The traditional community banking model, while still viable, is being challenged because of economic, competitive, technological and regulatory forces—many of which are beyond the control of any individual community bank. The largest banks have used their massive size, product set, and more recently, technology, to make dramatic gains in market share at the expense of community banks. I believe that progressive community banks should be considering new ways of doing business, especially in regards to their lending strategies.
Community banks do many things far better than their larger competitors, while enjoying a degree of trust and resiliency that the megabanks may never achieve. But those big banks boast something the community banks, standing alone, cannot match: the scale to operate the lending platforms which are now necessary in most lines of business—including commercial & industrial (C&I) lending. Many American businesses now require loan amounts of $50 million or more, a loan size that typically defines the low end of the “middle market.” Those loans required by middle market borrowers, companies providing goods and services serving a wide range of industries, far exceed the individual lending capacity of the typical community bank. The teams required to source, screen, underwrite and manage these larger loans are typically out of reach for a community bank.
To date, those megabank advantages have clearly outweighed the strengths of community banking in C&I lending. Without the ability to deliver many of the commercial loans that middle market businesses require, community banks are stuck in a quandary in which they often have to turn away customers with successful, growing businesses. The numbers are clear: In 1990, community banks with under $10 billion in assets accounted for over one-third of C&I loans held on the balance sheets of banks. By the end of 2014, community banks’ share of the C&I market has dropped to just over 15 percent of the market. The continuation of this trend will likely limit the profitability and growth of community banks as well as their ability to positively affect their communities in other lines of business. Equally important, it also subjects those banks to less diversified loan portfolios and the risk associated with loan concentrations, particularly in commercial real estate.
While each community bank may individually struggle to match the scale of the mega-banks, it is important to keep in mind that the biggest banks are saddled with their own challenges such as bureaucracy, legacy systems, resistance to change, customer fatigue and burdensome regulatory oversight.
Community banks, but for their individual lack of scale, ought to be well positioned to capitalize on these opportunities and to outcompete the megabanks. The innovation required for community banks to break this logjam—to free them to focus on their strengths—is here, and its essence is this: community banks no longer need to stand alone.
They can prosper by working together, particularly in gaining access to middle market lending. Community banks do have the scale enjoyed by the biggest banks, they just don’t have it on their own. Together, community banks hold $2.3 trillion in assets—13 percent of the assets held by US banks, and just shy of the assets of JPMorgan Chase & Co., the largest US bank. The question is how to leverage that scale while preserving the individuality, proximity to the customer and legendary service that contribute to their unique value.
Community banks should consider joining together in alliances or cooperatives in order to gain access to C&I loans, including diversified sectors such as manufacturing, healthcare, technology, and business services. In addition to using such partnerships to successfully source these loans on a national basis, other benefits such as diversification (size, geography, and industry type), access to larger customers, and combined expertise in underwriting and loan management can be achieved. One such cooperative, BancAlliance, consists of over 200 community bank members and has sourced over $2 billion in such loans.
Through partnerships such as these, community banks can succeed in delivering loans to job-creating middle market businesses throughout our country at a reasonable cost to each community bank, while adding to their net interest margin and diversifying their balance sheet.
If the economy’s backbone is small business, then small business’ backbone is community banking. Unfortunately, both economic and policy developments have dealt community banks a sustained blow from which they can only recover together. The challenge is for community banks to leverage the scale they lack as individual institutions but jointly possess.
The indications of stress are stark. It was just a generation ago that community banks accounted for nearly 80 percent of consumer loans. The number today is less than 10 percent. The largest banks are simply driving community banks out of the lending business.
The irony is that some of the difficulty community banks face actually results from policies intended to help them. Regulations that were supposed to limit the largest banks instead created impossible compliance burdens for small ones. The lifting of limits on interstate banking gave the big players a further leg up. But the biggest challenge has come from the shift of many types of lending away from relationship-based, customized lending (at which local banks excel) towards process-based, standardized lending (which requires scale to afford the systems, people, models, marketing and processes that are required).
