Turning Goals from Wishes to Outcomes

Community banks should measure their goals and objectives against four tests in order to craft sustainable approaches and outcomes.

Community banks set goals: growth targets for loans or deposits, an earnings target for the security portfolio, an return on equity target for the year. But aggressive loan growth may not be a prudent idea if loan-to-asset levels are already high entering a credit downturn. Earnings targets can be dangerous if they are pursued at any cost, regardless of risk. However, in the right context, each of these can lead to good outcomes.

The first test of any useful goal is answering whether it’s a good idea.

One personal example is that about a year ago I set a new goal to lose 100 pounds. I consulted with my doctor and we agreed that it was a good idea. So then we moved to the second test of a useful goal: Is it sustainable?

As “Atomic Habits: An Easy & Proven Way to Build Good Habits & Break Bad Ones” author James Clear puts it: “You do not rise to the level of your goals, you fall to the level of your process and systems.”

What good would my weight loss goal be if it wasn’t sustainable? If the approach I took did not change my habits and instead put me through a shock program, there would be little reason to doubt that the approaches and habits that led me to create this goal would bring me back there again. The only way to pursue my goal in a sustainable fashion would changing my habits — my personal processes and systems.

Banks often pursue goals in unstainable ways as well.

Consider a bank that set a goal in June 2018 of earning $3 million annually from its $100 million securities portfolio with no more than 5 years’ duration (sometimes called a “yield bogey”). Given a choice between a 5-year bullet agency at 2.86% and a 5-year, non-call 2-year agency at 3.10%, only the latter meets or beats the goal. A 3.10% yield earns $310,000 for this portfolio.

In June 2020, the callable bond got called and was replaced by a similar length bond yielding only 40 basis points, or $40,000, for the remaining three years. The sustainable plan would have earned us $286,000 for the past two years — but also $286,000 for the next three. To make earnings sustainable, banks always need to consider multiple scenarios, a longer timeframe and potentially relaxing their rigid “bogey” that may cost them future performance.

 The third test of a useful goal is specifying action.

The late New York Governor Mario Cuomo once said, “There are only two rules for being successful: One, figure out what exactly you want to do, and two, do it.”

In my case, I didn’t do anything unsustainable. In fact, I did not do anything at all to work toward my long-term goal. When I checked my weight six months later, it should not have surprised me to see I had lost zero pounds. A goal that you do not change your habits for is not an authentic goal; it is at best a wish.

My wish had gotten exactly what you would expect: nothing. Upon realizing this, I took two material steps. It was not a matter of degree, but of specific, detailed plans. I changed my diet, joined a gym and spent $100 to fix my bicycle.

The fourth test of a useful goal is if it is based on positive changes to habits.

Banks must often do something similar to transform their objectives from wishes to authentic goals. Habits — or as we call them organizationally, processes and systems — must be elevated. A process of setting an earnings or yield bogey for the bond portfolio relied on the hope that other considerations, such as call protection and rate changes, wouldn’t come into play.

An elevated process would plan for earnings needs in multiple scenarios over a reasonable time period. Like repairing my bike, it may have required “spending” a little bit in current yield to actually reach a worthy outcome, no matter which scenario actually played out.

If your management team does not intentionally pursue positive changes to processes and systems (habits), its goals may plod along as mere wishes. As for me, six months after making changes to my habits, I have lost 50 pounds with 50 more to go. Everything changed the day I finally took the action to turn a wish into a useful goal.

Capital, Digital Initiatives Set De Novos Up for Success

In 2018, Matt Pollock and a group of business leaders and experienced bankers organized a new bank to fill a gap they saw in the Oklahoma City market. And he believes their tech-forward approach sets them apart from competing financial institutions.

“A lot of [banks] fall into the same traps in how they approach client services and products and relationships, and they just don’t do a very good job,” says Pollock, the CEO of $110 million Watermark Bank, which opened its doors in January 2019. “So, we really focused on [building] the right team, with the right model that really drives the business community.”

Few de novo banks have formed since the 2008-09 financial crisis. Of the 1,042 community banks chartered in the eight years preceding that crisis, 13% failed and another 20% were acquired or liquidated, according to a 2016 Federal Deposit Insurance Corp. study. Overall, de novo banks accounted for 27% of all failures from 2008 to 2015, and exited at double the rate of small, established banks.

