How Nonbank Lenders’ Small Business Encroachment Threatens Community Banks

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A new trend has emerged as small businesses across the U.S. seek capital to ensure their survival through the Covid-19 pandemic: a significantly more crowded and competitive market for small business lending. 

Community banks are best-equipped to meet the capital needs of small businesses due to existing relationships and the ability to offer lower interest rates. However, many banks lack the ability to deliver that capital efficiently, meaning:

  • Application approval rates are low; 
  • Customer satisfaction suffers;  
  • Both the bank and small business waste time and resources; 
  • Small businesses seek capital elsewhere — often at higher rates. 

When community banks do approve small credit requests, they almost always lose money due to the high cost of underwriting and servicing them. But the real risk to community banks is that large players like Amazon.com and Goldman Sachs Group are threatening to edge them out of the market for small business lending. At stake is nothing less than their entire small business relationships.

Over the past few years, nonbank fintechs have infiltrated both consumer and business banking, bringing convenience and digital delivery to the forefront. Owners of small businesses can easily apply for capital online and manage their finances digitally.

Yet in 2018, only 11% of small banks had a digital origination channel for small business lending. In an age of smartphones, community banks still heavily rely on manual, paper-based processes for originating, underwriting and servicing small business loans. 

It was no surprise, then, when Amazon and Goldman Sachs announced a lending partnership geared toward third-party merchants using the retail giant’s platform. Soon, invited businesses can apply for a revolving line of credit with a fixed APR. Other major companies like Apple and Alphabet’s Google have also debuted innovative fintech products for consumers —it’s only a matter of time before they make headway into the small business space.

A 2016 Well Fargo survey found that small business owners are willing to pay more for products and services that make their lives easier. It makes sense that an independent retailer that already sells on Amazon would be more inclined to work with a lender that integrates directly into the platform. If your small business lending program isn’t fully online, customers will take the path of least resistance and work with institutions that make the process easier and more seamless.

Serving small business borrowers better
The issue isn’t that small businesses lack creditworthiness as prospective customers. Rather, it’s that the process is stacked against them. Small businesses aren’t large corporations, but many banks apply the same process and requirements for small credit requests as they do for commercial loans, including collecting and reviewing sophisticated financials. This eliminates any chance of profit on small credit requests. The problem is with the bank’s process — not its borrowers.

The solution is clear cut:

  • Digitize the lending process so customers don’t have to take time out of their busy day to visit a branch or speak with a loan officer. Note that this includes more than just an online application. The ability to collect/manage documents, present loans offers, provide e-contracts and manage payments are all part of a digitally-enabled lending process.
  • Incorporate SMB-specific credit criteria that accurately assess creditworthiness more effectively, like real-time cash flow and consumer sentiment.
  • Take advantage of automation without giving up control or increasing risk. For example, client notifications, scoring and application workflow management are all easy ways to save time and cut costs.
  • Free up lending officers to spend more time with your most-profitable commercial customers.

These changes can help turn small business customers into an important, profitable part of your bank. After all, 99% of all U.S. businesses are considered “small” — so the ability to turn a profit on small business lending represents significant upside for your bank. 

With better technology and data, along with a more flexible process, community banks can sufficiently reduce the cost of extending capital to small businesses and turn a profit on every loan funded. Next, banks can market their small business loan products to existing business customers in the form of pre-approved loan offers, and even gain new business customers from competitors that push small business borrowers away. 

Think about it: small business customers already have a deposit relationship at your bank. Community banks have this advantage over the likes of Amazon, Goldman Sachs, Apple and others. But when time is limited, small businesses won’t see it that way. By rethinking your small business lending process, it’s a win for your bank’s bottom line as well as a win in customer loyalty.

The Opportunistic Upside of New Capital Rules

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Looming new capital rules are an opportunity for banks to improve strategic planning and data management as they strengthen their compliance and reporting processes.

The coronavirus pandemic has delayed deadlines for complying with the latest round of capital guidelines dictated by Basel IV. Still, financial institutions should not lose sight of the importance of preparing for Basel IV, the difficulties it will create along the way and the ways they can leverage it as a potential asset. Compliance and implementation may be a significant expenditure for your bank. Starting now will lengthen your institution’s path to greater productivity and profitability to become a better bank, not just a more compliant one.

