Fifth Third’s Transformation

A few years ago, walls of black granite lined the entrance to Fifth Third Bancorp’s headquarters in downtown Cincinnati. Today, the entrance is an open atrium lined with artwork, a café and a small stage for the public to enjoy performances. Pithy reminders for employees dot the walls and elevator: “Be the bank people most value & trust,” and “Strengthen communities.”

As if to imply that the dark days at Fifth Third are behind it, a wall of windows lets light stream in. Fifth Third not only went through a physical renovation, but a financial one as well. The $205 billion bank’s performance was in the bottom half of peers eight and nine years ago. It’s now in the top quartile. It’s rebuilt its balance sheet and its reputation after the financial crisis, when its stock plummeted to about $1 per share and its ability to survive as an independent entity was in question.

Today’s Fifth Third has accomplished a vast financial comeback as well as a digital transformation executed in part by former CEO Greg Carmichael and Tim Spence, who in July became the youngest CEO among the 20 largest commercial banks in the country.

“That was the major task of the last five, six years: Return the bank to a place where it had the right to flex its muscle a little bit and go achieve great outcomes,” says Fifth Third’s Chief Strategy Officer Ben Hoffman. “Now the question for Tim is, ‘What do you do with that?’”

As if to emphasize the changes, Spence decided our interview would not take place in a conference room. He moved us to the open-office innovation studio that shares the same floor as the executive suite inside Fifth Third’s headquarters tower on Fountain Square. “Those of us who are here today get to operate on a platform that’s going to allow us to think about growth,” Spence says in hushed tones, so as not to disturb the employees working on computers around us. “How do we grow the business organically?”

To understand what happened at Fifth Third, you have to go back in time. Although the bank traces its roots back to The Bank of the Ohio Valley in 1858, it really began growing considerably in the 1980s. Its formidable former CEO, George Schaefer Jr., a West Point graduate and Vietnam War veteran, ran the bank starting in the 1990s until 2007. He created a hard-driving sales culture and had a reputation for frugality.

One reporter described his office furniture as not so much antique as shopworn. He was religious about making sure every employee wore the iconic 5/3 pin on their lapels. One former employee told me the bank was so conservative that women weren’t allowed to wear pantsuits. But it was also one of the top performing banks in the country.

Boosted by a high stock price multiple, Schaefer went on a buying spree that enlarged the bank’s footprint. In the 1990s alone, Fifth Third bought 21 other banks. By 1999, the bank had 384 banking centers in Florida, Ohio, Indiana and Kentucky, according to the company.

“Back in the 1990s, Cincinnati had two of the most highly regarded banks in the country,” says R. Scott Siefers, managing director and equity analyst at Piper Sandler & Co. “It was Fifth Third and Star Bank, which is now part of U.S. Bancorp in Minneapolis … they both had high multiples. Fifth Third might trade at 20 or 25 times earnings and would buy these companies at say, 10 or 12 times earnings. The math just worked fabulously because of the disparity. These deals were so accretive to earnings.”

But some of the deals didn’t work out so well, and investors became more cautious on the company, Siefers says. The financial crisis of 2007-08 came along, and Fifth Third was hit hard. Although the bank didn’t get into subprime lending, management was caught off guard by the sheer loss of value in the real estate industry and the collapse of the mortgage market.

Also, what regulators and the public demanded of banks changed dramatically, remembers Kevin Kabat, who was CEO from 2007 to 2015. Becoming CEO in 2007 was less than ideal. Kabat recalls that he had one good quarter before the crisis hit.

“It was stressful, to say the least,” he says. “We were probably the second most picked-on company after [National City Corp.], which went out of business.”

Congress passed the largest financial law in decades, the Dodd-Frank Act, in 2010.

“[The crisis] broadened in a much bigger way the definition of success,” Kabat says. “In [earlier] days, there was only one thing that mattered; it was earnings per share, period. There was not a lot of conversation about much else … I think what really changed from that perspective was the definition of success. The regulators had a stronger opinion about success. Your customers had a strong opinion of success. Your politicians and community leaders had a much different perspective of what success meant. It created a three-dimensional viewpoint of success, where we were pretty one-dimensional before that.”

Kabat recapitalized the business, with then-Chief Operating Officer Carmichael, and focused on changing the culture and de-risking the balance sheet. “When I joined the company, it was clear that the sales orientation, the sales focus was the No. 1 focus,” Kabat says. “We changed it from a sales focus to a customer focus. It’s not just what the next product is; it’s how the customer feels. How do they judge us? What’s their loyalty? And we began to measure all those things.”

There’s at least one entity that doesn’t believe Fifth Third totally changed: the Consumer Financial Protection Bureau. As of press time, the bureau continues to litigate its 2020 lawsuit against Fifth Third that accuses the bank of imposing sales goals on employees that resulted in unauthorized account openings for several years following the financial crisis, similar to practices at Wells Fargo & Co. that gained attention in 2016. The CFPB accuses Fifth Third of failing to take adequate steps to detect and stop the practices, or remediate harmed consumers.

