What a difference a year makes. Spring 2020 was like nothing we had ever seen: scheduled gatherings were cancelled and economic activity came to a screeching halt.
Yet today, after a year highlighted by social distancing, lockdowns and restrictions, there is a sense of anticipation that feels like a wave of pent-up demand ready to break-out, much like the buds on a flowering tree. Loans last year saw the prime rate plunge to 3.25% from its recent peak of 5%, as the Federal Reserve pushed its target back to zero to help keep the economy afloat. Banks and credit unions that built up significant portfolios of variable-rate loans experienced the pain of this unexpected rate shock in the form of margin compression.
But as flowers begin to bloom this spring, there is very little hope that short-term rates will follow suit. The Federal Open Market Committee signaled at its mid-March meeting that it expects to maintain a near-zero Fed Funds target all the way through 2023 with a goal of seeing inflation rise to more normal levels. For lenders holding floating-rate assets, waiting until the 2024 presidential primary season to experience any benefit from higher yields might seem unbearable. And with the sting of last year’s free fall still fresh, the prospect of slow and steady quarter-point bumps thereafter is not appealing.
Interestingly, there is a different story playing out when we examine the yields on longer-dated bonds. Because inflation erodes the future value of fixed-income coupon payments, bond market investors have grown nervous about the Fed’s increased desire and tolerance for rising prices. Consequently, while short-term rates have remained anchored, 10-year bond yields have surged by a full percentage point in less than six months, creating a sharply steeper yield curve. This is excellent news for asset-sensitive institutions that have interest rate hedging capabilities in their risk management toolkits. Rather than simply accepting their fate and holding onto low-yielding floating-rate assets in hopes the Fed will move earlier than expected, banks with access to swaps can execute a strategy that creates an immediate positive impact on net interest margin.
To illustrate, consider an asset-sensitive institution with a portfolio of prime-based loans. Using an interest rate swap, the lender can elect to pay away the prime-based interest payments currently at a 3.25% yield and receive back fixed interest payments based on the desired term of the swap. As of March 23, 2021, those fixed rates would be 3.90% for 5 years, 4.25% for 7 years, and 4.50% for 10 years. So, with no waiting and no “ramp,” the loans in question would instantly increase in yield by 0.65%, 1% or 1.25% for 5, 7 and 10 years, respectively, once the swap economics are considered.
The trade-off for receiving this immediate yield boost is that the earning rate remains locked for the term of the swap. In other words, when prime is below the swap rate (as it is on Day One) the lender accrues interest at the higher fixed rate; when prime exceeds the swap rate, the lender sacrifices what is then the higher floating-rate yield.
This strategy uses a straightforward “vanilla” interest rate swap, with a widely used hedge accounting designation. For banks that have avoided balance sheet hedging due to complexity concerns, an independent advisor can help with the set-up process that will open the door to access this simple but powerful tool.
In the days following March 2020 we often heard that “the only thing certain in uncertain times is uncertainty.” With swaps in the toolkit, financial institutions have the power to convert uncertain interest flows to certain, taking control of the margin and managing exposure to changing interest rates in a more nimble and thoughtful manner.
Artificial intelligence is undergoing an evolution in the financial services space: from completely innovative “hype” to standard operating technology. Banks not currently exploring its many applications risk being left behind.
For now, artificial intelligence remains a competitive advantage at many institutions. But AI’s increasing adoption and deployment means institutions that are not currently investing and exploring its capabilities will eventually find themselves at a disadvantage when it comes to customer satisfaction, cost saves and productivity. For banks, AI is not an “if” — it’s a “when.”
AI has proven use cases within the bank and credit union space, offering a number of productivity and efficiency gains financial institutions are searching for in this low-return, low-growth environment. The leading drivers behind AI adoption today are improvements in customer experience and employee productivity, according to a 2020 report from International Data Corporation. At Microsoft, we’ve found several bank-specific applications where AI technology can make a meaningful impact.
One is a front-office applications that create personalized insights for customers by analyzing their transaction data to generate insights that improve their experience, like a charge from an airline triggering a prompt to create a travel notification or analyzing monthly spend to create an automated savings plan. Personalized prompts on a bank’s mobile or online platform can increase engagement by 40% and customer satisfaction by 37%; this can translate to a 15% increase in deposits. Additionally, digital assistants and chatbots can divert call center and web traffic while creating a better experience for customers. In some cases, digital assistants can also serve as an extension of a company’s brand, like a chatbot with the personality of “Flo” that auto insurer Progressive created to interact with customers on platforms like Facebook, chat and mobile.
Middle-office fraud and compliance monitoring are other areas that can benefit from AI applications. These applications and capabilities come at a crucial time, given the increased fraud activity around account takeovers and openings, along with synthetic identity forgery. AI applications can identify fraudsters by their initial interaction while reducing enrollment friction by 95% and false positives by 30%. In fact, IDC found that just four use cases — automated customer service agents, sales process recommendation and automation, automated threat intelligence and prevention and IT automation — made up almost a third of all AI spending in 2020.
