The Biggest Risk in Banking

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Risk governance is undoubtedly one of the most challenging responsibilities of a bank board of directors. The issues are complex and often highly technical. Most bank directors come from outside the industry and have little experience managing financial assets, which are highly sensitive to changes in the economy. 

The risk environment presents a mixed picture. “Where exactly is the economy heading?” says Brandon Koeser, a senior analyst at the consulting firm RSM US LLP, in this edition of The Slant Podcast.

On the one hand, the U.S. economy grew 2.4% in the second quarter of 2023 and inflation has steadily subsided. A year ago, many economists were forecasting a recession by the end of 2023, although Federal Reserve Chair Jerome Powell said recently he does not anticipate an economic downturn by the end of the year.

“Maybe if we do have that downturn, it will be a little further out,” says Koeser. 

On the other hand, the Fed has raised the fed funds rate 11 times since March 2022 – most recently in July to a range between 5.25% and 5.5%. That dramatic shift in the Fed’s monetary policy has had a tremendous impact on bank balance sheets throughout the industry, and was a principal factor in the failure earlier this year of Silicon Valley Bank, First Republic Bank and Signature Bank.

Cyber risk, regulation and talent are additional challenges for all banks. But Koeser says the macro-economic environment is still the biggest risk that banks are currently facing. And he suggests that bank boards should take a hard look at how their institutions’ balance sheets will be impacted by sustained higher rates if the Federal Reserve maintains its monetary policy stance for the foreseeable future, and to consider how they should adjust their strategies accordingly.

“I think it’s really an opportunity for the board to engage – re-engage – with management about strategy,” he says.

Risk issues like these will be covered during Bank Director’s Bank Board Training Forum in Nashville Sept. 11-12, 2023. This episode, and all past episodes of The Slant Podcast, are available on BankDirector.com, Spotify and Apple Music.

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.

The Bumpy Road Ahead

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Banks are in the risk business, and 2023 is shaping up to be a risk-on environment that will keep management teams busy. 

The transformation of last year’s tailwinds into this year’s headwinds is stunning. Slowing economic growth, driven by monetary policy aimed at halting inflation, could translate into weaker loan growth. Piper Sandler & Co. analysts expect net interest margins to peak in the first quarter, before being eroded by higher deposit costs. Credit costs that cannot go any lower may start to rise. Banks may see little boost from fee income and may grapple with controlling expenses. Piper Sandler expects that financial service firms will have a “bumpy” 2023. 

The environment is so novel that Moody’s Analytics Chief Economist Mark Zandi made headlines by describing a new phenomenon: not a recession but a coming “slowcession — growth that comes to a near standstill but that never slips into reverse.” The research firm is baking a slowcession into its baseline economic forecast, citing “generally solid” economic fundamentals and well-capitalized banks, according to a January analysis.

This great uncertainty — and the number of ways banks can respond to it — is on my mind as I get ready for Bank Director’s 2023 Acquire or Be Acquired conference, which will run from Jan. 29-31 in Phoenix. Is growth in the cards this year for banks, and what would it look like? 

Historically, growth has been a necessity for banks. As long as banks can generate growth that outpaces the costs of that growth, they can generate increased earnings. Banks grow their asset base organically, or through mergers and acquisitions, have been two popular ways to generate growth. In a slowdown, some banks may encounter attractive opportunities to buy other franchises at a discount. But growth won’t be in the cards for all — and maybe that’s a blessing in disguise.

“[W]ith the threat of a recession and dramatically increasing cost of funds, there is a solid argument to be made that banks should be shrinking rather than growing,” wrote Chris Nichols in a recent article. Nichols is the director of capital markets at the $45 billion banking company known as SouthState Corp., in Winter Haven, Florida. Growth can exacerbate issues for banks that are operating below their cost of capital, which can push them toward a sale faster. Instead, he’s focused on operational efficiency.

“Financial pressure will be greater, and bank margins will be higher. This combination means that banks will need to focus on the quality of their earnings,” he wrote. Instead of growth, he argued bankers should focus on making their operations efficient, which will direct more profits toward their bottom line.