Fifth Third countered in public statements that those accounts involved less than $30,000 in improper charges that were waived or reimbursed years ago. The company currently does not have sales quotas or product-specific targets for retail employees, nor does it reward them for opening unauthorized accounts. “Starting in 2011 and 2012 and 2013, the measures we took since that point in time ensured we had a culture that put the customer at the center,” Spence says, adding that the company doesn’t comment on pending litigation.

It wasn’t just Fifth Third’s sales culture that was under the microscope. When Greg Carmichael arrived in 2015, the bank was in better shape, but it was trading at book value. Profitability was stoked by ownership of a payments business called Vantiv, but lots of investors discounted that value. Carmichael asked investors what they liked about Fifth Third and what they thought its issues or challenges were. Then, he and his management team studied banks that performed well through economic cycles, looking for their similarities. “Listen, it wasn’t rocket science,” says the matter-of-fact Carmichael, who is now executive chairman of the board. “You need a balance sheet that’s going to perform well when the credit cycle turns. You need a balance sheet that’s going to throw off strong returns, so you need to make sure you’re banking the right clients, and you have the full relationship. You need your fee businesses to be a larger portion of your business to offset low-rate environments.”

The management team committed to becoming a bank that would perform well through various interest rate environments and through the inevitable downturns. Carmichael and his team began to build larger fee income businesses, such as mortgages, capital markets and private banking. He committed the bank to quantifiable financial goals, such as return on tangible common equity and return on assets. “We communicated that strategy with financial targets, and we told our investors to hold us accountable, told our board to hold us accountable. And we also asked our employees to hold us accountable, hold themselves accountable for executing to this strategy. That was critical,” he says.

Still, investors weren’t always pleased. After Fifth Third announced the acquisition in 2018 of one of the larger banks in Chicago, MB Financial, for 2.8 times tangible book value, the stock price fell and didn’t recover fully until the end of 2019. “What they didn’t like is we paid a lot for it,” Carmichael says, “We proved them wrong … I would do that deal in a heartbeat at the same price again, and I wouldn’t bat an eye.”

The other thing Carmichael did was start building the bank’s portfolio of high-quality commercial and industrial loans in Texas and California, even in regions that didn’t have Fifth Third retail branches, says Christopher Marinac, director of research for Janney Montgomery Scott, who follows the company. The management team has been focused particularly on expanding the bank and its branches into growth markets in the Southeast.

The focus has paid off so far. Fifth Third placed No. 5 among the 33 commercial banks above $50 billion in assets in Bank Director’s RankingBanking study last year, based on return on average assets, return on average equity, capital adequacy, asset quality and one-year total shareholder return in 2021. For calendar year 2020, it was building reserves for the pandemic and ranked No. 21 on a similar Bank Director ranking called the Bank Performance Scorecard. For calendar year 2019, it ranked sixth.

After Carmichael transformed the bank, he handed the reins to Spence last summer. But before that, he had executed a two-year succession plan that involved rotating Spence through different roles to see if he could lead major businesses for the bank, bringing him to investor meetings and signifying to the world that Spence was his likely successor. “So, when I actually made the announcement [that] I was stepping down in a handful of months, there was no surprise who the person was, there was no issue with confidence that Tim couldn’t step right in, because he’s been part of [the] strategy,” Carmichael says. The choice was unusual. Instead of picking someone as a potential successor who had 20 or 30 years of service in banking, Carmichael picked someone he had hired from the consulting firm Oliver Wyman as his chief strategy officer in 2015, when Spence was still in his 30s. “He was much younger than I thought he was,” Carmichael says. “But he is well beyond his years in both maturity and leadership, and knowledge base of the banking sector. So, I never thought of Tim as a young man. I always thought of him as a seasoned leader.”

Spence was an unusual pick for another reason. He had a background in the tech sector. Spence learned how to code at the same time he learned how to write, in the first grade, although he never worked as a programmer.

The son of a financial advisor and a flight attendant who divorced, he wasn’t sure what he wanted to do. He grew up in Portland, Oregon, and got a bachelor’s degree in economics and English literature from Colgate University, a private school in New York. While in school, he asked his dad to send him a copy of an Oregon business journal and wrote letters to the paper’s list of the 50 fastest growing tech companies, offering to work for free if there was a possibility of long-term employment. He started out at a small startup as a finance intern, working his way up in corporate development and management before moving to a bigger tech company. But after years at tech firms, he reached a point where he would “sit and listen to our customers, and hear them describe big opportunities and challenges. We were this little component solution. I wanted to have the opportunity to help work on the big things, not just the pieces.”

He got a job at Oliver Wyman and worked there for about a decade, becoming a senior partner of its financial services practice and doing work for its client Fifth Third before Carmichael offered him a job. Given the costs of hiring a consulting firm, Carmichael joked at the time that the hire was a money-saving measure. “He’s very thoughtful in his approach,” Carmichael says. “He [is] very detail oriented when he gets into a subject matter, and he can go very deep, which I was really, really impressed with. And then his listening skills, he listens and that’s also not a trait many consultants have.”

