2023 Risk Survey: Complete Results

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Bank Director’s 2023 Risk Survey, sponsored by Moss Adams LLP, finds interest rates and liquidity risk dominating bank leaders’ minds in 2023.

The survey, which explores several key risk areas, was conducted in January, before a run on deposits imperiled several institutions, including $209 billion SVB Financial Corp., which regulators closed in March. Bank executives and board members were feeling pressure on deposit costs well before that turmoil, as the Federal Open Market Committee raised the federal funds rate through 2022 and into 2023.

Over the past year, respondent concerns about interest rate risk (91%), credit risk (77%) and liquidity (71%) all increased markedly. Executives and directors also identify cybersecurity and compliance as areas where their concerns have increased, but managing the balance sheet has become, by and large, their first priority.

Bank leaders name deposit pricing as the top strategic challenge their organization faces in 2023, and a majority say their bank has experienced some deposit loss, with minimal to significant impacts on their funding base. Most respondents say their No. 1 liquidity management strategy would be to raise the rates they pay on deposits, followed by increasing their borrowings from a Federal Home Loan Bank.

While SVB operated a unique business model that featured a high level of uninsured deposits and a pronounced concentration in the tech industry, many banks are facing tension as deposits reprice faster than the loans on their books.

Net interest margins improved for a majority of bank leaders taking part in the survey, but respondents are mixed about whether their bank’s NIM will expand or contract over 2023.

Click here to view the complete results.

Key Findings

Deposit Pressures
Asked about what steps they might take to manage liquidity, 73% of executives and directors say they would raise interest rates offered on deposits, and 62% say they would borrow funds from a Federal Home Loan Bank. Less favored options include raising brokered deposits (30%), the use of participation loans (28%), tightening credit standards (22%) and using incentives to entice depositors (20%). Respondents say they would be comfortable maintaining a median loan-to-deposit ratio of 70% at the low end and 90% at the high end.

Strategic Challenges Vary
While the majority of respondents identify deposit pricing and/or talent retention as significant strategic challenges, 31% cite slowing credit demand, followed by liquidity management (29%), evolving regulatory and compliance requirements (28%) and CEO or senior management succession (20%).

Continued Vigilance on Cybersecurity
Eighty-seven percent of respondents say their bank has completed a cybersecurity assessment, with most banks using the tool offered by the Federal Financial Institutions Examination Council. Respondents cite detection technology, training for bank staff and internal communications as the most common areas where they have made changes after completing their assessment. Respondents report a median of $250,000 budgeted for cybersecurity-related expenses.

Stress On Fees
A little over a third (36%) of respondents say their bank has adjusted its fee structure in anticipation of regulatory pressure, while a minority (8%) did so in response to direct prodding by regulators. More than half of banks over $10 billion in assets say they adjusted their fee structure, either in response to direct regulatory pressure or anticipated regulatory pressure.

Climate Discussions Pick Up
The proportion of bank leaders who say their board discusses climate change at least annually increased over the past year to 21%, from 16% in 2022. Sixty-one percent of respondents say they do not focus on environmental, social and governance issues in a comprehensive manner, but the proportion of public banks that disclose their progress on ESG goals grew to 15%, from 10% last year.

Stress Testing Adjustments
Just over three-quarters of respondents say their bank conducts an annual stress test. In comments, offered before the Federal Reserve added a new component to its stress testing for the largest banks, many bank leaders described the ways that they’ve changed their approach to stress testing in anticipation of a downturn. One respondent described adding a liquidity stress test in response to increased deposit pricing and unrealized losses in the securities portfolio.

Community Bankers Emphasize Calmness, Stability Amid Crisis

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You can’t communicate too much during a banking crisis – even when your bank is not the one actually experiencing the crisis.

After regulators shut down SVB Financial Group’s Silicon Valley Bank and Signature Bank two weeks ago, community bankers across the nation began working behind the scenes to field questions from their boards, their clients and their frontline staff. They checked their access to the Federal Reserve’s discount window and sought to reassure customers and directors of their own institution’s liquidity position.

Locality Bank, a de novo bank based in Fort Lauderdale, Florida, still has ample liquidity from its capital raising efforts and simply by virtue of being a new bank. The $116 million Locality, which first opened a little over a year ago, reiterated these points in a letter it sent out to clients the day after Silicon Valley Bank was closed by state regulators, CEO Keith Costello says.

