Busting the Logjam in Small Business Lending


Lending.png

With reports touting the health of the economy and the officials at the Federal Reserve talking about raising interest rates again, the lending environment must be good for small business owners, right? Wrong.

According to Babson’s 2016 State of Small Business in America report, obtaining capital is a challenge that frustrated SMB owners continue to face. Even those receiving a loan from a traditional lender obtain less than half the amount they applied for. What’s standing in the way of entrepreneurs borrowing from a traditional bank?

Lingering fear from the Great Recession: From 2008 to 2013, small businesses benefited from loosened lending restrictions. But in the past couple of years, fears about SMB lending has shifted thinking and brought about a tightening of standards–leading banks to provide available loan opportunities only to bigger businesses, which they view as less risky.

Fallout from Dodd-Frank: Post-2008 recession, new regulations created paperwork headaches for large lenders and small community banks alike. But the annoyances aren’t just isolated to a potential borrower being required to fill out a couple of additional forms. Compliance increased the cost of originating loans, so much so that it’s no longer fiscally responsible for lenders to issue lots of small loans.

In fact, Oliver Wyman research (PDF) indicates underwriting these loans costs a marginal $1,600 to $3,200 per loan. Compare these costs to the annual revenue smaller loans generate—$700 to $3,500 on average—and they’re clearly unprofitable.

Fewer lending options: It has also become very expensive to raise capital to open new community banks due to heightened regulatory requirements since the financial crisis. These local financial institutions are a great lending option for small business owners when big banks tighten their lending requirements. But with fewer local banks, SMB owners are left with fewer borrowing options than ever.

The stimulus encouraged banks to stockpile reserves: Prior to 2008, the U.S. economic structure encouraged financial institutions with large amounts of cash to lend it to other banks in need of liquidity. The federal stimulus pact reduced this cash flow, and large banks began sitting on their significant reserves–reducing the amount of available capital to smaller lenders, which in turn would be passed on to small business owners in their form of much needed credit.

Despite these obstacles, traditional lenders can and should break the SMB lending logjam. According to Barlow Research’s 2016 Small Business Annual Report, SMB loan demand is trending down slightly in a year-over-year comparison—off 9 percent between 2010 and 2016. However, this downward trend applies only to the traditional-lender space. New digital marketplace lenders are helping SMB borrowers to get around this credit logjam–and capturing more and more SMB lending business that used to go to banks.

According to one report by Morgan Stanley, loan origination at alternative lenders has doubled every year since 2010, reaching $12 billion in 2014. While banks are still the dominate credit source for small businesses, last year SMBs sought 22 percent of their financing from alternative lenders. That’s hardly a trend that benefits small businesses. Marketplace lenders do offer SMB borrowers fast, convenient loans–but that speed and convenience comes at a steep price, with expensive and often opaque lending terms that have attracted increasing scrutiny from regulators.

How can traditional lenders reverse this trend and break the SMB lending logjam? Simply put, banks need to harness the power of financial technology, machine learning and big data to bring small business lending online. By streamlining the origination process, banks can reduce operational costs dramatically for these loans while offering the speed and convenience SMB borrowers demand–and get–from alternative lenders. Reducing loan origination costs improves their profitability and introduces a virtuous circle of increased lending that expands lending options for borrowers at more competitive pricing.

The innovations don’t stop there. New machine learning algorithms can supplement the traditional, narrowly defined credit score criteria with enhanced, real-time data like shipping trends, social media reviews and other information relevant to a small business’ financial health. Thus armed, banks can identify an expanded field of highly qualified borrowers without increasing risk. They can pilot risk-based pricing models based on a borrower’s creditworthiness, ending the all-or-nothing style of flat pricing for approved loans. The possibilities are exciting and enormous. But traditional lenders will need the right financial technology to break this lending logjam and unleash the SBM market’s full potential.

A version of this article originally appeared on the Mirador blog.

Election Results Could Mean Less Regulation for Banks


Regulation-11-10-16.pngIt’s an understatement to say Republican presidential nominee Donald Trump’s surprise victory shook up the world Tuesday. Trump got elected promising change in Washington and made statements that portrayed a confusing mix of anti-bank and anti-regulation rhetoric. But with the House and Senate now controlled by Republicans, many industry observers are optimistic that the election will mean the appointment of more bank-friendly regulators, while the Consumer Financial Protection Bureau (CFPB) could also be weakened.