This evolution from handshakes in a local bank to anonymous clicks in online applications required massive investments in technological platforms that community banks were unable to make. Yet despite the pressures, community banks retain advantages with which no large bank can compete: the trust and genuine loyalty of local customers, a personal understanding of their needs and the willingness and ability to customize their offering to the specific needs of customers when appropriate.
But if they are to survive, personal service alone will not be enough. If these banks lose the ability to offer the broad array of products and services that have become process-intensive (consumer lending, small business lending, wealth management, etc.), they will lose their connection to their customers who are forced to look elsewhere. Community banks must combine what they are uniquely good at with the scale necessary to go toe-to-toe with the largest banks. The good news is that these banks, collectively, already have that scale. Taken together, community banks command $2.3 trillion in assets—14 percent of the economy and more than enough to compete with any of the largest banks.
“Together” is key. The imperative for community banks is to find ways to take advantage of their combined scale while retaining the local focus and service for which they are legendary.
One such model is BancAlliance—a collaboration, as the name suggests, of more than 200 community banks with more than $300 billion in assets in 40 states. That $300 billion would be enough to rank these institutions together as one of the 10 largest banks in the country. The network is managed by Alliance Partners.
Among other benefits, partnerships like BancAlliance can help community banks seize the opportunities in the financial markets that new technologies enable. New players like Lending Club are using high-end online platforms to provide first-in-class customer experiences that are taking ever larger swaths of the consumer lending business away from the largest mega banks.
The platforms are so sophisticated, though, that no single community bank has the resources to figure out how to forge a partnership with them. By partnering through collaborations like BancAlliance with lenders like Lending Club, community banks can combine their knowledge of their customers with the new lenders’ unmatched customer experience platforms. BancAlliance, for example, is allowing its members to achieve those benefits through a partnership under which the Lending Club platform is offered through community banks.
BancAlliance is a promising model for collaboration, but only one. Regulators are recognizing and encouraging the value of these efforts, even as tiered requirements and limits on consolidation are also improving the policy environment. The key to these collaborative efforts now is that community banks realize the value of their combined scale.
Community banks still have the best advantages in a business that ultimately distills to relationships and trust. But the detriments of smaller individual size have begun to erode those assets and, absent action, could threaten the sustainability of the community banking model. By joining forces—collaborating with each other and partnering with institutions that can give them access to the advantages of technology and reach—community banks can convert a serious problem into a compelling opportunity. And history tells us that when they are able to compete on a level playing field, community banks prevail.
Most of the news coverage about the potential for rising interest rates has assumed rising rates will help banks. But will it help your bank? It turns out, that’s not an automatic yes. This article will help board members understand how interest rates impact a bank’s profitability, and offers questions that you should be asking your management team.
Many of the biggest banks in the country, which are the subject of so much news and analyst coverage, are deliberately managed to be asset sensitive. That means that they benefit from a rising interest rate environment, because their “assets,” mainly loans, will generate higher income as rates rise. Many big banks have more variable-rate loans on their books, such as commercial and industrial loans, than community banks do, and those loans tend to reprice more quickly up or down when rates rise or fall.
However, community banks can’t make the assumption that they will benefit when rates rise. A careful analysis of their own particular situation is necessary.
“There does seem to be a general perception that rising rates are good for all banks. That’s simply not true,’’ says Matthew D. Pieniazek, president of Darling Consulting Group, in Newburyport, Massachusetts, which advises banks on asset liability management. Many community banks that manage as if they are asset sensitive will actually experience earnings pressures when interest rates rise, he says. (This is known as liability sensitivity, when funding costs increase faster than asset yields.) The biggest risk could come from deposits, but there are also impacts on loans and investment portfolios to consider.