It makes sense. In a bumpy slowcession, banks aren’t able to control the climb of interest rates and the subsequent changes in economic activity. They may not encounter growth opportunities that set them up for long-term success in this type of environment. But they can control their operational efficiency, innovation and execution — and we’ll talk about that at #AOBA23.

Winning Customer Loyalty During Trying Economic Times

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Bank leaders are preparing for an economic downshift; if done well, this can be a time to support customers’ financial health and improve long-term relationships. Proactive counsel, guidance and timely services can turn economic hardships into stronger financial foundations that benefit a bank’s bottom line.

That’s because consumers are facing the perfect storm of cash flow difficulty: Covid-related interventions have petered out, only to be replaced by a rise in the costs of goods, fuel and interest rates. Consumers cannot keep up with the pace of inflation; as of September 2022, 63% of Americans reported living paycheck to paycheck in order to make ends meet, and 43% expected to add to their debt in the next six months.

Economic hard times can give bank customers a sense of shame, discouragement and alienation. They may choose to ignore their financial troubles and debt and disengage with their financial institutions. Bankers can interrupt this pattern with more transparent and proactive best practices. They can provide support and education, in real time, that consumers need to be financially healthy.

Upwards of 80% of consumers prefer to receive money-related insights from more traditional sources such as banks, but only 14% believe their financial institution delivers such guidance. This needs to change. Banks have the unique advantage of owning the data and relationships necessary to proactively develop deep and meaningful experiences that support customers in hard times. They can use this data to maintain and protect customer relationships, rather than risk losing them to a competitor or fintech.

The first step for banks is to focus on customers’ needs, then educate them on helpful tools, best practices and how they can avoid missteps, such as products with predatory interest rates. While banks can’t control inflation, they can be a valuable partner for their customers.

Customers feel at ease when the guesswork is taken out of banking. Bankers need to eliminate the black box of uncertainty. For instance, a bank can analyze internal and external data streams, such as customer information from their loan database and the credit bureaus, to generate personalized pre-approved offers unique to its specific risk tolerance and portfolio. Such offers can include everything from home equity to auto loans, turning lending on its head from an application to a shopping cart scenario.

Banks should also consider out-of-the-box financial services and alternative offerings that can meet the evolving needs consumers face in 2023. For instance, if a consumer has a home equity surplus, the bank could suggest that they access this untapped equity in their homes for any pressing needs. The bank may offer to help a consumer with loan consolidation, or a better interest rate based on an improved credit score. Offering specific, personalized rates and services takes the mystery and chance of failure out of financial services. Banks can empower borrowers with knowledge of their unique opportunities — helping them make smart financial decisions while increasing their wallet share and gaining trust that lasts for a lifetime.

More than three in four Americans feel anxious about their financial situation. Banks must take this time to rethink the value they provide to customers. Those that prioritize personal, healthy financial guidance in 2023 will become trusted advisors and solidify relationships that last. 

As Economic Uncertainty Looms, Control What You Can Control

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With an economic downturn taking shape on the horizon, financial institutions must look inward to maintain margins and the health of their banks. In doing so, they will be able to serve customers better.

Astute executives I meet with realize the intrinsic value of “controlling what they can control.”
Banks can help customers optimize their cash and working capital. But to be able to serve customers with the best services at the most competitive prices, banks must first focus on the efficiency of their own organizations.

Invest in RPA, ITM Automation
Prudent investments in high-return technology can offer immediate benefits to bank efficiency. One such high-impact technology is robotic process automation, or RPA. RPA has evolved from a futuristic discussion at trade shows to a robust, enabling technology that can lower operating expenses raise productivity and reduce errors.

Automating labor-intensive processes enables banks to save time, leverage scarce resources and focus on creating unique customer experiences, while eliminating redundant work and tedious tasks. Getting started in RPA has become easier. A technical partner should offer pre-bots that are pre-designed, pre-built and developed from common industry-driven use cases. Pre-bots offer financial institutions an immediate, low-risk entry into RPA. These ready-to-run bots can offer a bridgehead and potential early success into RPA, along with providing an easier avenue toward more comprehensive automation.

Another high- and immediate-impact technology progressive banks are taking advantage of is integrated teller machines, or ITMs. ITMs provide an in-branch banking experience without customers ever having to leave their car. Consumers can interact with tellers via live video to make deposits, cash checks, make loan and credit card payments, withdraw funds and transfer funds. Exact change is available for check cashing.