Carmichael says that when he decided to develop Spence as the potential next CEO, he was looking for someone who really understood technology’s impact on financial services. “He really had appreciation for the technology space and a passion for leveraging technology for the success of our business,” Carmichael says. “And I just thought that was also an extremely important attribute and skill set to have, when you think about the future of a bank CEO.”

Spence has a round, boyish face, but he’s tall enough to be a basketball player. Moving through the open offices, employees stopped what they were doing to watch him walk past. “Tim’s mind is all over the place, and I don’t mean in a sloppy, disorganized way,” says Steve D’Amico, who worked for Spence as chief innovation officer for a year and a half, starting in 2016. “He’s a very diverse thinker, bringing lots of unusual ideas to bear.”

Ben Hoffman, Fifth Third’s chief strategy officer, says that Spence has the ability to identify what matters and what doesn’t. “My belief is that Tim’s superpower is focus,” Hoffman says. He’s not a micromanager, but he’s deeply interested in the details. “There have been multiple times where he’s asked me a question about footnote seven on page 87, in the appendix of a presentation.”

One of the details Spence is intensely interested in is the particulars of digital transformation. Spence wants to learn from the best examples of technology and customer service across all industries, not necessarily in banking. “If we need engineers, what does the best employer for an engineer look like?” Hoffman says. “We spend a lot more time thinking about JPMorgan [Chase & Co.] and Goldman Sachs [Group] and LendingClub [Corp.], and the credit funds, candidly, then we do about the traditional regional bank peers.” A few years ago, the bank designed a new consumer deposit account. The walls were filled with sticky notes as staffers wrote down the best brands for customer experiences, among them, Delta Air Lines, Hertz, Domino’s Pizza and Zappos.com.

Then, they came up with ideas about what the app should do, Hoffman says.

Chief Digital Officer Melissa Stevens was deeply involved in launching the bank’s Momentum Banking consumer deposit account product in 2021, all of it built in-house. Notably, it’s not called a checking account. It has an automatic savings tool and free access to wages up to two days in advance with direct deposit, even for gig workers. The account also gives customers additional time to make a deposit to avoid overdrafts and the ability to get an advance of funds against future pay. It has no minimum deposit opening amount, and it costs $0 per month.

Although none of those features are hugely unique in the world of fintechs, what is unique is Fifth Third’s approach to fintech partnerships. Fifth Third is a superregional bank with a tech budget of more than $700 million last year, growing at a compound annual rate of 10%. “They’re not going to have the technology budget of a Chase or a Bank of America [Corp.],” says Alex Johnson, creator of the Fintech Takes newsletter. “And they can’t keep up with those banks if they insist on building everything themselves. But if they can focus their own development resources just on the things that they can’t get by partnering or buying, they can have a much more efficient technology budget where they get more per dollar out of their tech budget because it’s more focused on the highest priorities.” That’s not easy to do, because it’s hard to tell a chief technology officer not to build what that person wants to build, Johnson adds. “I think Fifth Third, for the most part, has managed to sidestep that problem from of an internal politics perspective and just be really aligned from the top down on what their strategy is,” he says.

Fifth Third works with fintech partners for years before it decides, in some cases, to buy them. Hoffman’s team is responsible for venture capital funding and partnerships with fintechs. The bank was an early investor in 2018, for example, in Provide, a digital lending platform for medical practices, according to a 2022 article by Bonnie McGeer for Bank Director’s FinXTech.com division. The bank announced a deal to buy Provide in 2021 and purchased another fintech that finances solar panels in 2022. “I think the other competency you have to have if you’re going to do this well is you have to be really good at partnering and acquiring technology,” Johnson says. “Some of the best technology out there is coming from fintech companies, and most banks have no idea how to work with fintech companies.”

Spence’s job is to get the company’s managers and employees to think differently, and he sees working with fintechs as part of that strategy. “The single best way to do that,’’ he says, was to partner with and invest in fintechs who could help the bank’s employees grow. “One of the big mental model changes that has to still trickle into our industry is this idea of product life cycle management … [Instead of] build it and launch it and leave it, we have to move much more into a software-oriented mindset, where you develop a product and then every six to 12 months, you make it better.”

Spence acknowledges that he’s in an enviable position compared to his predecessors. He was handed a banking franchise in good shape and now needs to sustain it. “What Greg did was remarkable,” Spence says. “We need to continue the focus on profitability and operational excellence and resilience through cycles. We need to maintain those disciplines. We need to grow organically and take advantage of opportunities, particularly in terms of technology that allows us to inhabit a different position in people’s lives.”

Despite the focus on innovation, analysts such as Siefers get the impression that Spence is equally focused on careful, strategic thinking when it comes to the bank’s balance sheet. He doesn’t get the impression that Fifth Third is interested in big gambles, and the bank seems well positioned even heading into a potential downturn.

