Treasury Management Steps Into the Spotlight

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At Q2 we typically perform our “State of Commercial Banking” analysis and report on an annual basis. But 2023 has been no typical year for the banking industry. The tumultuous events that began in March prompted us to take stock earlier, with a mid-year analysis. You can download the full report here, but this article will focus on a particularly intriguing finding involving Treasury Management.

Before we dive into the numbers, a quick reminder: the data in this article is pulled primarily from Q2’s proprietary databases and reflects actual commercial relationships with more than 150 banks and credit unions in the United States — ranging from small community banks to top 10 U.S. institutions. We also gleaned insights from relationship manager pricing activity on the Q2 PrecisionLender platform. 

The Shift from NIM to NII
Until the first quarter of 2023, each progressive rate increase had a direct, positive impact on net interest margin. With deposit betas relatively low, the spread between lending rates and funding costs had widened with each Fed increase. But that positive correlation between the Federal Reserve’s fed funds rate and NIM came to an abrupt halt earlier this year, as industry wide NIM compressed despite rising rates.

 

Source: FDIC

Meanwhile, the rising costs associated with commercial lending – interest expense, liquidity premiums and loan loss provisions – have shone a light on cross-sell as banks seek to preserve or even strengthen profitability. After non-interest income had trended lower in the latter stages of 2022, the first quarter of 2023 saw a renewed focus on NII and some impressive gains.

Source: FDIC

Treasury Management Powers Relationship ROE
The data in those FDIC charts highlighted a trend we’d already suspected, confirming what we’d heard anecdotally during our daily conversations with bankers throughout the United States.

It’s hardly a surprise that banks are putting increased emphasis on cross-selling. Irrespective of the rate environment, relationships with ancillary business produce measurably stronger yields than those without. Cross-sell helps preserve long-term operating accounts, granting customers the benefits of earnings credit to offset the cost of the additional services, while also securing low-cost deposits for the bank. Additionally, the non-credit business itself is fee-rich and highly lucrative.

Still, when we delved into the Q2 PrecisionLender Commercial Pricing Database to get a measure of how big that cross-sell impact is, and what’s driving it, we were struck by what we found.

In the first half of 2023, with NIM still relatively high, credit-only relationships gave a solid 13.4% ROE. The ROE rose by nearly 40% (to 18.9%) when relationships also included deposits.

But take a look at what happens when the relationship includes treasury management (TM).

Source: Q2

The ROE on those relationships (both those that include a credit element and those that are only deposits and treasury management) averaged 39.2%!

Moving Forward
The data from the first half of 2023 shows that banks can no longer ride the wave of rate increases to maintain risk-adjusted returns. As lending costs rise, banks are putting increased emphasis on cross-sell. When that cross sell adds treasury management products and services to the relationship, the ROE impact can be powerful.

Mitigating Commercial Lending Rate Reset Risk Through Hedging

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Today’s elevated interest rate environment is challenging banks with managing their interest rate risk while meeting the needs of their customers, especially commercial borrowers. With interest rates constantly fluctuating, navigating these complexities to stay competitive and protect relationships may seem difficult. But combining loan hedging and forward rate lock (FRL) strategies can allow banks to mitigate rate-reset risk, protect against unexpected rate fluctuations and stabilize debt expense for their borrowers.

A forward rate lock is an agreement between a borrower and a bank to set a fixed rate for future financing. The FRL eliminates the risk of the borrower’s rate changing before financing begins, while incorporating a forward rate hedge preserves the bank’s loan pricing spread. Banks use FRLs most often to fix rates on permanent financing following construction and to fix future rates on existing resettable loans, which span up to 36 months or longer into the future. These strategies, often called “swaps,” are particularly useful when the yield curve is inverted or when rates have risen — both of which conditions currently exist.

