In this episode of Looking Ahead, David Ingles and Stephen Amdur, partners at Pillsbury Winthrop Shaw Pittman, focus on the rapidly evolving financial industry. Some of this technological shift, they explain, has been propelled by declining development costs and greater access to capital —and they point out where private equity investors are seeing opportunities. They also explore how large regional and national banks have shifted their M&A strategies to acquiring technology platforms.
In the middle of 2020, while some consumers were stockpiling essentials like water and hand sanitizer, many businesses were shoring up their cash reserves. Companies across the country were scrambling to build their war chests by cutting back on expenses, drawing from lines of credit and tapping into the Small Business Administration’s massive new Paycheck Protection Program credit facility.
The prevailing wisdom at the time was that the Covid-19 pandemic was going to be a long and painful journey, and that businesses would need cash in order to remain solvent and survive. Though this was true for some firms, 2020 was a year of record growth and profitability for many others. Further, as the SBA began forgiving PPP loans in 2021, many companies experienced a financial windfall. The result for community banks, though, has been a surplus of deposits on their balance sheets that bankers are struggling to deploy.
This issue is exacerbated by a decrease in loan demand. Prior to the pandemic, community banks could generally count on loan growth keeping up with deposit growth; for many banks, deposits were historically the primary bottleneck to their loan production. At the start of 2020, deposit growth began to rapidly outpace loans. By the second quarter of 2021, loan levels were nearly stagnant compared to the same quarter last year.
Another way to think about this dynamic is through the lens of loan-to-deposit (LTD) ratios. The sector historically maintained LTDs in the mid-1980s, but has recently seen a highly unusual dip under 75%.
While these LTDs are reassuring for regulators from a safety and soundness perspective, underpinning the increased liquidity at banks, they also present a challenge. If bankers can’t deploy these deposits into interest-generating loans, what other options exist to offset their cost of funds?
The unfortunate reality for banks is that most of these new deposits came in the form of demand accounts, which require such a high degree of liquidity that they can’t be invested for any meaningful level of yield. And, if these asset and liability challenges weren’t enough, this surge in demand deposits effectively replaced a stalled demand for more desirable timed deposits.
Banks have approached these challenges from both sides of the balance sheet. On the asset side, it is not surprising that banks have been stuck parking an increasing portion of the sector’s investment assets in low-yield interest-bearing bank accounts.
On the liabilities side, community banks that are flush with cash have prudently trimmed their more expensive sources of funds, including reducing Federal Home Loan Banks short-term borrowings by 53%. This also may be partially attributable to the unusual housing market of high prices and low volumes that stemmed from the pandemic.
As the pandemic subsides and SBA origination fees become a thing of the past, shareholders will be looking for interest income to rebound, while regulators keep a close eye on risk profiles at an institutional level. Though it’s too soon to know how this will all shake out, it’s encouraging to remember that we’re largely looking at a profile of conservative community banks. For every Treasury department at a mega bank that is aggressively chasing yield, there are hundreds of community bank CEOs that are strategically addressing these challenges with their boards as rational and responsible fiduciaries.
Visit https://www.otcmarkets.com/market-data/qaravan-bank-data to learn more about how Qaravan can help banks understand their balance sheets relative to peers and benchmarks.
Pent-up deal demand will define 2022, continuing this year’s momentum as pandemic-related credit concerns recede. Stinson LLP Partner Adam Maier believes banks can expect to see a high volume of deals in the space but anticipate approval slowdowns from regulatory scrutiny. He also shares his top advice for directors as their banks prepare for growth next year. Topics include:
- Deal Demand
- Regulatory Considerations
- Advice for Growth
Last Tuesday, payment company PayPal Holdings’ market capitalization of $277 billion was higher than the entire KBW regional bank index of $213.5 billion. This has been true for months now.
Tom Michaud, CEO of Keefe, Bruyette & Woods, noted PayPal’s valuation in a February presentation for Bank Director. “They can really afford to invest in ways a typical community bank can’t,” he said at the time.
PayPal’s market value is richer than several large banks, including PNC Financial Services Group, Citigroup and Truist Financial Corp.
But how can that be? When you compare the earnings reports of PayPal to the banks, you can see the companies’ focuses are entirely different. PayPal promotes its growth: growth in payment volume, growth in accounts and growth in revenue. Truist and PNC are more inclined to highlight their profitability, which is typical of well established, legacy financial companies.
Source: PayPal. Total payment volume is the value of payments, net of payment reversals, successfully completed on PayPal’s platform or enabled by PayPal on a partner platform, not including gateway exclusive transactions.
