Evaluating BOLI in a High Rate Environment

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With the quick rise in interest rates over the past 18 months, a question many bankers ask is “When will my bank-owned life insurance (BOLI) yields increase?”

BOLI is a long-term investment for banks. Banks purchase BOLI as an asset intended to be bought and held on bank balance sheets, often for 30 years or longer, to optimize the tax and diversification advantages of life insurance. BOLI net yields are typically higher than yields on other taxable bank-eligible investments, especially when death benefits are recognized, according to the COLI Consulting Group’s BOLI Tracker in the first quarter. The account value of BOLI policies accumulates on a tax-deferred basis; the death benefit proceeds are generally income tax free.

Insurance carriers have long-term benefit obligations, including BOLI. To match the duration of their liabilities, they invest in long-term assets, typically resulting in intermediate-term portfolio durations. That means the increasing interest rates over the past 18 months have only recently begun to impact the average investment yields of carriers’ portfolios. If rates remain high, insurers’ portfolio returns will increase over time and crediting rates will increase on a lagging basis.

Banks should focus on the long-term structural characteristics of BOLI that allow it to outperform bank-eligible portfolios of similar credit quality over full market cycles. The ability of insurers to purchase assets unavailable to, and at a scale unachievable by, most banks is a key characteristic of BOLI. The long-term nature of BOLI provides an important hedge to reinvestment risk, which is especially important as many believe rates are nearing a high point in the cycle and reinvestment risk on shorter-term investments is material. Notably, investments in general or hybrid separate account BOLI incur no market value or accumulated other comprehensive income adjustment, or AOCI, unlike most alternate investments. That can be an attractive feature as higher interest rates have caused many banks to sustain significant reductions in equity capital due to AOCI adjustments to their bond portfolios.

Current BOLI Versus Higher-Rate New BOLI
While moving an insurance policy from one carrier to another can be accomplished with a tax-free exchange, provided all applicable state and federal regulations are complied with, policy owners should keep in mind:

  • BOLI is a long-term investment and banks should not be overly swayed by higher new money rates. Sometimes, new money rates will exceed portfolio rates; at other times, portfolio rates will exceed new money rates. Long term, they trend toward equalization.
  • The minimum interest rate guarantee for new BOLI products will likely be lower than the current BOLI policy’s minimum interest rate.
  • Exchange charges, including market value adjustments, could significantly reduce the potential pickup in yield from moving coverage.
  • To qualify as life insurance, the bank must have an insurable interest in each insured on a new policy’s issue date, and this requirement may not be as easy to meet with 1035 exchanged policies.
  • Banks should be encouraged to look at the total return of their BOLI, including expected future death benefits proceeds, rather than solely focusing on cash value growth.
  • Generally, a carrier won’t allow the bank to purchase additional BOLI in the future if the bank moves coverage, limiting the bank’s options for future purchases.

Exceptions where it may be appropriate to consider a 1035 exchange:

  • Credit concerns regarding the current carrier.
  • The carrier has exited the BOLI space and is not meeting customer expectations.
  • Rates have been higher for several years and the carrier has not increased its rates.

With recent increases in interest rates, it’s tempting to expect rapid increases in yields on existing BOLI portfolios. However, BOLI is a long-term investment; crediting rates move up and down gradually, consistent with the duration of carriers’ portfolios. This gradual movement was much appreciated when rates moved down to near 0%, as many BOLI carriers continued to credit interest close to 3%.

Now that rates have increased and the yield curve has inverted, the lag in BOLI crediting rate movement may cause BOLI yields to temporarily be less than yields on some other available investments. But when held to maturity, BOLI typically produces more earnings than other bank-eligible investments. If your bank is considering a 1035 exchange of existing policies, be sure to evaluate the alternatives thoroughly and beware of pressured pitches to chase higher rates.

Insurance services provided through NFP Executive Benefits, LLC. (NFP EB), a subsidiary of NFP Corp. (NFP). Doing business in California as NFP Executive Benefits & Insurance Agency, LLC. (License #OH86767). Securities offered through Kestra Investment Services, LLC, member FINRA/SIPC. Kestra Investment Services, LLC is not affiliated with NFP or NFP EB. Investor Disclosures: https://bit.ly/KF-Disclosures

Life insurance products issued by Massachusetts Mutual Life Insurance Company (MassMutual) and its subsidiaries, C.M. Life Insurance Company (C. M. Life) and MML Bay State Life Insurance Company (MML Bay State), Springfield, MA 01111-0001. C.M. Life and MML Bay State are non-admitted in New York.

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How Rising Rates Impact BOLI

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Banks and insurance companies, both heavy investors in interest-sensitive products, have struggled to adapt their business models to this rising and high interest rate environment. It’s impacting their deposits, loans and securities portfolio. How does it affect their bank-owned life insurance assets?