The Federal Reserve has expressed a commitment to continue its tight monetary policy until inflation declines to its 2% target. Fed Governors have stated that rates will likely be higher for longer. However, bond market activity implies that the Fed will deviate from its current policy path sooner rather than later. This current disconnect between the bond market and Fed projections is reflected in an inverted yield curve, where short-term rates for floating rate loans are higher than fixed rates for mid- to longer-term structures. The market is ripe for lenders and borrowers to take advantage of this irregular trend. Here are three primary benefits of FRLs for both borrowers and banks:

1. Eliminating future rate uncertainty. Banks typically mitigate interest rate risk stemming from longer-term loans by adjusting the fixed rate every 5 years. However, with rates rising by 500 basis points in the last 16 months, these resets pose significant credit risk for the bank and market risk for the borrower. A FRL allows the borrower to set their rate today, but it’s not effective until the loan’s repricing date. This solution gives the borrower time to prepare for the higher debt service through cutting costs or increasing rents. Regulators will appreciate banks having a strategy in place to manage their reset risk.

2. Protecting banks and borrowers from credit stress due to higher reset rates. Although most banks stress test their loan portfolios, the magnitude of rate hikes over the last year means that some loans may be approaching debt service covenant limits or will at least create credit stress for both the bank and the borrower. Fixing the rate with an FRL before rates increase further helps the bank reduce credit stress for customers and itself. Regardless of what happens to rates in the next 12 to 24 months, borrowers are guaranteed a fixed rate they can budget around.

3. Preventing net interest margin (NIM) compression. In recent years, when interest rates were low, cost of funds didn’t become a significant issue for banks. This time, as rates have risen rapidly and higher than expected, banks are increasing the rates on their deposits to remain competitive. The substantially higher cost of funds has compressed NIM. Without hedging, banks have to wait for the reset period (e.g. a 5-year reset on a 10-year term loan) to reprice their loans, while paying higher rates on their deposits in the meantime. An FRL can help reduce that risk by essentially converting conventional loans that reprice at longer intervals to loans that reset every month, effective at their next reset. As rates go up, deposit costs increase, but they are matched by rising interest income on the loan — with the borrower still benefiting from the fixed rate.

Mitigating rate-reset risk is crucial for lenders in today’s financial landscape. Implementing the right commercial hedging strategy and utilizing forward rate locks can safeguard a bank and its borrowers from the impact of interest rate fluctuations. These solutions provide borrowers with stability and lenders with risk mitigation, ensuring long-term success and financial well-being.

How AI Can Cut Commercial Lending Cost

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Businesses rely on banks for the capital they need to grow, but that capital is locked behind mountains of paperwork.

Although now mostly digitized, all of this digital paperwork is largely processed manually, which increases costs, constrains volume, slows transactions and frustrates everyone.

Our team at Able has spent hundreds of hours on-site with commercial lenders, observing their credit delivery processes from start to finish. Most of these lenders employ highly paid team members who spend up to half their workdays doing paperwork that could easily be automated. At the same time, these lenders are struggling to hire and retain the workforce they need to handle any increase in volume. On the other end of the transaction, we routinely find borrowers who compare the paperwork process to “pulling teeth,” “a prostate exam” and “open-heart surgery.”

The root cause of all these problems is the same thing: paperwork. That’s where artificial intelligence (AI) comes in. Lenders can use AI to improve both efficiency and experience in one fell swoop.

Lenders can use AI to collect documents automatically. AI can create document checklists and all of the messaging needed to collect those documents. When a borrower returns the documents, the system can name, index and organize all of the documents, while keeping shared checklists up to date. It’s a much more pleasant experience for everyone. There’s very little manual work to do, saving time for borrowers and lenders alike. It also minimizes the possibility of filing errors that can cause costly problems down the line.

The benefits of AI go beyond onboarding. Once the AI has organized all of the documents, lenders can search for important information like names and dates as quickly and easily as searching Google.

As AI increases efficiency, the savings can add up quickly. Document checklists, for example, are one of many processes that repeat over and over throughout the credit life cycle. When lenders reduce the cost and time needed to create a checklist, they’ll save every time that process repeats. Multiply those saving times all of the loans processed in a year and the savings can quickly climb into the 7-figure range.

But isn’t AI risky? No, not with the right guardrails in place. Lenders will need to implement sound model governance policies to mitigate model errors, bias, and data drift. There are many technical controls that vendors and IT teams can perform to achieve this. One approach is a system called human-in-the-loop training, which relies on feedback from experts to approve or modify inferences made by the system. This setup allows models to minimize both human and model errors while learning as organizational rules change over time.