PNC reported net income of $7.5 billion, an increase of 40% from the year before, on total revenue of $13.7 billion in 2020. PayPal reported earnings of $4.2 billion in 2020, nearly double what the company had earned the year prior.
PayPal was trading at about 67 times earnings last Wednesday, while Truist was trading at about 19 and PNC at 28, according to the research firm Morningstar.
Of course, it’s silly to compare PayPal to banks. PayPal isn’t a bank, nor does it want to be, says Wedbush Securities managing director and equity analyst Moshe Katri. “It’s better than a bank,” he says. “What you’re getting from PayPal is a host of products and services that are more economical.”
Katri says PayPal, which owns the person-to-person payments platform Venmo, offers transaction fees that are lower than competitors. For example, PayPal advertises fees to merchants for online transactions for a flat 2.9% plus 30 cents. Card associations such as Visa and Mastercard offer a variety of pricing options for credit and debit cards.
Katri says PayPal’s valuation is related to its platform and its earnings power. PayPal has roughly 350 million consumers and about 29 million merchants using its platform, with potential to grow. Not only could PayPal expand its customer base, but it could also grow its transactions and fees per customer.
“It allows you to do multiple things: shop online, transfer funds, transfer funds globally, bill pay,” Katri says. “They offer other products and services that look and feel like you’re dealing with a bank.”
PayPal also offers small business loans, often for as little $5,000. It uses transaction data to underwrite loans to merchants that may appear unattractive to many banks.
But PayPal is more often compared to competitors Mastercard and Visa than to banks. Both Mastercard and Visa saw a decline in payment volume during the pandemic after losing some in-person merchant business, according to the publication Barron’s. In contrast, PayPal did especially well during 2020, when the pandemic forced more purchases to move online.
PayPal’s size and strength have helped it invest, including recent initiatives like an option to pay via cryptocurrency, a touchless QR-code payment option and a “buy now, pay later” interest-free loan for consumers.
PayPal CEO Dan Schulman said on a fourth-quarter earnings call that the company plans to enhance bill pay options this year and launch budgeting and savings tools. “We all know the current financial system is antiquated,” he said.
But the juggernaut that is PayPal may not ride so high a few years from now. Shortly after a February investor presentation where the company projected a compound annual growth rate of 20% in revenue, reaching $50 billion by 2025, the stock price skyrocketed to $305 per share.
It has come down considerably since then, along with many high-flying technology companies. PayPal’s stock sunk 20% to $242.8 per share at market close last Wednesday, according to Morningstar. Katri has a buy rating on the stock, assuming a price of $330 per share.
Morningstar analyst Brett Horn thinks PayPal’s long term prospects are less certain, even though few payments companies are as well positioned as PayPal right now. Competitors are active in mergers and acquisitions, getting stronger to go up against PayPal’s business model. Apple Pay remains a formidable threat.
On the merchant processing side, Stripe and Square are among the players growing considerably, too. What’s clear is that giant payments platforms may continue to erode interchange fees and other income streams for banks.
“The digital first world is no longer our future,” Schulman said in February. “It is our current reality and it will forever change how we interact in almost all elements of our lives.”
The nationwide pandemic and persistent economic uncertainty hasn’t slowed the growth of Idaho Central Credit Union.
The credit union is located in Chubbuck, Idaho, a town of 15,600 near the southeast corner, and is one of the fastest growing in the nation. It has nearly tripled in size over the last five years, mostly from organic growth, according to an analysis by CEO Advisory Group of the 50 fastest growing credit unions. It also has some of the highest earnings among credit unions — with a return on average assets of 1.6% last year — an enviable figure, even among banks.
“This is an example of a credit union that is large enough, [say] $6 billion in assets, that they can be dominant in their state and in a lot of small- and medium-sized markets,” says Glenn Christensen, president of CEO Advisory Group, which advises credit unions.
Unsurprisingly, growth and earnings often go hand in hand. Many of the nation’s fastest growing credit unions are also high earners. Size and strength matter in the world of credit unions, as larger credit unions are able to afford the technology that attract and keep members, just like banks need technology to keep customers. These institutions also are able to offer competitive rates and convenience over smaller or less-efficient institutions.
“Economies of scale are real in our industry, and required for credit unions to continue to compete,” says Christensen.
The largest credit unions, indeed, have been taking an ever-larger share of the industry. Deposits at the top 20 credit unions increased 9.5% over the last five years; institutions with below $1 billion in assets grew deposits at 2.4% on average,” says Peter Duffy, managing director at Piper Sandler & Co. who focuses on credit unions.