At Wolters Kluwer, we broke down the task — and opportunity — at hand for banks as they approach Basel IV compliance in our new whitepaper “Basel IV – Your Path to a more Profitable Business.” Here are some of the highlights for your bank:

Making Basel IV For Business
Where there is a will — along with the right tools — there’s a way to leverage the work required to comply with Basel IV for other commercial objectives. The new capital rules emphasize using forward-looking analysis, a holistic, collaborative organizational structure and data management capabilities for compliance and reporting purposes. These tools can all be leveraged for strategic planning and other commercial objectives, reducing or controlling long-term expenses while enhancing efficiency.

Central to this approach, however, is adopting the right attitude and approach. Executives should view Basel IV compliance as a potential asset, not just a liability, and be willing to make changes to the structure of operations and supporting data management systems.

A Familiar Approach
Basel IV is not a monolithic set of edicts; instead, it’s a package of regulatory regimens through which the Basel Committee on Banking Supervision’s guidelines will be put into practice. These measures are actually the final version of the Basel III guidelines issued in 2010 but were seen as such an expansion of what came before as to be thought of as an entirely new program. It contains elements that encourage and even require banks to act in ways that enhance business practices, not just compliance.

One element is the mandate for a holistic, collaborative approach to compliance. All functions within an institution must work in concert with one another, to create a data-driven, dynamic, three-dimensional view of the world. Another point of emphasis is the importance of prospective thinking: anticipating events from a range of alternatives, instead of accumulating and analyzing data that shows only the present state of play.

“What now?” to “What if?”
Banks can use Basel’s compliance and reporting data for business intelligence and strategic planning. Compliance efforts that have been satisfactorily implemented and disseminated allow  executives to create dynamic simulations displaying prospective outcomes under a range of scenarios.

The possibilities of leveraging Basel IV for business extends to the individual deal level. Calculations and analysis used for compliance can be easily repurposed to forecast the rewards and risks of a deal under a range of financial and economic scenarios whose probabilities themselves can be approximated. And because a firm’s risk models already will have been vetted in meeting Basel IV compliance standards, bankers can be confident that the results produced in the deal evaluation will be robust and reliable.

Another big-picture use of Basel IV for business is balance sheet optimization: forecasting the best balance sheet size for a given risk appetite. This can show the board opportunities that increase risk slightly but obtain far more profit, or sacrifice a bit of income to substantially reduce risk.

To turn Basel IV’s potential for business into practice requires openness and communication from senior executives to the key personnel who will have to work together to bring the plan to fruition. It will mean adopting a mindset that considers each decision, from the details of individual deals to strategic planning, along with its likely impact. Staff must also be supported by similarly structured data management architecture.

The emphasis on forward-looking analysis and a holistic, collaborative organizational structure for compliance and reporting purposes, supported by data management capabilities designed along the same lines, can be leveraged for strategic planning and other commercial objectives. Success in streamlining operations and maximizing productivity and profit potential, and any edge gained over the competition, can reap especially great long-term rewards when achieved at times like these. Leaders of financial institutions have a lot on their minds these days, but there is a persuasive case to be made right now for seizing the opportunity presented by Basel IV for business.

Opportunity Emerges from Coronavirus Crisis

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The banking industry has experienced shocks and recessions before, but this one is different.

Never has the economy been shut so quickly, has unemployment risen so fast or the recovery been so uncertain. The individual health risks that consumers are willing to take to create demand for goods and services will drive the recovery. As we weigh personal health and economic health, banking communities and their customers hang in the balance.

Ongoing economic distress will vary by market but the impact will be felt nationwide. Credit quality will vary by industry; certain industries will recover more quickly, while others like hotels, restaurants, airlines and anything involving the gathering of large crowds will likely need the release of a coronavirus vaccine to fully recover. As more employees work from home, commercial office property may never be the same. While this pandemic is different from other crises, some principles from prior experience are worth consideration as bankers manage through this environment.

Balance sheet over income statement. In a crisis, returns, margins and operating efficiency — which often indicate performance and compensation in a strong economy — should take a back seat to balance sheet strength and stability. A strong allowance, good credit quality, ample liquidity and prudent asset-liability management must take priority.

