiveness program started. In the anticipation of government forbearance coming to a close, now is a good time to think about restarting your program or even developing one. 

Americans now hold $1.59 trillion in student loan debt, according to the Federal Reserve. How did we get here? College got more expensive— much more expensive. 

Earlier this summer, the Federal Reserve and Aspen Institute had a joint summit to discuss household debt and its chilling effect on wealth building. The average cost of college tuition and fees at public 4-year institutions has risen 179.2% over the last 20 years for an average annual increase of 9.0%, according to EducationData.org.

At the same time, wages have not shown much inflation-adjusted growth. ProPublica found in 2018 that the real average wage of workers, after accounting for inflation, has about the same purchasing power it did 40 years ago. And inflation in 2022 has far outpaced wage increases. Some economists speculate that any pandemic-era wage increases are effectively nullified by this rapid inflation.

Not all borrowers are equally impacted. Sixteen percent of graduates will have a debt-to-income ratio of over 20% from their student loans alone, according to the website lendedu.com, while another 28% will have a DTI of over 15%. The 44% of graduates with that level of debt exiting school will face a steep climb to meaningful wealth building. The students that didn’t graduate will have an even harder climb.

Those graduates who struggle with their student loans will be less likely to buy a home or more likely to delay home ownership. They will be less likely to take on business debt or save for retirement. Housing prices have risen in tandem with education prices. The “starter home” of generations past has become unattainable to many millennial and Gen Z debt holders.

More than half of borrowers owe $20,000 or less. Seven percent of people with federal debt owe more than $100,000, according to The Washington Post. Economists at the Federal Reserve say borrowers with the least amount of debt often have difficulty repaying their loans, especially if they didn’t finish their degree. Conversely, people with the highest loan balances are often current on their payments. It’s likely that people with higher loan debt generally have higher education levels and incomes.

The Aspen Institute published a book known as “The Future of Building Wealth: Brief Essays on the Best Ideas to Build Wealth — for Everyone,” in conjunction with the Federal Reserve Bank of St. Louis. It illuminates long-term solutions for financial planning, focusing on policies and programs that could be applied at a national scale. 

In the absence of these national solutions, some employers are taking the matter into their own hands with company policies designed to help employees with student debt. Those banks are making a difference for their own employees and are part of the solution. 

Hail to the Chiefs

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Does creating snappy job titles lead to a better performing or more “in touch” bank? Possibly. But we are skeptical and at this point, it is too early to ascribe empirical evidence to say “yes’ or “no.”

The proliferation of titles such as “Head of Digital Banking,” “Head of Consumer Insights and Innovation,” “Cannabis Risk Officer” and so on have signaled priorities, but have they accomplished anything? In practice, it seems some new titles are not well aligned with the new skills needed to drive strategy or promote innovation. In some — or many — instances, it might be counterproductive if a bank is parsing responsibilities even further, muddying the waters on who is responsible for executing what.

We often see this in employee development. Many first-line supervisors, and even executive management, are under the false belief that the Chief People Officer, another name for the head of human resources, is primarily responsible for employee development. As a result, we see little execution that results in well-developed employees who can move the bank forward.

A common weakness uncovered in the bank strategy sessions or process improvement engagements that our firm undertakes is bank silos. Do titles lead to more silos or to more collaboration? Your chief innovation officer is not responsible for creating an end-to-end paperless mortgage experience that can go from application to close in less than three weeks. Your head of mortgage lending is — and that is based on knowing what customers demand.

Prior to advances in technology, the industry was awash in data. With these advances, there is even more of it. This is what drives banks to enlist data scientists, a functional position we highly support — although it is perhaps an exaggerated title. In a recent banking podcast, Kim Snyder, CEO and founder of data visualization firm KlariVis, spoke eloquently about data governance and integrity. How do we pull meaningful data out of our systems if we lack discipline in what we put in them?