“We don’t have a portfolio of low-interest securities or loans,” the letter reads in part. “We have capital of almost three times the level required to have a well-capitalized rating, and our liquidity ratio at 54.17% at month end of February is one of the strongest in the U.S. Our securities portfolio, because we bought our securities when rates went up, has no appreciable decline in value.”

That letter went a long way toward assuaging customer fears around the ongoing banking crisis, Costello says, adding, “We just got a tremendous response from clients who emailed, who called, who just said, ‘Hey, we love that letter. We feel so much better about everything.’”

Communicating with frontline staff has also been critical, says Julieann Thurlow, CEO of Reading Cooperative Bank in Massachusetts. Not only are those workers spending a lot of time interacting with customers, but they also may have their own questions about how ongoing events impact their livelihoods.

“Not every teller reads The Wall Street Journal,” Thurlow says. “So make sure that you actually communicate with them as well because there was a level of uncertainty … ‘Is the banking community in trouble?’”

Some community bankers also took to social media to get the word out, including Jill Castilla, CEO of $358 million Citizens Bank of Edmond. Since the March 12 failure of Silicon Valley Bank, Castilla has taken to Twitter and LinkedIn to provide a rundown of the crisis and explain how Silicon Valley Bank and Signature differed from a typical community bank.

Even larger banks whose stocks have taken a hit sought to distance themselves from those banks. Phil Green, CEO of Cullen/Frost Bankers in San Antonio, Texas, took to CNBC to discuss the subsidiary Frost Bank’s liquidity position. The $53 billion Frost Bank CEO told “Mad Money” host Jim Cramer that the bank has a low loan-to-deposit ratio and roughly 20% of its deposits are held in highly liquid accounts at the Federal Reserve.

Even though Cullen/Frost Bankers’ stock price has taken a hit this year — down more than 10% since Silicon Valley Bank failed, mirroring the fall in the KBW Nasdaq Bank Index this year — Green expressed confidence in the long term.

“Frost Bank’s deposit base has been very strong,” he said, adding “We’ve seen really no unusual activity.”

While Reading Cooperative already tests its liquidity lines on a quarterly basis, the $796-million bank double-checked its access to the Federal Reserve’s discount window after Silicon Valley Bank failed.

“We could almost refinance the entire bank with our liquidity lines,” she says.

Meanwhile, Costello says that a handful of customers made their accounts joint accounts in order to get coverage from the Federal Deposit Insurance Corp., and he said that Locality also tapped its cash service with IntraFi, a privately held deposit placement firm, for the first time. He also added that Locality’s messaging around the crisis and its own liquidity position and relative stability resonated with non-customers, too.

“You find people that aren’t your clients will call you at times like this, too,” Costello says. “We did actually pick up some business as a result.”

Other community bankers also reported a similar experience picking up new business in the crisis. In a post on LinkedIn, Castilla reported that deposits continued to increase at her bank and “my lobby today is full of happy customers!”

Thurlow says Reading Cooperative picked up a few new larger accounts, although she was also cautious not to characterize that as a “flight to safety.”

“It’s not something that we’re marketing or looking to capitalize on,” she says. “This is a time for calm. We’re not looking to create or exacerbate a problem.”

Will Regulators’ Actions Stem Deposit Runs, Banking Crisis?

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Bank regulators rolled out several tools from their tool kit to try to stem a financial crisis this week, but problems remain. 

The joint announcements followed the Friday closure of Silicon Valley Bank and the surprise Sunday evening closure of Signature Bank. 

Santa Clara, California-based Silicon Valley Bank had $209 billion in assets and $175 billion in deposits at the end of 2022 and went into FDIC receivership on March 10; New York-based Signature Bank had $110 billion in assets and $88.6 billion in deposits at the end of 2022 and went into receivership on March 12. Both banks failed without an acquiring institution and the FDIC has set up bridge banks to facilitate their wind downs.

Bank regulators determined both closures qualified for “systemic risk exemptions” that allowed the Federal Deposit Insurance Corp. to cover all the deposits for the failed banks. Currently, deposit insurance covers up to $250,000; both banks focused mainly on businesses, which carry sizable account balances. About 94% of Silicon Valley’s deposits were uninsured, and 90% of Signature’s deposits were over that threshold, according to a March 14 article from S&P Global Market Intelligence.

The systemic risk exemption means regulators can act without Congressional approval in limited situations to provide insurance to the entire account balance, says Ed Mills, managing director of Washington policy at the investment bank Raymond James. 