Quality over quantity. Growth can wait until the storm has passed. Focus on the quality of new business. In a flat yield curve and shrinking margin environment, resist the thinking that more volume can compensate for tighter spread. Great loans to great customers are being made at lower and lower rates; if the pie’s not growing, banks will need to steal business from each other via price in a race to the bottom. Value strong relationships and ask for pricing that compensates for risk. Resist marginal business on suspect terms and keep dry powder for core investments in the community.

Capital is king. It’s a simple concept, but important in a crisis. Allocate capital to the most productive assets, hold more capital rather than less and build capital early. A mistake banks made in prior crises was underestimating their capital need and waiting too long to build or raise capital. Repurchasing shares seems tempting at current valuations, but the capital may be more valuable internally. Some banks may consider cutting or suspend common stock dividends, but are fearful of condemnation in the market. The cost of carrying too much capital right now is modest compared to the cost of not having enough — for credit losses but equally for growth opportunity during the recovery.

The market here serves as the eye of the storm. The front edge of the storm saw the closure of the economy, concern for family, friends and staff and community outreach with the Paycheck Protection Program (PPP), not once but twice. Now settles in the calm. Banks have deployed capital, the infection rate is slowing and small businesses are trying to open up. But don’t mistake this period for the storm being over. There is a back edge of the storm that may occur in the fall: the end of enhanced unemployment insurance benefits, the exhaustion (and hopefully forgiveness) of PPP funds and the expiration of forbearance. Industries that require a strong summer travel and vacation season will either recover or struggle further. And any new government stimulus will prolong the inevitable as a bandage on a larger wound. Banks may see credit losses that rival the highest levels recorded during the Great Recession. Unemployment that hits Great Depression-era levels will take years to fully recover.

But from crisis comes opportunity. Anecdotal evidence suggests that business may shift back to community banks. When markets are strong, pricing power, broad distribution and leading edge technology attract consumers to larger institutions. In periods of distress, however, customers are reminded of the strength of human relationships. Some small businesses found it difficult to access the PPP because they were a number in a queue at a larger bank or were unbanked without a relationship at all. Consumers that may have found it easy to originate their mortgage online had difficulty figuring out who was looking out for them when they couldn’t make their payment. In contrast, those that had a banking relationship and someone specific to call for help generally had a positive experience.

This devastating crisis will be a defining moment for community banks, as businesses and consumers have new appreciation for the value of the personal banking relationship. Having the strength, capital, brand and momentum to take advantage of the opportunity will depend on the prudence and risk management that these same banks navigate the pandemic-driven downturn today.

Texas Strong: Banks Contend With Dual Threats

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“Texas has four seasons: drought, flood, blizzard and twister.” – Anonymous

To that list of afflictions you can add two more — the Covid-19 pandemic and a catastrophic collapse in global oil prices, creating double trouble for the Lone Star State.

There were over 50,500 coronavirus cases in Texas through May 20, an average of 174 per 100,000 people, according to the Center for Systems Science and Engineering at Johns Hopkins University. There were nearly 1,400 coronavirus-related deaths in the state.

In mid-March, Texas Gov. Greg Abbott imposed restrictions that limited social gatherings to 10 people or less, and effectively closed close-proximity businesses like restaurants and bars, health clubs and tattoo parlors. Even as Abbott reopens the state’s economy, many of its small businesses have already been hurt, along with many lodging and entertainment concerns.

“Shutting down the economy was probably a good health decision,” says F. Scott Dueser, chairman and CEO at $9.7 billion First Financial Bankshares in Abilene, Texas. “It wasn’t a good economic decision.”

And then there’s oil situation. An oil price war between two major producers — Russia and Saudi Arabia — helped drive down the price of West Texas Intermediate crude from over $60 per barrel in January to less than $12 in late April, before rebounding to approximately $32 currently.

Texas still runs on oil; while it is less dependent on the energy sector than in past cycles, its importance “permeates” the state’s economy, according to Dueser. “It is a major industry and is of great concern for all of us,” he says.