De novo institutions are particularly fragile: They don’t tend to be profitable in their early years as they invest in building their business and reputation in their markets. In today’s environment, low rates pressure net interest margins, exacerbating these challenges.

With that in mind, Bank Director used FDIC data to analyze the 24 de novo banks formed from January 2017 through December 2019 to understand how they’re performing today and how they might weather the current economic downturn. We examined efficiency, through the overhead and efficiency ratios, and profitability, through return on assets and return on equity, as of Dec. 31, 2019. We also included equity capital to assets and net interest margin in the analysis. Watermark came in fifth in our ranking.  

Today’s batch of de novo banks features higher capital levels, a requirement that has dampened new bank formation. (The FDIC doesn’t set a minimum capital threshold for de novo banks; expectations vary based on the bank’s market, size, complexity, activities and business model.)

If the recession deepens, those high capital levels could come in handy as banks find it trickier to raise more capital, says Nicholas Graham, senior managing director at FinPro. “Many of the de novos that formed over the past several years, in a very general statement, have not fully leveraged their capital to date,” he says. “Therefore, they have more capital right now, all else being equal, to potentially weather this storm.”

Stringent capital requirements led some bank organizers to acquire rather than start a bank from scratch. Not so for Watermark Bank. Acquiring a charter was too expensive due to high bank valuations toward the end of the cycle, says Pollock, and an acquisition would have bogged the founders down with legacy cultural and technological issues.

So, they decided to start fresh. “Let’s build our systems and our workflows exactly how we want to do it; we’ll have to roll up our sleeves, it will take a little bit longer, probably a little bit more work but in the end, it would be a benefit,” says Pollock. “We ran a very lean operation, opened with 12 people, got up and running, and we quickly got to a break-even faster than many others.”

Prioritizing technology sets Watermark and many of its de novo peers apart from those chartered before the 2008-09 crisis. And it allowed Watermark to rise to the occasion in issuing Paycheck Protection Program loans, despite high demand and a spare staff.

“We did as many PPP loans in 10 days as we did loan transactions in our first year of operation,” says Pollock. “There was some stress, but at the end of the day we walked away and said, ‘We have good processes and procedures, we have extremely talented people, and we’re capable of leveraging our platform and our operational capabilities that we have today to a much higher level,’” he says.

Flexibility and nimbleness give de novo banks an advantage. “They’re more quickly able to adapt and add new products and services that may be more beneficial in this time of uncertainty,” says Graham.

Savvy de novos are investing in the digital infrastructure needed for modern banking, says Rick Childs, a partner at Crowe LLP. But there’s one more attribute he believes strengthens a de novo: extensive banking experience on the board and management team.

“You can skin the cat a lot of different ways in banking, but if you don’t have a lot of capital to help you weather the lean years, and if you don’t have strong management and [directors] to make sure you’re not taking unnecessary risk,” it will be hard to survive, he says. “[If] you know how to react when a difficult time comes around, then the rest will follow.”

Top Performing De Novo Banks

Rank Bank Name Asset Size (000s) NIM (3/31/2020) Overall Score
#1 The Bank of Austin $202,738 3.36% 5.8
#2 CommerceOneBank $258,590 3.34% 6.2
#3 Winter Park National Bank $418,816 2.89% 7.0
#4 Tennessee Bank & Trust $272,173 3.25% 7.7
#5 Watermark Bank $110,423 3.40% 8.0
#6 Infinity Bank $110,145 4.41% 8.6
#7 Ohio State Bank $130,519 2.22% 9.5
#8 Gulfside Bank $97,154 3.14% 10.6
#9 The Millyard Bank $23,524 1.41% 11.2
#10 Beacon Community Bank $161,029 3.05% 12.1

Source: Federal Deposit Insurance Corp.
Each bank was ranked based on profitability, efficiency, NIM and capital as of Dec. 31, 2019. The overall score reflects the average of these ranks.

Opportunity Emerges from Coronavirus Crisis

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

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

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

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

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

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

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

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

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

Leverage Tech to Release HELOC Demand

Even though bank may still have limitations on physical operations due to the Covid-19 pandemic, they can still leverage technology to prepare for what a potential boom in home equity line of credit (HELOC) lending.

Inflation will happen and rates will once again rise, making the market ripe for HELOCs. Community and regional banks need to be savvy enough to compete against larger banks and rising fintech nonbank lenders for this growing market share, and they can do this by using technology to properly harness the data. Data is new currency.