BOLI is an asset that accrues value over its life, from the purchase price to an eventual maturity amount paid at the death of the insured. The rate of accrual changes yearly due to two primary factors: interest earnings and insurance charges. The maturity value never changes unless it’s increased to meet federal statutes on the definition of life insurance.

While the BOLI asset accrues, the bank recognizes noninterest income on a tax-preference basis, with a final noninterest income amount attributed to the payment of maturity value at death. BOLI is always carried at book value, and rising interest earnings in BOLI can improve bank noninterest income. Additionally, increased interest earnings can improve the long-term internal rate of return of the BOLI if they cause an increase in the maturity value.

Determining BOLI Interest Earnings
Generally, insurance carriers follow one of two methodologies for valuing their investment portfolios supporting BOLI contracts:
Book yield is commonly followed for general account and hybrid separate account products. Its yield is a consistent measure of the aggregate investment portfolio yield of insurance carriers and translates well to the interest earnings for general and hybrid account products.

Total return is associated with the stable value accounting methodology for separate account products. It’s a measure of the performance of the investment accounts underlying separate account products. The bank is exposed to potential interest earnings and asset value volatility, both investment risks associated with the investment accounts.

Two Ways to Declare Interest Earnings
Insurance carriers follow one of two approaches for declaring the interest earnings for BOLI: portfolio method or new money method.

The portfolio method is most commonly applied for BOLI contracts; the carrier determines an aggregate portfolio book yield for declaring interest earnings for all policyowners, regardless of the date of purchase. Carriers will often say their portfolios turn over, on average, 10% per year. This is due to maturities, selling decisions and net positive cash flow for new investment purchases. As the reinvestments occur, the overall portfolio book yield is influenced by the direction of the change in book yields of the new purchases compared to the aggregate portfolio book yield. If the new purchase book yield is below the aggregate book yield, the aggregate will fall. If the new purchase book yield is above the aggregate, the aggregate will rise.

The new money method is an approach where the initial interest earnings of the BOLI purchase are based on the book yield of new investments. Each BOLI purchase can have its own series of interest earnings, as the new money is integrated into the aggregate portfolio over time.

The future interest earnings blends the new money integrated into the aggregate portfolio over a period of years, consistent with the investment portfolio turnover rate. With new money products, every purchase group has its own series of interest earnings rates due to the starting point and the blending rate.

If new money rates are below portfolio rates, the projected cash value performance of new money products isn’t likely to meet the levels of portfolio products for many years into the future. This results from the fact that most insurance companies invest similarly, which translates to similar aggregate investment returns on their portfolios and creates an upper threshold on ultimate interest earnings.

The benefit of rising interest rates is an improvement in the accrued noninterest income, and perhaps the ultimate maturity value, of the BOLI asset for banks.

Insurance Products: 1) are not a deposit or other obligation of or guaranteed by, any bank or bank affiliate; 2) are not insured by the FDIC or any other federal government agency, or by any bank or bank affiliate; and 3) may be subject to investment risk, including possible loss of value. All guarantees are subject to the claims-paying ability of the issuing insurance company. Insurance services provided through NFP Executive Benefits, LLC (NFP EB), a subsidiary of NFP Corp. (NFP). Doing business in California as NFP Executive Benefits & Insurance Agency, LLC. (License #OH86767). Securities may be offered through Kestra Investment Services, LLC, member FINRA/SIPC. Kestra Investment Services, LLC is not affiliated with NFP or NFP EB.

3 Strategies for Gathering Deposits in a New Era

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With interest rates at their highest point in 16 years, financial institutions must revisit their deposit gathering strategies.

The conventional tactics like using rate specials for certificates of deposits and high yield online savings accounts are more expensive and less effective than they once were. And in a world where every customer can instantly withdraw funds for a better offer via a phone app, it’s not enough to simply attract deposits. Financial institutions must be able to retain those deposits with something beyond the best rates. Here are three strategies for banks to attract and retain primary deposit accounts in this challenging operating environment.

1. Personalized Approach for Individual Customers
In the age of big data, a personalized approach is not just possible, it’s necessary. Financial institutions should utilize the wealth of information they have on their customers to tailor services and products to individual needs.

  • Understand customers. While this strategy is obvious, its successful execution has been elusive. Too often, these data points are scattered between disparate systems; banks are challenged in reconciling them effectively and in a manner where they can be deployed where and when they’re needed. Financial institutions should be demanding this type of reconciliation from their digital banking vendors, which sit at the intersection of many internal systems, various fintech partners and the bank customer’s primary interaction point with their accounts.
  • Offer tailored products. Use the insights gathered to offer personalized savings plans, customized investment advice or bespoke financial products that encourage customers to maintain and increase deposits. Again, the idea is not original, but the execution is tricky. Making tailored offers at scale should be considered table stakes in modern banking but requires investments in both technology and talent. Simply enabling account holders to view balances on their phone is not enough to build loyalty. Financial institutions should think about how they can replicate the old school relationship banking approach, where a customer feels understood and doesn’t have to navigate bureaucracy and poor technology to get to the products and services they need.