“Kevin [Kabat] and then Greg Carmichael, they’ve been in reputation rebuild mode for the better part of the last decade,” Siefers says. “And they’ve done so quite successfully, particularly during Greg’s tenure. And ideally, that continuity will continue with Tim.”

Marinac also thinks the bank is well positioned given rising rates. “I think their ability to reset loan yields is better than other banks,” he says. “The industry is craving new ideas, new approaches, whether it’s taking out costs or building these new lending channels, or kind of rethinking the business. That’s where Tim comes in … 85% of banks follow and 15% lead. I think Fifth Third is demonstrating that they’re a leader.”

This article has been updated to reflect that Tim Spence was a senior partner in the financial services practice at Oliver Wyman.

The following feature appeared in the first quarter 2023 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.

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.”

Banks Are Letting Deposits Run Off, but for How Long?

In September, the CEO of Fifth Third Bancorp, Tim Spence, said something at the Barclays investor conference that might have seemed astonishing at another time. The Cincinnati, Ohio-based bank was letting $10 billion simply roll off its balance sheet in the first half of the year, an amount the CEO described as “surge” deposits.

In an age when banks are awash in liquidity, many of them are happily waving goodbye to some amount of their deposits, which appear as a liability on the balance sheet, not an asset.
Like Fifth Third, banks overall have been slow to raise interest rates on deposits, feeling no urgency to keep up with the Federal Reserve’s substantial interest rate hikes this year.

Evidence suggests that deposits have begun to leave the banking system. That may not be such a bad thing. But bank management teams should carefully assess their deposit strategies as interest rates rise, ensuring they don’t become complacent after years of near zero interest rates. “Many bankers lack meaningful, what I would call meaningful, game plans,” says Matt Pieniazek, president and CEO of Darling Consulting Group, which advises banks on balance sheet management.

In recent years, that critique hasn’t been an issue — but that could change. As of the week of Oct. 5, deposits in the banking system dipped to $17.77 trillion, down from $18.07 trillion in August, according to the Federal Reserve. Through the first half of the year, mid-sized banks with $10 billion to $60 billion in assets lost 2% to 3% of their deposits, according to Fitch Ratings Associate Director Brian Thies.

This doesn’t worry Fitch Ratings’ Managing Director for the North American banking team, Christopher Wolfe. Banks added about $9.2 trillion in deposits during the last decade, according to FDIC data. Wolfe characterizes these liquidity levels as “historic.”

“So far, we haven’t seen drastic changes in liquidity,” he says.

In other words, there’s still a lot of wiggle room for most banks. Banks can use deposits to fund loan growth, but so far, deposits far exceed loans. Loan-to-deposit ratios have been falling, reaching a historic low in recent years. The 20-year average loan-to-deposit ratio was 81%, according to Fitch Ratings. In the second quarter of 2022, it was 59.26%, according to the Federal Deposit Insurance Corp.

In September, the Federal Reserve’s Board of Governors enacted its third consecutive 75 basis point hike to fight raging inflation — bringing the fed funds target rate range to 3% to 3.25%. Banks showed no signs of matching the aggressive rate hikes. The median deposit betas, a figure that shows how sensitive banks are to rising rates, came in at 2% through June of this year, according to Thies. That’s a good thing: The longer banks can hold off on raising deposit rates while variable rate loans rise, the more profitable they become.

But competitors to traditional brick-and-mortar banks, such as online banks and broker-dealers, have been raising rates to attract deposits, Pieniazek says. Many depositors also have figured out they can get a short-term Treasury bill with a yield of about 4%. “You’re starting to see broker-dealers and money management firms … promot[e] insured CDs with 4% [rates],” he says. “The delta between what banks are paying on deposits and what’s available in the market is the widest in modern banking history.”

The question for management teams is how long will this trend last? The industry has enjoyed a steady increase in noninterest-bearing deposits over the years, which has allowed them to lower their overall funding costs. In the fourth quarter of 2019, just 13.7% of deposits were noninterest bearing; that rose to 25.8% in the second quarter of 2021, according to Fitch. There’s a certain amount of money sitting in bank coffers that hasn’t left to chase higher-yielding investments because few alternatives existed. How much of that money could leave the bank’s coffers, and when?

Pieniazek encourages bank boards and management teams to discuss how much in deposits the bank is willing to lose. And if the bank starts to see more loss than that, what’s Plan B? These aren’t easy questions to answer. “Why would you want to fly blind and see what happens?” Pieniazek asks.

What sort of deposits is the bank willing to lose? What’s the strategy for keeping core deposits, the industry term for “sticky” money that likely won’t leave the bank chasing rates? Pieniazek suggests analyzing past data to see what happened when interest rates rose and making some predictions based on that. How long will the excess liquidity stick around? Will it be a few months? A few years? He also suggests keeping track of important, large deposit relationships and deciding in what circumstances the bank will raise rates to keep those funds. And what should tellers and other bank employees say when customers start demanding higher rates?