There are several steps executives should focus on after deciding to implement AI technology. The first is on data quality: eliminating data silos helps to ensure a unified single view of the customer and drives highly relevant decisions and insights. Next, its critical to assemble a diverse, cross-functional team from multiple areas of the bank like technology, legal, lending and security, to explore AI’s potential to create a plan or framework for the bank. Teams need to be empowered to plan and communicate how to best leverage data and new technologies to drive the bank’s operations and products.
Once infrastructure is in place, banks can then focus on incorporating the insights AI generates into strategy and decision-making. Using the data to understand how customers are interacting, which products they’re using most, and which channels can be leveraged to further engage — unlocking an entire new capability to deliver business and productivity results
In all this, bank leadership and governance have an important role to play when adopting and implementing technology like AI. Incorporating AI is a cultural shift; executives should approach it with constant communication around AI’s usage, expectations, guiderails and expected outcomes. They must establish a clear set of governance guiderails for when, and if, AI is appropriate to perform certain functions.
One reason why individual banks may have held off exploring AI’s potential is concern about how it will impact current bank staff — maybe even replace them. Executives should “demystify AI” for staff by offering a clear, basic understanding of AI and practical uses within an employee’s work that will boost their productivity or decrease repetitive aspects of their jobs. Providing training that focuses on the transformational impact of the applications, and proactively creating new career paths for individuals whose roles may be negatively impacted by AI show commitment to employees, customers, and the financial institution.
It is critical that executives and managers are aligned in this mission: AI is not an “if” for banks, it is “when.” Banks that are committed to making their employees’ and customers’ lives better should seriously consider investing in AI capabilities and applications.
The nationwide pandemic and persistent economic uncertainty hasn’t slowed the growth of Idaho Central Credit Union.
The credit union is located in Chubbuck, Idaho, a town of 15,600 near the southeast corner, and is one of the fastest growing in the nation. It has nearly tripled in size over the last five years, mostly from organic growth, according to an analysis by CEO Advisory Group of the 50 fastest growing credit unions. It also has some of the highest earnings among credit unions — with a return on average assets of 1.6% last year — an enviable figure, even among banks.
“This is an example of a credit union that is large enough, [say] $6 billion in assets, that they can be dominant in their state and in a lot of small- and medium-sized markets,” says Glenn Christensen, president of CEO Advisory Group, which advises credit unions.
Unsurprisingly, growth and earnings often go hand in hand. Many of the nation’s fastest growing credit unions are also high earners. Size and strength matter in the world of credit unions, as larger credit unions are able to afford the technology that attract and keep members, just like banks need technology to keep customers. These institutions also are able to offer competitive rates and convenience over smaller or less-efficient institutions.
“Economies of scale are real in our industry, and required for credit unions to continue to compete,” says Christensen.
The largest credit unions, indeed, have been taking an ever-larger share of the industry. Deposits at the top 20 credit unions increased 9.5% over the last five years; institutions with below $1 billion in assets grew deposits at 2.4% on average,” says Peter Duffy, managing director at Piper Sandler & Co. who focuses on credit unions.
As of the end of 2019, only 6% of credit unions had more than $1 billion in assets, or 332 out of about 5,200. That 6% represented 70% of the industry’s total deposit shares, Duffy says. Members gravitate to these institutions because they offer what members want: digital banking, convenience and better rates on deposits and loans.
“The only ones that can consistently deliver the best rates, as well as the best technology suites, are the ones with scale,” Duffy says.
Duffy doesn’t think there’s a fixed optimal size for all credit unions. It depends on the market: A credit union in Los Angeles might need $5 billion in assets to compete effectively, while one in Nashville, Tennessee, might need $2 billion.
There are a lot of obstacles to building size and scale in the credit union industry, however. Large mergers in the space are relatively rare compared to banks — and they became even rarer during the coronavirus pandemic. Part of it is a lack of urgency around growth.
“For credit unions, since they don’t have shareholders, they aren’t looking to provide liquidity for shareholders or to get a good price,” says Christensen.
Prospective merger partners face a host of sensitive, difficult questions: Who will be in charge? Which board members will remain? What happens to the staff? What are the goals of the combined organization? What kind of change-in-control agreements are there for executives who lose their jobs?
These social issues can make deals fall apart. Perhaps the sheer difficulty of navigating credit union mergers is one contributor to the nascent trend of credit unions buying banks. A full $6.2 billion of the $27.7 billion in merged credit union assets in the last five years came from banks, Christensen says.
Institutions such as Lakeland, Florida-based MIDFLORIDA Credit Union are buying banks. In 2019, MIDFLORIDA purchased Ocala, Florida-based Community Bank & Trust of Florida, with $743 million in assets, and the Florida assets of $675 million First American Bank. The Fort Dodge, Iowa-based bank was later acquired by GreenState Credit Union in early 2020.