Video teller technology gives customers the ability to interact with a live video teller from a centralized location, extending the reach of a bank’s most capable client-facing staff. This can help banks efficiently expand into new, alternative markets.

Determine, Execute Your Strategy
Highly efficient banks identify their strategy and then execute the supporting tactics with a single-minded purpose. Smart bankers don’t try to be all things to all customers; instead, their focus is on one or two overriding objectives, such as becoming a low-cost provider, an exceptional service organization or a leader in innovation. While these goals are not mutually exclusive, in practice, few banks can progress them all in parallel.

The best bank leaders, choose their primary objectives wisely, then seek outside expertise in areas that help them accelerate strategic objectives and plans. They actively network with peers in industry events and conferences, they learn from best-in-class partners and they seek the advice of experienced banking experts. They never stop the learning process and apply a wide range of experiences to their own plans.

Continuously Improve Business Processes
Well defined, repeatable business processes provide the foundation for how work gets done within a financial institution. This allows for tasks, technology and tools supporting a process to be redefined or implement an entirely new process based on automation.

Business process improvement (BPI) actions, undertaken by subject matter experts, deliver the insight required to execute more efficiently, create value for customers or enhance revenue for the institution — or provide all three. Tactics for growing bonds that crossover business lines with BPI include:

• Establish cross-functional teams to participate in collaborative facilitated sessions to identify and help institute process changes.
• Have leaders “walk- he walk” by inviting peers from other business units to participate regularly in staff meetings.
• Distribute regular internal communications as widely as possible within an organization.
• Create centers of excellence for sharing and knowledge transfer.
• Reward collaborative efforts that produce tangible results.

BPI helps financial institutions uncover opportunities to eliminate non-value manual tasks while digitizing and removing paper from manual processes.

Align Skills With Strategy, Needs
The culture and people of today’s banks are critical in executing an organization’s strategy and tactics. As automation replaces mundane tasks, bankers must become universal relationship managers and problem solvers. Continuous training, like continuous process improvement, is the norm for well-functioning financial institutions.

Technology partners with robust training methodologies — which are also familiar with the newest business processes — can help bank personnel ensure they’re using procedures, workflows and technology that best meet their clients’ needs with the greatest efficiency.

Even in uncertain economic times, savvy bankers who invest in automation, determine and execute a well-defined strategy, continuously improve their business processes and ensure their staff have the correct skills will develop the framework that characterizes high-efficiency financial institutions. Those efficiencies will, in turn, empower banks to serve customers better and at lower cost.

2023 Bank M&A Survey: Complete Results

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Bank Director’s 2023 Bank M&A Survey, sponsored by Crowe LLP, surveyed 250 independent directors, chief executives, chief financial officers and other senior executives of U.S. banks below $100 billion in assets to examine current growth strategies, particularly M&A. The survey was conducted in September 2022, and primarily represents banks under $10 billion in assets. Members of the Bank Services program have exclusive access to the full results of the survey, including breakouts by asset category.

Despite a significant decline in announced deals in 2022, the survey finds that acquisitions are still part of the long-term strategy for most institutions. Of these prospective buyers, 39% believe their bank is likely to acquire another financial institution by the end of 2023, down from 48% in last year’s survey who believed they could make a deal by the end of 2022.

Less than half of respondents say their board and management team would be open to selling the bank over the next five years. Many point to being closely held, or think that their shareholders and communities would be better served if the bank continues as an independent entity. “We obviously would exercise our fiduciary responsibilities to our shareholders, but we feel strongly about remaining a locally owned and managed community bank,” writes the CEO of a small private bank below $500 million in assets.

And there’s a significant mismatch on price that prohibits deals from getting done. Forty-three
percent of prospective buyers indicate they’d pay 1.5 times tangible book value for a target meeting their acquisition strategy; 22% would pay more. Of respondents indicating they’d be open to selling their institution, 70% would seek a price above that number.