Regulators have made it clear that oversight of interest rate risk, or IRR, rests squarely on the shoulders of the board. The Office of the Comptroller of the Currency issued a joint “advisory on interest rate risk management in 2010” that emphasizes this point:
“Existing interagency and international guidance identifies the board of directors as having the ultimate responsibility for the risks undertaken by an institution, including IRR. As a result, the regulators remind boards of directors that they should understand and be regularly informed about the level and trend of their institutions’ IRR exposure. The board of directors or its delegated committee of board members should oversee the establishment, approval, implementation, and annual review of IRR management strategies, policies, procedures, and limits (or risk tolerances). Institutions should understand the implications of the IRR strategies they pursue, including their potential impact on market, liquidity, credit, and operating risks.”
How do rising interest rates impact deposits? Since late 2008, the Federal Reserve has kept interest rates near zero, resulting in all kinds of interest bearing deposits and investment products also hitting near zero yields. Alternatives to noninterest bearing deposits such as CDs and other term investments carry premiums that are hardly worth the trouble. There is almost no rate differential between a CD or even a government bond and an FDIC-insured nonmaturity account, such as a savings or checking account at a bank. As a result, the banking industry has experienced a substantial increase in non-maturity deposits. Pieniazek estimates that industry-wide, nonmaturity bank deposits are as much as 20 to 25 percent above normalized levels.
So it’s hard to know as rates rise, how much money will leave the bank. Some customers may do nothing. Others may move money into higher interest-bearing accounts or CDs at the bank. Still, others will put their money in investment accounts or move it to other banks and credit unions that are offering higher rates than your bank.
Pieniazek thinks there is a lot of pent-up demand for higher rates, as baby boomers are getting ready to retire and retirees have been sitting on low-earning deposits for many years. He says that a bank can look historically at its own deposit levels, and take appropriate actions to gauge how much of their non-maturity deposit base might be at risk.
It’s important as a board member to know what your bank’s plan is. “One hundred percent of financial institutions will see deposits leave,’’ Pieniazek says. Deciding how much the bank is willing to lose and the impact of rising rates on its deposit strategy is important for any board.
Questions to ask: When the Fed raises rates the first, second or third time, how are we going to react? Are we going to hold our rates and not chase money? Are we going to let deposits leave us? What are the ramifications and why is that our plan? What could occur that will cause us to change our plan?
Determining to what extent you will lose deposits when rates rise is somewhat of a guessing game, which makes it the hardest part of the balance sheet to assess. Your bank management team can look at particular characteristics of their deposit base to make assumptions about how “sticky” those deposits are, meaning how likely they are to stay with your bank, says Rick Childs, a partner with consulting and accounting firm Crowe Horwath LLP. How long has each customer had a deposit account with the bank? Do they have other accounts or products with the bank, such as loans? Do they direct deposit every month and pay bills out of the account? Or is it a stand-alone money market account where the customer has no other relationship with the bank? Those are the depositors most likely to leave when interest rates rise.
We haven’t seen a lull this long in interest rates so it’s hard to know what will happen, Childs says. If funds leave and you have to replace those funds at higher rates, how will margins be impacted?
Net interest margins are net interest expenses subtracted from net interest income, divided by earning assets, such as loans and investments. So the higher your interest expense, the lower your income. The cost of funds is what it takes to generate the funds your bank needs to operate and lend at the level it desires. While interest expense on deposits is a large part of that, funding costs will also be impacted by borrowings and deposit surrogates such as customer sweep accounts. Bank analysts such as Fig Partners are already looking at the cost of funds for various banks to determine which banks will do better when rates rise. The theory is that the lower the cost of funds, the better the bank will do because it won’t be forced to raise rates on deposits to compete for funds.
Your management team should have well developed assumptions about how deposit rates will be impacted and what the plan is for reacting to rising rates. In general, Childs says the board should be asking management: “Explain to me what those assumptions are and how you derive those.”
What are your bank’s assumptions about what will happen to interest rates and how are those derived? How will your bank react? Your management team should have assumptions about the lag time before your bank raises rates in its different products. For example, if the Federal Reserve raises the federal funds target rate by 100 basis points over time, how much will your NOW accounts (checking accounts that earn interest) go up?