The $5 billion asset MIDFLORIDA was interested in an acquisition to gain more branches, as well as Community Bank & Trust’s treasury management department, which provides financial services to commercial customers.
MIDFLORIDA President Steve Moseley says it’s probably easier to buy a healthy bank than a healthy credit union. “The old saying is, ‘Everything is for sale [for the right price],’” he says. “Credit unions are not for sale.”
Still, despite the difficulties of completing mergers, the most-significant trend shaping the credit union landscape is that the nation’s numerous small institutions are going away. About 3% of credit unions disappear every year, mostly as a result of a merger, says Christensen. He projects that the current level of 5,271 credit unions with an average asset size of $335.6 million will drop to 3,903 credit unions by 2030 — with an average asset size of $1.1 billion.
CEO Advisory Credit Union Industry Consolidation Forecast
The pandemic’s economic uncertainty dropped deal-making activity down to 65 in the first half of 2020, compared to 72 during the same period in 2019 and 90 in the first half of 2018, according to S&P Global Market Intelligence. Still, Christensen and Duffy expect that figure to pick up as credit unions become more comfortable figuring out potential partners’ credit risks.
In the last five years, the fastest growing credit unions that have more than $500 million in assets have been acquirers. Based on deposits, Vibe Credit Union in Novi, Michigan, ranked the fastest growing acquirer above $500 million in assets between 2015 and 2020, according to the analysis by CEO Advisory Group. The $1 billion institution merged with Oakland County Credit Union in 2019.
Gurnee, Illinois-based Consumers Cooperative Credit Union ranked second. The $2.6 billion Consumers has done four mergers in that time, including the 2019 marriage to Andigo Credit Union in Schaumberg, Illinois. Still, much of its growth has been organic.
Canyon State Credit Union in Phoenix, which subsequently changed its name to Copper State Credit Union, and Community First Credit Union in Santa Rosa, California, were the third and fourth fastest growing acquirers in the last five years. Copper State, which has $520 million in assets, recorded a deposit growth rate of 225%. Community First , with $622 million in assets, notched 206%. The average deposit growth rate for all credit unions above $500 million in assets was 57.9%.
CEO Advisory Group Top 50 Fastest Growing Credit Unions
“A number of organizations look to build membership to build scale, so they can continue to invest,” says Rick Childs, a partner in the public accounting and consulting firm Crowe LLP.
Idaho Central is trying to do that mostly organically, becoming the sixth-fastest growing credit union above $500 million in assets. Instead of losing business during a pandemic, loans are growing — particularly mortgages and refinances — as well as auto loans.
“It’s almost counterintuitive,” says Mark Willden, the chief information officer. “Are we apprehensive? Of course we are.”
He points out that unemployment remained relatively low in Idaho, at 6.1% in September, compared to 7.9% nationally. The credit union also participated in the Small Business Administration’s Paycheck Protection Program, lending out about $200 million, which helped grow loans.
Idaho Central is also investing in technology to improve customer service. It launched a new digital account opening platform in January 2020, which allows for automated approvals and offers a way for new members to fund their accounts right away. The credit union also purchased the platform from Temenos and customized the software using an in-house team of developers, software architects and user experience designers. It purchased Salesforce.com customer relationship management software, which gives employees a full view of each member they are serving, reducing wait times and providing better service.
But like Idaho Central, many of the fastest growing institutions aren’t growing through mergers, but organically. And boy, are they growing.
Latino Community Credit Union in Durham, North Carolina, grew assets 178% over the last five years by catering to Spanish-language and immigrant communities. It funds much of that growth with grants and subordinated debt, says Christensen.
Currently, only designated low-income credit unions such as the $536.5 million asset Latino Community can raise secondary capital, such as subordinated debt. But the National Credit Union Administration finalized a rule that goes into effect January 1, 2022, permiting non-low income credit unions to issue subordinated debt to comply with another set of rules. NCUA’s impending risk-based capital requirement would require credit unions to hold total capital equal to 10% of their risk-weighted assets, according to Richard Garabedian, an attorney at Hunton Andrews Kurth. He expects that the proposed rule likely will go into effect in 2021.
Unlike banks, credit unions can’t issue stock to investors. Many institutions use earnings to fuel their growth, and the two measures are closely linked. Easing the restrictions will give them a way to raise secondary capital.
A separate analysis by Piper Sandler’s Duffy of the top 263 credit unions based on share growth, membership growth and return on average assets found that the average top performer grew members by 54% in the last six years, while all other credit unions had an average growth rate of less than 1%.
Many of the fastest growing credit unions also happen to be among the top 25 highest earners, according to a list compiled by Piper Sandler. Among them: Burton, Michigan-based ELGA Credit Union, MIDFLORIDA Credit Union, Vibe and Idaho Central. All of them had a return on average assets of more than 1.5%. That’s no accident.