The main drawback of AI for lenders is the cost of building, training and monitoring a production-grade AI system. Even with recent advancements, getting a new AI system up and running safely requires a significant upfront investment. For any one AI model — even one leveraging off-the-shelf technology like Alphabet’s Bard or OpenAI’s ChatGPT — the model (the black box in the figure below) needs to be accompanied by a much larger and expensive suite of tools to ensure its reliability and quality in a production setting.

D. Sculley et al. (Google). Hidden Debt in Machine Learning Systems Neural Information Processing Systems, Proceedings. 2015.

That kind of investment and time horizon would probably be difficult for most banks to prioritize, which makes outside vendors a good option. These outside vendors have an advantage not only in resource investment but also in training data. Why? Vendors that serve multiple high-volume lenders can accrue training data while maintaining strict privacy and compliance guidelines much faster than any single bank can on its own. The more data the system has, the faster it learns, the better it gets, the greater the savings. Everyone benefits as a result.

When I say “everyone benefits,” that includes the workforce. Some believe AI is out for our jobs. I believe that AI is out to change our jobs. Remember those employees I mentioned, the ones who spend half their day doing work that could be automated? Do you know how happy they are now that we’ve automated that work for them? They’re thrilled. They get to spend less time doing the same thing over and over. Who wouldn’t be happy about that?

I know that, for many of you, AI sounds far off in the future. But it’s here, in banks, delivering efficiency and experience gains today. AI will make lenders more competitive, agile, scalable and accessible. We’ll all be better off for it.

Don’t Rely on Inertia to Manage Deposit Pricing

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After a year of steadily increasing interest rates, bankers may be feeling hopeful that the Federal Open Market Committee will soon slow its pace so deposit pricing can get under control.

But even if the Fed’s rate-setting body eases up on raising the federal funds rate, it’s unlikely that will immediately translate into lower deposit costs, simply because liabilities and assets will reprice at different times and frequencies.

“The Fed may stop raising rates at some point, but the cost of deposits of banks most likely will keep going up, only because they’re catching up,” says Christopher Marinac, director of research at Janney Montgomery Scott. “Some of it is just timing: If you have [certificates of deposits], and they are renewing in the third and fourth quarter, those are generally going to be higher than they were a year ago.”

Deposit betas, or the portion of change in the fed funds rate that banks pass onto their customers, occupy a good deal of bankers’ attention right now. Higher deposit betas mean higher rates paid on deposit accounts, and lower deposit betas mean lower funding costs. Banks that want to improve their net interest margin generally want to know how to keep their deposit betas lower without sacrificing liquidity.

A recent analysis by S&P Global Market Intelligence showed that a sample of 20 banks with lower deposit betas in the fourth quarter of 2022 were generally more likely to let money walk out the door in search of higher rates. That in turn allowed those banks to expand their margins more substantially through the end of the year.

Broadly speaking, however, inertia has worked in a lot of banks’ favor when it comes to deposit pricing, Marinac says. Though some high net-worth or commercial customers with significant deposits are increasingly asking for higher rates, which is leading bankers to implement exception pricing, most deposit clients simply don’t bother.

But some banks already feel that exception pricing has become unsustainable, says Neil Stanley, founder and CEO of The CorePoint, a consulting firm focused on deposit pricing. Because exception pricing decisions are made on an ad hoc basis, it can be difficult for banks to anticipate scenarios and build forward guidance. Exception pricing can become a problem if those decisions are too frequent, and are seen as random and even discriminatory.

Stanley also points out that compared to past periods of Fed tightening, a much larger proportion of bank deposits are now noninterest bearing demand deposits, meaning that while they may cost the bank next to nothing, they can also walk out the door at any moment.

“How long will those deposits stay on your books at no interest? That is a huge question,” Stanley says. “Without a really good answer to that, we’re left in a very vulnerable spot.” The advent of open banking may change the game this time around. Open banking gives people more control over their finances, allowing them to leverage application programming interfaces to move funds. Google and social media also give customers an additional window into which banks offer better rates, adding a new layer of complexity. In response, Stanley generally advises that banks maintain a good mix of time deposits like CDs that have a bit more staying power compared to noninterest bearing checking accounts.