Most banks use vendors to provide interest rate risk modeling tools, and those models will have default assumptions of their own. It’s important to note that the board is responsible for making sure the bank is assessing the appropriateness and reasonableness of those assumptions. It’s not enough to outsource decision-making about interest rate risk and assume you are taking care of your oversight responsibilities.
The good news is that most banks do some kind of stress testing to see what happens to the bank under a variety of interest rate “shock” scenarios. For example, what happens if short-term rates rise 50 basis points? What about 100 basis points? How will that impact earnings? You might read or hear about a phenomenon known as the “flattening of the yield curve.” The yield curve refers to the difference between short and long-term rates or, for example, the fed funds rate versus a 10-year Treasury yield. If short-term rates increase while long-term rates don’t, that lessens the difference between those rates. A more ideal yield curve would have an upward slope, with short-term rates significantly lower than long-term rates. Flatter yield curves are generally bad for banks, because the cost of funds are driven by short-term rates.
How will rising rates impact loans? Your bank has a particular mix of terms on its loans that will impact what happens to your bank when rates rise.
You probably have a number of floating rate loans that are at a floor, meaning your bank won’t make loans or enable loans to reprice below that level despite prevailing market rates. How much will interest rates need to rise before prevailing rates go above the floor? How long will it take?
Obviously, variable rate loans in a rising rate environment are good for the bank. The bank will see increased interest income as a result. If interest income rises faster than the cost of funds, that means the bank is asset sensitive and earnings will improve in that scenario.
How will rising rates impact our investment portfolio? There are questions to ask about the bank’s securities portfolio as well. Does the bank own any securities with material extension risk? What is the concentration? Material extension risk is when the life of the security extends in a rising rate environment. Mortgage-backed securities are a good example, and plenty of banks have these. In a rising rate environment, borrowers are less likely to pay off their mortgages. Does the bank have callable bonds? These are bonds where the lender can call the bond early if rates drop, or extend the life of the bond if rates rise, Pieniazek says. Is the bank monitoring opportunities to sell bonds with undue extension risk?
Another factor to consider is what happens if rates don’t rise. Or, they rise much less and more slowly than the Fed portends. For many banks, this could be very harmful, especially if the bank is already experiencing continued declines in net interest margin… For most banks, the sustained low-rate environment is the most problematic issue, Pieniazek says. It’s important to consider this alternative scenario, as well.
In the end, all banks will be impacted by the rate environment. Understanding how your bank is affected by interest rates and the assumptions going into those estimations is a crucial ingredient to providing good oversight both today and in the years ahead.
Faced with heightened competition, a slow economic recovery, and tepid loan demand, community banks are looking to enhance profitability through prudent lending with attractive yields, often outside of the real estate sector where they have significant concentrations. Commercial and industrial loan participation arrangements may offer one answer, but it’s important to choose a participation partner carefully. Here is a list—by no means exhaustive—of what you might look for in potential partners.
1. Consider your bank’s business objectives.
Your bank’s core mission is to serve your community. Before joining a participation organization, ensure that you understand how a relationship with that group will align with that mission. Look for an organization that will help you meet your bank’s strategic goals and benefit you in terms of enhanced profitability and asset diversification. Of course, you should consult with your own advisors to ensure that all of your questions are satisfactorily answered.
2. Look beyond size.
Loan participation arrangements offer community banks more than just the opportunity to serve clients with credit needs that are otherwise too large for the bank. Participations also offer the potential for geographic and industry diversification, which can be especially beneficial to community banks facing protracted regional recoveries. Participations can offer a buffer against fluctuating local economic conditions without increasing banks’ existing overhead costs.
3. Communicate with your regulators, and look for a partner who does the same.
Community bank examiners may review closely any loan participation arrangements. Open and early communication with examiners may help avert potential concerns and improve their understanding of the business line. An ideal loan participation partner regularly communicates with all applicable banking regulators and provides support to banks looking to satisfy applicable guidance and regulations.
4. Remember that loan participations may involve a relationship with a third-party service provider and involve certain risks.