How to use the data, how to make sure the data is well aligned across the organization and determining  who is responsible is the conundrum all banks face. Commercial lenders might belly ache about being held accountable for a client’s total relationship, which may affect compensation or how employees or how a bank markets their services. But this makes the lender keenly interested in viewing the total relationship across loans and deposits, wealth and other third-party systems that impacts many organizational silos.

Why would banks want to create even more silos with these newfangled chiefs? Convincing executive management teams that they are responsible for the entire bank, not solely their functional positions, has been a struggle. Would we exacerbate that struggle by creating positions that tell the head of commercial lending they are no longer responsible for their employees’ development or the department’s diversity since the bank now has a chief diversity officer? When many are responsible, nobody is accountable.

When executing a mission in the military, the senior officer of the operation issues something called a “Commander’s Intent.” This communicates to each unit what the commander deems success, such as “It is the Commander’s Intent that this mission degrades the enemy’s surface to air missile capability by 75%.” Each unit commander plays a role in executing the Commander’s Intent, with appropriate coordination. Could banking use such cultural discipline to achieve executives or the boards’ intent, without developing creative job titles or dispersing responsibilities to chief this or chief that?

We at The Kafafian Group think so. Keep your organization simple. Define roles and accountabilities. Issue your Commander’s Intent for missions that you currently use chiefs to define. Coordinate accountabilities and focus on execution and organizational learning. Success will be evident; one day, your bank will be called a “Top Performer” or an “Innovator” — a title that any executive management team can get behind.

Why Community Banks Should Use Derivatives to Manage Rate Risk

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As bank management teams turn the page to 2022, a few themes stand out: Their institutions are still flush with excess liquidity, loan demand is returning and the rush of large M&A is at a fever pitch.

But the keen observer will note another common theme: hedging. Three superregional banks highlighted their hedging activity in recent earnings calls.

  • Birmingham, Alabama-based Regions Financial Corp. repositioned its hedging book by unwinding $5 billion of receive-fixed swaps and replacing them with shorter-term receive fixed swaps. Doing so allowed the $156 billion bank to lock in gains from their long-term swaps.
  • Columbus, Ohio-based Huntington Bancshares increased its noninterest income in a scenario where rates increase 100 basis point from 2.9% to 4%. The $174 billion bank terminated certain hedges and added $6 billion of forward starting pay fixed swaps.
  • Providence, Rhode Island-based Citizens Financial Group executed $12 billion of receive fixed swaps in 2021, including $1.25 billion since June 30, 2021. The $187 billion bank’s goal is to moderate their asset sensitivity and bring forward income.

These banks use derivatives as a competitive asset and liability management tool to optimize client requests, investment decisions and funding choices, rather than be driven by their associated interest rate risk profile.

Why do banks use derivatives to hedge their balance sheet?

  • Efficiency. Derivatives are efficient from both a timing and capital perspective. In a late 2021 earnings call outlining their hedging strategy, Citizens Financial’s CFO John Woods said, “We think it’s a bit more efficient to do that (manage interest rate risk) off-balance sheet with swaps.”
  • Flexibility. It’s more flexible than changing loan and deposit availability and pricing.
  • Cost. It’s often less expensive when compared to cash products.

Why are some banks hesitant to use swaps?

  • Perception of riskiness. It’s easy for a bank that hasn’t used derivatives to fall into the fallacy that swaps are a bet on rates. In a sense, though, all the bank’s balance sheet is a bet on rates. When layered into the bank’s asset-liability committee conversations and tool kit, swaps are simply another tool to manage rate risk, not add to it.
  • Accounting concerns. Community banks frequently cite accounting concerns about derivatives. But recent changes from the Financial Accounting Standards Board have flipped this script:  Hedge accounting is no longer a foe, but a friend, to community banks.
  • Fear of the unknown. Derivatives can bring an added layer of complexity, but this is often overdone. It’s important to partner with an external service provider for education, as well as the upfront and ongoing heavy lifting. The bank can continue to focus on what it does best: thrilling customers and returning value to shareholders.
  • Competing priorities. Competing priorities are a reality, and if something is working, why bother with it? But growth comes from driving change, especially into areas where the bank can make small incremental adjustments before driving significant overhauls. Banks can transact swaps that are as small as $1 million or less.