Losses in bank security portfolios during the second and third quarters have affected that divide, as sellers don’t want to take a lower price for a temporary loss. But the fact remains that buyers paid a median 1.55 times tangible book in 2022, based on S&P data through Oct. 12, and a median 1.53 times book in 2021.

Click here to view the complete results.

Key Findings

Focus On Deposits
Reflecting the rising rate environment, 58% of prospective acquirers point to an attractive deposit base as a top target attribute, up significantly from 36% last year. Acquirers also value a complementary culture (57%), locations in growing markets (51%), efficiency gains (51%), talented lenders and lending teams (46%), and demonstrated loan growth (44%). Suitable targets appear tough to find for prospective acquirers: Just one-third indicate that there are a sufficient number of targets to drive their growth strategy.

Why Sell?
Of respondents open to selling their institution, 42% point to an inability to provide a competitive return to shareholders as a factor that could drive a sale in the next five years. Thirty-eight percent cite CEO and senior management succession.

Retaining Talent
When asked about integrating an acquisition, respondents point to concerns about people. Eighty-one percent worry about effectively integrating two cultures, and 68% express concerns about retaining key staff. Technology integration is also a key concern for prospective buyers. Worries about talent become even more apparent when respondents are asked about acquiring staff as a result of in-market consolidation: 47% say their bank actively recruits talent from merged organizations, and another 39% are open to acquiring dissatisfied employees in the wake of a deal.

Economic Anxiety
Two-thirds believe the U.S. is in a recession, but just 30% believe their local markets are experiencing a downturn. Looking ahead to 2023, bankers overall have a pessimistic outlook for the country’s prospects, with 59% expecting a recessionary environment.

Technology Deals
Interest in investing in or acquiring fintechs remains low compared to past surveys. Just 15% say their bank indirectly invested in these companies through one or more venture capital funds in 2021-22. Fewer (1%) acquired a technology company during that time, while 16% believe they could acquire a technology firm by the end of 2023. Eighty-one percent of those banks investing in tech say they want to gain a better understanding of the space; less than half point to financial returns, specific technology improvements or the addition of new revenue streams. Just one-third of these investors believe their investment has achieved its overall goals; 47% are unsure.

Capital to Fuel Growth
Most prospective buyers (85%) feel confident that their bank has adequate access to capital to drive its growth. However, one-third of potential public acquirers believe the valuation of their stock would not be attractive enough to acquire another institution.

2023 Bank M&A Survey Results: Can Buyers and Sellers Come to Terms?

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Year after year, Bank Director’s annual M&A surveys find a wide disparity between the executives and board members who want to acquire a bank and those willing to sell one. That divide appears to have widened in 2022, with the number of announced deals dropping to 130 as of Oct. 12, according to S&P Global Market Intelligence. That contrasts sharply with 206 transactions announced in 2021 and an average of roughly 258 annually in the five years before the onset of the pandemic in 2020.

Prospective buyers, it seems, are having a tough time making the M&A math work these days. And prospective sellers express a preference for continued independence if they can’t garner the price they feel their owners deserve in a deal.

Bank Director’s 2023 Bank M&A Survey, sponsored by Crowe LLP, finds that acquisitions are still part of the long-term strategy for most institutions, with responding directors and senior executives continuing to point to scale and geographic expansion as the primary drivers for M&A. Of these prospective buyers, 39% believe their bank is likely to acquire another financial institution by the end of 2023, down from 48% in last year’s survey who believed they could make a deal by the end of 2022.

“Our stock valuation makes us a very competitive buyer; however, you can only buy what is for sale,” writes the independent chair of a publicly-traded, Northeastern bank. “With the current regulatory environment and risks related to rising interest rates and recession, we believe more banks without scale will decide to sell but the old adage still applies: ‘banks are sold, not bought.’”

Less than half of respondents to the survey, which was conducted in September, say their board and management team would be open to selling the bank over the next five years. Many point to being closely held, or think that their shareholders and communities would be better served if the bank continues as an independent entity. “We obviously would exercise our fiduciary responsibilities to our shareholders, but we feel strongly about remaining a locally owned and managed community bank,” writes the CEO of a small private bank below $500 million in assets.

