5 Key Takeaways From the State of Commercial Banking

In January, Q2 released the 2023 State of Commercial Banking Report, which analyzed data from Q2’s PrecisionLender proprietary database that includes commercial relationships from more than 150 banks and credit unions throughout the United States, along with other sources. Report author Gita Thollesson weighs in on the uncertainty of the 2023 outlook and other key takeaways from the report.

Takeaway 1: All we can say with certainty about the economic outlook for 2023 is that it’s uncertain.
We’re seeing a lot of mixed signals in the market right now. On one hand, gross domestic product, or GDP, went from an actual rate of 5.5% at the end of 2021 to 2.1% by December 2022. Two quarters of negative GDP growth and an inverted yield curve are often two key predicators of recession, and 2022 had both.

On the other hand, the U.S. economy has enjoyed record low unemployment and a strong jobs market, robust industrial production and positive GDP growth in the latter half of 2022. These mixed signals suggest this recession will be different.

Takeaway 2: Banks are bracing for a downturn, but…
There’s wide consensus that there could be an economic downturn. However, bank credit metrics are currently holding strong; although some financial institutions are expecting some deterioration, it hasn’t materialized yet.

Looking at risk metrics in commercial real estate and commercial and industrial lending, delinquency rates are trending lower and charge-offs have fallen off a cliff. Despite that, we’re seeing banks increase their loan loss provisions, which could indicate they’re bracing for rough weather ahead.

It’s also worth noting that when we look at the probability of default (PD) grades on loans — both below and above $5 million — in our proprietary data, we found a tremendous amount of stability in terms of ratings in 2022. PD grades are often a much earlier indicator of borrower health than delinquencies; the stability suggests that customers are not yet showing signs of weakness.

Takeaway 3: Renewed focus on deposits amid a competitive lending climate.
We’re seeing a tremendous amount of competitive pressure from a pricing perspective. This runs counter to what we typically see at this stage of the cycle: Usually in a pre-recessionary period, banks begin to tighten up, but we’re not seeing that in the data yet. If anything, spreads are getting narrower.

Last year, the industry experienced climbing deposits through mid-year 2022 before balances started to flatten out. The Fed raised rates, but banks didn’t follow suit and deposits started leaving the banking industry, according to weekly data from the Federal Reserve’s H8 releases. By year end, these figures were heading south. Not surprisingly, deposit growth has risen to the top of the strategic priority list for 2023. Banks are raising deposit betas, passing a greater portion of the interest rate increases to customers, especially on commercial accounts to preserve liquidity.

Takeaway 4: Digital reaches deep into the financial institution.
What was once primarily a conversation about the online banking platform has evolved into so much more. We’re now seeing a real focus on the part of financial institutions to center and target their digital spending on client experiences and create internal efficiencies by providing more tools to employees to streamline and automate processes that have largely been manual in the past. Our research finds that these both are two of the top priorities for banks.

Takeaway 5: Payments innovation is leveling the playing field.
We’re also seeing tremendous change on the payments front. Real-time payment rails, which are slated to be the first new rails in 40 years, include a broader payment message set that covers the life cycle of a payment and enables the invoice/remittance data to travel with that payment from start to finish. The changes are leveling the playing field, and the benefits go far beyond the immediacy of the payments. The true value for business is in the remittance data.

Despite technological advancements, adoption has been slow; the industry still needs more financial institutions to get on board. Fortunately, new innovations that leverage the full power of real-time payments rails are set to hit the market in 2023.

The Future of Commercial Banking

Most of the attention around bank digitalization has focused on the retail experience. Retail banks have readily embraced technology to enhance the customer experience. But commercial banking can catch up, complete with business insights that increase customer engagement and add real value. In doing so, a bank can elevate its position from trusted transactional banker to strategic business partner.

In the U.S., there were more than 32 million small-to-medium size businesses (SMBs) in 2021, according to the Small Business Administration. Collectively they create 1.5 million jobs annually, according to Fundera, citing SBA data; this is around 64% of total new jobs. But the stakes of owning an SMB are high: almost half fail within the first five years and 20% fail within the first year, according to the Bureau of Labor Statistics. Most failures cite cash flow as a major contributor to failure. Banks can and should do more to help.