Although many economists feel Trump’s policies would be bad for the national economy, bankers by and large felt Trump would actually be good for the economy, according to a Bank Director poll in September.

“We think the main result of Donald Trump’s election will be that Trump will be able to appoint regulators who are more industry friendly than regulators appointed by President Obama,’’ wrote Brian Gardner, an analyst with investment banking company Keefe, Bruyette & Woods, in a note to investors Wednesday. “The regulatory implications are more important than what might come out of Congress but are broadly positive for financials in our view.”

CFPB
As far as banking regulations, the biggest thing in jeopardy may be the CFPB. President Trump will be able to appoint someone to head the agency, and a Republican-led Congress may make a move to gut or end it. That’s not to say such a move would be easy to do, but if Congressional elections in 2018 remove even more Democrats from office, it’s a possibility. The existence and approach of the CFPB has been a thorn in the side of many.

The Dodd-Frank Act
It’s unlikely the Dodd-Frank Act will be gutted entirely even with a Republican-controlled Congress. Democrats still will have at least 47 seats in the Senate and be able to block legislation that they don’t support, as 60 votes are needed to pass legislation in the Senate, Gardner wrote.

Even some industry lobbyists will be advocating against that, as it would create even more uncertainty. “Our industry has spent billions implementing Dodd Frank and complying with the CFPB,’’ said Richard Hunt, the president and CEO of the Consumer Bankers Association, in an interview Wednesday. “The last thing the banking industry needs is a whipsaw effect of uncertainty.”

Instead, some lobbyists are advocating for measures that would ease regulation on community banks, especially. The Independent Community Bankers of America “believes the unified Republican control of the executive and legislative branches presents a unique opportunity for enacting significant community bank regulatory relief and fully intends to leverage this opportunity for the benefit of community banks, their customers, and the communities they serve,” the group wrote in a memo to members and published on its website.

Wall Street Reform
The Republican Party platform this year, which former Trump campaign manager Paul Manafort said was in fact Trump’s platform, supported the return of the Glass-Steagall Act, which forbid banks from having both commercial and investment banking businesses. It was a surprising move, as the other person supporting the return of Glass-Steagall was Massachusetts Democratic Senator Elizabeth Warren. But few expect Trump to actually push hard for this, let alone be successful.

Aite Group senior analyst Javier Paz, who covers assets managers, wrote in a note that there was talk of President Trump leaning hard on Wall Street, but “we believe this was a tactical shift to keep Hillary Clinton from outflanking him on the topic of Wall Street reform. Time will tell, but we highly doubt new pieces of legislation building on what Dodd-Frank started will be forthcoming under President Trump.”

Hunt says he counted about 35 seconds of anti-bank rhetoric during four presidential and vice presidential debates. “There is campaigning and then there’s governing,’’ he says. “This is where Speaker Ryan, McConnell and the president will get together and come up with a shared vision for what they want the first 100 days and first year to look like to show the American people that Washington can work.”

Federal Reserve
There is a lot of uncertainty about what impact a Trump presidency will have on the Federal Reserve. Trump has been critical of Fed Chairwoman Janet Yellen and the central bank’s policies. He has said the Fed has been artificially keeping rates too low but his views on the Fed have not been consistent. He will be able to appoint two members to the Federal Reserve after he takes office, and Yellen’s term ends in January 2018, according to Gardner. Although the Fed was widely expected to raise rates in December, some predict that won’t happen now, as uncertainty about the markets could lead the Fed to delay a rate hike.

Rates Are Lower for Longer: How Do I Find Yield for My Bank?


BOLI-11-2-16.pngAs U.S. Treasury bond yields worsen, the banking industry finds itself in a familiar position. Bank portfolio managers would like better yield, but regulations restrict banks from going down the credit stack or out the curve to reach for yield. Net interest margins are at all-time lows and regulations compel us to manage regulatory risk first—price, rate and repayment risks are now secondary. Banking as we know it has changed, and not necessarily for the better. But there is a silver lining.

In December 2015, the Federal Reserve raised the funds rate 25 basis points. Immediately, foreign purchasers starving for yield drove prices to new highs, resulting in yields that were lower than before the Fed increased the rate. In early 2016, several countries moved to negative rates. Should the Fed raise rates again soon, more foreign deposits will find Treasury bonds even more compelling again.

Long term, given that the U.S. national debt stands at $19.5 trillion, the U.S. Treasury can’t afford rates to be appreciably higher. The recession of 2007, the war on terror and expansion of social programs has greatly limited options. Most economists agree that the treasury debt market will remain in the lower-for-longer phase for quite some time. Ouch. So, what to do?