As of the end of 2019, only 6% of credit unions had more than $1 billion in assets, or 332 out of about 5,200. That 6% represented 70% of the industry’s total deposit shares, Duffy says. Members gravitate to these institutions because they offer what members want: digital banking, convenience and better rates on deposits and loans.
“The only ones that can consistently deliver the best rates, as well as the best technology suites, are the ones with scale,” Duffy says.
Duffy doesn’t think there’s a fixed optimal size for all credit unions. It depends on the market: A credit union in Los Angeles might need $5 billion in assets to compete effectively, while one in Nashville, Tennessee, might need $2 billion.
There are a lot of obstacles to building size and scale in the credit union industry, however. Large mergers in the space are relatively rare compared to banks — and they became even rarer during the coronavirus pandemic. Part of it is a lack of urgency around growth.
“For credit unions, since they don’t have shareholders, they aren’t looking to provide liquidity for shareholders or to get a good price,” says Christensen.
Prospective merger partners face a host of sensitive, difficult questions: Who will be in charge? Which board members will remain? What happens to the staff? What are the goals of the combined organization? What kind of change-in-control agreements are there for executives who lose their jobs?
These social issues can make deals fall apart. Perhaps the sheer difficulty of navigating credit union mergers is one contributor to the nascent trend of credit unions buying banks. A full $6.2 billion of the $27.7 billion in merged credit union assets in the last five years came from banks, Christensen says.
Institutions such as Lakeland, Florida-based MIDFLORIDA Credit Union are buying banks. In 2019, MIDFLORIDA purchased Ocala, Florida-based Community Bank & Trust of Florida, with $743 million in assets, and the Florida assets of $675 million First American Bank. The Fort Dodge, Iowa-based bank was later acquired by GreenState Credit Union in early 2020.
The $5 billion asset MIDFLORIDA was interested in an acquisition to gain more branches, as well as Community Bank & Trust’s treasury management department, which provides financial services to commercial customers.
MIDFLORIDA President Steve Moseley says it’s probably easier to buy a healthy bank than a healthy credit union. “The old saying is, ‘Everything is for sale [for the right price],’” he says. “Credit unions are not for sale.”
Still, despite the difficulties of completing mergers, the most-significant trend shaping the credit union landscape is that the nation’s numerous small institutions are going away. About 3% of credit unions disappear every year, mostly as a result of a merger, says Christensen. He projects that the current level of 5,271 credit unions with an average asset size of $335.6 million will drop to 3,903 credit unions by 2030 — with an average asset size of $1.1 billion.
CEO Advisory Credit Union Industry Consolidation Forecast
The pandemic’s economic uncertainty dropped deal-making activity down to 65 in the first half of 2020, compared to 72 during the same period in 2019 and 90 in the first half of 2018, according to S&P Global Market Intelligence. Still, Christensen and Duffy expect that figure to pick up as credit unions become more comfortable figuring out potential partners’ credit risks.
In the last five years, the fastest growing credit unions that have more than $500 million in assets have been acquirers. Based on deposits, Vibe Credit Union in Novi, Michigan, ranked the fastest growing acquirer above $500 million in assets between 2015 and 2020, according to the analysis by CEO Advisory Group. The $1 billion institution merged with Oakland County Credit Union in 2019.
Gurnee, Illinois-based Consumers Cooperative Credit Union ranked second. The $2.6 billion Consumers has done four mergers in that time, including the 2019 marriage to Andigo Credit Union in Schaumberg, Illinois. Still, much of its growth has been organic.
Canyon State Credit Union in Phoenix, which subsequently changed its name to Copper State Credit Union, and Community First Credit Union in Santa Rosa, California, were the third and fourth fastest growing acquirers in the last five years. Copper State, which has $520 million in assets, recorded a deposit growth rate of 225%. Community First , with $622 million in assets, notched 206%. The average deposit growth rate for all credit unions above $500 million in assets was 57.9%.
CEO Advisory Group Top 50 Fastest Growing Credit Unions
“A number of organizations look to build membership to build scale, so they can continue to invest,” says Rick Childs, a partner in the public accounting and consulting firm Crowe LLP.
Idaho Central is trying to do that mostly organically, becoming the sixth-fastest growing credit union above $500 million in assets. Instead of losing business during a pandemic, loans are growing — particularly mortgages and refinances — as well as auto loans.