Bank boards play an important oversight role in asset/liability management at their financial institutions. Stanley recommends that directors ask management for a list of the bank’s largest deposit holders, and know who is in charge of tending to those relationships. Bankers should check in with those clients and make sure they aren’t feeling neglected, especially if they could pull their money at a moment’s notice. Directors might also consider establishing a chief deposit officer or otherwise centralizing some authority over the bank’s deposit gathering efforts, including exception pricing decisions. And bankers should have a clear line of communication to that person so they can quickly respond to requests for exception pricing.

Banks have grown accustomed to a low-rate environment with little competition for deposits. That’s changed. “When we had a surplus of deposits, it didn’t make any sense to put time and energy into it,” Stanley says. “Now, [banks] don’t want to be laissez-faire. They want to be intentional.”

Along those lines, bank leaders should evaluate their current suite of deposit products and services, and understand how those compare with nonbank competitors. And they can think about how to emphasize the value of keeping cash in accounts insured by the Federal Deposit Insurance Corp.

Finally, while it’s ostensibly on the other side of the balance sheet, bank leaders could consider the importance of commercial and industrial lending as part of their broader asset/liability management strategy. C&I loans reprice faster, which can prove beneficial in a rising rate environment. Those clients — many of them small businesses — can also become a source of stickier, lower cost deposits.

“C&I customers have deposits, and they tend to put deposits with banks,” Marinac says. “That’s kind of the secret sauce.” And financial institutions should view building core relationships as something that happens in good times and bad. “Some organizations are wired that way, so it’s not a problem,” he says. “Other organizations are not.”

Banking During a Time of Uncertainty

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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.”

Safeguarding Credit Portfolios in Today’s Uncertain Economic Landscape

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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.

3 Ways to Help Businesses Manage Market Uncertainty

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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.

How to Capitalize on Sustainability Growth

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The automotive sector is a vital part of the US economy, accounting for 3% of the country’s gross domestic product. But the increasing demand for electric vehicles (EVs) and evolving battery and fuel cell technology means it is experiencing incredible disruption. These ripple effects will be felt across the entire automotive value chain.

Three years ago, EVs represented just 2% of all new car sales in the U.S. A year later, it doubled to 4%. In 2021, it doubled again to 8%; this year, it’s forecast to double yet again to 16%. We can only expect this trend to continue. For example, California regulators unveiled a proposal in April to ban the sale of all new vehicles powered by gasoline by 2035, as the state pushes for more EV sales in the next four years.

How will these transition risks — which includes changing consumer demand, policy and technological disruption — impact the creditworthiness of the 18,000 new-car dealerships, 140,000 used-car dealerships and 234,700 auto repair and maintenance centers across the country? What are the implications for the banks that lend to them?

Some of the world’s largest automotive brands have published bold commitments that will hasten their transformation and the industry’s shift. Last year, Ford Motor Co. announced that it expects 40% to 50% of its global vehicle volume to be fully electric by 2030, while General Motors Co. plans to exclusively offer electric vehicles by 2035.

But these commitments won’t just impact the Fortune 500 companies that are making them – businesses of all sizes, across the automotive value chain, will be affected. To stay in business, these firms will need to update their supply chains and distribution models, invest in new technologies, processes, people and products. In some cases, they may even potentially need to build an entirely new brand.

Banks will have an important role to play in funding much of this transition.

The pool of potential borrowers is getting bigger. Opportunities for banks don’t just exist in being a partner for helping automotive businesses transition — there is also a growing number of new automotive businesses and business models designed for the net-zero future that will require funding as they scale. Tesla isn’t even two decades old but last year, it produced more than 75% of U.S. all-electric cars. With growing consumer demand for EVs, the need for more EV charging stations is also rising. The global market for EV charging stations is estimated to grow from $17.6 billion in 2021 to $111.9 billion in 2028, according to Fortune Business Insights.

Electrify America, ChargePoint, and EVgo are brands that didn’t exist 15 years ago because they didn’t need to. How many more businesses will be born in the next five, 10 or 15 years, which will need loans and investments to help them scale? This is an opportunity worth billions a year for banks — if they have the foresight to anticipate what’s coming and take a forward-looking view.