According to a J.D. Power study on HELOC satisfaction, 88% of consumers say they started the HELOC process without being prompted by a bank employee. That percentage is even greater for millennials: 94%. This a trend that is likely to continue.

Fast-paced technology allows consumers online options to do their banking from their smartphone, and many don’t want to speak to a banker unless they cannot get the answer online. They are signing up for loans, transferring funds to another account or opening new accounts — all transactional services that can be done with a few keystrokes and mouse clicks, without having to visit a local branch.

This same technology can be applied to the HELOC application process, which banks can use to greatly improve interactions with consumers. So why aren’t more banks embracing this technology? Why do we keep seeing phone numbers or “email us” prompts under the HELOC section of a bank website? It seems home equity lending is stuck in the 1990s.

This has to change to capture customers’ attention. The rise in home prices means millennials have more equity in their homes, and 59% gather their information online — 50% through smartphones only, according to the J.D. Power study. Banks have not been actively marketing to this group, making it a crucial area for improvement with the use of technology.

For any technology to be successful, banks need to change their approach or mindset regarding their HELOC application process. There are many options that can be used on the front-end of the HELOC experience as more banks streamline their digital processes. Others are using their loan origination system as a robust starting point in this process; one that should be easy, fast and intuitive.

Technology can automatically order the necessary data, like credit, income, flood and instant title reports. If the title data is not readily available, it can use intelligence logic to select the best data property report provider, based on turn time and price. That information is then delivered in one report that is custom-tailored to each lender’s unique loan fulfillment requirements.

Other technology can help with the front end, digital marketing and other aspects of the business, from the top of the funnel to eClosing. The constant change means that systems put in place three years ago were probably more expensive than some banks were willing to invest. Those systems might not have featured all the functionality a bank needed; now, they are outdated. Even if banks previously considered and decided against possible systems for whatever reason, it is paramount that they take another careful look today.

Some banks may be content with their current level of home equity loans; however, as the market starts to ramp up, they risk leaving significant business on the table or losing a customer to a non-bank fintech. Recent advancements mean there are innovative and inexpensive systems available that do not require a total retooling of a bank’s existing technology stack. What is the price on shaving 25 days off the process? What price can your bank can put on saving 25 days in the process? With the right approach, these new tools can help banks be cost neutral, or even save money.

Practical AI Considerations for Community Banks

A common misconception among many community bankers is that it isn’t necessary to evaluate (or re-evaluate for some) their use of artificial intelligence – especially in the current market climate.

In reality, these technologies absolutely need a closer look. While the Covid-19 crisis and Paycheck Protection Program difficulties put a recent spotlight on outdated financial technology, slow technology adoption is a long-standing issue that is exacerbating many concerning industry trends.

Over the last decade, community banks have faced massive disruption and consolidation — a progression that is likely to continue. It’s imperative that bank executives take a clear-eyed look at how advanced technologies such as AI can support their business objectives and make them more competitive, while gaining a better understanding of the requirements and risks at play.

Incorporating AI to Elevate Existing Business Processes
This may seem like a contrarian view, but banks do not need a specific, stand-alone AI strategy. The value of AI is its ability to improve upon existing structures and processes. Leadership teams need to be involved in the development process to identify opportunities where AI can tangibly drive business objectives, and manage expectations around the resources necessary to get the project up and running.

For example, community banks should review how AI can automate efficiencies into their existing compliance processes — particularly in the areas of anti-money laundering and Bank Secrecy Act compliance. This application of AI can free up manpower, reduces error rates and help banks make informed decisions while better serving their customers.

It’s necessary to have a strong link between a bank’s digital transformation program and AI program. When properly incorporated, AI helps community financial institutions better meet rising customer expectations and close the gap with large financial institutions that have heavily invested in their digital experiences.

Practical Steps for Incorporating AI
Once a bank decides the best path forward for implementing AI, there are a few technical and organizational steps to keep in mind:

Minimizing Technical Debt and “Dirty Data”: AI requires vast amounts of data to function. “Dirty data,” or information containing errors, is a real possibility. Additionally, developers regularly make trade-offs between speed and quality to keep projects moving, which can result in greater vulnerability to crashes. Managing these deficiencies, “or technical debt,” is crucial to the success of any AI solution. One way to minimize technical debt is to ensure that both the quantity and quality of data taken in by an AI system are carefully monitored. Organizations should also be highly intentional about the data they collect.More isn’t always better.