“It’s almost counterintuitive,” says Mark Willden, the chief information officer. “Are we apprehensive? Of course we are.”
He points out that unemployment remained relatively low in Idaho, at 6.1% in September, compared to 7.9% nationally. The credit union also participated in the Small Business Administration’s Paycheck Protection Program, lending out about $200 million, which helped grow loans.
Idaho Central is also investing in technology to improve customer service. It launched a new digital account opening platform in January 2020, which allows for automated approvals and offers a way for new members to fund their accounts right away. The credit union also purchased the platform from Temenos and customized the software using an in-house team of developers, software architects and user experience designers. It purchased Salesforce.com customer relationship management software, which gives employees a full view of each member they are serving, reducing wait times and providing better service.
But like Idaho Central, many of the fastest growing institutions aren’t growing through mergers, but organically. And boy, are they growing.
Latino Community Credit Union in Durham, North Carolina, grew assets 178% over the last five years by catering to Spanish-language and immigrant communities. It funds much of that growth with grants and subordinated debt, says Christensen.
Currently, only designated low-income credit unions such as the $536.5 million asset Latino Community can raise secondary capital, such as subordinated debt. But the National Credit Union Administration finalized a rule that goes into effect January 1, 2022, permiting non-low income credit unions to issue subordinated debt to comply with another set of rules. NCUA’s impending risk-based capital requirement would require credit unions to hold total capital equal to 10% of their risk-weighted assets, according to Richard Garabedian, an attorney at Hunton Andrews Kurth. He expects that the proposed rule likely will go into effect in 2021.
Unlike banks, credit unions can’t issue stock to investors. Many institutions use earnings to fuel their growth, and the two measures are closely linked. Easing the restrictions will give them a way to raise secondary capital.
A separate analysis by Piper Sandler’s Duffy of the top 263 credit unions based on share growth, membership growth and return on average assets found that the average top performer grew members by 54% in the last six years, while all other credit unions had an average growth rate of less than 1%.
Many of the fastest growing credit unions also happen to be among the top 25 highest earners, according to a list compiled by Piper Sandler. Among them: Burton, Michigan-based ELGA Credit Union, MIDFLORIDA Credit Union, Vibe and Idaho Central. All of them had a return on average assets of more than 1.5%. That’s no accident.
Top 25 High Performing Credit Unions
Credit unions above $1 billion in assets have a median return on average assets of 0.94%, compared to 0.49% for those below $1 billion in assets. Of the top 25 credit unions with the highest return on average assets in 2019, only a handful were below $1 billion in assets, according to Duffy.
Duffy frequently talks about the divide between credit unions that have forward momentum on growth and earnings and those who do not. Those who do not are “not going to be able, and have not been able, to keep up.”
Leading with merchant services can help a bank acquire new customers, according to a recent Accenture study commissioned by Fiserv. On average, these accounts are more profitable: Compared to other business accounts, merchant account holders generate 2.6 times more revenue. In this video, Michael Rogers of Fiserv explains how these accounts help banks grow and offers considerations for how bank leaders can enrich this valuable product.
- Leading With Payments
- Building Relationships
- Strengthening Your Offering
To access Fiserv’s study, “From Revenue to Retention: Growing Your Deposits With Merchant Services,” click HERE.
Will deal volume pick up pace in 2021? Despite credit concerns and negotiation hurdles, Stinson LLP Partner Adam Maier predicts a stronger appetite for deals — but adds that potential acquirers will have to be aggressive in pursuing targets that align with their strategic goals.
- Predictions for 2021
- Capital Considerations
- Regulatory Hurdles to Growth
nCino, a cloud-based technology and lending platform for banks, navigated the challenges of going public while working remotely. The firm’s success story speaks to the critical importance of digital transformations to the survival of any company, especially as the pandemic has changed consumer mindsets about delivery and the way banks approach their business.
nCino CEO Pierre Naudé virtually sat down with Bank Director CEO Al Dominick to share the lessons he took from the IPO experience and maintains the company culture now that it’s public. Banks can also hear about how nCino strengthened its board, and managed communications in the remote environment.
Community banks should measure their goals and objectives against four tests in order to craft sustainable approaches and outcomes.
Community banks set goals: growth targets for loans or deposits, an earnings target for the security portfolio, an return on equity target for the year. But aggressive loan growth may not be a prudent idea if loan-to-asset levels are already high entering a credit downturn. Earnings targets can be dangerous if they are pursued at any cost, regardless of risk. However, in the right context, each of these can lead to good outcomes.