The Smaller the Detail, the Greater the Value
Currently, most climate analyses work at a broad sector level, looking no deeper than the sub-sector level. This provides some indication of a bank’s exposure, but such a broad view lacks the insight needed to really understand the impact and trends at the individual borrower level.

To get a true grasp on this opportunity, banks should look for solutions that include financial forecasts and credit metrics at the borrower level across several climate scenarios and time horizons. Institutions can directly input these outputs into their existing risk rating models to drive a climate-adjusted risk rating and apply them across the full credit lifecycle, from origination and ongoing monitoring to conducting portfolio level scenario analysis.

Throughout the pandemic, banks enjoyed a unique opportunity to rebuild public trust and goodwill that was lost during the financial crisis 12 years earlier. Climate change is another chance, given that sustainability will be the growth story of the 21st century. With the right technological investments, strategic partnerships and data, banks have an opportunity to be one of the protagonists.

OakNorth will be diving deep into the challenges and issues facing the automotive value chain in an upcoming industry webinar on June 16, 2022, at 1 p.m. EST. Register now at https://hubs.li/Q01bPN1v0.

The Digitalization of Commercial Lending

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Commercial lending is a balance of risk and reward.

When properly managed, this business line can be a bank’s profit leader. Part of that competitive edge is employing a digital strategy specifically tailored to match your bank’s commercial lending vision. No doubt your institution has shifted resources to more fully support digital banking in 2020 — not only to benefit your customers, but to address the challenges of staff operating remotely. Automation that was thought to be nice-to-have became critical infrastructure both to expedite loan origination and to efficiently manage the volume of loan servicing. The commercial loan life cycle is evolving, creating opportunities for digital improvement at all stages.

Simplifying applications. While the banking industry lacks a standard commercial lending application, it is possible to dramatically reduce the burdensome data collection exercise that banks have traditionally required of their business borrowers. Technology can create significant lift during this phase. Integrating credit policy data into the digital application and automating the retrieval of public data to reduce the number of fields an applicant must complete can reduce the time required to complete an application to minutes.

The democracy of automated underwriting. Automated underwriting used to be premier software intelligence harnessed by only the most enterprising of institutions. However, as the technology has become more commonplace and pricing models have moderated, institutions of all sizes can take advantage of efficiencies that can shave weeks off the process.

Dynamic documenting. One of the many risks associated with commercial lending is the accuracy, validity and enforceability of the loan documentation. Compliance solutions that are integrated with loan origination systems minimize duplicate data entry and render a complete and compliant commercial loan document package based on an institution’s criteria. This technology can significantly reduce human touchpoints, improving the speed and efficiency with which loan documentation is assembled.

E-signing and paperless transactions. If any single innovation has already transformed the lending experience, it is e-signing. Electronic signatures and electronic contracts were granted validity and legal effect through the passage of the Electronic Signatures in Global and National Commerce Act. It’s been 20 years since the act became law, but e-signing commercial loan documents and conducting commercial loan transactions electronically have only recently gained wider traction with institutions. It’s evolved into an expectation of some customers, expedited in no small part by the continuing coronavirus pandemic and related social distancing guidelines.

Generally, commercial loans that are unsecured or secured by personal property can be paperless and conducted electronically. Those secured by real estate, on the other hand, have traditionally required some wet ink signatures because of notarization and recording requirements. However, electronic and remote notarization in conjunction with electronic recording has increased the likelihood of completely electronic and paperless transactions.

Twenty-five states have passed laws authorizing remote notarizations, with another 23 states implementing emergency remote notarization procedures in response to the pandemic. While state requirements of remote notarization vary, this potentially allows commercial loan documentation signed electronically to be notarized online instead of requiring parties to be physically present in the same room.

Electronic recording is rapidly becoming the standard for real property documents, with more than 68% of U.S. counties now supporting e-recording. Documents with the recording stamp can be returned immediately after recording, speeding up delivery of the recorded documents to the title insurance company. Electronic recording also allows for the e-signing of real property documents instead of requiring wet ink signatures.

The increasing availability of e-signing and electronic and remote notary technology and resources means more institutions will be able to move entirely to or provide support for electronic and paperless commercial loan transactions.