For banks that have steered clear of swaps — believing they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help separate facts from fears and make the best decision for their institution. The reality is community banks can leverage the same strategies that these superregional banks use to enhance yield, increase lending capacity and manage excess liquidity.

New Synergies in Risk Management for 2022

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The past two years have created massive, life changing challenges for just about everyone on the planet — and bank managers and board members are certainly no exception. While the public has been dealing with the Covid-19 nightmare, remote work challenges, child and elder care woes, and concerns about family physical and mental health, bank leadership has had to deal with increased internal risks (operational, cyber, staffing) and external ones (rapid market changes, stressed industries, and a lack of traditional financial measurements, since many businesses did not produce audited financial statements during much of 2020).

As we enter 2022, no one knows for certain how, or if, all of those daunting issues will be resolved. In recent statements, the banking regulatory agencies are suggesting cautious optimism in 2022, though they are wary of complacency and loosening credit underwriting standards. One of the key forces that drive innovation and change in the world is a crisis, and if nothing else, 2020 and 2021 have seen rapid change and massive innovation, including in banking. With this backdrop, let’s look at some of the related developments and some new trends in credit risk management that will likely take place in 2022.

One significant industry change preceded Covid, and that was another acronym that started with a “C,” which was CECL. The story behind the current expected credit losses accounting standard is long and tedious — but a by-product of that rule for most bankers was a newfound understanding of the value of their portfolio’s credit data and how that data ties directly to reserves, risk and profitability. Thanks to CECL’s requirement for vast amounts of historical data, including credit attributes like collateral types, delinquency, payments and segmentation, many banks invested a lot of time and resource gathering, inventorying and cleaning up their credit data for CECL compliance. A result of this activity was that like never before more banks have more information about their loan portfolios, borrowers and their historical and current behavior.

During the time that CECL implementations started, Covid hit and bank managers were challenged with remote work requirements along with addressing PPP and other fast-moving emergency credit programs — creating a need for innovation and automation. Many areas of the bank were suddenly faced with new processes, operations and technology tools that were unplanned. A result of this accelerated change was that areas like commercial lending, credit and loan review were forced to adopt new innovative ways to work. While some of these areas may return to “the old normal,” many will retain most, if not all, of the new improved processes and tools that were needed to survive the challenges of the Covid crisis.

Those two developments, along with a growing understanding of the importance of credit concentration management, are driving new opportunities and synergies in credit risk management in 2022. The concept of credit concentration management is not a new one in banking. Even before the Great Recession of 2007-2009, the agencies made it clear that concentrations could be “bank killers,” with subprime lending and investor-owned commercial real estate (CRE) clear priorities. But now, the combination of more readily available, relevant credit concentration data and new tools and automation have made it significantly easier for banks of all sizes to proactively manage their concentrations.

A very obvious but valuable case study on the importance of concentration management is going on right now at the start of 2022 within the retail, office and the hospitality industry segments. Suddenly understanding exposure to these industries and property type segments is a high priority. Unlike the past, this time banks are much better positioned with improved data, tools and a more automated approach. The next use case to look at in 2022 is portfolio concentrations based on exposure to acute environmental threats like forest fires, hurricanes and flooding. That will likely be an early first step as more banks incorporate the environmental, social and governance framework into their risk management programs.

Another often neglected, proactive credit risk management process that has gotten a lot more attention during the past two years is portfolio stress testing, or “shocking segments of the portfolio.” This practice was used widely in banking during the end of the Great Recession to effectively monitor CRE risk, but by 2015, most smaller banks performed only annual tests, most of which were not looked at as having much, if any, strategic value. Part of the issue was that the banks simply weren’t collecting enough credit data to perform meaningful testing, and there was a sense that money for stress testing tools could be better spent elsewhere.