The 65-year-old Dueser has been First Financial’s CEO since 2008, and guided the bank successfully through the Great Recession. “I thought I’d be retired by the next recession but unfortunately, we weren’t planning on a pandemic and it has come faster than I thought,” Dueser says.

This downturn could be as bad or worse as the last one. But so far, damage to First Financial’s profitability from the combined effects of the pandemic and cheap oil has been minor. The bank’s first quarter earnings were off just 2.6% year over year, to $37 million. Like most banks, First Financial has negotiated loan modifications with many of its commercial borrowers that defer repayment of principal and/or interest for 90 days.

Dueser won’t know until the expiration of those agreements how many borrowers can begin making payments, and for how much — clouding the bank’s risk exposure for now. But with a Tier 1 capital ratio over 19%, Dueser has the comfort of a fortress balance sheet.

“We unfortunately have been down this road before … and capital is king because it’s what gets you through these times,” he says.

Dueser made a decision early in the pandemic that as much as possible, the bank would remain open for business. It encouraged customers to use branch drive-thru lanes, but lobbies have remained open as well.

“So far we have been very successful here at the bank in staying open, not locking our doors, not limiting hours, keeping our people safe and at the same time serving more customers than we ever have in the history of the bank,” Dueser says.     

The bank has followed Covid-19 safety requirements from the Center for Disease Control. “The most important things are don’t let your people come to work sick and social distancing,” Dueser says. “We split every department, such as technology, phone center, treasury management and so on with having half the department work from home or from another one of our locations. That way we had only half the people here, which allowed us to put people in every other desk or cubicle.”

To date, the bank has had only four Covid-19 cases among its employees. “Thankfully, all four of those individuals are healthy and back at work,” Dueser says. “With each situation we learn more on how to protect our employees and customers.”

Dueser is one of 39 people on a task force appointed by Abbott to advise him on reopening the state’s economy. “I am very supportive of what he is doing, in the fact that we are getting the state back open,” he says. “The virus is not winning the war, which is good. We have a lot to learn so that we can live with the virus without having to go home and hide in a closet.”

One of Dueser’s biggest priorities through the economic hardship was to make sure retail and commercial customers knew that it would stand by them, come what may. That led to a recent marketing campaign designed around the phrase “Texas Strong,” a slogan used throughout the state that traces back to Hurricane Harvey, which devastated Houston in 2017.

“We want our customers to know that we’re safe, sound and strong,” says Will Christoferson, the bank’s senior vice president for advertising and marketing. “What’s stronger than Texas? We couldn’t think of anything.”

The CARES Act: What Banks Need to Know

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Banks will play a critical role in providing capital and liquidity to American businesses and consumers, and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) includes several provisions that benefit depository institutions. The implications for bank directors and officers are significant; they may need to make major decisions quickly.

Expanded SBA Lending
The CARES Act appropriates $349 billion for “paycheck protection loans” to be made primarily by banks that will be 100% guaranteed by the Small Business Administration (SBA) through its 7(a) Loan Guaranty Program. The SBA issued an interim final rule on the program on April 2 and has issued additional formal and informal guidance since that date. Application submissions began on April 3. Banks and borrowers will want to move quickly, due to the limited funds available for the program.

Provisions Benefitting Depository Institutions Directly

Troubled Debt Restructuring Relief. A financial institution may elect to suspend the requirements under generally accepted accounting principles and federal banking regulations to treat loan modifications related to the COVID-19 pandemic as troubled debt restructurings. The relief runs through the earlier of Dec. 31 or 60 days after the termination date of the national emergency, and does not apply to any adverse impact on the credit of a borrower that is not related to the COVID-19 pandemic.

CECL Delay. Financial institutions are not required to comply with the current expected credit losses methodology (CECL) until the earlier of the end of the national emergency or Dec. 31.

Reduction of the Community Bank Leverage Ratio. Currently, a qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio of greater than 9% will be considered to have met all regulatory capital requirements. The CARES Act reduces the community bank leverage ratio from 9% to 8% until the earlier of the end of the national emergency or Dec. 31. In response to the CARES Act, federal banking regulators set the community bank leverage ratio at 8% for the remainder of 2020, 8.5% for 2021 and 9% thereafter.