And there’s a significant mismatch on price that prohibits deals from getting done. Forty-three percent of prospective buyers indicate they’d pay 1.5 times tangible book value for a target meeting their acquisition strategy; 22% would pay more. Of respondents indicating they’d be open to selling their institution, 70% would seek a price above that number.

Losses in bank security portfolios during the second and third quarters have affected that divide, as sellers don’t want to take a lower price for a temporary loss. But the fact remains that buyers paid a median 1.55 times tangible book in 2022, based on S&P data through Oct. 12, and a median 1.53 times book in 2021.

Key Findings

Focus On Deposits
Reflecting the rising rate environment, 58% of prospective acquirers point to an attractive deposit base as a top target attribute, up significantly from 36% last year. Acquirers also value a complementary culture (57%), locations in growing markets (51%), efficiency gains (51%), talented lenders and lending teams (46%), and demonstrated loan growth (44%). Suitable targets appear tough to find for prospective acquirers: Just one-third indicate that there are a sufficient number of targets to drive their growth strategy.

Why Sell?
Of respondents open to selling their institution, 42% point to an inability to provide a competitive return to shareholders as a factor that could drive a sale in the next five years. Thirty-eight percent cite CEO and senior management succession.

Retaining Talent
When asked about integrating an acquisition, respondents point to concerns about people. Eighty-one percent worry about effectively integrating two cultures, and 68% express concerns about retaining key staff. Technology integration is also a key concern for prospective buyers. Worries about talent become even more apparent when respondents are asked about acquiring staff as a result of in-market consolidation: 47% say their bank actively recruits talent from merged organizations, and another 39% are open to acquiring dissatisfied employees in the wake of a deal.

Economic Anxiety
Two-thirds believe the U.S. is in a recession, but just 30% believe their local markets are experiencing a downturn. Looking ahead to 2023, bankers overall have a pessimistic outlook for the country’s prospects, with 59% expecting a recessionary environment.

Technology Deals
Interest in investing in or acquiring fintechs remains low compared to past surveys. Just 15% say their bank indirectly invested in these companies through one or more venture capital funds in 2021-22. Fewer (1%) acquired a technology company during that time, while 16% believe they could acquire a technology firm by the end of 2023. Eighty-one percent of those banks investing in tech say they want to gain a better understanding of the space; less than half point to financial returns, specific technology improvements or the addition of new revenue streams. Just one-third of these investors believe their investment has achieved its overall goals; 47% are unsure.

Capital To Fuel Growth
Most prospective buyers (85%) feel confident that their bank has adequate access to capital to drive its growth. However, one-third of potential public acquirers believe the valuation of their stock would not be attractive enough to acquire another institution.

To view the high-level findings, click here.

Bank Services members can access a deeper exploration of the survey results. Members can click here to view the complete results, broken out by asset category and other relevant attributes. If you want to find out how your bank can gain access to this exclusive report, contact [email protected].

Top Priorities for Compensation Committees Today

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The compensation landscape in banking is constantly evolving, and compensation committees must evolve with it. We want to highlight three priorities for bank compensation committees today: the rising cost of talent, the uncertain economic environment, and the link between environmental, social, and governance (ESG) issues and human capital and compensation.

The Rising Cost of Talent
The always-fierce competition for top banking talent has intensified in recent years, especially in certain pockets like digital, payments and commercial banking. Banks are using a variety of approaches to compete in this market and make their compensation and benefits programs more attractive, including special one-time cash bonuses or equity awards, larger annual or off-cycle salary increases, flexible work arrangements and other enhanced benefits.

In evaluating these alternative approaches, compensation committees must weigh the value each offers to employees compared to the cost to the bank and its shareholders. For example, increasing salaries provides near-term value to employees but results in additional fixed costs. Special equity awards that vest over multiple years provide less near-term value to employees but represent a one-time expense and are more retentive.

We expect the “hot” talent market, combined with inflation, to continue applying upward pressure on compensation. However, the recent rate of increase in compensation levels is untenable over the long-term, particularly in the current uncertain economic environment. Banks will need to optimize other benefits, such as work-life balance and professional development opportunities, to attract and retain top talent.