With a wealth of transactions data at their fingertips, banks can help SMBs understand their cash flow and manage their liquidity better. But transactional data is only part of the story. If banks can access their customer data held on internal accounting systems, they can obtain a holistic view of cash flow, gain unique insight into how their customer’s business is running, and offer help exactly when and where it’s needed.

Bank customers are increasingly willing to share their data: 82% of SMBs say they are willing to share data with their primary financial provider, particularly in return for business benefits, according to FIS research conducted in 2022. Moreover, we found that 66% of SMBs are interested in trusted advisory services. The time is right for such services.

Technically, it is quite simple for a bank to orchestrate data flows. Over 64% of SMBs in the U.S. use accounting software, such as Quickbooks, Xero, Sage and a handful of others, minimizing the amount of integration work and number of interfaces needed. So how can banks help SMBs businesses survive and prosper?

The Ideal SMB Banking Overview
A combined view of transactional bank data and accounting data allows banks to help an SMB understand exactly how much cash it has now and whether it has sufficient liquidity to meet upcoming obligations.

Incorporating accounting data can pull in open invoices and bills combined with cash flow forecast to build an accurate picture of how money is flowing throughout the business and compute standard accounting ratios. Such information can give an SMB owner, most of which don’t have much knowledge of accounting, some valuable business insight into how their business is performing.

A snapshot of cash flows allows users to modeling future performance by using “what if” criteria. Users can set thresholds of a minimum cash position to eliminate financial shocks to the business. If cash shortfalls seem likely, the user can be prompted to transfer funds from account, consider credit options or arrange to speak with a banker.

Benefits for Banks
All of this information that’s available to the customer can also be accessed by a banker, who can help with financial decisions and offer advice. Although this may be an opportunity for a bank to sell products, the real benefit is to add value to the relationship and build customer loyalty.

With all the relevant information in one place, bankers can be better prepared for customer meetings and, if required, can meet customers where they are. With many bank branches being repurposed as advice centers, bankers can use tablets to review customer business plans either in branch, at a remote location or in a virtual meeting. Whatever the location, this is relationship banking at its very best.

Millennials are currently the largest group of bank customers, according to the American Bankers Association. In the wake of Covid-19, many have reflected on their career choices; some have launched new businesses and entrepreneurship is a goal for 56% of the cohort. These individuals have bank accounts, and many will need business banking either now or in future. They see little distinction between retail and commercial banking. Banks must acknowledge that the retail customers of today are the business owners of tomorrow.

Crafting and Implementing an Effective Loan Review Function

Performing the loan or credit review function is a regulatory requirement for banks of all sizes and a key credit risk management practice.

Loan review not only helps banks assess emerging risk in their portfolios, but can also protect the institution by identifying loans with potential risk rating downgrades before regulators do. Sometimes called the last or “third line of defense,” an effective loan review function includes a partnership between the loan review staff and the lenders and credit teams that make up the first and second lines of defense to ensure the ongoing constructive monitoring of the bank’s credit quality.

Bank boards have several options when choosing how to implement the commercial credit/loan review function. This includes outsourcing the function to an expert third party loan review service provider, building out their own loan review department internally staffed or blending the two approaches for a hybrid, co-sourced arrangement. Each model has elements and considerations that executives should explore before making final decisions, including the cost to the bank, regulatory expectations, overhead, internal staffing issues and quality of work. Some bank executives are also sensitive to perceptions that institutions above a certain size should internalize the loan review function.

According to high-level members of bank regulatory agencies we have talked with, there is no regulatory expectation for a bank’s loan review model based on the bank’s asset size and no expectation of rotating outsourced loan review providers. The factors most important to the regulators are independence from the internal lending and approving function, the expertise of the loan review analysts, the supportability of loan review’s conclusions and the quality of the entire process. The bank and its board has great freedom to shape the department and its scope to accomplish these objectives.