Now with additional risk management tools and better data, stressing concentrations simply makes sense and is achievable for most banks. New stress testing programs for concentrations like restaurants and business hotels are the norm, while more comprehensive, and strategic programs are starting to be put in place in banks of all sizes.

As we look back at the years of the Covid crisis, it is only natural to think of the disruption, challenges and uncertainty that banks faced, some of which are still being faced today. But thanks to the forces that drove the challenges in 2020 and 2021, bankers rapidly embraced automation and performed proactive credit data management leveraging innovative practices. Banks need to seize those opportunities and continue to enhance their risk management processes, not letting those benefits pass them by. A 2022 with this more synergistic approach to credit risk management may make the future a little bit brighter for bank management.

Digital Deniers Need Not Apply

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There are few bankers who understand the process of digital transformation better than Mike Butler.

Beginning in 2014, Butler oversaw the evolution of Boston-based Radius Bancorp from a federally chartered, brick-and-mortar thrift to one of the most tech-forward banks in the country. Radius closed all its branches except for one (federal thrifts are required to have at least one branch) and adopted a digital-only consumer banking platform.

The digital reinvention was so successful that in February 2020, LendingClub Corp. announced a deal to buy Radius to augment that marketplace lender’s push into digital banking. Now Butler is off on another digital adventure, this time as president and CEO of New York-based Grasshopper Bancorp, a five-year-old de novo bank focused on the small business market. Like Radius, Grasshopper operates a digital-only platform.

Butler will moderate a panel discussion at Bank Director’s upcoming Acquire or Be Acquired Conference focusing on the importance of integrating bank strategy with technology investments. The conference runs Jan. 30-Feb. 1, 2022, at the JW Marriott Desert Ridge Resort and Spa in Phoenix.

Butler says that successful transformation begins with the bank’s executive management team and board of directors, where discussions about technology need to be an integral part of strategic planning. And most importantly, management and the board need to see digital transformation as crucial to the bank’s future success. Butler says there are still plenty of “digital deniers” among bankers who believe they can be successful without strengthening their institution’s digital capabilities.

“Have you embraced the kinds of changes that are taking place inside the industry?” Butler says. “And do you have a very strong cultural commitment to be a part of that change? When you do that, you start to look to technology as the enabling driver to get you to that place.”

Management teams that are just starting out on a path to digital transformation can easily find themselves overwhelmed by the sheer number of potential projects. “The most important thing to do is to prioritize and recognize that you cannot do this all at once,” Butler says. “It would be a mess if you tried. Pick two to three things that you think are critically important.”

A third element of a successful transformation process is finding the right person to lead the project. “You’ve got to have the right talent to do it,” Butler says. “That leader better be somebody who has been pushing it rather than you push it on them as CEO. You can’t say, ‘Joe, you’ve been running branches for 30 years, do you believe in digital? Eh, kind of. Okay, I want you to put in a digital platform.’ That’s not going to work.”

Butler goes so far as to say that only true believers should run those fintech projects. “You cannot do this without people that have the passion and the belief to get to the other side, because you will hit a lot of roadblocks and you’ve got to be able to bust through those roadblocks,” he says. “And if you don’t believe, if you don’t have the passion, there’s a lot of reasons to stop and go a different way.”

Butler might not seem the most likely person to be a digital change agent. He spent 13 years at Radius and pursued a branch banking strategy in the early years. Prior to joining Radius, Butler was president of KeyCorp’s national consumer finance business. He did not come from the fintech sector. He has a traditional banking background. And yet as Butler is quick to point out, Radius didn’t reinvent banking, it reinvented the customer experience.