Minimizing technical debt and dirty data is also key to a smooth digital transformation process. Engineers can add value through new and competitive features rather than spending time and energy addressing errors — or worse, scrapping the existing infrastructure altogether.

Security & Risk Management: Security and risk management needs to be top-of-mind for community bankers any time they are looking to deploy new technologies, including leveraging AI. Most AI technologies are built by third-party vendors rather than in-house. Integrations can and likely will create vulnerabilities. To ensure security and risk management are built into your bank’s operating processes and remain of the highest priority, chief security officers should report directly to the CEO.

Managing risks that arise within AI systems is also crucial to avoid any interruptions. Effective risk management ties back to knowing exactly how and why changes affect the bank’s system. One common challenge is the accidental misuse of sensitive data or data being mistakenly revealed. Access to data should be tightly controlled by your organization.

Ongoing communication with employees is important since they are the front line when it comes to spotting potential issues. The root cause of any errors detected should be clearly tracked and understood so banks can make adjustments to the model and retrain the team as needed.

Resource Management: An O’Reilly Media survey from 2018 found that company culture was the leading impediment to AI adoption in the financial services sector. To address this, leaders should listen to and educate employees within each department as the company explores new applications. Having a robust change management program — not just for AI but for any digital transformation journey — is absolutely critical to success. Ongoing education around AI efforts will help garner support for future initiatives and empower employees to take a proactive role in the success of current projects.

At a glance, implementing AI technologies may seem daunting, but adopting a wait-and-see approach could prove detrimental — particularly for community banks. Smaller banks need to use every tool in their toolkit to survive in a consolidating market. AI poses a huge opportunity for community banks to become more innovative, competitive and prosperous.

Loan Growth: Curation, Credit Monitoring

SavvyMoney.pngOne community bank is using a fintech to deepen lending relationships with customers and help them monitor and improve their credit score.

Watford City, North Dakota-based First International Bank and Trust wanted to offer customers a way to proactively monitor their credit and receive monthly or incident-related alerts about any changes — without needing to use external vendors, granting external access to accounts or even paying for it. It chose to partner with SavvyMoney, which provides customers with their credit scores and reports alongside pre-qualified loan offers from within the bank’s online and mobile apps.

The fruits of the relationship were one reason the fintech was awarded the Best Solution for Loan Growth at Bank Director’s 2020 Best of FinXTech Award in May. CommonBond, a student loan refinancer, and Blend, which offers banks an online, white-label mortgage processing solution, were also finalists in the category.

In exploring how it could help customers improve their credit score and manage their finances, First International knew some customers were already using similar services through external websites. But the $3.6 billion bank wanted to convey that it had invested time and IT resources to ensure SavvyMoney’s validity, accuracy and status as a trusted partner, says Melissa Frohlich, digital banking manager. The SavvyMoney feature takes about 45 seconds to activate once a customer is logged in, and the customer experience is the same in the mobile app or website.

“From the fraud standpoint, we definitely recommend to our customers that … they use SavvyMoney because it’s free to them,” Frohlich says. “Especially with all the breaches that happen, it’s a good way for them to self-monitor their credit.”

The bank also uses the platform to share specialized credit offers along with a customers’ loan information and credit score, which it crafts using public records and extends based on internal criteria. It has launched two credit card balance transfer offers since rolling out the product two years ago. The fintech offers First International a way to “slice and dice” data to truly target customers with customized offers, as opposed to “throwing out a fishing line and hoping someone bites,” she says.

Launching the offers takes “very little” time to implement and consists of updating a term sheet, whipping up bank graphics and sending out a simple email blast. The first offer netted more than $190,000 in balance transfers — all from one email campaign.

“It was just very, very little work for us with pretty significant impact, without a ton of manpower or money that we had to put into it,” Frohlich says.

The balance transfer offer included messaging about how much customers would save with the new interest rate. If First International wanted to offer auto loan refinancing, it could input different rates based on the year of the vehicle and loan term.

First International was drawn to SavvyMoney in part because it had an existing relationship with a variety of core providers. That’s key, given that SavvyMoney connects to a bank’s core to pull in personal customer information from online and mobile banking sources. And because it would be sharing customer data, First International spent several months conducting due diligence, combing through SavvyMoney’s system and organization controlsreports and speaking with both its core and the fintech.