Banks should examine the risks of third-party arrangements just as they would examine the risks of their own activities. Third-party arrangements require thorough risk management to carefully evaluate and continuously monitor potential partners. Therefore, if you are seeking out a loan participation partner, look for one who offers comprehensive disclosure materials and historical credit performance data. Ask for and review all documentation that explains the risks involved. Remember that not all partners are the same. Some are Registered Investment Advisers with fiduciary duties to their clients and are paid for providing advice. Others generate income predominately by reselling assets.
5. Strong communication is essential in any relationship.
Loan participation organizations should put their clients’ needs first. Bankers should be attentive to potential sources of conflicting interests and what, if anything, the organization does to align its interests with its clients’ interests. Ideally, bankers participating in the loans should help govern the organization’s direction, operations and credit policies. If participants would like an increased focus on a particular loan type, they can work together to achieve that objective. They should be able to regularly communicate with each other, and all bankers aligned with such an organization should have the opportunity to learn from each other and to express opinions on relevant matters.
6. Be selective, and expect the same from your partner.
Not every loan is right for every bank. Loan participation organizations should thoroughly evaluate potential loans on a variety of criteria and only recommend those loans that meet every criterion. They should also have some type of risk retention procedure. Banks should always have the option, whatever the reason, not to participate in a particular loan. No bank should be compelled to make a loan that doesn’t align with its business objectives.
7. Establish lending policies and procedures and ensure that an independent credit decision is made on each loan.
Expect your loan participation partner to maintain lending policies, and be sure to also have your own. Such policies should define limits around participation loans and identify the bank employees responsible for managing the business and reporting the results to senior management. The credit information necessary to both underwrite and conduct ongoing monitoring of borrowers should be easily available through a secure document delivery system. Banks should use this information to make their own, independent decisions about which loans they fund.
The large financial institutions that were heavily involved in equipment financing have reduced the size of their portfolios from pre-crisis days. Does that mean there is an opportunity for smaller banks, even with soft growth in the U.S. economy? BancAlliance thinks so. The Washington, D.C.-based network of member banks pool their resources to access national commercial and industrial loans, gaining access to larger loans than they might otherwise be able to finance. It recently added a new equipment finance team lead by Jay Squiers, who talks about trends in the sector.
Why did BancAlliance get into equipment financing?
Our members have told us that they would like to see a variety of C&I loan opportunities, including equipment finance. We are focusing on larger equipment loans to larger companies—these loans just would not fit on the balance sheet of a community bank. We have a lot of experience with the underwriting and collateral associated with these loans, and many community banks don’t have the resources to access this asset class on their own. It is a solid asset class that community banks will appreciate—with tangible collateral—but still very different from commercial real estate loans.
Why is it a good asset class?
It is a market in which many of the larger players have exited. A few years ago, a number of large financial companies were active in this space, building significant portfolios. As a result of the financial crisis, the capacity of these financial players has diminished, and capital costs have increased. We believe that we will be able to go into the market and access good loans that are well structured and acquire them on behalf of our member banks, and we can be a significant player in this market.
Are you essentially buying loans from these big lenders?
As we get this asset class up and running, we are working with agents who already have loans in the pipeline. As we continue to grow, we will have the capacity to originate our own loans. We will base our strategy on member preferences.
What does the market look like, economically speaking?
We’re in a replacement cycle—not a growth cycle. Companies have tightened their belts for the last few years. The equipment that needs financing right now is absolutely an essential part of a company’s ongoing business. As a lender, you want to finance essential equipment for a business because you know they’ll take care of their equipment and stay current on the loan. When you’re talking about real estate, that’s all about location and the local economy. When you’re talking about equipment, it runs on a different economic cycle than local real estate.
What are the special challenges for doing these loans?
You have to be comfortable with collateral valuations, including a sense for projected valuations. If depreciation dramatically exceeds amortization, you’re going to end up with an underwater loan that is not covered by your collateral. The valuation is affected by a lot of factors: Can this equipment be redeployed? Is it going to maintain its value? How comfortable am I that the market is going to be there in three to five years? To answer these questions, we use an independent evaluator, with strong credentials, who performs detailed analysis. It is analogous to the appraisal process on real estate loans. The appraisers are independent, experienced and knowledgeable about the type of equipment we’re asking them to value.
