How to Protect Against the Downside, Prepare for the Upside

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“If you’re left in a situation where you’re defending, where you’re shrinking your balance sheet, where you’re worried about your capital, where you’re continually cajoling shareholders, or clients to stick with you — you’re not focused on growing.”

Those are wise words from William Demchak, chief executive officer of PNC Financial Services Group. PNC is one of the largest banks in the U.S. and an OakNorth customer.

He said this in an interview with the Financial Times in May 2020 — a couple of months after the country had gone into lockdown under full force of the coronavirus pandemic. At the time, he was discussing PNC’s rationale for selling its stake in asset manager BlackRock, which was prompted in part by increasing concerns about the U.S. economy as a result of the Covid-19 pandemic.

But fast forward the clock two and a half years, and he could just as easily be speaking about the economic situation in the U.S. today. Increasing economic uncertainty and interest rates at their highest point since 2008, many commercial bankers are focused on protecting their downside risk. As a result, many are likely missing the upside opportunity.

Protecting Against Downside Risk

1. Granular data. Most banks tend to lump their borrowers into one of a dozen or so broad sectors: all restaurants, bars, hotels, golf clubs and spas, for example, will be classified as “hospitality and leisure.” This classification approach misses the fundamental differences between how these businesses operate and how their capital and operational expenditures may be impacted by changes in the economy. In order to quickly identify where the most vulnerable credits lie in their portfolio, banks need to get to much more granular industry view — even going as far down as 6-digit NAICS codes — in their analysis.

2. Forward-looking scenario analysis. Banks need to be able to run multiple macroeconomic scenarios on their loan book using forward-looking scenarios to explore how a borrower would perform at different financial and credit metric level. This gives them the ability to plan ahead for market changes such as rate rises and house price fluctuation by formulating targeted risk mitigation strategies that can reduce defaults and charge-offs and better manage capital requirements.

3. Proactive monitoring. Banks need to be able to identify potential credit issues faster and earlier, so they can take proactive steps to reduce the chances of negative outcomes during a downturn.

Effectively Navigating Upside Opportunities

1. Granular data. in an economic downturn, there are always winners and losers that emerge; more often than not, it’s specific businesses or sub-sectors rather than entire industries. As consumer confidence wanes and inflation tightens purse strings, it’s likely that budget retailers and discount stores will see increased demand while their high-end alternatives experience the opposite. Both are classified as “retail” but will have dramatically different experiences in an economic downturn. Banks need the right data and tools to identify businesses that may need additional capital to make it through the economic cycle from the businesses that need additional investment capital to pursue potential growth opportunities arising in it.

2. Forward-looking scenario analysis. Banks need to be able to create configurable scenarios that reflect their internal economic outlook by adjusting macroeconomic variables, such as interest rates and inflation, among others. This means they can make more informed decisions about high risk, high opportunity industries and borrowers in their loan book and adjust their activities accordingly.

3. Proactive monitoring. In times of turmoil, most banks tend to segment their portfolio from highest to lowest exposure, starting with their largest and working their way down. Not only is this approach incredibly time consuming, it also means a lot of team time is spent running analysis on credits that don’t end up presenting a credit issue. Banks need to be able to segment credits on a high to low risk spectrum within a matter of hours, so they can identify the credits that require intensive versus light touch reviews, freeing up resources to pursue new loan origination.

Report from Audit Conference: Banking Still Faces Headwinds

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asset-quality-6-11-15.pngSure, banks have seen asset quality improve. Profitability is higher than it was during the recession. The SNL U.S. Bank and Thrift Index of publicly traded banks has risen 88 percent since the start of 2012. But all is not happy-go-lucky in bank land.

Speakers at Bank Director’s Bank Audit and Risk Committees Conference discussed the slow economic recovery and the headwinds banks are facing as a result. The banking industry’s compound annual loan growth rate during the last few years of 3 percent is down from the average of 7 percent from 1993 to 2007, said Steve Hovde, president and CEO of the Chicago-based investment bank Hovde Group. Net interest margins are 50 basis points lower than they were at the start of the decade. Combined with low interest rates, weak loan demand is hurting growth and profitability. Banks are stretching for loans and pricing competition is difficult. The median return on average assets (ROAA) was .93 percent in the first quarter of 2015, even though half of the banking industry made an ROAA of 1 percent or better pre-recession, Hovde said.

“In this environment, net interest margins are the lowest point they’ve been in 25 years,’’ Hovde said. “Clearly, if we had a more vibrant economy, banks could go back to making more money.”

With the Federal Reserve keeping rates low for the foreseeable future, and all the pricing competition, bubbles could be forming in some sectors, Hovde said. He specifically mentioned multi-family housing and junk bonds as possibilities.

Even stock prices aren’t that great from a historical perspective. The SNL U.S. Bank and Thrift Index has only climbed 4.2 percent since the start of 2000, compared to 40.7 percent for the S&P 500 during that time.

And what about the economic forecast for housing, a significant economic driver and source of revenue for many banks? 

Doug Duncan, the chief economist for Fannie Mae, said the housing market is in no way back to pre-recession levels. Although he expects an increase in mortgage originations in 2015 and 2016, refinancing volume is down. 

Households are still deleveraging in the aftermath from the Great Recession, but that has stabilized somewhat. Consumer spending in this economic recovery has been “incredibly weak,’’ Duncan said. Only recently have consumers in surveys reported an expectation for future income gains. 

Household growth, or the rate at which people are forming new households, has been depressed, as young adults have not been leaving the nest and getting their own apartments or buying homes in large numbers. Large numbers of adult children live at home. Millennials, burdened by college debt and the aftermath of the recession, are forming households at a slower pace than previous generations, and their real incomes are lower than the same generation a decade ago. It’s not that they don’t want to own houses, Duncan said. He said 76 percent of them think owning a house is a good idea financially. It’s just that they can’t afford it. 

But household formation is expected to rebound in 2015 to 2020, as the economy continues to improve and employment grows, he said.