The fact that Butler lacked a technology background didn’t deter him from pursuing a transformational strategy at Radius. He was smart enough to see the changes taking place throughout the industry, so he understood the business case, and he was also smart enough to surround himself with highly committed people who did understand the technology.

In building out its digital consumer banking platform, Radius worked with a number of third-party fintech vendors. “I wasn’t making technology decisions about whose technology was better, but I surely was making decisions about the companies that we were partnering with and what type of people we were willing to work with,” Butler says. “I met every single CEO of every company that we did business with, and that was a big part of our decision as to why we would partner with them.”

At Grasshopper, Butler says he prefers the challenge of building a new digital bank from scratch rather than converting a traditional bank like Radius to a digital environment. Sure, there are all the pain points of a startup, including raising capital. But the advantages go beyond starting with a clean piece of paper from a design perspective. “It’s really hard to transform a culture into something new inside of an organization,” Butler says. “So, I’d say the upside is that you get to start from scratch and hire the right people who have the right mindset.”

Choosing BOLI as a Long-Term Asset

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The keys to a bank’s success include its understanding of risk management, its approach to long-term planning and the lifelong relationships it develops with customers. 

A vital consideration for bank management teams when selecting financial products and services is a like-minded alignment and shared approach to planning for risks that span decades, not quarters. As bankers diligently work with borrowers and customers, these turbulent times reaffirm a bank’s decision to acquire a valuable long-term asset: bank-owned life insurance, or BOLI.


Many bank executives and directors view BOLI as an asset that remains on their balance sheet for decades. It’s a sizable asset for many banks. While the average BOLI contract at MassMutual is around $3 million, we work with many clients with larger policies. 

And because it’s a long-term decision, selecting a competitively priced product from a financially strong carrier helps ensure asset quality. This can provide bank boards with the assurance that their BOLI product is stable and that their carrier has the financial strength necessary to pay a market-competitive crediting rate at a time when banks need it most.

Demonstrated Commitment

Stability in the BOLI business is a strength; banks need their insurance carriers’ commitment to the BOLI market to be unwavering. During volatile economic times, the long-term commitment and stability of your BOLI provider can be a key asset for your bank.

As bank management evaluates which companies to work with, some of the considerations should include:

Longevity: How long has the insurer been continuously active in this space and across market cycles?

Service commitment: What types of servicing protocols are in place for existing clients, and how are advisor relationships supported?

Values: Does the insurer share similar values as the bank, and how does it demonstrate those values through community involvement and investment?

Investment Philosophy Underpins Stability

Boards have an obligation to govern and supervise their BOLI holdings, as well as the insurers with which they do business. Selecting a BOLI carrier is a vote of confidence in that firm’s long-term portfolio management and risk management philosophy.  It is incumbent that boards focus on their BOLI insurer’s approach to underwriting and its underlying long-term investment philosophy.

We believe the mutual company structure naturally gives MassMutual a long-term perspective when it comes to planning and investing, as we focus on economic value and not short-term stock prices.

The uncertainty caused by the coronavirus pandemic provides insight into how an insurer’s investment strategy performs in a volatile market. When it comes to due diligence on BOLI carriers, credit ratings are a great place to start. But directors should also look at the insurer’s capital levels, liquidity and financial cushion. 

To meet long-term commitments, insurers must follow an appropriate asset-liability matching program, while achieving attractive portfolio returns to back customer obligations. An insurer’s general investment account should be well diversified and managed with a long-term view that withstands short-term fluctuations in asset values.  Even in the most volatile market conditions, your bank’s BOLI provider should be positioned to meet the needs of those who rely on them. 

In view of today’s economic uncertainty, we understand BOLI may not be top of mind for directors and banks.  However, it’s important to understand the differences and nuances when it comes to BOLI management and investment. 

Evaluating and aligning with companies that share a similar approach to risk management, long-term commitment and sound investment philosophy have proven to pay dividends over the long term. While post-pandemic planning may be hard to conceptualize, banks operate and run for the long term, and should consider relationships with companies that feel the same.