Lending is the first most obvious answer but regulations remain confounding. Many bankers feel as if they are only able to grow by stealing market share. Multiple banks chasing the same high quality loans exacerbate spread compression. Agency debt and mortgage-backed securities have yields basically stuck in the 1.70 percent to 1.75 percent range. Municipals remain relatively attractive, but the laborious process, small sizes, ongoing care and price sensitivity make them less compelling.

The judicious use of Bank Owned Life Insurance (BOLI) could be a winning answer. Hear me out—with crediting rates (yield) at nearly 4 percent the concept has merit. Most money center banks and many super regionals maintain BOLI holdings at maximum allowable percentages. Yields are compelling, counterparty risk is stable and price risk is minimal. Interestingly, large banks are more likely than small banks to use the maximum allowable BOLI. Community bankers sometimes forget this break is available to all banks regardless of asset size.

BOLI has a positive effect upon your efficiency ratio as it provides additional tax-free dollars for employee benefits. Since efficiency ratio equals expenses divided by revenue, every additional dollar of revenue results in an ever-larger denominator, hence the ratio shows an immediate positive impact. BOLI is purchased at par and is always held at par eliminating price risk. Given the current cheapness of the asset, BOLI can be surrendered within a year (net of taxes and penalties) and still provide a higher return than mortgage-backed securities.

BOLI can be viewed as outsourcing a portion of your portfolio. Choose a provider that only uses insurance carriers that are A+ rated or better and that employ seasoned, capable portfolio managers. In the event of an untimely loss of an insured employee, the insurance payments help the family and assist the institution to pay for costs related to replacement.

Recently, I met with the president of an $8 billion asset bank who commented, “I really thought I didn’t want to discuss my BOLI holdings. Then I realized it’s a $100 million asset on my books and I’d better get interested in how to optimize it!” We are currently completing a review of his policy holdings.

In the current market, the BOLI asset is extraordinarily cheap. It is a high yielding, low risk asset with a superb degree of price stability. Does it solve every answer? No. Will BOLI always be this cheap? No. But given recent advancements by insurance carriers and asset managers, it is a financial tool that really demands a hard look.

Are Your Owners Violating the Change in Bank Control Act?


Change-in-Control-10-18-16.pngMore people probably violate the Change in Bank Control Act (CBCA) than any other banking statute, as it is complicated and easy to do. But knowing the law and helping your shareholders keep up with their ownership filings is important. The law requires regulatory approvals before a person or group of persons “acting in concert” may take actions to directly or indirectly “control” a bank or savings association. Consequently, the CBCA impacts both bank and thrift holding companies and, with minor variations, all of the federal regulators have implementing regulations for the CBCA. Although the focus of this article is the Federal Reserve Board regulations regarding changes in control of bank holding companies, it is fair to say that given the intricacy of control determinations, the CBCA is likely one of the most inadvertently violated banking statutes currently on the books. The inadvertent CBCA violations often occur because of the presumption that certain groups are “acting in concert,” and the application of the CBCA requirements to these groups.

The CBCA requires that any person or groups of persons “acting in concert” must file change in bank control notices with the applicable federal regulator if the individual or group reaches an ownership level of 25 percent or more of any class of voting securities of an institution. The definition of “person” under the CBCA is very broad and includes individuals, corporations, partnerships, trusts, associations and other forms of business entities. Acting in concert is defined as knowing participation in a joint activity or parallel action towards a common goal of acquiring control of a bank or bank holding company, whether or not pursuant to an express agreement.

There is a rebuttable presumption that an acquisition of voting securities of a bank holding company is the acquisition of control under the CBCA, requiring a notice filing, if, immediately after the transaction, the acquiring person or persons acting in concert will control 10 percent or more of any class of voting securities of the institution, and if the institution has registered securities under the Securities Exchange Act of 1934 or if no other person will own, control, or hold the power to vote a greater percentage of that class of voting securities immediately after the transaction.