Top 25 High Performing Credit Unions
Credit unions above $1 billion in assets have a median return on average assets of 0.94%, compared to 0.49% for those below $1 billion in assets. Of the top 25 credit unions with the highest return on average assets in 2019, only a handful were below $1 billion in assets, according to Duffy.
Duffy frequently talks about the divide between credit unions that have forward momentum on growth and earnings and those who do not. Those who do not are “not going to be able, and have not been able, to keep up.”
Small banks hoping for a delay in the new loan loss accounting standard could get their wish, following a change in how the accounting board sets the effective dates for new standards.
On July 17, the Financial Accounting Standards Board (FASB) proposed pushing back the effective date of major accounting changes like revenue recognition, leases and — key to financial institutions — the current expected credit loss model (CECL). The board hopes the additional time will offer relief to smaller companies with fewer resources and provide more space to learn from the implementation efforts of larger peers. Under the proposal, community banks and credit unions now have a new effective date of Jan. 1, 2023, to implement CECL.
The board’s proposal also provided relief for a new category they call “small reporting companies,” and thus simplified the three-tiered effective dates into two groups. The proposal retains the 2020 effective date for companies that file with the U.S. Securities and Exchange Commission that are not otherwise classified as a small reporting companies.
CECL will force banks to set aside lifetime loss reserves at loan origination, rather than when a loss becomes probable. The standard has been hotly contested in the industry since its 2016 passage, and banking groups and members of Congress had unsuccessfully sought a delay in the intervening years.
But on Wednesday, some finally got what they were looking for. The proposed CECL delay for many banks comes as FASB grapples with how it sets the effective dates for different standards, said board member Susan Cosper in an interview conducted prior to the July 17 meeting.
In the past, FASB would pass a new accounting standard and set an effective date for SEC filers and public business entities in one year, then give private companies and nonprofit organizations an extra year to comply. The gap in dates recognizes the resource constraints those firms may face as well as the demand for outside services, and provide time for smaller companies to learn from the implementation lessons of large companies. However, the board’s advisory councils said this may not be enough time.
“What we’ve learned … is that the smaller companies wait longer to actually start the adoption process,” Cosper says. “There are many community banks that haven’t even begun the process of thinking about what they need to do to apply the credit loss standard.”
The extra time should allow these companies the ability to digest and implement the credit loss overhaul using existing resources. During the meeting, FASB member R. Harold Schroeder said that bankers tell him they could quickly apply the CECL standard in a “compliance approach” as a “box-checking exercise” for their banks. But, they tell him, they need more time if they want to implement CECL in a way that allows them to use it to make business decisions.
“The companies I talked to are taking these standards seriously as an opportunity to improve; ‘We want the data to flow through our systems, but it takes more time,’” he said.
The board also adopted an SEC filer category, called “small reporting companies” or SRCs. The SEC defines a small reporting company as a firm with a public float of less than $250 million, or has annual revenues of less than $100 million and no annual float or a public float of less than $700 million. For CECL, SRCs have the same implementation deadline as their private and not-for-profit peers. Companies with a 2023 effective date have the option of adopting the standard early.
The proposal to extend the CECL effective dates for small companies received unanimous support from the board. The proposal now goes out for public comment.
“The process of gathering, cleaning and validating [loan loss] data has taken longer than we expected,” says Mike Lundberg, national director of financial institutions services at accounting firm RSM US. “Having a little more time[for banks] to run parallel paths or fine-tune their models is really, really helpful.”
Lundberg points out that small banks will now have nearly six years to implement the standard, which passed in 2016. He also warns against bankers’ complacency.
“[The implementation] will take a long time and is a big project,” he says. “It’s definitely a ‘Don’t take the foot off the gas’ situation. This is the time to get it right.”
FASB also offered additional assistance to financial institutions with a newly published Q&A document around the “reasonable and supportable” forecast, and announced a multi-city roadshow to meet with small practitioners and bankers. Cosper says the Q&A looks to narrow the work banks need to do in order to create a forecast and includes additional forward-looking metrics banks can consider.
“I think that people really get nervous with the word ‘forecast,’” she says. “What we tried to clarify in the Q&A is that it’s really just an estimate, and it goes on to describe what that estimate should include.”
The recent acquisition of LegacyTexas Financial Group by Prosperity Bancshares serves as a microcosm for the changing bank M&A landscape.
The deal, valued at $2.1 billion in cash and stock, combines two publicly traded banks into one large regional institution with over $30 billion in assets. Including this deal, the combined companies have completed or announced 10 acquisitions since mid-2011. Before this transaction, potential sellers had two active publicly traded buyers that were interested in community banks in Texas; now, they have one buyer that is likely going to be more interested in larger acquisitions.
The landscape of bank M&A has evolved over the years, but is rapidly changing for prospective sellers. Starting in the mid-1990s to the beginning of the Great Recession in late 2007, some of the most active acquirers were large publicly traded banks. Wells Fargo & Co. and its predecessors bought over 30 banks between 1998 and 2007, several of which had less than $100 million in assets.