Frohlich says the actual implementation took about a month and was as straightforward as flipping a switch to activate the capability in customer accounts. She continues to work with her representative at SavvyMoney to add or change loan offers.

“They have probably the best integration that I’ve seen with Fiserv from a third party or a fintech, out of any other product that Fiserv doesn’t own,” she says. “The actual implementation was the best that I’ve ever taken part in.”

SavvyMoney can also integrate with the bank’s new loan platform that was slated for a March launch, a fact that Frohlich didn’t know when the bank selected either. Loan applications submitted through SavvyMoney will feed into the software’ auto decision-making.

“That will be a game changer for us, then we will heavily start doing more promotions,” she says.

Even after the bank switched cores, it has been able to keep SavvyMoney given its vendor relationships with other cores. “There have been other solutions, that now that we’re moving to a different platform, that I could consider,” Frohlich says. “But to be honest, our experience has been so great with SavvyMoney that I have no reason to look elsewhere.”

How Experience FinXTech Parallels The NFL Draft

By the time the NFL announced plans to host the draft from various remote locations, nearly every other sports league had postponed or canceled their events.

The decision raised eyebrows.

The NFL draft has become a must-attend in-person event, as evidenced by the record-breaking 600,000 turnout in Nashville, Tennessee, last year. As a fan, I wondered if the league was putting their own interests too far ahead of others by going forward with a new, unproven format just to keep to this activity on the calendar.

It turns out, the digital nature of the three-day event resonated in many positive ways. The draft was viewed by 55 million viewers over the three-day event, according to the league. Naturally, some of the viewership reflected an appetite for new, non-pandemic related content. But from a business perspective, it showed how migrating an in-person event entirely online could, in a pinch, work.

As we all try our best to live normal lives from our homes, the NFL’s success with the draft gives me confidence in our decision to go remote with our annual Experience FinXTech.

Much as the NFL drew a great audience to Music City last year, so too were we excited to welcome a stellar audience to Bank Director’s hometown in early May. Just as the NFL figured out how to provide viewers with new glimpses into their team’s futures, so too will our Experience FinXTech as we move online. Ours will just be in terms of how and where financial technology companies and financial institutions might develop relationships that beget future successes.

Experience FinXTech parallels the NFL draft based on the concept of team-building. Just as every NFL franchise faces its own challenges, so too does every financial institution. Indeed, the ever-expanding digital chasm between the biggest banks and community institutions remains a major strategic challenge in terms of talent, tools and dollars spent.

While there is no one-size-fits-all approach to building a team, there are lessons that executives and leadership teams might entertain from their peers during a program like this one. Indeed, we have heard and seen incredible examples of community banks pulling together to serve their constituents as best they can, however they can, during this time. This program allows us to share examples.

Bank Director’s desire to help community banks succeed in all circumstances provides an impetus for moving to video and webinars instead of waiting until the late fall to meet in person. Helping banks and fintechs get smarter about immediate opportunities to develop meaningful relationships is incredibly relevant. The time is now to assess a business strategy and make decisions that could reshape your institution’s future. Access to timely, verified and reliable information is something we didn’t want to delay in providing.

Indeed, Experience FinXTech will touch on areas where technology can assist banks to provide counseling, assistance and a personal touch to their existing and potential customers. In addition, we talk about authentication. The need to embrace the cloud. Filling in the missing pieces in the digital commercial banking product set.

Beginning on May 5, we take a pragmatic approach to new business relationships, collaborations and strategic investments. We offer virtual demonstrations to help viewers see proven technologies available to banks with regards to security, data and analytics, internal systems, lending, digital banking, payments, compliance and the customer experience.

With so many elements of our economy being challenged, we know our “next normal” will look very different from what we’ve become accustomed to. Connecting interests, and ideas, to help banks and fintechs navigate their futures is why we ultimately decided to offer this year’s experience online, for free, to anyone interested in joining us.

I look forward to welcoming people to this year’s Experience FinXTech and promise that references to certain NFL teams will be kept to a minimum.

Thanks to the support of these companies, we are able to extend complimentary registration for Experience FinXTech. To sign up, please click here.

Preparing to Be There for Your Community

The fallout from COVID-19 will likely take some time to stabilize. The personal and social costs are already significant, and neither is independent of economic and business disruptions.

Especially impacted are the businesses on Main Streets everywhere that are served by community banks. Community banks will be essential to any recovery, so it is important that they take steps now to ensure they’re positioned to make a difference.