Revival of Bank Debt Guarantee Program. The CARES Act provides the Federal Deposit Insurance Corp. with the authority to guarantee bank-issued debt and noninterest-bearing transaction accounts that exceed the existing $250,000 limit through Dec. 31. The FDIC will determine whether and how to exercise this authority.

Removal of Limits on Lending to Nonbank Financial Firms. The Comptroller of the Currency is authorized to exempt transactions between a national bank or federal savings association and nonbank financial companies from limits on loans or other extensions of credit — commonly referred to as “loan-to-one borrower” limits — upon a finding by the Comptroller that such exemption is in the public interest.

Provisions Related to Mortgage Forbearance and Credit Reporting

The CARES Act codifies in part recent guidance from state and federal regulators and government-sponsored enterprises, including the 60-day suspension of foreclosures on federally-backed mortgages and requirements that servicers grant forbearance to borrowers affected by COVID-19.

Foreclosure and Forbearance on Residential Mortgages. Companies servicing loans insured or guaranteed by a federal government agency, or purchased or securitized by Fannie Mae or Freddie Mac, must grant up to 180 days of forbearance to borrowers who request and affirm financial hardship due to COVID-19 through the period ending on the later of July 25, or the end of the national emergency.

Servicers are not required to document the borrower’s hardship. The initial 180-day forbearance period must be extended up to an additional 180 days at the borrower’s request., Servicers of federally backed mortgage loans may not assess fees, penalties, or interest beyond the amounts scheduled or calculated during this forbearance period, as if the borrower made all contractual payments on time and in full under the terms of the mortgage contract. The law also imposes a foreclosure moratorium on federally backed mortgage loans of at least 60 days, beginning on March 18.

Forbearance on Multi-Family Mortgages. Multifamily borrowers with a federally backed multifamily mortgage loan that was current on its payments on Feb. 1, may request forbearance for a 30-day period with up to two 30-day extensions, during the covered period. Servicers are required to document borrower’s hardship. Borrowers must provide tenant protections, including prohibitions on evictions for non-payment and late payment fees, in order to qualify for the forbearance, and servicers are required to document the borrower’s hardship.

Moratorium on Negative Credit Reporting. Any furnisher of credit information that agrees to defer payments, forbear on any delinquent credit or account, or provide any other relief to consumers affected by the COVID-19 pandemic must report the credit obligation or account as current if the credit obligation or account was current before the accommodation.

Why This Crisis Is Different

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The USS Economy is steaming into dangerous waters and the country’s banks are trapped aboard with the rest of the passengers.

A public health policy of social distancing and lockdowns in response to the COVID-19 virus is creating a devastating impact on the U.S. economy, which in recent years has been driven by consumer spending and a historically low unemployment rate. According to the Bureau of Labor Statistics, the U.S. labor market added 273,000 jobs in February, while private sector wages grew 3%. Moody’s Investors Service also says that the U.S. economy grew 2.3% last year, with personal consumption expenditures contributing 77% of that growth.

That is changing very quickly. Brace yourself for the virus economy.

Wall Street firms are forecasting that the U.S. economy will contract sharply in the second quarter — with Goldman Sachs Group expecting a 24% decline in gross domestic product for the quarter.

“The sudden stop in U.S. economic activity in response to the virus is unprecedented, and the early data points over the last week strengthened our confidence that a dramatic slowdown is indeed already underway,” Goldman’s chief economist Jan Hatzius wrote in a March 20 research note.

My memory stretches back to the thrift crisis in the late 1980s, and there are others that have occurred since then. They’ve all been different, but they generally had one thing in common: They could be traced back to particular asset classes — commercial real estate, subprime mortgages or technology companies that were grossly overfunded, resulting in dangerous asset bubbles. When the bubbles burst, banks paid the price.

What’s different this time around is the nature of the underlying crisis.

The root cause of this crisis isn’t an asset bubble, but a public health emergency that is wreaking havoc on the entire U.S. economy. Enforced governmental policies like social distancing and sheltering in place have been especially hard on small businesses that employ 47.5% of the nation’s private workforce, according to the U.S. Small Business Administration. It puts a lot of people out of work when those restaurants, bars, hardware stores and barber shops are forced to close. Economists expect the U.S. unemployment rate to soar well into double digits from its current rate of just 3.5%.   