Since the Great Recession, the largest banks like Wells and Bank of America Corp. slowed or stopped buying banks. Now, the continued consolidation of former buyers like LegacyTexas is reducing the overall buyer list and increasing the size threshold for the combined company’s next deal.
From 1999 to 2006, banks that traded on the Nasdaq, New York Stock Exchange or a major foreign exchange were a buyer in roughly 48 percent of all transactions. That has declined to 39 percent of the transactions from 2012 to the middle of 2019. Deals conducted by smaller banks with over-the-counter stock has increased as a total percentage of all deals: from only 4 percent between 1999 and 2006, to over 8 percent from 2012 to 2019.
Part of this stems from the declining number of Nasdaq and NYSE-traded banks, which has fallen from approximately 850 at the end of 1999 to roughly 400 today. At the same time, the median asset size has grown from $500 million to over $3 billion over that same period of time. By comparison, the number of OTC-traded banks was relatively flat, with 530 banks at the end of 1999 decreasing slightly to 500 banks in 2019.
This means that small community banks are facing a much different buyer landscape today than they were a decade or two ago. Many of the publicly traded banks that were the most active after the Great Recession are now above the all-important $10 billion in assets threshold, and are shifting their focus to pursuing larger acquisitions with publicly traded targets. On the bright side, there are also other banks emerging as active buyers for community banks.
Privately traded banks Privately traded banks have historically represented a large portion of the bank buyer landscape, and we believe that their role will only continue to grow. We have seen this group move from being an all-cash buyer to now seeing some of the transactions where they are issuing stock as part or all of the total consideration. In the past, it may have been challenging for private acquirers to compete head-to-head with larger publicly traded banks that could issue liquid stock at a premium in an acquisition. Today, privately traded banks are more often competing with each other for community bank targets.
OTC-traded banks OTC-traded banks are also stepping in as an acquirer of choice for targets that view acquisitions as a reinvestment opportunity. Even though OTC-traded banks are at a relative disadvantage against the higher-valued publicly traded acquirers when it comes to valuation and liquidity, acquired banks see a compelling, strategic opportunity to partner with company with some trading volume and potential future upside. The introduction of OTCQX marketplace has improved the overall perception of the OTC markets and trading volumes for listed banks. This has helped OTC-traded banks compete with the public acquirers and gain an edge against other all-cash buyers. Some of these OTC-traded banks will eventually choose to go public, so it could be attractive to reinvest into an OTC-traded bank prior to its initial public offering.
Credit Unions In the past, credit unions usually only entered the buyer mix by bidding on small banks or distressed assets. This group has not been historically active in community bank M&A because they are limited to cash-only transactions and subject to membership restrictions. That has changed in the last few years.
In 2015 there were only three transactions where a credit union purchased a bank, with the average target bank having $110 million in assets. In 2018 and 2019, there have been 17 such transactions with a bank, with the average target size exceeding $200 million in assets.
The bank buyer landscape has changed significantly over the past few years; we believe it will continue to evolve over the coming years. The reasons behind continued consolidation will not change, but the groups driving that consolidation will. It remains important as ever for sellers to monitor the buyer landscape when evaluating strategic alternatives that enhance and protect shareholder value.
Information contained herein is from sources we consider reliable, but is not guaranteed, and we are not soliciting any action based upon it. Any opinions expressed are those of the author, based on interpretation of data available at the time of original publication of this article. These opinions are subject to change at any time without notice.
Smaller institutions should think of financial technology firms as friends, not foes, as they compete with the biggest banks.
These companies, often called fintechs, pose real challenges to the biggest banks because they offer smaller firms a way to tailor and grow their offerings. Dozens of the biggest players are set to reach a $1 billion valuation this year—and it’s not hard to see why. They’ve found a niche serving groups that large banks have inadvertently missed. In this way, they’re not unlike community banks and credit unions, whose people-first philosophy is akin to these emerging tech giants.
Ironically, savvy fintechs are now smartly capitalizing on their popularity to become more like big banks. These companies have users that are already highly engaged; they could continue to see a huge chunk of assets move from traditional institutions in the coming year. After all, what user wouldn’t want to consolidate to a platform they actually like using?
The growth and popularity of fintechs is an opportunity for community banks and credit unions. As customers indicate increasing openness to alternative financial solutions, these institutions have an opportunity to grab a piece of the pie if they consider focusing on two major areas: global trading and digital capabilities.
Since their creation, community banks and member-owned organizations have offered many of the same services as their competitors. However, unlike fintechs, these financial institutions have already proved their resilience in weathering the financial crisis. Community banks can smartly position themselves as behind-the-scenes partners for burgeoning fintechs.
It may seem like the typical credit union or community banking customer would have little to do with international transactions. But across the world, foreign payments are incredibly common—and growing. Global trading is an inescapable part of everyday consumer life, with cross-border shopping, travel and investments conducted daily with ease. Small businesses are just as likely to sell to a neighbor as they are to a stranger halfway around the globe. Even staunchly conservative portfolios may incorporate some foreign holdings.