The Challenge Of A “New Normal”
Financial markets were in “price discovery” mode this spring, but that phase is unlikely to last for long. If Treasury rates rise from their current levels, banks are likely to do well with their traditional models. But if they remain low, and spreads eventually stabilize to 2019 levels, nearly every institution will encounter pressure that could undermine their efforts to be a catalyst for Main Street’s recovery.

Bank Director’s recent piece “Uncharted Territory” warned that the experience of past financial crises could mislead bankers into complacency. Last time, dramatic reductions in funding costs boosted net interest margins, which helped banks offset dramatically higher loan losses. The difference today is that funding costs are already very low — leaving little room for similar reductions.

Consider asset yields. Even without significant credit charge-offs, community bank profitability could face headwinds. Community banks entered 2020 with plenty of fuel to support their thriving Main Streets. Their balance sheets had been established for a Treasury rate environment that was 100 basis points higher than today’s. If rates settle here for the next couple of years and existing assets get replaced at “new normal” levels, yields will fall and net interest margins, or NIMs, could take a hit.

Banks could have trouble “being there” for their communities.

Where do the current assets on banks’ balance sheets come from? They were added in 2018, 2019 and the first quarter of 2020. If we assume a fixed rate loan portfolio yields somewhere around 300 basis points over the 5-year swap rate at closing (which averaged about 1.75% over 2019), and floating rates loans yield somewhere around 50 basis points over prime day to day, we can estimate banks’ first quarter loan yields at perhaps 4.75% fixed-rate and 5.25% prime-based.

Prime-based yields have already dropped for the second quarter and beyond: They are now earning 3.75%. Fixed-rate loans continue to earn something like 4.75%, for now.

Banks that can quickly reduce funding costs might, in fact, see a short-term bump in net interest margins. If they can stave off provision expenses, this might even translate into a bump in profitability. But it will not last.

If Treasury rates remain at these historic lows and spreads normalize to 2019 levels, current balance sheets will decay. Adjustments today, before this happens, are the only real defense.

Banks’ fixed rate loans will mature or refinance at much lower rates — around 3.50%, according to our assumptions. Eventually, banks that enjoyed a 3.50% NIM in 2019 will be looking at sustained NIMs closer to 2.50%, even after accounting for reduced funding costs, if they take no corrective steps today. It will be difficult for these banks to “be there” for Main Street, especially if provision expenses begin to emerge.

Every community bank should immediately assess its NIM decay path. How long will it take to get to the bottom? This knowledge will help scale and motivate immediate corrective actions.

For most banks, this is probably a downslope of 18 to 30 months. For some, it will happen much more rapidly. The data required may be in asset and liability management reports. Note that if your bank is using year-end reports, the intervening rate moves mean that the data in the “100 basis points shock” scenario from that report would represent the current rates unchanged “baseline.” Reports that do not run income simulations for four or more years will also likely miss the full NIM contraction, which must be analyzed to incorporate full asset turnover and beyond.

Times are hectic for community banks, but in many cases commissioning a stand-alone analysis, above and beyond standard asset-liability compliance requirements, is warranted.

Then What?
The purpose of analyzing a bank’s NIM timeline is not to determine when to start taking action, but to correctly size and scope the immediate action.  All the levers on the balance sheet— assets, liabilities, maybe even derivatives — must be coordinated to defend long-term NIM and the bank’s ability to assist in Main Street’s recovery.

The Small Business Administration’s Paycheck Protection Program lending is fully aligned with the community bank mission, but it is short term. Banks must also plan for sustainable net interest income for three, four and five years into the future, and that planning and execution should take place now. The devised NIM defense strategy should be subjected to the same NIM decay analysis applied to the current balance sheet; if it’s insufficient, executives should consider even more significant adjustments for immediate action.

The economic environment is out of bankers’ control. Their responses are not, but these require action in advance. Banks can — and should — conduct a disciplined, diagnostic analysis of their NIM decay path and then correct it. This interest rate environment could be with us for some time to come.

Whipsawed by Interest Rates

One of the things that bankers hate most is uncertainty and abrupt changes in the underlying economics of their business, and the emerging global crisis caused by the COVID-19 pandemic is confronting them with the perfect storm.

You can blame it all on the Federal Reserve.

Indeed, the higher rates that the Fed gave in 2018, it is now taken away — and that is creating a big challenge for banks as they scramble to adapt to a very different interest rate scenario from what they were dealing with just 15 months ago.