Bank profitability will be under pressure for the remainder of the year. It began two weeks ago when the Federal Reserve Board began cutting interest rates practically to zero, which will put net interest margins in a vice grip. One bank CEO I spoke to recently told me that every 25-basis-point drop in interest rates clips 4 basis points off his bank’s margin — so the Fed’s 150 basis point rate cut reduced his margin by 20 basis points. Worse yet, he expects the low-rate environment to persist for the foreseeable future.

Making matters worse, banks can expect that loan losses will rise over time — perhaps precipitously, if we have a long and deep recession. Many banks are prepared to work with their cash-strapped borrowers on loan modifications to get them through the crisis; federal bank regulators have said lenders will not be forced to automatically categorize all COVID-19 related loan modifications as troubled debt restructurings, or TDRs.

Unfortunately, a prolonged recession is likely to outpace most banks’ abilities to temporarily forego principal and interest payments on their troubled loans. A sharp rise in loan losses will reduce bank profitability even more.

There is another way in which this crisis is different from previous crises that I have witnessed. The industry is much stronger this time around, with roughly twice the capital it had just 12 years ago at the onset of the subprime mortgage crisis.

Think of that as first responder capital.

During the subprime mortgage crisis, the federal government injected over $400 billion into the banking industry through the Troubled Asset Relief Program. The government eventually made a profit on its investment, but the program was unpopular with the public and many members of Congress. The full extent of this banking crisis remains to be seen, but hopefully this time the industry can finance its own recovery.

Seven Small Business Lending Trends In 2020

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There are roughly 5.1 million companies that comprise the small to medium-sized business (SMB) category in the U.S. today — and that segment is growing at 4% annually. Many of these businesses, defined as having less than 1,000 employees, may need to seek external funding in the course of their operations. This carves out a lucrative opportunity for community and regional banks.

To uncover leading trends and statistics, the Federal Reserve’s 2019 Small Business Credit Survey gathered more than 6,600 responses from small and medium U.S.-based businesses with between 1 and 499 employees. These are the top seven small business lending statistics of 2019 — along with some key insights to inform your bank’s small business lending decisions in 2020.

1. Revenue, employee growth in 2018
The U.S. small business landscape remains strong: 57% of small businesses reported topline growth and more than a third added employees to their payrolls. Lending to these companies isn’t nearly as risky as it once was, and the right borrowers can offer an attractive opportunity to diversify your bank’s overall lending portfolio.

2. Steady rise in capital demand
Small businesses’ demand for capital has steadily risen: in 2017, 40% of surveyed businesses applied for some form of capital. In 2018, the number grew to 43%, with no drop-off in sight. Banks should not wait to tap into this lucrative trend.

3. Capital need
With limited and/or inconsistent cash flow, small businesses are almost bound to face financial hurdles. Indeed, 64% of small businesses said they needed capital in the last year. But when seeking capital, they typically find many banks turning their backs for reasons related less to credit-worthiness, and more to slimmer bank margins due to time-consuming due diligence.

As a result, over two-thirds of SMBs reported using personal funds — an outcome common to many small businesses owners. This is a systemic challenge, with a finding that points to an appealing “white space” opportunity for banks.

4. Capital received
Too many small businesses are settling for smaller loans: 53% of small businesses that sought capital received less funding than they wanted. Banks can close this funding gap for credit-worthy small businesses and consistently fill funding requests by decreasing the cost of small business lending.

5. Funding shortfalls
Funding shortfalls were particularly pronounced among specific small businesses, with particular credit needs. Businesses that reported financing shortfalls typically fell into the following categories:

• Were unprofitable
• Were newer
• Were located in urban areas
• Sought $100,000 to $250,000 in funding

Of course, not all small businesses deserve capital. But some shortfall trends — like newer businesses or those in urban areas — may suggest less of a qualification issue and more to systemic barriers.

6. Unmet needs
Optimistic revenue growth paired with a lack of adequate funding puts many viable small businesses at unnecessary risk. The survey found that 23% of businesses experienced funding shortfalls and another 29% are likely to have unmet funding needs. Capitalizing on these funding trends and increasing small business sustainability may well benefit both banks, businesses and communities in the long run.