Outsourced Loan Review
The outsourced loan review model has a number of advantages over internal models. It is almost always the most cost-effective approach. A competent outsourced provider can typically review borrowers in the portfolio more quickly than internal staff, due to their use of best practices and concise analytical approach. Third-party experts usually have deep expertise in a wider range of credit specialty areas, such as commercial real estate segments, agriculture, commercial and industrial, leveraged lending or leasing. An outsourced provider with a broad view of the industry and into similar institutions’ portfolios can add valuable perspective, such as best practices, regulatory intelligence and general peer information. Additionally, the tight labor market has underlined the difficulty of attracting and maintaining staff; loan review departments have had significant issues finding and keeping people. Outsourcing avoids that issue completely, leaving the efforts of hiring, training and retaining competent staff to the provider.

Internal Loan Review
Setting up and maintaining an internal loan review department can help executives build stronger team interaction and relationships within the bank. Internal staff can attend meetings like loan committees and special assets to better understand the bank’s risk appetite. Continuously monitoring the lending portfolio internally can enable the bank to more easily detect shifts in underwriting quality or patterns of emerging risk. A loan review department manager with effective internal staffing can build relationships and set expectations for resolving conflicts. In most cases, the most efficient and effective internal loan review departments use specially developed loan review automation software to enable better staff management, perform more efficient exams and provide consistent results. The competition for seasoned loan review staff can also make effective internal staffing difficult.

Hybrid Loan Review
Using a “hybrid” loan review model where internal staff works with external third-party loan review experts can offer some of the best of both models. Hybrid models can have various configurations: the third party can function like an extension of the internal staff in an arrangement sometimes called “co-sourcing,” or can work independently, reporting to the outsourced provider’s management when working on specific segments of the portfolio. These segments could be the larger or smaller borrower relationships, special problem assets or borrowers in specialized industries or loan types.

The advantages of this model include being able to quickly scale up or down in department size and scope while gaining the benefit of external knowledge from the third-party provider. The hybrid approach works best when all exam work — internal and external — is performed on automated loan review software. Software ensures that the results and findings of the exams are reasonably consistent in nature and the work product and other reports are comprehensive, regardless of whether internal or external resources do the analysis.

Bank boards should leverage loan review resources constructively, no matter what model they choose, being mindful of pitfalls and expense along the way. An effective loan review program protects the bank’s safety and soundness, its customers and shareholders — as well as the board, no matter what model they used.

How Banks Kept Customers During the Pandemic, Even Commercial Ones

Digital transformation and strategy are examined as part of Bank Director’s Inspired By Acquire or Be Acquired. Click here to access the content on BankDirector.com.

Despite closed branches and masked interactions, the coronavirus pandemic may have actually improved customers’ relationships with their banks. They have digital channels to thank.

That’s a shift from the mentality pervading the industry before the pandemic. Business lines like commercial lending seemed firmly set in the physical world: a relationship-driven process with high-touch customer service. The Paycheck Protection Program from the U.S. Small Business Administration completely uprooted that approach. Banks needed to deliver loans “as fast as possible” to their small commercial customers, says Dan O’Malley, CEO of data and loan origination platform Numerated during Bank Director’s Inspired By Acquire or Be Acquired. More than 100 banks are currently using the platform either for PPP applications or forgiveness.

The need for rapid adoption forced a number of community banks to aggressively dedicate enough resources to stand up online commercial loan applications. Sixty-five percent of respondents to Bank Director’s 2020 Technology Survey said their bank implemented or upgraded technology due to the coronavirus. Of those, 70% say their bank adopted technology to issue PPP loans. This experiment produced an important result: Business customers were all too happy to self-service their loan applications online, especially if it came from their bank of choice.

“Self-service changes in business banking will be driven by customer demand and efficiency,” O’Malley says, later adding: “Customers are willing to do the work themselves if banks provide them the tools.”

Digital capabilities like self-service platforms are one way for banks to meaningfully deepen existing relationships with commercial borrowers. Numerated found that borrowers, rather than bankers, completed 84% of PPP loan applications that were done using the company’s platform, and 94% of forgiveness applications. That is no small feat, given the complexity of the application and required calculations.