For its part, Fifth Third has been working hard in recent years to ensure it has a solid base of core deposits and a disciplined pricing strategy that will keep rising rates from leading to drastically higher funding costs. It’s been a long time since banking has been in this predicament. It’s anyone’s guess what happens next.

FinXTech’s Need to Know: Cash Flow

This article is the second in a series focusing on small business banking financial technology. The first covers accounts payable technology and can be found here.

There are 33.2 million small businesses in the United States. With a looming recession, many may soon be looking for ways to lower their budgets, be it by reducing staff, cutting back on hours or even terminating contracts with other vendors. The median small business holds only 27 days of cash on hand, according to a 2016 study from the JPMorgan Chase Institute — an amount that could be challenged by the changing economic state.

Financial institutions should see cash flow management as an opportunity to provide their small business customers with integrated products and services they used to go elsewhere for.

Business owners decide where, when and how to invest and spend revenue after tallying bills, employee hours and balance sheets. They now have modern tools and ways to leverage third-party softwares to automate their balances.

Banks can provide this software to their small business customers, and they don’t have to start from scratch: They can turn to a fintech partner.

Here are three fintechs that could satiate this software need.

Boston-based Centime launched its Cash Flow Control solution in partnership with $26 billion First National Bank of Omaha in 2019. Centime gathers accounts receivable and accounts payable data to provide accurate, real-time forecasts to business customers. Any bank can integrate the solution as an extension of their online banking or treasury management services.

Banks can profit off of these cash flow products, too. Small business customers have access to a direct credit line through the analytics platform. And in a still rising interest rate environment, expanding the lending portfolio will be crucial to a bank. Banks that offer Cash Flow Control to their business customers can play a strategic role in their clients’ cash flow control cycle, gain visibility into their finances and provide streamlined access to working capital loans and lines of credit.

Centime states that it works best with banks with more than $1 billion in assets.

Cash flow solutions can also provide essential insight into current and projected business performance for a bank’s own purposes. Less than 50% of banks said that not effectively using and/or aggregating their data was one of their top concerns in Bank Director’s 2022 Technology Survey. Data segmented into business verticals could shed light into what businesses need from their banks and when they need it.

Monit from Signal Finance Technologies is another cash flow forecasting and analytics solution available to small businesses. Monit aggregates data from the small business’s accounting software, like QuickBooks, Xero or FreshBooks, along with data inputs from the business owner. The projections are dynamic: Business owners can dive deeper into exact factors that influence anticipated dips in cash flow. They can also model alternative scenarios to find ways to avoid the shortfall.

Using the projections, Monit provides business owners with suggestions for the future success of their business, such as opening a new line of credit or slowing down on hiring.

Accessing business data and the third-party apps that house it is another way to strengthen a bank’s understanding of their business clients, as well as indicate how, where and when to help them. UpSWOT’s data portal could be the right solution for a bank looking to gather better data on their business customers and connect with the third-parties that house it.

UpSWOT uses application programming interfaces, or APIs, to collect data from over 150 business apps and provide key performance indicators, marketing data and actionable insights to both bank and business users. It can even notify a bank about a small business client’s activity such as new hires, capital purchases like real estate or vehicles, payment collection and accounts receivable, financial reporting and tax information.

The upSWOT portal also creates personalized marketing and sales dashboard, which bankers can use to anticipate their business clients’ needs before their balance sheets do.

Essential to every single one of the more than 30 million small businesses in the U.S. is cash. And without the ability to effectively forecast and manage it, these small businesses will fail. Banks can help them flourish with the aid of fintech partners.

Centime, Monit and upSWOT are all vetted companies for FinXTech Connect, a curated directory of technology companies who strategically partner with financial institutions of all sizes. For more information about how to gain access to the directory, please email finxtech@bankdirector.com.

What to Consider as Regulators Scrutinize Bank-Fintech Partnerships

Fintech partnerships, specifically banking as service arrangements, are changing the risk profile at community banks and require heightened risk management from executives and the board.

Banking as a service has evolved from the niche domain of certain community banks to a business line facilitated by software. The growth of the industry, and its concentration among small banks, has attracted the attention of the Office of the Comptroller of the Currency, and its Acting Comptroller Michael Hsu. Experts say that community banks should respond by increasing their due diligence and strengthening their risk management oversight, practices and processes ahead of potentially more scrutiny from regulators.

“The growth of the fintech industry, of [banking as a service] and of big tech forays into payments and lending is changing banking, and its risk profile, in profound ways,” Hsu said in prepared remarks at a conference hosted by The Clearing House and the Bank Policy Institute in New York City in September. 

Banking as a service leverages an institution’s charter so a nonbank partner can offer banking products or services to customers. It creates a series of layers: A bank services a fintech, who offers products to a business or individual. And increasingly, the connection between the fintech and the bank is facilitated, partially or completely, by software that is in the middle of the fintech and bank relationship, called middleware. 