The Uncertain Economic Outlook
In 2021, many banks had strong earnings as the quicker-than-expected economic recovery allowed them to reverse their loan loss provisions from 2020. As a result, many banks could afford to pay significantly higher incentives for 2021’s performance than they did for 2020’s performance. The performance outlook for 2022 is unclear. Inflation, rising interest rates and macroeconomic uncertainty will impact bank performance results in 2022. Results will likely vary significantly from bank to bank, based on the institution’s business mix and balance sheet makeup.

Compensation committees will need to consider how the push and pull of these factors impact financial results and, as a result, incentive payouts. Some compensation committees may need to consider adjusting payouts to recognize the quantifiable financial impact of unanticipated conditions outside of management’s control, like the Federal Reserve’s aggressive interest rate increases. Banks may find it harder to quantify the financial impact of other economic conditions, like inflation. As a result, many compensation committees may find it more effective to use discretion to align incentive compensation with their overall view of performance.
Bank compensation committees considering using discretion to adjust incentive payouts for 2022 should follow three principles:

1. Be consistent: Apply discretion when macroeconomic factors negatively or positively impact financial results.
2. Align final payouts with performance and profitability.
3. Clearly communicate rationale to participants and shareholders.

Compensation committees at public banks should also be aware of potential criticism from shareholders or proxy advisory firms. The challenge for compensation committees will be balancing these principles with the business need to retain key employees in a tight labor market.

ESG and the Compensation Committee
Bank boards are spending more and more time thinking about their bank’s ESG strategies. The role of many compensation committees has expanded to include oversight of ESG issues related to human capital, such as diversity, equity and inclusion (DEI). Employees, regulators and shareholders are increasingly paying attention to DEI practices and policies of banks. In response, many large banks have announced public objectives for increasing diversity and establishing cultures of equity and inclusion.

In an attempt to motivate action and progress, compensation committees are also considering whether ESG metrics have a place in incentive plans. In recent years, the largest banks have disclosed that they are considering progress against DEI objectives in determining incentive compensation for executives. Most of these banks disclose evaluating DEI on a qualitative basis, as part of a holistic discretionary assessment or as part of an individual or strategic component of the annual incentive plan. Banks considering adopting a DEI metric or other ESG metrics should do so because the metric is a critical part of the business strategy, rather than to “check the box.” Human capital is a critical asset in banking; many banks may find that DEI is an important part of their business strategy. For these banks, including a DEI metric can be a powerful way to signal to employees and shareholders that DEI is a focus for the bank.

The Return of the Credit Cycle

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It has been like waiting for the second shoe to fall.

The first shoe was the Covid-19 pandemic, which forced the U.S. economy into lockdown mode in March 2020. Many banks prepared for an expected credit apocalypse by setting up big reserves for future loan losses — and those anticipated losses were the second shoe. Sure enough, the economy shrank 31.4% in the second quarter of 2020 as the lockdown took hold, but the expected loan losses never materialized. The economy quickly rebounded the following quarter – growing an astonishing 38% — and the feared economic apocalypse never occurred.

In fact, two and a half years later, that second shoe still hasn’t dropped. To this day, the industry’s credit performance since the beginning of the pandemic has been uncommonly good. According to data from S&P Global Market Intelligence, net charge-offs (which is the difference between gross charge-offs and any subsequent recoveries) for the entire industry were an average of 23 basis points for 2021. Through the first six months of 2022, net charge-offs were just 10 basis points.

Surprisingly, the industry’s credit quality has remained strong even though U.S. economic growth was slightly negative in the first and second quarters of 2022. The Bureau of Economic Analysis, which tracks changes in the country’s gross domestic product, had yet to release a preliminary third quarter number when this article published. However, using its own proprietary model, the Federal Reserve Bank of Atlanta estimated in early October that U.S. GDP in the third quarter would come in at 2.9%.

This would suggest that the industry’s strong credit performance will continue for the foreseeable future. But an increasing number of economists are anticipating that the U.S. economy will enter a recession in 2023 as a series of aggressive rate increases this year by the Federal Reserve to lower inflation will eventually lead to an economic downturn. And this could render a significant change in the industry’s credit outlook, leading to what many analysts refer to as a “normalization of credit.”

So why has bank loan quality remained so good for so long, despite a bumpy economy in 2022? And when it finally comes, what would the normalization of credit look like?