On March 3, as the economic impact of the coronavirus both globally and in the United States was becoming more apparent and fears about a possible recession were mounting, the Fed made an emergency 50 basis-point cut in interest rates, to a range of 1% to 1.25%. The Fed’s action was dramatic not only because of the size of the reduction, but also because this action was taken “off cycle” — which is to say two weeks prior to the next scheduled meeting of the Federal Open Market Committee, which is the Fed’s rate-setting body.

And as this article was being posted, many market observers were expecting that the Fed would follow with another rate cut at its March 17-18 meeting, which would drive down rates to their lowest levels since the financial crisis 12 years ago. Needless to say, banks have been whipsawed by these abrupt shifts in monetary policy. The Fed increased rates four times in 2018, to a range of 2.25% to 2.50%, then lowered rates three times in 2019 when the U.S. economy seemed to be softening, to a range of 1.50% to 1.75%.    

Now, it appears that interest rates might go even lower.

What should bank management teams do to deal with this unexpected shift in interest rates? To gain some insight into that question, I reached out to Matt Pieniazek, president of the Darling Consulting Group in Newburyport, Massachusetts. I’ve known Pieniazek for several years and interviewed him on numerous occasions, and consider him to be one of the industry’s leading experts on asset/liability management. Pieniazek says he has been swamped by community banks looking for advice about how to navigate this new rate environment.

One of Pieniazek’s first comments was to lament that many banks didn’t act sooner when the Fed cut rates last year. “It’s just disappointing that too many banks let their own biases get in the way, rather than listen to their balance sheets,” he says. “There are a lot of things that could’ve been done. Now everyone’s in a panic, and they’re willing to talk about doing things today when the dynamics of it are not very encouraging. Risk return or the cost benefit are just nowhere near the same as what they were just six months ago, let alone a year, year and a half ago.”

So, what’s to be done?

Pieniazek’s first suggestion is to dramatically lower funding costs. “No matter how low their funding costs are, very few banks are going to be able to outrun this on the asset side,” he says. “They’ve got to be able to [be] diligent and disciplined and formalized in their approach to driving down deposit costs.”

“In doing so, they have to acknowledge that there could be some risk of loss of balances,” Pieniazek continues. “As a result, they need to really revisit their contingency liquidity planning. They have to also revisit with management and the board the extent to which they truly are willing to utilize wholesale funding. The more you’re willing to do that, the more you would be willing to test the water on lowering deposits. I think there is a correlation to comfort level and challenging yourself to lower deposits and well thought out contingency planning that incorporates the willingness and ability to prudently use the wholesale market. Aggressively attacking deposit costs has to be accompanied by a real hard, fresh look at contingency liquidity planning and the bank’s philosophy toward wholesale markets.”

This strategy of driving down funding costs might be a hard sell in a market where competitors are still paying relatively high rates on deposits. “Well, you know what?” Pieniazek says. “You’ve got two choices. You either let village idiots drive your business, or you do what makes sense for your organization.”

Most banks will also feel pressure on the asset side of their balance sheets as rates decline. Banks that have a large percentage of floating rate loans may not have enough funding to offset them. As those loans reprice in a falling rate environment, banks will feel pressure to correspondingly lower their funding costs to protect their net interest margins as much as possible. And while community banks typically don’t have a lot of floating rate loans, they do have high percentages of commercial real estate loans, which Pieniazek estimates have an average life span of two and a half years. The only alternative to lowering deposit costs to protect the margin would be to dramatically grow the loan portfolio during a time of great economic uncertainty. But as Pieniazek puts it, “There’s not enough growth out there at [attractive] yield levels to allow people to head off that margin compression.”

Pieniazek’s second suggestion is to review your loan documents. “While I’m not suggesting [interest] rates are going to go negative, most banks do not have loan docs which prevent rates from going negative,” he says. “They need to revisit their loan docs and make sure that there’s lifetime floors on all of their loans that will not enable the actual note rate to go zero. They could always negotiate lower if they want. They can’t negotiate up.”

His final suggestion is that community banks need to strongly consider the use of derivatives to hedge their interest rate exposure. “If you think in an environment like this that your customers are going to allow you to dictate the structure of your balance sheet, you better think again,” he says. “Everyone’s going to want to shorten up … What you’re going to find is retail customers are going to keep their money short. In times of uncertainty, what do people want to do? They want to keep their cash close to them, don’t they?”