Enabling global trades on a seamless digital scale is one of the best avenues for both community banks and credit unions to expand their value and ensure their continued relevance. But the long list of requirements needed to facilitate international transactions has limited these transactions to the biggest banks. Tackling complex regulatory environments and infrastructure can be not only intimidating, but downright impossible for firms without an endless supply of capital earmarked for these such investments.
That means that while customers prefer community banks and credit unions for their personalization and customer service, they flock to big banks for their digital capabilities. This makes it all the more urgent for smaller operations to expand while they have a small edge.
Even as big banks pour billions of dollars into digital upgrades, an easy path forward for smaller organizations can be to partner with an established service that offers competitive global banking functions. Not only does this approach help them save money, but it also allows them to launch new services faster and recapture customers who may be performing these transactions elsewhere.
As fintechs continue to expand their influence and offerings, innovation is not just a path to success—it’s a survival mechanism.
Gone are the days of bank employees repetitively completing their tasks. A productive day in today’s banking environment consists of collaboration and teamwork to solve challenging problems.
Community banks and credit unions need to deliver on two industry trends to succeed: 1) managing interest rate, compliance, and regulatory risks, and 2) adapting with technology and products to compete against a decline in branch visitors, check volume, and cash transactions. The question is, how?
The answer is new ideas. Managers and leaders must cultivate an entrepreneurial environment where employees are not afraid to share them, because they are the future of the banking industry.
1. Refine the team Leader Bank itself is an entrepreneurial venture started in 2002 with $6 million in assets. After spending the first six years focusing on implementing traditional methods, we began shifting our hiring practices to include employees with little or no banking experience but that had a lot of potential for creative problem solving. Today, almost 40 percent of our employees (excluding loan officers) are new to the banking industry.
By not hiring solely based on education and experience, and focusing more on potential, we have seen some of our most successful periods of growth to date.
2. Listen to customers New ideas often present themselves as customer issues.
Take this example: A landlord customer encounters legal complications with his tenant’s security deposit, so to avoid future issues he assumes a greater risk by no longer requiring security deposits. Identifying this real-world problem led to the creation of a new security deposit platform that manages compliance headaches for landlords.
3. Pursue lopsided opportunities All ideas come with upsides and downsides, but as we all know, the best ideas are asymmetrical, meaning the upsides outweigh the downsides.
A great example is when we developed our rewards checking product.
Before developing the product, we knew we not only wanted to grow deposits but also reward our customers for using us as their primary bank. We analyzed the downside versus the potential upside before deciding to move forward.
The downside vs. the upside A downside is best kept small and finite. It’s something you would be comfortable with if it actually happened.
With our rewards checking product, the only real downside we could foresee was lack of participation. There is always a risk with a new product or process that the client may not fully adopt it.
However, in this particular situation, the upsides significantly outweighed our fear of failure.
To start, we developed Zeugma in-house. We had existing employees working on it, to keep our cost of investment low. It gave us control of the product features, which allowed us to differentiate leading to strong growth in deposits.
Assessing the upside vs. downside With any new idea, senior management and the board will want to know what the downside is, and if it is limited. That limitation is finite and can be articulated, then odds of approval increase.
When trying to measure the downsides relative to the upsides, there are questions we ask to lean one way or the other:
Is the total potential financial loss greater than the cost of the project?
Could the project cause significant reputational damage?
Does the project require additional resources?
Does the project effort need significant interdepartmental coordination?
If the answers are “no,” then the idea likely carries low risk and can move quickly.
There are also additional ways to mitigate risks throughout the launch process of any new idea.
Start a focus group There is no better way to see how a new idea works before launching full-force than experimenting with beta groups. Testing the product with hand-selected, vested people first helps gives managers an idea how customers will use the product and understand pitfalls before going live.
Conduct weekly meetings Weekly meetings are great for adapting procedures as necessary throughout the development and launch process. Teams from product development to marketing can share ideas on how to develop and grow the product to its utmost potential.
Maintain strong financial tracking Tracking every penny will ease the anxiety that comes along with the development and launch process of any new idea. Start a shared spreadsheet among involved employees and enter in the income and expenses along the way. If the financial budget is kept in check, it is easier to plan where to allocate future expenses.
Also don’t forget to track success, including each new customer acquired or deposit gathered.
Moving forward Banks are inherently risk-management institutions, which is why understanding the downsides of new ideas is so important.
Transitioning a financial institution to an entrepreneurial, spirited workforce takes time, patience and dedication. Every idea, whether a success or a failure, is a stepping stone to the next. Over time, even in a highly regulated industry like banking, a culture of energy and entrepreneurship can be a competitive advantage.
A new front has developed in the ongoing battle between banks and credit unions. While relatively unheard of in prior years, credit unions have been aggressively pursuing bank acquisitions over the last three years, winning over sellers with large cash premiums and frustrating potential bank buyers that cannot bid competitively. Given the competitive advantage that credit unions have in the bidding process, this trend is expected to continue for the foreseeable future.