The bank regulators also announced a special funding facility, which would help banks ensure they have access to adequate liquidity to meet the demands of their depositors. The facility, called the Bank Term Funding Program or BTFP, will offer wholesale funding loans with a duration of up to one year to eligible depository institutions that can pledge U.S. Treasuries, agency debt and mortgage-backed securities and other qualifying assets as collateral. The combined measures attempt to stymie further deposit runs and solve for the issue that felled Silicon Valley and Signature: a liquidity crunch. 

In a normal operating environment, banks would sell bonds from their available-for-sale securities portfolio to keep up with liquidity demands, whether that’s deposit outflows or additional lending opportunities. Rising rates over the last five quarters means that aggregate unrealized losses in securities portfolios grew to $620 billion at the end of 2022 — losses many banks want to avoid recording. In the case of Silicon Valley, depositors began to pull their money after the bank announced on March 8 it would restructure its $21 billion available-for-sale securities portfolio, booking a $1.8 billion loss and requiring a $2 billion capital raise. 

“The BTFP will be an additional source of liquidity [borrowed] against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress,” the Federal Reserve said in its release on the facility. Importantly, the pledged collateral, such as U.S. Treasurys, will be valued at par. That is the “most beneficial portion” of the program and eliminates the discount many of these securities carry given their lower yields, Mills says. 

The hope is that banks pledge their underwater bonds to increase their liquidity should deposits begin to leave their institution. One concern, then, is that banks hesitate to use it as a sign of weakness, Mills says. But he says, “conversations about impacts to earnings and impacts to reputation are secondary to solvency.”

Former Comptroller of the Currency Gene Ludwig tells Bank Director that he appreciates the steps the regulators took, and of President Joe Biden’s messaging that accompanied Sunday’s actions. 

“I realized that for the regulators, because of the speed and the need to react quickly and over a weekend, there was a lot of wood to chop,” he says. “ It takes time, but I think they reacted with vigor.”

Although he wasn’t at the FDIC, Ludwig’s career touches on the importance of deposit coverage. In addition to serving as comptroller in the 1990s, he founded and later sold IntraFi, a reciprocal deposit network. He encourages banks to at least establish lines to the BTFP, since the application and transfers can take time.

It remains to be seen whether regulator actions will be enough to assuage depositors and the broader public. Banks have reportedly borrowed $11.9 billion from the new facility and another $152.8 billion from the discount window, according to a Bloomberg article published the afternoon of March 16. However, the facilities don’t fully address the problem that most banks are carrying substantial unrealized losses in their bond books — which may only continue to grow if the Federal Open Market Committee continues increasing rates.

“This announcement was about stemming the immediate systemic concerns, but it absolutely did not solve all of the banks’ woes,” Mills says.

It’s also possible that those tailored actions may be insufficient for certain institutions that resemble Silicon Valley Bank or Signature Bank. Clifford Stanford, an Atlanta-based partner of law firm Alston & Bird and a former assistant general counsel at the Federal Reserve Bank of Atlanta, remembers how bank failures and weakness would come in waves of activity during the Great Recession and afterward. 

“There’s a lot of unknowns about who’s got what holes in their balance sheet and who’s sitting on what problems,” he says. “Every board of every bank should be asking their management right now: Do we have this problem? If we do have a risk, how are we hedging it? What sort of options do we have to backstop liquidity? What’s our plan?”

5 Key Takeaways From the State of Commercial Banking

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

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

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

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

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

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

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

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

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

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

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

In Pursuit of Deposits, Think Outside the Box

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The script flipped.

During parts of the coronavirus pandemic, banks were so flooded with deposits that some bankers were happy when a portion of them fled. Now, at a time when the Federal Reserve has raised interest rates at the fastest pace since the 1980s, banks are battling for deposits to the point where some bankers are proactively calling customers, imploring them to stay.

The industry’s hot pursuit of deposits won’t stop soon, either. According to the What’s Going On In Banking 2023 study by Cornerstone Advisors, banks seeking to grow deposits among their retail base of customers more than doubled, from 21% in 2022 to 51% in 2023. Moreover, banks wanting small business deposits jumped to 72% in 2023, from 41% in 2022. The ability to bring in deposits is influencing senior executives’ bonuses.

In the quest for deposits, it’s likely time for banks to go beyond offering a sign-up bonus or higher savings rates. Here are three other ideas to consider.