In determining whether persons are engaging in concerted action, there is a rebuttable presumption that the following groups are acting in concert:

  • A company and any controlling shareholder, partner, trustee, or management official of the company, if both the company and the person own voting securities of the institution;
  • An individual and the individual’s immediate family, which includes a person’s father, mother, stepfather, stepmother, brother, sister, stepbrother, stepsister, son, daughter, stepson, stepdaughter, grandparent, grandson, granddaughter, father-in-law, mother-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law, the spouse of any of the foregoing, and the person’s spouse;
  • Companies under common control;
  • Persons that are parties to any agreement, contract, understanding, relationship, or other arrangement, whether written or otherwise, regarding the acquisition, voting, or transfer of control of voting securities of an institution, other than through certain types of a revocable proxy;
  • Persons that have made, or propose to make, a joint filing under certain sections of the Securities Exchange Act of 1934; and
  • A person and any trust for which the person serves as trustee.

With respect to inadvertent CBCA violations, the most likely “acting in concert” scenario is the consolidation of voting securities held by an individual and the individual’s “immediate family” members. To the extent a family group owns at least 10 percent of a bank holding company, a new notice filing may be required any time the family group or ownership mix changes. Violations of the CBCA are inadvertently committed literally all the time by family groups as ownership is realigned at death, through estate planning or gifting, as minors age into formal ownership stakes and by birth or marriage.

Although the burden of obtaining regulatory approval is on the person or group of persons acquiring control, not the institution, the issue has recently been arising with great frequency when bank holding companies seek to acquire other institutions. As part of the review process, the Federal Reserve has requested current shareholder lists to compare them to prior control determinations made by the Federal Reserve. If a review of the shareholder list indicates changes, even intra-family changes, in the control group, the Federal Reserve may require that a new notice be filed.

Although at least in the family context, CBCA issues are generally easily resolved by filing an after-the-fact corrective notice, reviewing your bank holding company shareholder lists for technical changes in family group ownership may prevent a holdup down the line as you seek approval for future expansion.

Small Business Lending: Partnering Your Way to the Top


small-business-loans-4-25-16.pngSmall business (SB) lending is a large and yet still underserved market in which community banks are generally well positioned to compete. The SB commercial loan market represents approximately $1 trillion in outstanding loans, of which banks hold over $500 billion. Approximately one-third of these assets are currently held by community banks. Despite those impressive figures, the existing small business market is smaller than it could be as large numbers of creditworthy small businesses needing smaller loans are not able to access the credit for which they likely could qualify, largely due to the costs of accessing and underwriting those loans.

Critically, it is the smaller SB loans—i.e. those below $250,000—that constitute the majority of the potential market of borrowers: a recent Federal Reserve survey suggests that applicants seeking less than $250,000 represent approximately 70 percent of total small business applicants. But most banks struggle to make such loans profitable, due to the fixed costs of traditional underwriting and processing relative to the smaller revenue opportunities.

On the other side of the equation, the lending market is undergoing a transformation driven by technology and new competition that is rapidly increasing the investment and scale necessary to compete. This technology is designed to reduce underwriting costs, shorten approval timelines and provide a more user-friendly customer experience. Larger banks and new, nonbank lenders are aggressively using this technology to expand share in SB lending, especially in the underserved smaller balance loan space that is so important to community banks.

Community banks are already gradually ceding SB market share—first to the larger banks and more recently to new technology-enabled nonbank lenders, commonly referred to as fintech lenders. Unfortunately, each community bank alone typically lacks the individual scale required to invest in technology that is now required to compete.

Banks, and particularly the largest banks, appropriately see the emergence of fintech lenders as a potential threat. But, since many community banks lack the resources to build or buy a technology platform on their own, the emergence of fintech lenders who can partner with community banks provides a new and attractive option for community banks to serve these important SB customers and to gain market share.

Federal Reserve Governor Lael Brainard summed up the opportunity for community banks as follows:

“Some view the growth of online platforms as a challenge to community banks in their traditional core businesses. But it is also possible that the very different strengths of community banks and online lenders could lead to complementarity and collaboration in the provision of credit to small business….”
… By working together, lenders, borrowers, and regulators can help support an outcome whereby credit channels are strengthened and possible risks are being proactively managed.”

Fintech partnerships designed to empower community banks should demonstrate the following characteristics:

  • Enable banks to offer a product that is otherwise not widely available through that bank and/or to replace a costlier or inefficient product with a better solution;
  • Enable banks to provide a “yes” to more of their customers, facilitating access to credit even if the customer is not yet able to meet bank credit standards;
  • Ensure banks retain control of the customer relationship and the customer’s experience;
  • Increase fee income and earning assets; and
  • Ensure banks are able to meet regulatory expectations and best practices.