Since 2011 there have been 16 acquisitions of banks by credit unions nationally, including several transactions that are currently pending. Initially starting as a trickle, the pace has been picking up steam in recent years. There were a handful of deals between 2011 and 2014, three deals announced in 2015, four in 2016, and four in 2017—and the year is not over. Many industry experts believe that several additional transactions will be announced before year-end. Much of this activity has been in the Midwest and Southeast, which traditionally have been large markets for credit unions.
Credit unions are cash buyers and have two big advantages over banks during the bidding process. First, because they have no shareholders looking over their shoulders, credit unions can more aggressively price a transaction without fear of shareholder retribution. Second, credit unions can offer a far higher premium than bank suitors since credit unions are exempt from federal and most state taxes.
What does this mean? On one hand, banks that want to cash out are able to obtain a higher premium for the institution, which ultimately is good for shareholders. However, banks that want to grow through acquisition could miss out on attractive acquisition opportunities that only a few years ago would have been within their grasp. The tax advantage enjoyed by credit unions poses a significant hurdle for traditional bank bidders. Even banks sitting on the sidelines will be affected by this trend, as local competitors are acquired by credit unions.
If the banking industry determines that bank acquisitions by credit unions are, on balance, a net negative, one solution is to advocate for an “acquisition tax” to be paid by credit unions at the state and/or federal level at the time of acquisition. Such a tax could help level the playing field and protect taxpayers (at least in part) from the loss of tax revenue generated on income of the bank going forward.
Another strategy is for banks, either individually or together with other institutions, to explore the possibility of turning the tables and acquiring a credit union. Such a transaction would eliminate a credit union competitor and also give credit union members a one-time payment, compensating them for the loss of any perceived benefits that a credit union may have with regard to more favorable customer interest rates and fees. Challenges abound with this strategy, including finding a suitably motivated credit union, navigating a very complex structuring and regulatory approval process, and retaining the credit union’s members as customers.
Regardless of the industry response to this issue, selling banks need to understand and appreciate the complexity posed by a credit union acquisition. Since a credit union cannot acquire a bank charter, the transaction needs to be structured as a purchase and assumption transaction, in which assets and liabilities need to be individually transferred and assigned. This is a costly and burdensome process and requires, among other things, consents from vendors and service providers, the preparation of mortgage assignments and allonges, and the filing of deeds and other documents related to the transfer of real estate.
Since the transaction must be structured as a cash asset sale, the transaction is taxable to the bank and shareholders. Additionally, the selling bank and, if applicable, its bank holding company, has to go through a liquidation and dissolution process, which is further complicated if there is outstanding debt at either the bank or holding company level. All of these costs need to be considered in determining the adequacy of the final bid. Finally, in our experience, the regulatory approval process is much longer than a traditional bank acquisition.
Whatever your bank’s situation, it is important to understand that credit unions and their investment bankers are actively and aggressively searching for banks to acquire, adding a new and rapidly expanding dimension to credit union competition.
After sweeping the sidewalk, the first job G. Henry Cook had more than four decades ago at his family-owned Somerset Trust Co. in Somerset, Pennsylvania, was putting checks in alphabetical order. This was the “most mindless, frustrating and stupid job I have ever done in my life,’’ he says. “That week was when I developed a commitment to figure out how technology can make banks smarter, so we can free up our people to really take care of customers.”
Today, Cook is president, chairman and CEO of Somerset Trust Co., which is on the leading edge of community banks in terms of mobile technology. At roughly $1 billion in assets, the bank has a mobile app that allows customers to log in with a fingerprint instead of a password, turn on and off their debit cards using the app and pay their bills with their smartphone camera. Soon, the bank will make it possible for new customers to open an account using the mobile app, instead of signing up through online banking or walking into a branch. The first step is to roll out the mobile platform inside a couple of branches, so bank staff can quickly enroll new customers using an iPad. In the first quarter, the bank hopes to make mobile account opening available to customers using their own devices anywhere, says Chief Operating Officer John Gill.
Mobile account opening is so new, it’s hard to find statistics on it. Almost all the banks that allow it are larger than $50 billion in assets. But it’s increasingly talked about as an avenue to generate new customers and accounts in an age when consumers increasingly rely on their smartphones for everything.
“Most community institutions do not really have a good strategy for account opening on the phone,’’ says Jim Burson, senior director at Cornerstone Advisors, a consulting firm in Scottsdale, Arizona. “Most people have the basic functional [items such as], ‘I can make a payment, I can check my account balance.’ But the big gap that needs to be closed is the account origination and loan origination piece of mobile.”
Gill says the bank simplified a lot of its own front-end and back-end processes to make it happen, so the app, for example, will scan identification such as a driver’s license, process the identification verification and order debit cards automatically. The bank also sends disclosures electronically. The same account opening system will work online as on the mobile app. “We’re trying to make this device independent,’’ he says. “Our branches say it is so time consuming to open an account. It really makes the customer experience better.”