You underwrite both the collateral and the borrower?
Yes. You want someone who is a good operator and is generating sufficient cash flow to repay you. We look at the downside scenario as part of the underwriting. We need to be comfortable that we are lending to an experienced operator who is not prone to mistakes. Equipment loans are typically structured on a full recourse basis. In addition, a secured claim with priority in bankruptcy exists against particular pieces of equipment if that scenario ever occurs.
What types of equipment are we talking about?
We will cover a broad range of sectors, including manufacturing, oil and gas, trucks and railcars, cargo carriers, tankers or barges, and equipment used to process and haul commodities. Medical equipment is a really competitive space right now, but we will do it if we find the right opportunities. I think we’ll very much focus initially on the U.S. middle market and larger loans, $5 million to $100 million.
Community banks have been pushed, squeezed and shoved out of the lending market during the past two decades for many types of commercial and industrial loans, where the pricing has become so competitive that it’s not worth the effort. But with the pitfalls of high concentrations in commercial real estate so obvious now, many banks are trying to diversify revenue streams in order to survive. John Delaney and Lewis “Lee” Sachs founded asset manager Alliance Partners in June 2011 to help community and regional banks diversify income and gain access to C&I loans too big to otherwise put on their books. The related entity, BancAlliance, is a cooperative of member banks that identifies, evaluates and refers loans to members. Bank Director magazine talked to John Delaney and Lee Sachs about the market for C&I loans and how their company works.
Why did you think there was a need for this?
Lee Sachs: From the bank’s perspective, for the last 20 years, they’ve been pushed out of so many different markets. As a consequence, community banks have gone from having around 60 percent of their loan assets in real estate to some having almost 80 percent of their assets in real estate. That is not a sustainable business model over time.
John Delaney: Banks do better when they have balance and choice, and the problem with community banks is they don’t have balance and they don’t have a lot of choice. A lot of community banks have just become local real estate lenders. Much of the growth occurring in our country is in the middle markets. The U.S. is more of a service economy and service-based businesses tend to be more regional and national, and you need a certain amount of scale to successfully compete for loans in that market. Right now, a disproportional benefit of that growth goes to large banks. If you look at where jobs are being created, it’s at fast growing, mid-sized business that go from 100 employees to 1,000 employees in a couple years. The middle market requires loans of $50 million to $250 million, which are bigger than what a lot of community banks can handle. However, these borrowers would prefer to do business with community banks. Truly, that’s what they would rather do.
Lee Sachs: Sometimes a Main Street bank will lose a client as that client grows, because the bank can’t accommodate the larger loans. One of the things we help our members do is retain that client.
Who are your members and what does it cost to join?
Lee Sachs: We have 38 members and they’re all over the country, from $200-million asset banks to $10 billion. They don’t pay anything to join. We receive asset management fees based on the volume for the loans they fund through BancAlliance. The banks set the parameters for the loans, policies and procedures, and they tell us what kind of loans they want. Each individual loan may or may not fit with every bank’s needs. We introduce a loan to the membership and each member decides if that loan works for them. We service the loans on behalf of the group. We consider ourselves an extension of their loan department.
John Delaney: We’ve looked at 450 opportunities, and a little less than 10 percent made it through our filter, so 40 loans have been approved on behalf of the network.
C&I lending is a fairly competitive business, especially in terms of pricing, so how do you think you can offer a strategy that will be attractive to community banks?
John Delaney: For small banks, there are too few opportunities in C&I lending and too many banks going after that. In terms of national credits and mid-sized businesses, we find that to be a market that has average competition. We don’t think it is nearly as competitive as the C&I loans in the local footprints. The return profile is better and the risk profile is better.
How do the regulators view your model?
Lee Sachs: We’ve gotten good feedback. We are doing this very carefully; we designed this in a way that fits with regulatory guidelines. The former Comptroller of the Currency, John Dugan, has been outside counsel for BancAlliance and has been instrumental in helping us think this through.