1. Provide Banking as a Service
When banks “rent” their charter to nonbank financial services companies to serve a specific consumer group, they are providing banking as a service, or BaaS. While not the norm, the fintech-bank partnership has become more popular. Of the roughly 300 financial institutions surveyed for the Cornerstone report, 13% said they are considering the possibility of launching BaaS services.

The allure of the partnership is its ability to grow noninterest income and deposits in new markets. Adding to the appeal: According to the Cornerstone report, the return on assets and equity for BaaS banks exceeds the industry averages for all banks.

What to watch: This isn’t a strategy for all banks, of course. It comes with risk and attention from regulators. According to a recent Restive Ventures report, “[r]egulators are posing hard questions about consumer data and are seeking to understand where risk actually lies in the three-way relationships among fintechs, BaaS providers, and the actual regulated bank.”

2. Recruit Fintech Talent
While the unemployment rate remains low, banks are still struggling to recruit talent. But with tech companies eliminating thousands of positions, there are strong candidates for your bank to hire.

Hop on LinkedIn, where numerous fintech companies are sharing lists of recent employee layoffs. Seek out people who could develop your next product or service invention and send them a message.

Also, widen your network and mingle at new events. In so doing, you may discover someone with a skill set that’s different from others already working at your institution. For example, of there’s a reception celebrating female talent at an industry event, attend it regardless of your gender.

What to watch: If recruiting an entrepreneur, there’s a good chance the person is creative. In working within more rigid environments like a bank, they’ll need an outlet to discover ideas to try. Offer them a budget to take classes they wish to pursue.

3. Reevaluate How People Join Your Bank Online
The way someone becomes a bank customer online has long been cumbersome. The application often still requires too much manual entry of would-be customers, causing them to abandon the chore.

It’s high time to invest in a system that simplifies the process of signing up for an account online, while still complying with know your customer rules. The good news: In 2023, more than one in four banks expect to select a new or replacement commercial digital account opening app, according to the Cornerstone report; 21% of banks plan to do the same thing for their consumer account opening app.

What to watch: Go beyond making the application form easier to fill out on a phone and address the other hassles interfering with why someone doesn’t switch. For example, U.S. Bancorp partnered with Atomic, a company that offers payroll connectivity services, to roll out a feature that lets new account holders switch their direct deposit information in minutes, removing a barrier of why someone might drop their account.

Your bank needs to think outside of the box to secure more business at a time when deposit competition is fierce. As Curt Queyrouze, president of Seattle-based Coastal Community Bank, said in the report: “I think we’re spending too much energy trying to protect the status quo instead of embracing innovation. The slow tide of customer preference will soon turn into a tidal wave and it will be too late to catch up. These transformations take years.”

Don’t Rely on Inertia to Manage Deposit Pricing

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Deposit Costs Creep Up Following Rate Increases

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The rapidly rising interest rate environment is beginning to impact the funding dynamics at banks as deposit competition increases and they pay up for time deposits.

While rising rates are generally good for lending, the unrelenting climb in interest rates hasn’t been uniformly positive for banks. Since the pandemic, many banks have had historic deposit growth and liquidity. The aggressive and continuous rising interest rate environment could change that. 

There was a 1.1% drop in total deposits at all Federal Deposit Insurance Corp.-chartered banks in the third quarter, according to a November report from analysts at Janney Montgomery Scott. Excluding time deposits like certificates of deposits, or CDs, core deposits dropped 2%. But over that time, 40% of banks reported positive deposit growth in excess of 1%. That could mean that as core deposits leave banks, they are growing time deposits. 

The median cost of deposits for banks in the Kroll Bond Rating Agency universe more than doubled in the third quarter to 37 basis points. 

“No longer content with letting the hot money exit, this sharp increase in deposit costs is the product of a strategy of rate increases designed to stem outflows of less sticky or rate sensitive deposits,” wrote KBRA in a Nov. 15 report.  

One reason for this deposit shift is consumers and businesses are leveraging technology to move their funds into higher rate accounts. Core deposit outflows in future quarters could be unpredictable for institutions: they might happen at a faster pace or higher volume than a bank is prepared for, or a few large, important deposit relationships may leave. This could deplete available cash on hand that an institution would use for ongoing operations or to fund new loan opportunities. 

“The last time we went through a significantly rising rate environment, in the 1970s, money market funds did not exist. People were captive to the bank,” says Nate Tobik, CEO of CompleteBankData and author of “The Bank Investor’s Handbook.” “Now we’re [repeating] the ‘70s, except there are alternatives.”