In its January 2015 paper on collaboration by community banks, the Office of the Comptroller of the Currency (OCC) states: “As a group of like-minded institutions, community banks may find the benefits of collaboration outweigh competitive challenges and could strengthen the future viability of community banks. The OCC supports community banks in exploring opportunities to achieve economies of scale and the other potential benefits of collaboration.” The OCC goes on to note that community banks that collaborate must manage the risks inherent in such a collaborative arrangement but states “there are risks to collaborative relationships, but there are also risks to doing something alone without the proper expertise or in an inefficient or ineffective manner.”

I couldn’t say it any better. In connection with SB lending, therefore, community banks should assess the extent to which a collaborative approach may offer benefits of collective scale, expertise and efficiency in a controlled and compliant manner. They may just find that the benefits readily outweigh the risks, and that fintech offers a powerful opportunity for community banks to regain share in a number of product lines that have come to be dominated by the largest banks.

Captive Insurance Subsidiaries Proliferate Among Bank Holding Companies


captive-insurance-3-2-16.pngBanking is the business of managing risk. Be it credit risk, interest rate risk or technological risk, bankers are trying to control a highly leveraged earnings engine while avoiding risks that can result in sudden reversals of fortune.

Yet many of the biggest risks faced by bankers today are both uninsurable and unreserved for on the bank’s books, such as certain cyber risks and reputational risks. Even where third-party insurance policies may be available, they may provide coverage that bankers feel is cost-prohibitive. That’s where a captive insurance company may present a cost-effective, tax-efficient solution. A captive insurance company is the insurance company that you own. It allows you to insure the risks that your bank, holding company and the holding company’s other operating subsidiaries may face, writing real insurance policies against which you can make claims for losses.

While a variety of structures may be used to create captive insurance companies, so-called “small” captives provide a number of unique tax advantages for owners of small to mid-sized bank holding companies. They often are referred to as 831(b) captives, named after the Internal Revenue Code section that provides tax incentives for the creation and use of such entities.

Potential benefits of 831(b) captives are well-documented and will be enhanced in coming years by recent amendments made under the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). These include:

  • Insurance for risks that you already have on your books and for which policies in the marketplace are either prohibitively expensive or nonexistent;
  • Up to $1.2 million ($2.2 million beginning in 2017) in deductible premium expenses for your bank or bank holding company; and
  • Up to $1.2 million ($2.2 million beginning in 2017) in tax-free premium income to the captive insurance company.

While the changes under the PATH Act are new, the legislation facilitating small captives has been in place since 1986, which begs the question, why aren’t more bankers using them? The short answer is that, until recently, implementation of captives was very expensive and the legal underpinnings for them were somewhat shaky.  

However, the number of captives across the county has increased rapidly in recent years according to examiners we’ve spoken with from the Federal Reserve. This increase has resulted in part from a proliferation of “turnkey” providers who have developed proven models and technical solutions to reduce the costs of creating and administering a captive insurance company.

At the same time, the legal underpinnings of captive insurance companies have matured. Once a business relegated to exotic, typically offshore jurisdictions, captive insurance companies now may be formed in any one of the many states that have adopted comprehensive captive insurance company legislation, such as Delaware, Vermont, Nevada and Tennessee.

Furthermore, changes implemented by the PATH Act provide much-needed clarity on the types of captive structures that will be permitted under the Internal Revenue Code and therefore eligible for the tax advantages conferred by Section 831(b). While the types of tax avoidance structures that were targeted by the PATH Act probably would never have been permissible in banking due to affiliate transaction restrictions, the legislation provided clarity as to the types of diversification and/or ownership criteria that must be met to pass muster under IRS rules.

Finally, bank holding companies are allowed to underwrite any type of insurance for affiliated or unaffiliated entities. In addition, some state banking regulators have signaled their willingness to permit the formation of captive insurance companies in light of the activities that have been authorized for national banks by the Office of the Comptroller of the Currency.

Turnkey captive insurance providers have designed solutions that capitalize on this guidance to create compliant captives that can be taken “off the shelf” and plugged into your bank holding company structure. Altogether, this means that forming a captive is now cheaper and less risky from a legal and regulatory perspective than it has been in the past.

So, is your bank holding company a good candidate for a captive? Historically, forming a captive required owners to engage and work extensively with a team of attorneys, actuaries, accountants and other professionals. This resulted in customized solutions that were tailor-made for the company’s overall objectives. As it has become easier to form a captive using turnkey solutions, the customization and optimization of the captive for the sponsor’s overall business can be lost.