Joe Evans, chairman and CEO of State Bank Financial Corp out of Atlanta, shares his lending strategy in a weak economy and tumultuous real estate market in Georgia.
Over his 30 year career, Joe Evans has run some of Georgia’s beset community banks. In December 2006, Joe Evans sold Atlanta-based Flag Financial Corp. to the U.S. arm of Royal Bank of Canada for $456 million. Since starting State Bank, Evans and his team have acquired several failed banks in the Metro Atlanta area.
In 2011, State Bank was named the top performing bank in the United States by Bank Director magazine in our 2011 Bank Performance Scorecard, a ranking of the 120 largest U.S. publicly traded banks and thrifts.
Watch the below video filmed during Bank Director and NASDAQOMX’s inaugural Boardroom Forum on Lending held last December in New York City.
With traditional bank lending, one of the credit risk red flags was always a lack of borrower diversity. How could a company risk having all its eggs in one basket? The extra pain extracted from highly correlated bank portfolios (i.e. both with real estate and geographic concentrations) in this crisis has brought that proverbial chicken home to roost in our own industry. Conceptually, we all now understand this; how do we practically affect this change?
Here’s a possible five-step plan for your bank to consider:
Step One: Adopt strategic plans that include alternative loan products, such as those tied to C&I (commercial & industrial) lending, or indirect / dealer automobile lending or even mortgage warehousing. Small Business Administration loans are another possibility. Recruit the talent that can implement these strategies for you.
Step Two: Disabuse yourselves of the following anti-C&I biases:
It’s become just a consumerized product. This is a byproduct of the underwriting laziness adopted by many, where a small business owner’s credit score was the primary driver for this loan product.
It’s tantamount to unsecured lending. Because it tends to focus on the top of the balance sheet, assets for collateral, lines of credit can be monitored effectively by procedures that use collateral such as stepped borrowing base agreements.
It’s asset-based lending. We’re not talking about factoring-like products (buying or funding a customer’s accounts receivable at a discount) that proliferated the ’90’s. They often failed because they were unwisely sold to banks as having primarily operational rather than credit risks at their heart.
Step Three: Ditch (or at least modify) the hunter-skinner delivery system for your bank’s loan officers. It doesn’t work. Some of the so-called efficiencies gained lend themselves better to the book and forget mindset that too often characterized our industry’s fixation on commercial real estate. This strategy also robs us of broad-based credit talent needed to fulfill the axiom: the market place rewards value-added.
Step Four: Train and re-train lenders and related lending staff (analysts, underwriters, credit officers) in the ways of cash flow and cash cycle analyses. Twenty years ago, most commercial bankers were experts in these classical credit tenets—and frankly treated real estate as a form of specialty lending. Over the past decade, commercial banks have been copying mortgage lending, abdicating too much of their core underwriting to third parties such as appraisers and credit rating agencies. The fundamentals of classic credit underwriting are not that intimidating—and like riding a bike, can come back to even the most dedicated commercial real estate devotees.
Step Five: Create the infrastructure needed to deliver and oversee this diversity investment. In addition to front-end underwriting, enhance:
Use of practical loan covenants and borrowing base certificates to justify lines of credit;
Portfolio servicing (post-booking checks of a borrower’s risk trends);
Probative risk management tools (looking at future risks);
Staff. Remember, the cost of one or two additional full-time equivalents pales in comparison to the bloodletting the industry has experienced, due in some part to bare-boned risk management infrastructures.
Lest one think these initiatives are designed to address only the risk component of lending, I would offer that they also help return the community banker back to the successful production role of lending to a diverse borrowing base: a win-win.
*Another version of this article was previously published in Carolina Banker in 2009.
Steve Trager is president and CEO of Republic Bancorp, Inc., a Louisville, Kentucky-based, $3.1 billion-asset publicly traded company with 43 bank branches in Kentucky, Florida, Indiana and Ohio. Despite the crummy economic environment, poor loan demand and high regulatory demands, Republic Bancorp has maintained high profitability; even with half its loans in residential mortgages, and most of the rest in commercial real estate, construction, business and consumer loans.