The first test of any useful goal is answering whether it’s a good idea.
One personal example is that about a year ago I set a new goal to lose 100 pounds. I consulted with my doctor and we agreed that it was a good idea. So then we moved to the second test of a useful goal: Is it sustainable?
As “Atomic Habits: An Easy & Proven Way to Build Good Habits & Break Bad Ones” author James Clear puts it: “You do not rise to the level of your goals, you fall to the level of your process and systems.”
What good would my weight loss goal be if it wasn’t sustainable? If the approach I took did not change my habits and instead put me through a shock program, there would be little reason to doubt that the approaches and habits that led me to create this goal would bring me back there again. The only way to pursue my goal in a sustainable fashion would changing my habits — my personal processes and systems.
Banks often pursue goals in unstainable ways as well.
Consider a bank that set a goal in June 2018 of earning $3 million annually from its $100 million securities portfolio with no more than 5 years’ duration (sometimes called a “yield bogey”). Given a choice between a 5-year bullet agency at 2.86% and a 5-year, non-call 2-year agency at 3.10%, only the latter meets or beats the goal. A 3.10% yield earns $310,000 for this portfolio.
In June 2020, the callable bond got called and was replaced by a similar length bond yielding only 40 basis points, or $40,000, for the remaining three years. The sustainable plan would have earned us $286,000 for the past two years — but also $286,000 for the next three. To make earnings sustainable, banks always need to consider multiple scenarios, a longer timeframe and potentially relaxing their rigid “bogey” that may cost them future performance.
The third test of a useful goal is specifying action.
The late New York Governor Mario Cuomo once said, “There are only two rules for being successful: One, figure out what exactly you want to do, and two, do it.”
In my case, I didn’t do anything unsustainable. In fact, I did not do anything at all to work toward my long-term goal. When I checked my weight six months later, it should not have surprised me to see I had lost zero pounds. A goal that you do not change your habits for is not an authentic goal; it is at best a wish.
My wish had gotten exactly what you would expect: nothing. Upon realizing this, I took two material steps. It was not a matter of degree, but of specific, detailed plans. I changed my diet, joined a gym and spent $100 to fix my bicycle.
The fourth test of a useful goal is if it is based on positive changes to habits.
Banks must often do something similar to transform their objectives from wishes to authentic goals. Habits — or as we call them organizationally, processes and systems — must be elevated. A process of setting an earnings or yield bogey for the bond portfolio relied on the hope that other considerations, such as call protection and rate changes, wouldn’t come into play.
An elevated process would plan for earnings needs in multiple scenarios over a reasonable time period. Like repairing my bike, it may have required “spending” a little bit in current yield to actually reach a worthy outcome, no matter which scenario actually played out.
If your management team does not intentionally pursue positive changes to processes and systems (habits), its goals may plod along as mere wishes. As for me, six months after making changes to my habits, I have lost 50 pounds with 50 more to go. Everything changed the day I finally took the action to turn a wish into a useful goal.
“I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question,” Bezos said in 2012. “I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two, because you can build a business strategy around the things that are stable in time.”
In few industries is this truer than banking.
Much of the conversation in banking in recent years has focused on the ever-evolving technological, regulatory and operational landscapes. The vast majority of deposit transactions at large banks nowadays are made over digital channels, we’re told, as are a growing share of loan originations. As a result, banks that don’t change could soon go the way of the dinosaurs.
This argument has merit. But it also needs to be kept in perspective. Technology is not an end in itself for banks, it’s a means to an end — the end being to help people better manage their financial lives. Doing this in a sustainable way calls for a marriage of technology with the timeless tenets of banking.
It’s with this in mind that Bank Director and nCino, a provider of cloud-based services to banks, collaborated on a new report, The Flywheel of Banking: Six Timeless Tenets of Extraordinary Banks.
The report is based on interviews of more than a dozen CEOs from top-performing financial institutions, including Brian Moynihan at Bank of America Corp., Rene Jones at M&T Bank Corp. and Greg Carmichael at Fifth Third Bancorp. It offers unique and invaluable insights on leadership, growth, risk management, culture, stakeholder prioritization and capital allocation.
The future of banking is hard to predict. There is no roadmap to reveal the way. But a mastery of these tenets will help banks charge ahead with confidence and, in Bezos’ words, build business strategies around things that are stable in time.
The Six Tenets of Extraordinary Banks
Jonathan Rowe of nCino describes the traits that set exceptional banks — and their leaders — apart from the industry.
To download the free report, simply click here now.