Insurance products issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111-0001. 

CRN202205-265653

Window of Opportunity for Sub Debt

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Bankers who have not done so recently may want to revisit their subordinated debt playbooks so they can successfully navigate an emerging window of opportunity.

Market activity is up significantly due to interest rate trends, regulatory developments and other factors. Bank management teams who are prepared to act quickly can capitalize on the opportunity.

Sub debt is a long-term debt obligation with a maturity typically ranging from 10 to 15 years, a fixed (or fixed-to-floating) interest rate and the ability for the issuer to redeem the notes under certain circumstances. It has become a staple of bank capital planning, because it can qualify as Tier 2 capital if properly structured. Most banks can even use it to generate Tier 1 capital at the bank level, a strategy even more banks can employ following the 2018 changes to the Federal Reserve’s Small Bank Holding Company Policy Statement.

However, executives must be mindful of certain limitations of sub debt. In particular, its treatment as Tier 2 capital is phased out by 20% per year, beginning five years before maturity. Additionally, the interest rate typically flips from a fixed rate to a floating rate during the last five years, which is often higher than the fixed rate. Accordingly, banks that issued sub debt in 2014 and 2015 — when they were preparing for Basel III capital rules and, in some cases, repaying comparatively expensive Troubled Asset Relief Program funding — may now have the opportunity to refinance that sub debt.

New Issuances
Banks considering a new sub debt offering need to consider several matters in planning the transaction. These include many familiar decision points, such as selecting a placement agent or underwriter, deciding whether to seek a credit rating, consulting with regulators and determining the proposed offering terms, including offering size, maturity, interest rate structure, use of proceeds and other matters. In addition, banks will need to be mindful of federal securities laws that govern the offering.

There are also new issues for management teams to consider, like selecting a benchmark rate for the floating rate component. Historically, sub debt floating rates have been calculated based on the London Interbank Offered Rate, or LIBOR. Given LIBOR’s likely disappearance after 2021, issuers will need to evaluate whether to preserve the flexibility to select an alternate benchmark rate at the beginning of the floating rate period or to preemptively commit to an alternate benchmark.

Directors will want to make sure they have a clear understanding of how the offering complies with the company’s long-term capital plan and review the pro forma effects of the offering on capital ratios. From a fiduciary perspective, they also need to understand how the sub debt fits into the capital structure and how the organization will use the proceeds.

Given the significant planning needed ahead of a sub debt issuance, banks should begin the process at least two to three months before they need the capital.

Redeeming Existing Sub Debt
The mechanics of redeeming existing sub debt are relatively straightforward, and are governed by the terms of the notes and any applicable indenture. The terms can limit the dates on which a redemption can be completed, require some notice period to holders and dictate that partial redemptions be allocated pro rata among noteholders.

But before taking any steps, it is critical that issuers consult with their regulators and be mindful of related issues, including compliance with the Federal Reserve’s SR letter 09-4, which prescribes certain actions and considerations in connection with return of capital transactions. Depending on an institution’s size and other characteristics, it may need to obtain prior regulatory approval. Directors will need to understand the effects of the redemption on the organization’s capital structure and pro forma capital ratios.

Public Company Considerations
Banks with publicly listed holding companies will also want to evaluate whether to conduct a public offering through their shelf registration statement. This generally requires an indenture, clearinghouse eligibility, prospectus supplements, a free writing prospectus, limitations on credit rating disclosure and other actions. However, it can improve execution by making it easier for purchasers to resell their notes. Public companies also need to comply with their Exchange Act reporting obligations.

While there are several other issues to be considered in connection with any sub debt issuance or redemption transaction, management teams and boards of directors who have a basic understanding of the considerations outlined above will be well positioned to develop and maintain a strong capital foundation to execute their strategic growth initiatives.