One company that makes such an operating system is Treasury Prime, where Sheetal Parikh works as associate general counsel and vice president of compliance solutions. 

“We’ve learned how to become more efficient; we have a lot of these banks with antiquated technology systems and cores that can’t necessarily get fintech companies or customers to market as quickly as maybe they could,” says Parikh.  

While software and operating systems can make the onboarding and connections easier between the parties, it doesn’t ease the regulatory burden on banks when it comes to vendor due diligence and customer protections. A bank can delegate different aspects and tasks within risk management and fraud detection and prevention, but it can’t outsource the responsibility.

“The banks that do it [banking as a service] well have constant engagement with their fintechs,” says Meg Tahyar, co-head of Davis Polk’s financial institutions practice and a member of its fintech team. “You need someone at the end to hold the bag – and that’s always the bank. So the bank always needs to have visibility and awareness functions.” 

Even with middleware, running a rigorously managed, risk-based BaaS program in a safe and sound manner is “operationally challenging” and “a gritty process,” says Clayton Mitchell, Crowe LLP’s managing principal of fintech. The challenge for banks adding this business line is having a “disciplined disruption” approach: approaching these partnerships in an incremental, disciplined way while preparing to bolster the bank’s risk management capabilities.

This can be a big ask for community institutions — and Hsu pointed out that banking as a service partnerships are concentrated among small banks; in his speech, he mentioned an internal OCC analysis that found “least 10 OCC-regulated banks that have BaaS partnerships with nearly 50 fintechs.” The found similar stats at banks regulated by the Federal Reserve and FDIC; most of the banks with multiple BaaS partnerships have less than $10 billion in assets, with a fifth having less than $1 billion.

Tahyar says she doesn’t believe Hsu is “anti-banking as a service” and he seems to understand that community banks need these partnerships to innovate and grow. But he has a “sense of concern and urgency” between fintech partnerships today and parallels he sees with the 2007 financial crisis and Great Recession, when increasing complexity and a shadow banking system helped create a crisis.  

“He understands what’s happening in the digital world, but he’s ringing a bell, saying ‘Let’s not walk into this blindly,’” she says. “It’s quite clear that [the OCC] is going to be doing a deep dive in examinations on fintech partnerships.”

To start addressing these vulnerabilities and prepare for heightened regulatory scrutiny, banks interested in BaaS partnerships should make sure the bank’s compliance teams are aligned with its teams pushing for innovation or growth. That means alignment with risk appetite, the approach to risk and compliance and the level of engagement with fintech partners, says Parikh at Treasury Prime. The bank should also think about how it will manage data governance and IT control issues when it comes to information generated from the partnership. And in discussions with prospective partners, bank executives should discuss the roles and responsibilities of the parties, how the partnership will monitor fraud or other potential criminal activity, how the two will handle customer complaints. The two should make contingency plans if the fintech shuts down. Parikh says that the bank doesn’t have to perform the compliance functions itself — especially in customer-facing functions.  But the bank needs strong oversight processes. 

OCC-regulated banks engaged in fintech partnerships should expect more questions from the regulator. Hsu said the agency is beginning to divide and classify different arrangements into cohorts based on their risk profiles and attributes. Fintech partnerships can come in a variety of shapes and forms; grouping them will help examiners have a clearer focus on the risks these arrangements create and the related expectations to manage it.

What is clear is that regulators believe banking as a service, and fintech partnerships more broadly, will have a large impact on the banking industry — both in its transformation and its potential risk. Hsu’s speech and the agency’s adjustments indicate that regulatory expectations are formalizing and increasing. 

“There is still very much a silver lining to this space,” says Parikh. “It’s not going anywhere. Risk isn’t all bad, but you have to understand it and have controls in place.”

How Legacy Systems, Tech Hold Bank Employees Back

The recent explosion in financial technology firms has allowed banks to make massive strides in improving the customer experience.

The most popular solutions have focused on making processes and services faster and easier for customers. For example, Zelle, a popular digital payments service, has improved the payments process for bank customers by making transfers immediate — eliminating the need to wait while those funds enter their checking account. There are countless examples of tools and resources that improve the bank customer experience, but the same cannot be said for the bank staffers.

Bank employees often use decades-old legacy systems that require weeks or months of training, create additional manual work required to complete tasks and do not communicate with each other. Besides creating headaches for the workers who have to use them, they waste time that could be better spent meaningfully serving customers.

The Great Resignation and tight labor market has made it difficult to find and retain workers with adequate and appropriate experience. On top of that, bankers spend significant amounts of time training new employees on how to use these complicated tools, which only exacerbates problems caused by high turnover. The paradox here is that banks risk ultimately disengaging their employees, who stop using most of the functionality provided by the very tools that their bank has invested in to help them work more efficiently. Instead, they revert to over-relying on doing many things manually.