Somerset is using Bolts Technologies to launch the new account opening platform. It already uses Malauzai Software for its mobile platform and Fiserv as its core processor. Gill and Cook declined to provide estimates of the costs and savings associated with mobile account opening. But being a privately owned bank certainly helped justify the investment, Cook says. “An awful lot of traditional businesses [are] very afraid of taking the incremental risk because some Wall Street types are going to be on their backs: ‘What about this quarter?’ The job of the CEO is to maximize shareholder wealth over time, and somehow that has been lost.”
Only about 10.6 percent of all the banks and credit unions in the country had fingerprint authentication as of March, 2016, according to an estimate in Mobile Banking Quantified, a report by research firm Celent and FI Navigator. Fewer than 1 percent had photo bill pay and 4.1 percent had debit card on/off switches in the app.
Why does Somerset, a community bank, want to be in the league of only a few banks offering such services? In the late 90s, the bank was struggling to grow and had only about $200 million in assets. It surveyed about 10,000 people, who said they wanted to do business with a community bank, but perceived that community banks just can’t “keep up.” Cook decided that the bank, in fact, would need to keep up. “Why do people not deal with local banks? They don’t think they’re experts. What does an expert mean in this day and age? We think technology is part of that answer.”
During what I would argue was a defining moment of his presidency, Bill Clinton under oath was asked about why he had previously denied that he was in a relationship with Monica Lewinsky. He said his answer depended on the definition of the word “is,” basically that he hadn’t lied because the question had been posed in the present tense and there was no such present relationship. Such dissembling may be maddening when it comes from a president, and it’s equally upsetting when it comes from your business partners.
Few chief information officers have the time necessary to spend pouring through the thousands of pages of the core and IT contracts they sign from each and every vendor. What ends up happening more often than not is that time passes, management changes, renewals occur, technology fades or is upgraded and products are added without scrutiny—all in the name of efficiently running institutions and ensuring a competitive edge.
Any reasonable bank leader could make the assumption that the most current deal takes precedent over the past. Ambiguity is trumped by good faith born from long-term loyalty. After all, why would old agreements govern new technology? Well, it depends on what your definition of is, is.
My company, Paladin fs, was recently retained by a banking client in Massachusetts with $400 million in assets and charged with the task of restructuring each of its core and IT vendor agreements. In our initial research, we saw that for nearly a decade, this bank went to a core processor for account processing, as well as ATM and electronic funds transfer needs, but—curiously—maintained a 13-year relationship with a competing core processor for item processing. It made good business sense to move the bank’s item processing and negotiate a better deal for improved pricing.
With 12 months remaining on the bank’s existing item processing agreement, we calculated the termination expense to be somewhere in the neighborhood of $130,000, based on the “estimated remaining value” for the previous three months multiplied by 60 percent—a standard termination computation. But to our surprise, the core processor had a very different number in mind: $252,000.
When challenged, the core processor happily provided us text and verse from their 2003 agreement with our client. The note was handwritten on paper, but clearly stated that based on its definition of “estimated remaining value,” the company had the right to go back through the entire 13-year relationship with the bank, find the three highest-charged months including taxes, and multiply that total by 60 percent to calculate the accurate “termination for convenience” penalty.
Though we tried, rationalizing with the core processor went nowhere, as it had nothing to gain by being either reasonable or fair—it was losing the business anyway. This illustrates how vendors continually prey on unsuspecting, out-gunned and ill-equipped banks and credit unions. Skilled at garnering trust from bankers, rather than verifications, core and IT vendors know that they will always have the upper hand in professional technology negotiations. They leverage the power of the oligopoly to bilk billions from the community banking industry on a daily basis, while delivering sub-standard products and services that leave institutions wanting. And they do it by choosing their own definitions.
The only way we can combat their cunning nature is with numbers of our own—both by collecting market data, and by coming together as allies. After almost a decade of filling our database with thousands of vendor contract terms and pricing details to help us fight the good fight on behalf of banks, I’ve realized that the oligopoly is just too powerful to take down with a one-bank-at-a-time approach. I’ve now teamed up with Pillsbury Winthrop Shaw Pitman, LLP, and together we’ve built the Golden Contract Coalition (GCC) to tackle vendors’ uncontrollable terms and bad contract deals that our community banks and credit unions fall victim to, time and time again.
An alliance of large groups of community banks, credit unions and key players from within the banking community, the GCC gives us the capacity to leverage our collective influence and untold millions in combined contract value to negotiate fair deals with the unscrupulous core and IT vendors. For the first time in history, the power will be in the hands of institutions, giving us the protection we need to challenge the core and IT vendor oligopoly and end the era of underperforming IT functionality, unfavorable contract terms and one-sided deals.
From here on out, the definitions in our core and IT contracts, will be dictated by those affected most.