Those capabilities can carve out efficiencies by saving on data entry and input, requesting and receiving documentation, the occasional phone call and the elimination of other time-consuming processes. One regional bank that is “well known for being very relationship driven” was able to process 3,000 “self-service” PPP loan applications in a morning, O’Malley says. Standing up these systems helped community banks avoid customer attrition, or better yet, attract new customers, a topic that Bank Director magazine explored last year. Already, banks like St. Louis-based Midwest BankCentre are reaping the gains from digital investments. The $2.3 billion bank launched Rising Bank, an online-only bank, in February 2019, using fintech MANTL to open accounts online.

The impetus and inception for the online brand dates back more than three years, says President and CFO Dale Oberkfell during an Inspired By session. Midwest didn’t have a way to open accounts online, and it wanted to expand its customer base and grow deposits. It also didn’t want to replicate the branch experience of opening an account — Midwest wanted to compress the total time to three minutes or less, he says.

Creating the brand was quite an investment and undertaking. Still, Rising Bank has raised $160 million in deposits — as many deposits as 10 branches could — with only two additional employees.

“We didn’t spend the dollars we anticipated spending because of that efficiency,” Oberkfell says.

Midwest BankCentre is exploring other fintech partnerships to build out Rising Bank’s functionality and product lines. The bank is slated to add online loan portals for mortgages and home equity lines of credit — creating the potential for further growth and efficiencies while strengthening customer relationships. He adds that the bank is looking to improve efficiencies and add more tools and functionality for both customers and employees. And how are they going to fund all those technology investments?

Why, with the fees generated from PPP loans.

What’s Changed In Business Lending

In today’s fast-moving world, business leaders expect quick decisions, and forward-thinking banks are speeding up the loan process to serve clients in less than three minutes. So what’s changed — and what hasn’t changed — in commercial lending? In this video, Bill Phelan of PayNet explains that relationships still drive business banking and shares how the development of those relationships has changed. He also provides an update on Main Street credit trends.

  • How Banks Are Enhancing Credit Processes
  • New Ways to Build Relationships
  • Small Business Credit Trends

The Great Payments Opportunity

payments-5-20-19.pngBanks have an opportunity to deepen relationships with their corporate customers facing payment challenges. One promising product could be integrated receivables solutions.

While most business-to-business payments are still done through paper check, electronic payments are growing rapidly. Paper checks remain at about 50 percent of business-to-business payments, according to the 2016 Electronic Payments Survey by the Association for Financial Professionals. But Automated Clearing House payments grew 9.4 percent in 2018, according to the National Automated Clearinghouse Association — a trend that is forcing businesses with high receivables volumes to look for ways to process electronic payments more efficiently.

Electronic payments create unique challenges for bank corporate customers. While the deposit is received electronically at the bank, the remittance and detailed payment information are typically sent separately in an email, document or spreadsheet. The corporate treasurer must manually connect, or re-associate, the remittance information to the deposit, which creates delays in crediting the customers’ account. As electronic ACH volumes increase, treasurers solve this problem by hiring more accounting staff to reconcile these payments.

Corporates also face added complexity from payment networks, which are becoming a more common way for large companies to pay their suppliers. While more efficient for the payer, this process requires treasury staff to log onto multiple payment network aggregation sites and download the remittance information. These downloaded files require manual re-association to the payment in order to credit the customer’s account, which requires adding more staff.

Corporates are also using mobile to accept field payments, like collecting payment on the delivery of goods or services, new customer orders or credit holds and collections. However, mobile payments again force treasurers to manually reconcile them. Moreover, most commercial banking mobile applications are designed for the treasurer of the business, with features such as balances, history and transfers. Collecting field payments needs to be configured so that field representative can simply collect the payments and remittance.

The corporate treasurer needs increased levels of automation to solve these challenges and problems. Traditional bank lockbox processing was designed for checks and relies on manual entry of the corporate’s payments and delivery of a reconciled file. This paper-based approach will be insufficient as more payments become electronic.

Treasurers should consider integrated receivables systems that match all payments types from all payment channels using artificial intelligence. A consolidated payment file updates the corporate’s enterprise resource planning system once these payments are processed. The integrated receivable solution then provides the corporate with a single archive of all their payments, rather than just a lockbox.

Right now, corporate customers are looking to financial technology firms for integrated receivable solutions because banks are moving too slowly. This disintermediates corporate customers from the banks they do business with. But almost 73 percent of corporate treasurers believe it is important or very important for their bank to provide integrated receivables, according to Aite.