If bank staff used tools that were as intuitive as those available to the bank’s customers, they would spend less time in training and more time connecting with customers and delivering valuable services. Improvements to their experience accomplishes more than simply making processes easier and faster. As it stands now, bank teams can spend more time than desired contacting customers, requesting documents and moving data around legacy systems. This manual work is time-consuming, robotic and creates very little profit for the bank.

But these manual tasks are still important to the bank’s business. Bankers still need a way to contact customers, retrieve documents and move data across internal systems. However, in the same way that customer-facing solutions automate much of what used to be done manually, banks can utilize solutions that automate internal business processes. Simple, repetitive tasks lend themselves best to automation; doing so frees up staff to spend more of their time on tasks that require mental flexibility or close attention. Automation augments the workers’ capabilities, which makes their work more productive and leads to a better customer experience overall.

There are good reasons to improve the experience of bank employees, but those are not the only reasons. Quality of life enhancements are desirable on their own and create a greater opportunity for employees to serve customers. When deciding which tools to give your staff, consider what it will be like to use them and how effectively they can engage customers with them.

Safeguarding Credit Portfolios in Today’s Uncertain Economic Landscape

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

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

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

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

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

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

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

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

Asking the Right Questions About Your Bank’s Tech Spend

Bank Director’s 2022 Technology Survey, sponsored by CDW, finds 81% of bank executives and board members reporting that their technology budget increased compared to 2021, at a median of 11%. Much of this, the survey indicates, ties to the industry’s continued digitization of products and services. That makes technology an important line item within a bank’s budget — one that enables bank leaders to meet strategic goals to serve customers and generate organizational efficiencies.

“These are some of the biggest expenditures the bank is making outside of human capital,” says John Behringer, risk consulting partner at RSM US LLP. The board “should feel comfortable providing effective challenge to those decisions.” Effective challenge references the board’s responsibility to hold management accountable by being engaged, asking incisive questions and getting the information it needs to provide effective oversight for the organization.  

Banks budgeted a median $1 million for technology in 2022, according to the survey; that number ranged from a median $250,000 for smaller banks below $500 million in assets to $25 million for larger banks above $10 billion. While most believe their institution spends enough on technology, relative to strategy, roughly one-third believe they spend too little. How can boards determine that their bank spends an appropriate amount?

Finding an apples to apples comparison to peers can be difficult, says Behringer. Different banks, even among peer groups, may be in different stages of the journey when it comes to digital transformation, and they may have different objectives. He says benchmarking can be a “starting point,” but boards should delve deeper. How much of the budget has been dedicated to maintaining legacy software and systems, versus implementing new solutions? What was technology’s role in meeting and furthering key strategic goals? 

A lot of the budget will go toward “keeping the lights on,” as Behringer puts it. Bank of America Corp. spends roughly $3 billion annually on new technology initiatives, according to statements from Chairman and CEO Brian Moynihan — so roughly 30% of the bank’s $11 billion total spend.

For banks responding to the survey, new technology enhancements that drive efficiencies focus on areas that keep them safe: For all banks, cybersecurity (89%) and security/fraud (62%) were the top two categories. To improve the customer experience, institutions have prioritized payments capabilities (63%), retail account opening (54%), and consumer or mortgage lending (41%).

Benjamin Wallace says one way board members can better understand technology spend is to break down the overall technology cost into a metric that better illustrates its impact, like cost per account. “For every customer that comes on the board, on average, let’s say $3.50, and that includes the software, that includes the compensation … and that can be a really constructive conversation,” says Wallace, the CEO of Summit Technology Group. “Have a common way to talk about technology spend that you can look at year to year that the board member will understand.”

Trevor Dryer, an entrepreneur and investor who joined the board of Olympia, Washington-based Heritage Financial Corp. in November 2021, thinks boards should keep the customer top of mind when discussing technology and strategy. “What’s the customer’s experience with the technology? [W]hen do they want to talk to somebody, versus when do they want to use technology? When they do use technology, how is this process seamless? How does it align with the way the bank’s positioning itself?” If the bank sees itself as offering high-touch, personal service, for example, that should be reflected in the technology.

And the bank’s goals should drive the information that floats back to the boardroom. Dryer says $7.3 billion Heritage Financial has “great dashboards” that provide important business metrics and risk indicators, but the board is working with Chief Technology Officer Bill Glasby to better understand the impact of the bank’s technology. Dryer wants to know, “How are our customers interacting with our technology, and are they liking it or not? What are the friction points?” 

Some other basic information that Behringer recommends that bank leaders ask about before adopting new technology include whether the platform fits with the current infrastructure, and whether the pricing of the technology is appropriate. 

Community banks don’t have Bank of America’s $11 billion technology budget. As institutions increase their technology spend, bank leaders need to align adoption with the bank’s strategic priorities. It’s easy to chase fads, and be swayed to adopt something with more bells and whistles than the organization really needs. That distracts from strategy, says Dryer. “To me, the question [banks] should be asking is, ‘What is the problem that we’re trying to solve for our customers?’” Leadership teams and boards that can’t answer that, he says, should spend more time understanding their customers’ needs before they go further down a particular path. 