One option banks had in the past to raise short-term liquidity — selling securities marked as available for sale (AFS) — may be off the table for the time being. The bank space carried a total unrealized loss, mostly tied to bonds, of more than $450 billion in the second quarter, according to the FDIC. This loss is recorded outside of net income, in a call report line item called accumulated other comprehensive income. Selling AFS securities right now would mean the bank needs to record the loss. 

“Over the past couple weeks, we have had multiple discussions with community bankers that have been very focused on deposit generation,” wrote attorney Jeffrey Gerrish, of Gerrish Smith Tuck, in a late October client newsletter. “Unfortunately, many of these community banks have a securities portfolio that is so far under water they really don’t see the ability to sell any securities to generate cash because they cannot afford to take the loss. This is a very common scenario and will result in a pretty healthy competition for deposits over the next 12 to 24 months.”

In response, banks will need to consider other options to raise alternative funds fast. Noncore funding can include brokered CDs, wholesale funding or advances from the Federal Home Loan Banks system. Tobik says CDs appeal to banks because they are relatively easy to raise and are “time deterministic” — the funding is locked for the duration of the certificate. 

All of those products come at a higher rate that could erode the bank’s profit margin. 

Another ratio to watch at this time is the liquidity ratio, wrote Janney analysts in a Nov. 21 report. The liquidity ratio, which compares liquid assets to total liabilities, is used by examiners as a more “holistic” alternative to ratios like loans-to-deposits. The median liquidity ratio for all publicly traded banks at the end of the third quarter was 20%, with most banks falling in a distribution curve ranging from 10% to 25%.

The 20% median is still 4% higher than the median ratio in the fourth quarter of 2019. The effective federal funds rate got as high as 2.4% in summer 2019, compared to 3.08% in October. Janney did find that banks between $1 billion and $10 billion had “relatively lower levels” of liquidity compared to their smaller and bigger peers.

But for now, they see little to worry about, but a lot to keep their eyes on. “Our analysis shows that while liquidity has tightened slightly by several measures since a [fourth quarter 2021] peak, banks still maintain much higher levels of liquidity than prior to the pandemic and have plenty of capacity to take on additional wholesale funding as needed to supplement their core funding bases,” they wrote.

Going forward, banks will need to balance the tension between managing their liquidity profile and keeping their cost of funds low. What is the line between excess liquidity and adequate liquidity? How many deposit relationships need to leave any given bank before it starts a liquidity crunch? What is cost of paying more for existing deposits, versus the potential cost of bringing in wholesale or brokered deposits? 

The answers will be different for every bank, but every bank needs to have these answers.

Student Loans Come Due

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Just as the Federal Reserve raises rates and inflation hits a 40-year high, Americans with federal student loan debt will start making payments on the debt after a two-year pause. On Aug. 31, the Department of Education will require 41 million people with student loans to begin paying again. 

According to the Federal Reserve, about one in five Americans have federal student loan debt and they saved $5 billion per month from the forbearance. It’s safe to say that a lot of people are going to struggle to restart those payments again and some of them work for banks.

The good news is that there are new employee programs that can help. One CARES Act provision allowed companies to pay up to $5,250 toward an employee’s student loans without a negative tax hit for the employee. Ally Financial, Fidelity Investments, SoFi Technologies, and First Republic Bank are a few of the many financial companies offering this benefit to employees. First Republic launched its program in 2016, after its purchase of the fintech Gradifi, which helps employers repay their employees’ loans. These programs typically pay between $100 and $200 a month on an employee’s loans, and usually have a cap.

The 2020 Bank Director Compensation Survey shows that 29% of financial institutions offered student loan repayment assistance to some or all employees. Many of those programs discontinued when the student forgiveness program started. In the anticipation of government forbearance coming to a close, now is a good time to think about restarting your program or even developing one. 

Americans now hold $1.59 trillion in student loan debt, according to the Federal Reserve. How did we get here? College got more expensive— much more expensive. 

Earlier this summer, the Federal Reserve and Aspen Institute had a joint summit to discuss household debt and its chilling effect on wealth building. The average cost of college tuition and fees at public 4-year institutions has risen 179.2% over the last 20 years for an average annual increase of 9.0%, according to EducationData.org.