Republic Bancorp had the second and third highest return on average assets and return on average equity last year, and the fifth best performance overall in Bank Director magazine’s ranking of the top 150 banking companies in the nation.
To be sure, the bank has experienced problems, too.Its non-performing assets are 1.28 percent of total loans as of the second quarter, a decline from previous quarters, and it took a $2 million charge in second quarter earnings over a civil penalty from the Federal Deposit Insurance Corp. relating to its IRS tax refund anticipation loan service. (The company says it will contest the fine before an administrative law judge and will work to make sure its tax firm clients comply with applicable banking regulations).
Trager talked to Bank Director recently about how he’s handling the challenges of the current regulatory and economic environment.
Can you talk about what sort of lending you do?
The challenge for us in residential mortgages is we compete with a government product that is a 15- and 30-year fixed rate at 3.5 percent for 15 years and 30 years at 4.25 percent and only the government would make a 15- or 30-year fixed rate loan at those kind of rates, with that kind of interest-rate risk. We are proud to be able to offer that government product to our customers as well and we service that product as a competitive edge. Every single one of our products is delivered by a Republic Bank banker as opposed to a broker and that is competitive difference for us. We sell those (government-backed) loans on the secondary market so we don’t keep them on our books.
So what kind of residential mortgages do you keep in your portfolio?
There’s an expanding universe of people who aren’t able to comply with the government’s rigid requirements. Some of those requirements don’t reflect credit quality. Some folks are very capable with good debt service characteristics, low loan-to-value. They might want to buy a condo and the secondary market is very difficult for condos.
We would love to expand our offering to an even bigger group of customers who are very credit worthy, if we could get a little better pricing. The biggest risk today is regulatory risk. The mortgages we do, the rates we do, and whom we make them to, is just subject to so much scrutiny, that we can’t take a chance to expand our portfolio credit offering to those who need it.
Didn’t your $2.2 billion loan portfolio grow a little bit in the second quarter, by 2 percent?
Absolutely, (it grew) by about $50 million. That was a little bit more than half commercial and some residential. I think customers see Republic Bank and our financial health as a stable, long-term option.
We’re still in the market for residential mortgages because we have enough size and enough volume. The risks are so great that it has pushed a lot of other lenders out of the market. Any mortgage loan we make, we’ve got to gather tons of fields of demographic information, for thousands of loans per year. It frustrates customers.
Have you loosened your underwriting standards recently?
We have not. Our underwriting standards have remained relatively stable over the last five years. I do worry that in this market, where there is not much loan demand and a lot of banks in desperate need of loans that that’s a dynamic that might cause some to stretch their underwriting models. We’re never going to sacrifice the long-term viability of Republic Bank or our customers for short-term gain.
Your focus has been maintaining a highly profitable bank. You saw profits rise 50 percent in the first half of the year compared to the same time a year ago to $80 million. How?
I think it’s a combination of the stability that our core bank provides. We haven’t been haunted by credit quality. We have had good demand from both the deposit and loan side. It’s just trying to do the right thing over and over again for a long period of time, and having the right people do it. We’ve got 780 associates and they do a spectacular job.
We also have niche businesses that supplement our bottom line. We are the largest provider of electronic tax refunds in the country. We service folks like Jackson Hewitt, Liberty and other tax services around the country, processing electronic refunds for their customer base. A small percentage of the customers would like to get an advance on their refund within 24 or 36 hours. That represented about 700,000 of our four million tax refund customers in the first quarter. For the rest, when the IRS pays it, we make sure our customers get it quickly.
What advice do you have for other bankers in this difficult time to grow lending?
Go out and encourage and support a good lending staff. Get out and pound the pavement. Our lending staff is very incentivized to do that. Their incentives are tied to loan quality. Part of their annual bonus is determined by production and delinquency. We are fortunate enough to have had a lot of folks who have been with us for a long period of time, and that helps.