The best companies leverage technology to solve a business problem, but too many management teams let the tail wag the dog, says Wallace. “The board can make sure — before anyone signs a check for a technology product — to press on the why and what’s driving that investment.” 

Forty-five percent of respondents worry that their bank relies too heavily on outdated technology. While the board doesn’t manage the day-to-day, directors can ask questions in line with strategic priorities. 

Ask, “’Are we good at patching, or do we have a lot of systems where things aren’t patched because systems are no longer supported?’” says Behringer. Is the bank monitoring key applications? Have important vendors like the core provider announced sunsets, meaning that a product will no longer be supported? What technology is on premises versus hosted in the cloud? “The more that’s on prem[ises], the more likely you’ve got dated technology,” he says.

And it’s possible that banks could manage some expenses down by examining what they’re using and whether those solutions are redundant, a process Behringer calls “application rationalization.” It’s an undertaking that can be particularly important following an acquisition but can be applied just as easily to organic duplication throughout the organization. 

A lack of boardroom expertise may have members struggling to have a constructive conversation around technology. “Community bank boards may not have what we would consider a subject matter expert, from a technology standpoint,” says Behringer, “so they don’t feel qualified to challenge.” 

Heritage Financial increased the technology expertise in its boardroom with the additions of Dryer and Gail Giacobbe, a Microsoft executive, and formed a board-level technology committee. Dryer led Mirador, a digital lending platform, until its acquisition by CUNA Mutual Group in 2018. He also co-founded Carbon Title, a software solution that helps property owners and real estate developers understand their carbon impact. 

Experiences like Dryer’s can bring a different viewpoint to the boardroom. A board-level tech expert can support or challenge the bank’s chief information officer or other executives about how they’re deploying resources, whether staffing is appropriate or offer ideas on where technology could benefit the organization. They can also flag trends that they see inside and outside of banking, or connect bank leaders to experts in specific areas. 

“Sometimes technology can be an afterthought, [but] I think that it’s a really critical part of delivering banking services today,” says Dryer. “With technology, if you haven’t been in it, you can feel like you’re held captive to whatever you’re being told. There’s not a really great way to independently evaluate or call B.S. on something. And so I think that’s a way I’ve been trying to help provide some value to my fellow directors.”  

Less than half of the survey respondents say their board has a member who they’d consider a tech expert. Of the 53% of respondents who say their board doesn’t have a tech expert, just 39% are seeking that expertise. As a substitution for this knowledge, boards could bring in a strategic advisor to sit in as a technologist during meetings, says Wallace. 

On the whole, boards should empower themselves to challenge management on this important expense by continuing their education on technology. As Wallace points out, many boards play a role in loan approvals, even if most directors aren’t experts on credit. “They’re approving credit exposure … but they would never think to be in the weeds in technology like that,” he says. “Technology probably has equal if not greater risk, sometimes, than approving one $50,000 loan to a small business in the community.”

The ways in which banks leverage technology have been featured recently in Bank Director magazine. “Confronting the Labor Shortage” focuses on how M&T Bank Corp. attracts and trains tech talent. “Community Banks Enter the Venture Jungle” examines bank participation in fintech funds; a follow-up piece asks, “Should You Invest in a Venture Fund?”  Some institutions are evaluating blockchain opportunities: “Unlocking Blockchain’s Power” explores how Signature Bank, Customers Bancorp and others are leveraging blockchain-based payments platforms to serve commercial customers; risk and compliance considerations around blockchain are further discussed in the article, “Opportunities — and Questions — Abound With Blockchain.” 

Technology is an important component of a bank’s overall strategy. For more information on enhancing strategic discussions, consider viewing “Building Operational Resiliency in the Midst of Change” and “Board Strategic Leadership,” both part of Bank Director’s Online Training Series.   

Bank Director’s 2022 Technology Survey, sponsored by CDW, surveyed 138 independent directors, chief executive officers, chief operating officers and senior technology executives of U.S. banks below $100 billion in assets to understand how these institutions leverage technology in response to the competitive landscape. Bank Services members have exclusive access to the complete results of the survey, which was conducted in June and July 2022. 

3 Ways to Help Businesses Manage Market Uncertainty

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

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

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

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

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

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

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

Capitalism with a Conscience

In this edition of The Slant Podcast, Julieann Thurlow, CEO of the $691 million Reading Cooperative Bank in Massachusetts and vice chair of the American Bankers Association, discusses the bank’s new retail banking apprenticeship. Like many of its peers in the cooperative banking movement, Reading Cooperative is owned by its customers and was founded in 1886 primarily to help working families buy homes. And there are some interesting parallels between that mission and the work it’s doing today in the city of Lawrence. The bank has been on a years-long journey to establish a branch in Lawrence, where it will offer check cashing services as part of a broader appeal to the city’s unbanked.

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