At the same time, wages have not shown much inflation-adjusted growth. ProPublica found in 2018 that the real average wage of workers, after accounting for inflation, has about the same purchasing power it did 40 years ago. And inflation in 2022 has far outpaced wage increases. Some economists speculate that any pandemic-era wage increases are effectively nullified by this rapid inflation.

Not all borrowers are equally impacted. Sixteen percent of graduates will have a debt-to-income ratio of over 20% from their student loans alone, according to the website lendedu.com, while another 28% will have a DTI of over 15%. The 44% of graduates with that level of debt exiting school will face a steep climb to meaningful wealth building. The students that didn’t graduate will have an even harder climb.

Those graduates who struggle with their student loans will be less likely to buy a home or more likely to delay home ownership. They will be less likely to take on business debt or save for retirement. Housing prices have risen in tandem with education prices. The “starter home” of generations past has become unattainable to many millennial and Gen Z debt holders.

More than half of borrowers owe $20,000 or less. Seven percent of people with federal debt owe more than $100,000, according to The Washington Post. Economists at the Federal Reserve say borrowers with the least amount of debt often have difficulty repaying their loans, especially if they didn’t finish their degree. Conversely, people with the highest loan balances are often current on their payments. It’s likely that people with higher loan debt generally have higher education levels and incomes.

The Aspen Institute published a book known as “The Future of Building Wealth: Brief Essays on the Best Ideas to Build Wealth — for Everyone,” in conjunction with the Federal Reserve Bank of St. Louis. It illuminates long-term solutions for financial planning, focusing on policies and programs that could be applied at a national scale. 

In the absence of these national solutions, some employers are taking the matter into their own hands with company policies designed to help employees with student debt. Those banks are making a difference for their own employees and are part of the solution. 

Inflation, Interest Rates and ‘Inevitable’ Recession Complicate Risks

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What is the bigger risk to banks: inflation, or the steps the Federal Reserve is taking to bring it to heel?

Community banks are buffeted by an increasingly complicated operating environment, said speakers at Bank Director’s 2022 Bank Audit and Risk Committees Conference in Chicago, held June 13 to 15. In rather fortuitous timing, the conference occurred in advance of the Federal Reserve’s Federal Open Market Committee’s June meeting, where expectations were high for another potential increase in the federal funds rate. 

On one hand, inflation remains high. On the other hand, rapidly increasing interest rates aimed at interrupting inflation are also increasing risk for banks — and could eventually put the economy into a tailspin. Accordingly, interest rates and the potential for a recession were the biggest issues that could impact banks over the next 12 to 18 months, according to a pop up poll of some 250 people attending the event.  

Brandon Koeser, a financial services senior analyst at audit and consulting firm RSM US, said that inflation is the “premier risk” to the economic outlook right now. He called the consumer price index trend line “astonishing” — and its upward path may still have some momentum, given persistently high energy prices. Just days prior, on June 10, the Bureau of Labor Statistics announced that the CPI increased 1% in May, to 8.6% over the last 12 months. 

Koeser also pointed out that inflation is morphing, broadening from goods into services. That “rotation” creates a stickiness in the market that will be harder for the Federal Reserve to fight, increasing the odds that inflation persists.

It is “paramount” that the economy regain some semblance of price stability, Koeser said. In response, central bankers are increasing the pace, and potential size, of federal fund rate increases. But jacking up rates to lower prices without causing a recession is a blunt approach akin to “trying to thread a needle wearing boxing gloves,” he said.

While higher interest rates are generally good for banks, an inflationary environment could dampen loan growth while intensifying interest rate and credit risk, according to the Federal Deposit Insurance Corp.’s 2022 Risk Review. Inflation could lead consumers to cut back on spending, leading to lower business sales, and it could make it harder for borrowers to afford their payments.

At the same time, banks awash in pandemic liquidity added longer-term assets in 2021 in an attempt to capture some yield. Assets with maturities that were longer than three years made up 39% of assets at banks in 2021, compared with 36% in 2019, according to the FDIC. Community banks were even more vulnerable. Longer-term assets made up 52% of total assets at community banks at the end of 2021.

Managing this interest rate risk could be a challenge for banks that lack institutional knowledge of this unique environment. Kyle Manny, a partner at audit and consulting firm Plante Moran, pointed out that many banks are staffed with individuals who weren’t working in the industry in the 1980s or prior. He shared an anecdote of a seasoned banker who admitted he was “caught flat footed” by taking too much risk on the yield curve in the securities portfolio, and was now paying the price after the fair value of those assets fell. 