Automation in servicing. Many traditionally manual processes associated with the review, servicing, tracking and maintenance of commercial loan transactions can be automated. For example, transactions often require parties to provide financial documents to the institution. Instead of manually entering those requirements into a spreadsheet and creating calendar reminders, institutions can leverage technology to automate reports and reminders for the financial document delivery requirements. Similar automated reminders and tracking can be used for collateral, compliance, document and policy issues and exceptions.

The effect of these digitalization opportunities — available at every step in the process, aggregated over your portfolio — can significantly accelerate your institution’s transition to a more touchless loan process.

“The Best Strategic Thinker in Financial Services”

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strategy-7-19-19.pngThe country’s most advanced bank is run by the industry’s smartest CEO.

Co-founder Richard Fairbank is a relentless strategist who has guided Capital One Financial Corp. on an amazing, 25-year journey that began as a novel approach to designing and marketing credit cards.

Today, Capital One—the 8th largest U.S. commercial bank with $373.2 billion in assets—has transformed itself into a highly advanced fintech company with national aspirations.

The driving force behind this protean evolution has been the 68-year-old Fairbank, an intensely private man who rarely gives interviews to the press. One investor who has known him for years—Tom Brown, CEO of the hedge fund Second Curve Capital—says that Fairbank “has become reclusive, even with me.”

Brown has invested in Capital One on and off over the years, including now. He has tremendous respect for Fairbank’s acumen and considers him to be “by far, the best strategic thinker in financial services.”

I interviewed Fairbank once, in 2006, for Bank Director magazine. It was clear even then that he approaches strategy like Sun Tzu approaches war. “A strategy must begin by identifying where the market is going,” Fairbank said. “What’s the endgame and how is the company going to win?”

Fairbank said most companies are too timid in their strategic planning, and think that “it’s a bold move to change 10 percent from where they are.” Instead, he said companies should focus on how their markets are changing, how fast they’re changing, and when that transformation will be complete.

The goal is to anticipate disruptive change, rather than chase it.

“It creates a much greater sense of urgency and allows the company to make bold moves from a position of strength,” he said.

This aggressive approach to strategy can be seen throughout the company’s history, beginning in 1988 when Fairbank and a former colleague, Nigel Morris, convinced Richmond, Virginia-based Signet Financial Corp. to start a credit card division using a new, data-driven methodology. The unit grew so big so fast that it dwarfed Signet itself and was spun off in 1994 as Capital One.

The company’s evolution since then has been driven by a series of strategic acquisitions, beginning in 2005 when it bought Hibernia Corp., a regional bank headquartered in New Orleans. Back then, Capital One relied on Wall Street for its funding, and Fairbank worried that a major economic event could abruptly turn off the spigot. He sought the safety of insured deposits, which led not only to the Hibernia deal but additional regional bank acquisitions in 2006 and 2008.

Brown says those strategic moves probably insured the company’s survival when the capital markets froze up during the financial crisis. “If they hadn’t bought those banks, there are some people like myself who don’t think Capital One would be around today,” he says.

As Capital One’s credit card business continued to grow, Fairbank wanted to apply its successful data-driven strategy to other consumer loan products that were beginning to consolidate nationally. Over the last 20 years, it has become one of the largest auto lenders in the country. It has also developed a significant commercial lending business with specialties like multifamily real estate and health care.

Capital One is in the midst of another transformation, to a national digital consumer bank. The company acquired the digital banking platform ING Direct in 2011 for $9 billion and rebranded it Capital One 360. Office locations have fallen from 1,000 in 2010 to around 500, according to Sandler O’Neill, as the company refocuses its consumer banking strategy on digital.

When Fairbank assembled his regional banking franchise in the early 2000s, the U.S. deposit market was highly fragmented. In recent years, the deposit market has begun to consolidate and Capital One is well positioned to take advantage of that with its digital platform.

Today, technology is the big driver behind Capital One’s transformation. The company has moved much of its data and software development to the cloud and rebuilt its core technology platform. Indeed, it could be described as a technology company that offers financial services, including insured deposit products.

“We’ve seen enormous change in our culture and our society, but the change that took place at Capital One’s first 25 years will pale in comparison to the quarter-century that’s about to unfold,” Fairbank wrote in his 2018 shareholders letter. “And we are well positioned to thrive as technology changes everything.”

At Capital One, driving change is Fairbank’s primary job.