7. Online lenders
Online lending activity is on the rise: 32% of applicants turned to online lenders in 2018, up from 24% in 2017 and 19% in 2016. The digital era has made convenience king — something especially true for small business owners who wear multiple hats and are naturally short on time. Online lending options can offer small business owners greater accessibility, efficiency and savings throughout the lending process, especially as digital lending solutions become increasingly sophisticated.

Bracing for Changes in the Bank Control Rules

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Executives and directors at public banks need to prepare for new rules this spring that will make it easier for investors to accumulate meaningful stakes in their companies.

The Federal Reserve Board has approved an update to the control framework for investors in banks or bank holding companies that goes into effect April 1. The update comes as the marketplace undergoes a structural shift in flows from active fund management to passive investing. The changes should make it easier for investors — both passive and active — to determine whether they have a controlling influence over a bank, and provides both banks and investors with greater flexibility.

“Anything that’s pro-shareholder, a bank CEO and board should always be happy to support,” says Larry Mazza, CEO at Fairmont, West Virginia-based MVB Financial, which has $1.9 billion in assets. “The more shareholders and possible shareholders you can have, it’s very positive for the owners.”

The Fed last updated control rules in 2008. This update codifies the regulator’s unwritten precedent and legal interpretations around control issues, which should increase transparency for investors, says Joseph Silvia, a partner at Howard & Howard.

“The goal of the regulators is to make sure that they understand who owns those entities, who runs those entities and who’s in charge, because those entities are backed by the Federal Deposit Insurance Corp.,” he says. “The regulators take a keen interest, especially the Fed, in who’s running these entities.”

The question of who controls a bank has always been complicated, and much of the Fed’s approach has been “ad hoc,” Silvia says. The latest rule is largely a reflection of the Fed’s current practice and contains few changes or surprises — helpful for banks and their investors that are seeking consistency. Large shareholder should be able to determine if their stakes in a bank constitute control in a faster and more-straightforward way. They also may be able to increase their stakes, in some circumstances. Silvia specifically highlights a “fantastic,” “wildly helpful” grid that breaks down what the regulator sees as various indicia of control, which observers can find in the rule’s appendix.

“A lot of investors don’t like the pain of some of these regulations — that helps and hurts. [The] regulation creates predictability and stability,” Mazza says. “Where it hurts is that investors may not go forward with additional investments, which hurts all shareholders.”

Shareholders, and banks themselves that may want to take stakes in other companies, now have increased flexibility on how much money they can invest and how to structure those investments between voting and non-voting shares, as well as how board representation should figure in. Silvia says this should advance the conversations between legal counsel and investors, and spare the Fed from weighing in on “countless inquires” as to what constitutes control.

“Both banks and shareholders will likely benefit from the changes, as it could lower the cost of capital for banks while allowing for a greater presence of independent perspectives in the board room,” wrote Blue Lion Capital partner and analyst Justin Hughes in an email. Blue Lion invests in bank stocks.

The change impacts active and passive investors, the latter of which have grown to be significant holders of bank stocks. Passive vehicles like exchange-traded and mutual funds have experienced $3 trillion in cumulative inflows since 2006, while actively managed funds have seen $2.1 trillion in outflows, according to Keefe, Bruyette & Woods CEO Tom Michaud. Passive ownership of bank stocks has increased 800 basis points since 2013, representing 17.1% of total shares outstanding in the third quarter of 2019. Some funds may be able to increase their stakes in banks without needing to declare control, depending on how the investments are structured.

Still, banks may be concerned about the potential for increased activism in their shares once the rule goes into effect. Silvia says the Fed is familiar with many of the activists in the bank space and will watch investment activity after the rule. They also included language in the final update that encourages investment vehicles who have not been reviewed for indicia of control from the Fed to get in touch, given than no grandfathering was provided to funds that had not been reviewed.

“They’re not really grandfathering any investments,” Silvia says. “There’s not a lot of additional protection.”

If nothing else, the rule is a chance for bank executives and directors to revisit their shareholder base and makeup and learn more about their owners, he adds. They should keep track if the makeup of their shareholders’ stakes changes once the rule goes into effect, especially investors that may become activists.