Of course, while depositors are going to keep their money on a short leash, borrowers “are going to want to know what the 100-year loan rate is,” Pieniazek says. And this scenario creates the potential for disaster that has been seen time and again in banking — funding long-term assets with short-term deposits.

The only thing you can do is augment customer behavior through the use of derivatives,” Pieniazek says. “Interest rate caps are hugely invaluable here for banks to hedge against rising rates while allowing their funding costs to remain or cycle lower if rates go lower. In a world of pressure for long-term fixed rate assets, being able to do derivatives … allows banks to convert fixed-rate loans in their portfolio to floating for whatever time period they want, starting whenever they want.”

During times of uncertainty and volatility, Pieniazek says it’s crucial that bank management teams make sound judgments based on a clear understanding of their ramifications. “Don’t let panic and fear result in you changing your operating strategy,” he says. “The worst thing to do is make material changes because of fear and panic. Let common sense and a clear understanding of your balance sheet, your risk profile, drive your thought process. And don’t be afraid to take calculated risks.”

AI: The Slingshot for Small Banks

Regional and community banks are struggling with growth and profitability in the face of competitive pressure from large national banks and fintech startups. Executives at these institutions are instructed to invest in technology, and to leverage data and artificial intelligence to compete more effectively.

While that sounds good, smaller banks are often constrained by a dependence on legacy core vendors that limits their IT potential, encounter difficulties in accessing their own data, lack skilled data scientists, and have no clear vision on where to start.

This conundrum came up during Bank Director’s 2020 Acquire or Be Acquired conference in Phoenix. I rubbed shoulders with fellow conference attendees over the course of three days, sharing ideas about the state of the banking sector and how community banks could leverage data and AI to drive business results. The talent gap was a frequent topic. Perhaps unsurprisingly, only a miniscule number of community banks have hired data scientists. The majority of banks have not prioritized data science capabilities; the few who are actively recruiting data scientists are struggling to attract the right talent.

But even if community banks could arm up with data scientists, what volume of data will they be working on to derive insights to fuel their business strategy? A $1 billion asset bank may have 50,000 to 75,000 customers — not a lot of data to start with. Furthermore, a number of bankers point to the difficulties they encounter in accessing their data in their legacy core systems.

As we were having these discussions, conversations were raging about the need for smaller banks to prepare for an existential threat. At the World Economic Forum in Davos, attendees were assessing comments from Bank of America Corp. Chairman and CEO Brian Moynihan that the bank could double its U.S. consumer market share. Back-of-envelope calculations indicate that if Bank of America manages to accomplish that growth, more than 1,000 community banks could be out of business. Can technology enable these banks to retain their core customer base, grow and avoid this fate? I think so.

One promising area of AI application for community banks is loan and deposit pricing. Community banks have little or no analytic tools beyond competitive rate surveys; most rely on anecdotal feedback from customers and front-line bankers. But price setting and execution on both assets and liabilities is one of the most important levers a bank can use to drive both growth and improve its net interest margin. Community banks should take advantage of new tools and data to level the playing field with the big banks, which are already well ahead of them in adopting price optimization technology.   

Small banks can gain the upper hand in this “David versus Goliath” scenario because accessible cloud-based technology works in their favor. True, big banks have worked with price optimization technology and leveraged large amounts of customer behavioral data for years. But community banks tend to have stronger customer relationships and often better pricing power than their larger competitors. Now is the time for community banks to take control of their destiny by adopting new technology and tools so they can better compete on price.

There are three reasons why cloud computing and the power of AI will be the slingshot of these ‘David’ banks:

  1. Scalable computing power, instantly on tap. Cloud-based computing and pre-configured pricing solutions are affordable and can be implemented in days, not months.
  2. Big data — as a service. Community banks can quickly leverage AI-based pricing models that have been trained on hundreds of millions of transactions. There is no need to build their own analytic models from a small customer footprint.
  3. Plug-and-play IT. It’s much easier today to integrate cloud-based platforms with a bank’s core system providers, which makes accessing their own data and implementing smarter pricing feasible.

Five years ago, it would have seemed crazy to think that in 2020, community banks would be applying AI to compete against the nation’s top banks. But the first wave of early adopters are already deploying AI for pricing. I predict we’ll see more institutions embracing AI and machine learning to improve their NIM and increase growth over the coming years.