And high enough rates may ultimately send the economy into a recession. In Koeser’s poll of the audience, about 34% of audience members believe a recession will occur within the next six months; another 36% saw one as likely occurring in the next six to 12 months. Koeser said he doesn’t think it’s “impossible” for the central bank to avert a recession with a soft landing — but the margin for error is getting so small that a downturn may be “inevitable.”

Banks have limited options in the face of such macroeconomic trends, but they can still manage their own credit risk. David Ruffin, principal at credit risk analytics firm IntelliCredit, a division of Qwickrate, said that credit metrics today are the most “pristine” he had seen in his nearly 50 years in the industry. Still, the impact of the coronavirus pandemic and inflation could hide emerging credit risk on community bank portfolios. Kamal Mustafa, chairman of the strategic advisory firm Invictus Group, advised bankers to dig into their loan categories, industry by industry, to analyze how different borrowers will be impacted by these countervailing forces. Not all businesses in a specific industry will be impacted equally, he said.

So while banks can’t control the environment, they can at least understand their own loan books. 

The Unlimited Potential of Embedded Banking

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With fewer resources and smaller customer bases, community banks often find themselves on the losing end of a tug-of-war game when getting involved in emerging technologies. But that’s where embedded banking is a game-changer.

Embedded banking offers every financial institution — regardless of size — a chance to grab market share of this relatively untapped, billion-dollar opportunity.

Embedding financial services into non-financial applications is a market that could be worth almost $230 billion in revenues by 2025, according to a report from Lightyear Capital. That means forward-thinking community banks could see a big upside if they make the strategic investment — as could their non-bank partners. And those companies that are orchestrating integrations behind the scenes could also reap rewards in the form of subscription or transactional services. And ultimately, end users will benefit from the seamless experience this technology provides. While it’s a winning proposition for all, a successful embedded finance operation involves preparation and strategy. Let’s take a closer look at the four players who stand to benefit with embedded banking.

Community Banks: Building Reach
As community banks retool their strategies to adapt to more digital users, they also face growing challenges from digital-only neobanks and fintechs to retain their existing customers. They will need innovative features on-par with their big-budgeted competitors to thrive in the space.

Embedded banking is a legitimate chance for these banks to stake out a competitive advantage. Embedded banking, a subset of banking as a service (BaaS), allows digital banks and other third parties to connect with banks’ systems directly via application programming interfaces, or APIs. Today, 70% of banks that sponsor BaaS opportunities have less than $10 billion in assets. The cost to compete is low, and the services that non-bank entities are seeking are already available on banking platforms.

To start, institutions work with a technology company that can build APIs that can extend their financial services, then identify partners looking to embed these services on their digital platform. A best-case scenario is finding a digital banking partner that can deliver the API piece and has connections with potential embedded banking partners. Once a bank has an embedded banking strategy in place, expansion opportunities are unlimited. There are numerous non-bank partners across many industry verticals, offering entirely new customers at a lower cost of a typical customer acquisition. And these partnerships will also bring new loans, deposits and payment transactions that the bank wouldn’t otherwise have.

Nonbanks: Retaining Customers, Bolstering Satisfaction
Companies outside of the finance industry are rapidly recognizing how this technology can benefit them. Customer purchases, loans or money transfers can all be facilitated using services from a bank partner via APIs. Companies can offer valuable, in-demand financial services with a seamless user experience for existing customers — and this innovation can fuel organic growth. Additionally, the embedded banking partnership generates vast amounts of customer data, which companies can use to enhance personalization and bolster customer loyalty.

Consumers: Gaining Convenience, Personalization
Making interactions stickier is key to getting consumers to spend more time on a website. Sites should be feature-rich and comprehensive, so users don’t need to leave to perform other functions. Embedding functionality for relevant financial tasks within the platform allows users to both save time and spend more time, while giving them valuable financial products from their trusted brand. They also benefit from data sharing that generates personalized content and offers.

Tech Companies: Growing Partnerships, New Opportunities
Technology providers act as the conduit between the financial institution’s services and the non-bank partner’s experience. These providers — usually API-focused fintech companies — facilitate the open banking technology and connections. By keeping the process running smoothly, they benefit from positive platform growth, the creation of extensible embedded banking tools that they can reuse and revenue generated from subscription or transaction fees.

Everyone’s a Winner
This wide-open embedded banking market has the potential to be a game changer for so many entities. The good news is there is still plenty of room for new participants.