That’s why we recommend working with a team of advisers who are familiar with captives and can assist your turnkey provider in integrating a captive as part of your overall business and risk-management goals.

Five Steps for Dealing With Subjective Regulation


bank-regulation-2-24-16.pngThere has always been a level of subjectivity in the regulatory process. In the past, it manifested itself as interpretations of written regulations. The post-crisis regulatory environment continues to evolve—as does the subjective aspect of regulation—creating new challenges for bank boards. Bank directors are now faced with subjective terms like “risk culture” and “deceptive acts and practices” included in their exam reports as standards, as well as a regulatory focus on “adequacy” when evaluating strategic planning and capital and liquidity management. Bank directors are now challenged to understand what needs to be done to meet these evolving subjective expectations of the regulators and, in turn, hold senior management accountable.

Trying to define these terms is probably futile, but there are things the board can and should do to ensure these standards are being met.

Educate Yourself
Directors should start by learning as much as they can about these subjective requirements. Understanding how they evolved and what they are intended to correct or prevent will help you understand what has to be done to meet them. The regulators have made it clear they have higher expectations for director oversight of risk taking activities, and the board is expected to challenge, question and, where necessary, oppose management proposals. Education is key to meeting these expectations.

Identify Behaviors
Actions speak louder than words. Too many organizations rely solely on policies or pronouncements to demonstrate compliance with subjective requirements. Take risk culture, for example. The board should ask and understand how everyone in the firm is held accountable for risk. How do compensation plans incorporate risk concepts? How do you deal with policy violations? Are employees rewarded for identifying and addressing risk matters? Directors must then ask whether the answers to these questions demonstrate the type of risk culture the firm is trying to achieve.

Learn From Others
Directors should be acutely aware of industry trends when it comes to subjective regulation. Regulators are relying more and more on horizontal reviews of financial firms to identify best practices. Understanding what has been considered inadequate when it comes to a financial firm’s capital or liquidity planning can provide guidance on evaluating a firm’s own plans. For example, the Federal Reserve publishes the results of its Comprehensive Capital Analysis and Review for the largest banks, which is a good place to start. The public release of capital planning results showed there is both a quantitative and qualitative aspect to planning. While the quantitative aspect of planning is made public through establishing acceptable minimums, the qualitative aspect (how you got there) can best be met by understanding how others succeeded or failed to properly plan.

Create a Program
Understanding what needs to be done is the first part of the challenge. The second step is making sure your firm is doing it properly. Subjective standards have to be incorporated into risk and audit programs. It may seem impossible to audit for something like risk culture, and an audit of risk culture is certainly more art than science, but some questions the audit should include are:

  • Is there an understanding, communication and alignment of values in the firm? 
  • Are risk commitments being met and does the firm and management do what they say they will do?
  • Are there any exploitations of gray areas to benefit individuals?
  • Is there evidence of a balance in the firm between achieving results and managing risk?

Bottom line is the board should insist audits and risk assessments take into consideration how these areas of subjective regulation are reflected in the operation of each area, procedure or process they review.

Tell Your Story
Directors should be ready and able to express their understanding of how they meet today’s subjective standards. For example, understanding the strategic planning process and the manner risk factors are taken into account in both planning and execution of strategy allows directors to ask the right questions throughout the process. The same is true for capital and liquidity planning, where reflecting the right level of question and debate in the minutes will likely be crucial to meeting the regulatory “adequacy” standard.

The examples shared are just some of the subjective terms permeating the regulatory process in today’s environment. Like written regulations, they will continue to evolve and will be heavily influenced by the regulatory climate. Dealing with this regulatory uncertainty will continue to be an important practice for directors.

Will Higher Rates Help or Hurt Banks? The Answer Is “Yes.”


interest-rates-12-28-15.pngWill the long awaited hike in interest rates turn out to be good or bad for U.S. banks? The honest answer is probably yes to both possibilities, depending on the size of the bank in question and how the Federal Reserve manages monetary policy over the next couple of years.

In case you just got back from Mars, the Fed announced on December 16 that it was raising the interest rate on overnight borrowings between banks (known as the federal funds rate) by a quarter of a percentage point. The significance of the Fed’s action had less to do with the size of the increase than with the fact that this was the first time the central bank had raised rates in more than seven years. There was a lot of commentary after the rate hike about how this would impact the U.S. economy, although a strong case can be made that this was actually a vote of confidence in the economy’s long-term prospects. The job market has rebounded since the recession ended in June 2009 and unemployment was 5.5 percent in May, according to the Bureau of Labor Statistics. While the recovery is still a work in progress, Fed Chairman Janet Yellen expressed confidence in the economy’s future during a press conference after the rate increase was announced.