Answering the first question is easy. The federal government responded to the pandemic with two major stimulus programs – the $2.2 trillion CARES Act during President Donald Trump’s administration, which included the Paycheck Protection Program, and the $1.9 trillion American Rescue Plan Act during President Joe Biden’s administration — both which pumped a massive amount of liquidity into the U.S. economy.

At the same time, the Federal Reserve’s Federal Open Market Committee cut the federal funds rate from 1.58% in February 2020 to 0.05% in April, and also launched its quantitative easing policy, which injected even more liquidity into the economy through an enormous bond buying program. Combined, these measures left both households and businesses in excellent shape when the U.S. economy rebounded strongly in the third quarter of 2020.

“You had on one hand, just a spectacularly strong policy response that flooded the economy with money,” says R. Scott Siefers, a managing director and senior research analyst at the investment bank Piper Sandler & Co. “But No. 2, the economy really evolved very quickly on its own, such that businesses and individuals were able to adapt and change to circumstances [with the pandemic] very quickly. When you combine those two factors together, not only did we not see the kind of losses that one might expect when you take the economy offline for some period of time, we actually created these massive cushions of savings and liquidity for both individuals and businesses.”

The second question — what would a normalized credit environment look like? — is harder to answer. Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities, says the bank’s economists are forecasting that the U.S. economy will enter a relatively mild recession in 2023 from the cumulative effects of four rate increases by the Federal Reserve — including three successive hikes of 75 basis points each, bringing the target rate in September to 3.25%. The federal funds rate could hit 4.4% by year-end if inflation remains high, and 4.6% by the end of 2023, based on internal projections by the Federal Reserve.

“There’s obviously a lot of debate around the [likelihood of a] recession today, but generally our view is that we will gradually start seeing [a] normalization and higher credit losses next year, even if it were not for an outright recession,” Poonawala says. While a normalized loss rate would vary from bank to bank depending on the composition of its loan portfolio, Poonawala says a reasonable expectation for the industry’s annualized net charge-off rate would be somewhere between 40 and 50 basis points.

That would be in line with the six-year period from 2014 through 2020, when annual net charge-offs for the industry never rose above 49 basis points. And while loan quality has been exceptional coming out of the pandemic, that six-year stretch was also remarkably good — and remarkably stable. And it’s no coincidence that it coincides with a period when interest rates were at historically low levels. For example, the federal funds rate in January 2014 was just 7 basis points, according to the Federal Reserve Bank of St. Louis’ FRED online database. The rate would eventually peak at 2.4% in July 2019 before dropping back to 1.55% in December of that year when the Federal Reserve began cutting rates to juice a sagging economy. And yet by historical standards, a federal funds rate of even 2.4% is low.

Did this sustained low interest rate environment help keep loan losses low during that six-year run? Siefers believes so. “I don’t think there’s any question that cheap borrowing costs were, and have been, a major factor,” he says.

If interest rates do approach 4.6% in 2023 — which would raise the debt service costs for many commercial borrowers — and if the economy does tip into a mild recession, the industry’s loan losses could well exceed the recent high point of 49 basis points.

“There is a case to be made that a recession could look a bit more like the 2001-02 [downturn] in the aftermath of the dot-com bubble [bursting],” says Poonawala. “You saw losses, but it was an earnings hit for the banks. It wasn’t a capital event.”

That recession lasted just eight months and the decline in GDP from peak to trough was just 0.3%, according to the National Bureau of Economic Research. The industry’s net charge-off ratio rose to an average of 107 basis points in 2002 before dropping to 86 basis points in 2003, 59 basis points in 2004 and bottoming out at 39 basis points in 2006.

This same cyclical pattern repeated itself in 2008 — the first year of the financial crisis – when the average net charge-off rate was 1.30%. The rate would peak at 2.67% in 2010 before declining to 68 basis points in 2013 as the economy gradually recovered.

When we talk about the normalization of credit, what we’re really talking about is the return of the normal credit cycle, where loan losses rise and fall with the cyclical contraction and expansion of the economy. Banks have experienced something akin to a credit nirvana since 2014, but it looks like the credit cycle will reappear in 2023 — aided and abetted by higher interest rates and an economic downturn.