This is an opportunity for bankers. The integrated receivable market offers many software solutions for banks so they can quickly ramp up and meet the needs of their corporate customers.

Bankers have a wide range of fintech partners to choose from for integrated receivables software and should look for one with expertise and knowledge of the corporate market. The solutions should leverage artificial intelligence and robotic process automation to process payments from any channel, include security with high availability and be easy for the bank and corporate customers to use.

Bridging The Gap Between Retail & Business Banking

Speed, ease of use and convenience define the customer experience today for both retail and commercial clients. In this video, First Data’s Christian Ofner and Eric Smith explain what retail and commercial customers expect from banks today—and you might be surprised to find they have similar needs. They also share how banks should enhance the experience.

  • Strengthening the Retail Experience
  • Enhancing Commercial Clients’ Experience
  • Technologies Banks Should Consider
  • Evaluating Your Bank’s Digital Strategy

Understanding the New Age of Integrated Payables

payments-7-25-18.pngUntil now, treasury management solutions have been focused almost solely on helping clients execute payments. These solutions have emphasized simplified payments and payment method flexibility. This can be referred to as Integrated Payables 1.0.

New and disruptive accounts payable automation has enabled banks to offer a more holistic solution, which caters to their customers’ end-to-end accounts payable process while addressing an even broader range of customer pain points. This can be called Integrated Payables 2.0.

Offering solutions that leverage automated processes can provide benefits for commercial banks they aren’t realizing with the legacy solutions. A couple of key benefits that offering Integrated Payables 2.0 technology provides to banks in comparison to traditional Integrated Payables 1.0 solutions include:

Addressing the end-to-end accounts payable process, instead of just payment execution, provides customers with more value.

The first step to understanding the benefits Integrated Payables 2.0 solutions provide is centered on understanding the end-to-end accounts payable process for their customers. This process, regardless of company or industry, generally involves four steps:

  1. Invoice Capture: Lifting data from vendor invoices and coding it into an accounting system.
  2. Invoice Approval: Confirming vendor invoices are accurate and reflect the agreed upon amount.
  3. Payment Authorization: Creating a payment run, getting the payment approved by an authorizer, and leveraging the correct payment type and bank account to use.
  4. Payment Execution: Sending money to vendors.

Within this process, Integrated Payable 1.0 solutions are only serving step #4: Payment Execution. The truth is every payment is the result of an invoice, and the process of making a payment includes all of the steps in between receiving the invoice and paying it. By not streamlining steps leading up to the payment, Integrated Payables 1.0 solutions allow opportunity to improve efficiency.

Integrated Payables 2.0 solutions streamline all four steps by providing one simple user interface that eliminates unnecessary manual processing. By offering Integrated Payables 2.0 solutions, banks provide more value to their customers by addressing the pain each of these manual steps brings throughout the AP process.

Becoming a strategic partner (instead of just a solution provider) to customers drives retention by creating switching costs.

There are a lot of costs associated with manual accounts payable that businesses face every day. Some are very straightforward and easy to track, like processing fees. But there are other costs that are less apparent, but have much broader cost implications on the business. These costs include:

  • Wasted time reconciling duplicate invoice payments.
  • Missed revenue from rebates and early-pay discounts.
  • Value-added projects that never get done.

With the middle-market businesses paying more than 100 invoices every month, costs add up tremendously over the course of a year. When you can eliminate these costs from your customers’ accounts payable process by providing them with an end-to-end accounts payable solution, you will be able to establish a loyal list of customers.

With only a small fraction of businesses currently automating accounts payable, it is clear Integrated Payables 2.0 solutions are still approaching it’s tipping point.

Banks have an opportunity to get ahead of competitors and differentiate themselves by offering a disruptive solution. Then, when their customers get offers from other banks to switch, the switching costs associated with going back to manual accounts payable are likely to dissuade them from making the switch.

Although Integrated Payables 1.0 solutions have been helpful to your customers for years, new disruptive technology is creating even greater capabilities for mid-sized businesses to efficiently pay their bills, and for you to further strengthen your relationships with customers by providing this technology in the form of a white-label solution.