Although the Fed’s central mission is to fight inflation, deflation—which is a persistent decline in asset values and consumer prices—has actually been a much greater risk in recent years. Having cut the fed funds rate to nearly zero, and embarking upon a controversial strategy of massive bond purchases to pump money into the economy—known as quantitative easing—there was little more the Fed could do other than wait for the economy to heal itself, which it largely has. Yellen and the Federal Open Market Committee, the 12-member group at the Fed that actually sets monetary policy, has been waiting for an opportunity to begin pushing rates back up. Clearly the time was right.

How will this affect the nation’s banks? The impact of a quarter-point increase in the fed funds rate should be manageable, at least for now. Comptroller of the Currency Thomas Curry has expressed publicly his concern that some banks might be exposed to interest rate risk as the Fed tightens its monetary policy. Large banks, which tend to use variable rate pricing on their commercial and industrial loans, permitting lenders to reprice them if rates go up, will probably experience less economic impact than smaller banks. Many small banks don’t have the same flexibility to reprice their business loans. So as rates go up, smaller banks could actually see their net interest margins tighten even more as their deposit costs rise.

Still, the rate increase had been anticipated, predicted and over analyzed for so long that no bank should have been taken by surprise. Managing interest rate risk is an important task for management and the board, and the industry has been given ample time to prepare.

Ultimately, the impact of higher rates on the banking industry might be determined by how quickly the Fed tightens its policy. The Fed has said that it wants to continue raising rates gradually over the next few years—the exact term it used was to “normalize” rates but how gradually? Hike rates too quickly and some smaller banks could be stressed if they can’t reprice their loan portfolios fast enough to keep pace. But if banks are impacted disproportionately depending on whether they are asset or liability sensitive (being asset sensitive means your loans reprice faster than your deposits, while being liability sensitive means the reverse is true), one thing that would hurt everyone is a slow-down in the economy. Here, I would expect the Fed to be very careful. Having nursed the economy back to health, I think the last thing it wants to do is tip the economy back into a recession by acting too aggressively.

At the very least, banks should know what to expect, and the Fed—which has been very transparent under Yellen—will no doubt let them know when to expect it.

Does Market Volatility Impact Bank M&A?


While the volatility in the stock market garners the attention of investors, it is also a worrisome topic for bank boards. As the Federal Reserve considers its first rate increase in close to 10 years—and China’s growth outlook continues to wane and impact economies around the world—bank boards have to consider the impact on their growth strategies, including any planned capital raises, IPOs or mergers and acquisitions.

Certainly, unexpectedly large swings in daily share prices make it difficult to price a potential M&A deal. This comes in an environment where bank M&A volume has not increased much, if at all, depending on how you look at the numbers. As you can see in the chart below, we have had just 34 deals with a value of more than $50 million year to date through Sept 7, 2015, which puts us slightly below the rate of 2014, according to Mark Fitzgibbon, a principal and the director of research at investment bank Sandler O’Neill + Partners.

Most bank deals are smaller than $50 million in value, however. In an upcoming article for BankDirector.com, Crowe Horwath LLP, a consulting and accounting firm, looked at all deal volume through June 30, 2015, and found 140 deals, slightly above last year’s volume in the same time frame of 130 deals.

Clearly, the lion’s share of the transactions has been small bank deals, and we have not seen many large transactions this year. Fitzgibbon is of the opinion that there are three dynamics that have slowed the pace of consolidation: (a) recent market volatility makes it tough to price deals, (b) large banks have generally been more internally focused than M&A focused, and (c) regulators have been slow to approve some deals, giving pause to some buyers.

This complements the perspectives of Fred Cannon, executive vice president and global director of research at Keefe, Bruyette & Woods, who reminded me that the pace of M&A “is simply a lot slower than it was prior to the crisis, and those of us who remember pre-crisis M&A, it will likely never be the same. We don’t have national consolidators buying up banks, and regulation does not allow the same speed of consolidation we previously had.”  In Cannon’s words, “volatility certainly slows deals a bit, but it postponed deals rather than stopped them.”

Contrast that with initial public offerings, which can really take a beating in a volatile market. Depending on the market and the individual bank’s potential value, it may no longer make sense to price an IPO, or it may make sense to delay it.