A Long-Term Approach to Credit Decisioning

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Alternative data doesn’t just benefit banks by enhancing credit decisions; it can help expand access to capital for consumers and small businesses. But effectively leveraging new data sources can challenge traditional banks. Scott Spencer of Equifax explains these challenges — and how to overcome them — in this short video. 

  • The Potential for Alternative Data
  • Identifying & Overcoming Challenges
  • Considerations for Leadership Teams

 

Six Reasons Banks Are Consenting to C-PACE Financing

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lending-8-13-19.pngBanks looking to stay abreast of emerging commercial real estate trends should consider an innovative way to fund certain energy improvements.

Developers increasingly seek non-traditional sources to finance construction projects, making it crucial that banks understand and embrace emerging trends in the commercial real estate space. Commercial Property Assessed Clean Energy (C-PACE) financing is one of the fastest-growing source of capital for new construction and historic rehabilitation developments throughout the country, and banks are jumping on board to consent to the use of this program.

C-PACE financing programs allow for private funders, like Twain Financial Partners, to provide long-term, fixed-rate financing for 100% of the cost of energy efficiency, renewable energy and water conservation components of real estate development projects. This financing often replaces more expensive pieces of the construction capital stack, like mezzanine debt or preferred equity. Currently, over 35 states have passed legislation enabling C-PACE; new programs are currently in development in Illinois, Pennsylvania, New York, among others.

C-PACE financing can typically fund up to 25% of the total construction budget, is repaid as a special assessment levied against the property and is collected in the same manner as property taxes. Like other special assessments, a lien for delinquent C-PACE assessments is on par with property taxes. Due to the lien priority, nearly all C-PACE programs require the consent of mortgage holders prior to a C-PACE assessment being levied against the property.

C-PACE industry groups report that over 200 national, regional and local mortgage lenders have consented to the use of this type of financing to date. While there are many reasons mortgage holders consent to C-PACE, below are the top six reasons banks should consider consenting:

C-PACE Financing Cannot be Accelerated. In the event of a default in the payment of an annual or semi-annual C-PACE assessment obligation, only the past due portion of the C-PACE financing is senior to a mortgage lender’s claim. For example, assume Twain Financial provided $1 million of C-PACE financing to a project, with a $100,000 annual assessment obligation due each year over a 20-year term. In the event of non-payment of the C-PACE assessment in year 1, Twain could not accelerate the entire $1 million of C-PACE. Rather, Twain’s lien against the property is limited to $100,000.

C-PACE Financing Does Not Restrict a Senior Lender’s Foreclosure Rights. Unlike other forms of mezzanine financing, C-PACE funders do not require an intercreditor agreement with a senior lender. Rather, the senior lender can foreclose on its mortgage interest in the property in the event of a default on the senior lender’s debt, in the same manner as if it was the sole lienholder on the property. The C-PACE lender does not have any right to prevent, restrict, or otherwise impact the senior lender’s foreclosure.

Senior Lenders May Escrow the C-PACE Assessment. In many cases, senior lenders will require a monthly escrow of the annual C-PACE assessment obligation, in the same manner as property tax and insurance escrow requirements. The C-PACE escrow serve to further mitigate risks associated with the failure to pay the C-PACE assessment when due.

C-PACE Funds Fully Available as of Date of Closing. C-PACE financing typically closes simultaneous with the senior lender. At the closing date, all C-PACE funds are deposited into an escrow account, to be withdrawn as eligible costs are incurred. Senior lenders have the reassurance of knowing the funds are available to be drawn as of the date of closing.

C-PACE Financing May Increase the Value of the Senior Lender’s Collateral. In most states, a threshold requirement for C-PACE financing is that an engineer establish the savings-to-investment ratio is greater than one. In other words, the savings achieved by the financed improvements over the term must outweigh the cost of the improvements. PACE projects directly reduce a building’s operating costs, increasing its net operating income and valuation.

Relationships matter. Nearly every C-PACE project involves a lender’s customer who wants or needs to complete a project. C-PACE funded projects make good business sense for the building owner and the building’s mortgage lender.