Powering Payments For Your Business Customers

Business payments are evolving rapidly, with capabilities advanced by technology and rising expectations from business users for simple and seamless payments. In this video, Bill Wardwell of Bottomline Technologies explains:

  • The Business Payments Landscape
  • What Business Customers Want in a Solution
  • Exceeding Customer Expectations

How Strategic Plans for Community Banks Should Change

strategy-5-21-18.pngThe commercial banking industry is undergoing a structural transformation. The Federal Reserve’s response to the recession in the last decade has had a continuing, unanticipated impact on community banks. Yet most banks are relying on legacy strategic planning tools and processes that won’t allow them to see – and solve – upcoming problems.

Quantitative easing (QE) pumped funds in the marketplace (deposits), while banks contended with an extended low interest rate environment. Moving forward, as QE is reversed, deposits will be withdrawn while interest rates gradually rise. Already, the largest banks are sucking up the best deposits, which will leave community banks scrambling for funds.

All banks do strategic planning. Most banks tend to extrapolate accounting data to generate pro forma reports and analysis. Prior to 2008, this process worked well, and many consulting firms and banks developed analytical tools and processes to help in strategic planning.

But dependence on these traditional strategic planning tools and processes is risky. Accounting statements camouflage critical data that is relevant to bank pro forma performance and strategic planning. This data may not have mattered prior to the recession, but it is essential in today’s banking environment.

The monetary policy of the last decade has led to hidden time bombs in banks’ balance sheets, masked by traditional financial reporting and ignored by most market analysts. Unfortunately, the inevitable rising rate environment will expose this harm, blindsiding most bank management, investors and shareholders.

Year to date, declining gross loan yields have been offset by declining cost-of-funds (primarily deposits) and an increase in the supply of these deposits. During this extended post-recession period, net interest margins (NIMs) have remained relatively strong, creating a pattern of reasonable earnings, year after year. Unfortunately, in a rising rate environment this process will reverse itself.

Many banks will attempt to use the ALCO process to mitigate these trends. Unfortunately, ALCO is primarily a short-term tuning process, not a long-term strategic tool. It is not designed to solve long-term gross yield and cost-of-funds issues. Given that the “Normalization Period” will extend for several years, corrective actions using ALCO may serve to further aggravate the long-term situation.

Community banks need to focus on methods designed to meaningfully change the mix, rate and duration of their asset portfolios. They must also recognize that deposits, whose availability and pricing have been taken for granted for several years, will be of increasing importance in the years to come.

Community banks need to be prepared to move away from their dependence on traditional analytics that cannot identify, quantify and provide solutions to these unprecedented problems in the U.S. community banking market.

Given the slow turnover rate of loan portfolios, any real change in a bank’s assets and their composition by type, rate and maturity can only be accomplished through the merger and acquisition (M&A) M&A process. Similarly, improving loan-to-deposit ratios and deposit composition can only be truly accomplished through M&A.

But many banks are not even including an M&A scenario in their strategic planning exercises. And that is a big mistake. While there is no guarantee that an appropriate target exists, or, if it exists, that it is available for sale at the appropriate price, it is imperative that community bank management explore this possibility thoroughly before resigning themselves to more traditional and less effective approaches to solving the upcoming problems.

Banks that successfully use M&A in an appropriate manner have an extraordinary opportunity to separate themselves from the pack.

For banks that are prepared to explore the M&A option, CEOs and boards should realize that times have changed. Traditional M&A valuation techniques and dependence on ratios such as multiple-to-book and payback period are no longer relevant and generally misleading.

It is necessary to analyze in depth, not only the fixed and floating interest rates built into a target’s loan portfolio, but also the individual duration and maturities of their loan portfolios as they extend into the future. Traditional accounting systems tend to obscure this critical data, and the commonly used extrapolations of GAAP financial statements generally lead to misleading and erroneous conclusions.

The increasing value of deposits needs to be quantified in the appropriate manner. Again, traditional techniques for valuing deposits are either too short-term oriented or based on methodologies used in entirely different economic environments, rendering their conclusions meaningless.

M&A can be a powerful catalyst to solve problems in today’s complicated banking environment. It does not have to tie up too much bank time or management resources, if it is done correctly with the right analytics.