Here, I agree with Cannon’s assertion that a weak market is “more detrimental to IPOs than M&A. With M&A, the relative value of the buyers’ currency is often more important than the absolute level.” So if values fall for both the buyer and seller, the deal may still make sense for both of them. For potential deal making, market volatility is rarely good news, but it may not be as bad as it seems.

The Impact of Rising Interest Rates on BOLI


BOLI-7-9-15.pngSince the Great Recession of 2007-2009, the Federal funds rate has been held near zero to help spur the U.S. economic recovery. However, with the decline in the unemployment rate, strong jobs growth in the second quarter of 2015 and low inflation, the Federal Reserve may begin to raise short-term interest rates before the end of this year.

Although no one can predict exactly when interest rates will rise or by how much, we all understand it will occur at some point. Because we have been in a low interest rate environment for so long, the natural question is how will higher market interest rates impact the credited interest rates on bank-owned life insurance (BOLI) policies?

To understand the impact of rising interest rates on BOLI carriers offering fixed-income products, it is first necessary to understand the carriers’ investment philosophies, portfolio compositions and interest crediting methodologies. Although the investment philosophy of each BOLI carrier differs, there are generally some common threads. The investment objective of most BOLI carriers is to build a diversified portfolio of securities across and within asset classes with a long-term orientation that optimizes yield within a defined set of risk parameters. The portfolio strategy often targets investment grade securities, both public and privately issued, with cash inflows that reasonably match the projected cash outflows of their projected liabilities. Corporate bonds are usually the largest holding in the portfolio along with commercial mortgages/mortgage backed securities, private placements, government/municipal bonds and other holdings. The duration of these portfolios is typically four to ten years.

Insurance companies use different interest crediting methodologies for BOLI business. Some carriers use a portfolio approach while others use a new money rate approach. In most cases, the carriers who use a new money rate approach blend it into the portfolio over time. The crediting rate in products from new money rate carriers is based on the carrier’s expected rate of return on premiums received currently. The crediting rate in products from portfolio rate carriers is based on a combination of the rate of return from new premiums as well as the balance of the general account assets of the company or the assets of the specific BOLI portfolio.

Rising interest rates will affect both new BOLI cases as well as existing BOLI policies. As noted above, insurance companies invest heavily in bonds. When market interest rates rise, yields on new bonds will increase while prices on existing bonds will decline. In anticipation of rising interest rates, some carriers shorten the duration of their portfolios or pursue a hedging strategy to manage risks.

Carriers using the new money approach will see a more immediate and positive impact on their initial credited rate for new BOLI policies as their rates, for newly issued policies,  are based on current investments yields. Assuming a modest increase in rates, carriers using the portfolio approach may see little or no immediate change in their rate, but will likely see an increase in their credited interest rate over time. This will occur as the portfolio turns over and as new premium that is received is invested at a higher rate.

For existing general account and hybrid separate account BOLI policies, whether a new money or portfolio approach was used, there is no mark-to-market risk as the insurance company, not the policyholder, bears the price risk. For new money products, the interest rate credited to a new purchase is not likely to increase for several years after purchase since the underlying investments supporting the new money purchase typically have durations of four to ten years. Assuming slow and steady interest rate increases, both new money and portfolio products will likely increase over time with the portfolio products expected to increase more rapidly than the new money products. This is because the portfolio products will receive more new cash flows to invest at the higher rates.

A significant interest rate increase over a short period of time may cause most new premium to be placed in new money products, thereby reducing the new premium received into a portfolio product and slowing the time period it takes for the crediting rate to grow to market levels. If this were to occur, the crediting rates on portfolio and new money products would be expected to increase at about the same pace.

Please also bear in mind that it is important for directors and senior management of a bank to monitor not only changes in credited interest rates, but also the net yields. The net yield reflects the actual credited rate less mortality charges and, in some cases, policy fees or other administrative expenses. Accordingly, it is possible for one carrier to have a higher interest rate than another, but a lower net yield.

Many BOLI service providers will meet with their clients at least once a year to discuss the status and performance of their policies. At that meeting, it is vital for board members and senior management to review, among other things, the net yield earned on their policies to determine whether those yields are competitive in light of the type of policy purchased (new money, portfolio, blended portfolio) and current market conditions. Your service provider is well positioned to help you with that analysis and discussion of options, if changes are needed.

In conclusion, rising interest rates will occur at some point, but are likely to have a favorable interest rate impact on both new and existing BOLI clients using a fixed account over the long-term.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.