2. Sophisticated Treasury Tools for Businesses
Today’s businesses need more than a simple deposit account. They require comprehensive financial solutions that support their operations, manage risks and foster growth. A growing number of these businesses are using these sophisticated services — often from third parties. Integrating sophisticated treasury tools into business accounts can make these accounts stickier and more attractive for current and prospective customers.

  • Cash management tools. Advanced cash management tools can provide businesses with real-time visibility into their cash flow, enabling them to optimize liquidity. This includes tools for automated receivables, payables and sweep accounts to manage balances across multiple accounts, along with optimizing interest rate options.
  • Risk management tools. Effective risk management tools are essential in helping businesses navigate today’s myriad financial risks. This can include foreign exchange tools to manage currency exposure, interest rate derivatives to handle interest rate fluctuations and fraud detection tools to safeguard against malicious activities.
  • Digital payment solutions. Digital payment solutions can streamline transactions, making daily operations smoother and more efficient. From Automated Clearing House payments to wire transfers, mobile payments and integrated payables, these tools provide flexibility, speed and convenience in handling transactions.

3. Investment in Technology and Innovation
Adopting the above strategies requires banks to make a significant investment in technology and innovation. However, this is a crucial step to stay competitive in the evolving financial landscape.

  • Robust data infrastructure. Invest in a robust data infrastructure to support the implementation of a data-driven personalized approach. This includes advanced data analytics tools and machine learning algorithms that can extract valuable insights from customer data.
  • Advanced treasury tools. Develop and integrate these sophisticated tools into business accounts. This may require investing in fintech partnerships or in-house innovation and offering value-added services beyond traditional banking.
  • Digital platforms. Enhance the user experience, making it easy for individuals to manage their accounts and for businesses to use their treasury tools. This includes intuitive interfaces, real-time updates and seamless integration with other financial systems.

In this era of high interest rates and less sticky deposits, traditional strategies are losing their charm. In order to stay competitive, financial institutions must innovate and personalize their approach to gathering primary deposit accounts. Understanding and catering to the needs of individual customers and businesses will allow financial institutions to attract and retain more deposits and successfully navigate the challenges of this high-rate environment.

Curious About Cannabis

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As the smoke clears around banking the marijuana industry, more banks are exploring its potential to drive deposits and revenue, according to Bank Director’s 2023 Risk Survey. 

While few banks actively count marijuana businesses as customers, 43% of the bank executives and board members responding to Bank Director’s survey in January indicated their bank had discussed working with those businesses. That interest represents an uptick compared to the survey in 2021, when 34% said their bank’s leadership had discussed potential opportunities or risks. 

Though it is still illegal on a federal level, marijuana has been legalized for recreational and medical use in 22 states and Washington, D.C. and approved for medical use only in 16 states, according to an analysis by CNN. In Bank Director’s survey, 36% said their bank was headquartered in a state where marijuana was fully legal; another 35% said marijuana was approved for medicinal use only. 

Expanding legalization plays a hand in banks’ growing interest in providing financial services to this industry, as does its growth outlook. The cannabis data firm BDSA projects legal cannabis sales in the U.S. to grow at a compound annual growth rate of roughly 11%, increasing from $26.2 billion in 2022 to $44.6 billion in 2027. 

“You look at a typical community bank board, and you have lots of entrepreneurs and real estate developers,” says Tony Repanich, CEO of Shield Compliance, a compliance platform focused on helping financial institutions bank cannabis. “They are seeing what’s going on in the industry, and they’re asking management, ‘Should we be considering this?’” 

As the cannabis industry matures and regulatory expectations become more clear, best practices have evolved around working with those and other high-risk businesses. Banks will need to invest more in staffing, expertise and technology, and enhance existing policies and procedures, says Joseph Silvia, an attorney at Dickinson Wright.  

“A lot of the risk that banks are looking at is much less about cannabis and more about the fundamental compliance, BSA [Bank Secrecy Act] or risk management components,” Silvia says. “It’s less that cannabis is high risk and more that we need to have these systems, reporting, compliance staff expertise, and so forth. It doesn’t really matter whether it’s cannabis or money services businesses, money transmitters or virtual currency.” 

In 2014, the Financial Crimes Enforcement Network (FinCEN) issued guidance intended to clarify customer due diligence and reporting requirements for banks interested in serving marijuana-related businesses. But as more financial institutions have begun banking cannabis businesses and successfully passing regulatory examination cycles, that’s provided an added level of assurance that bankers who are meeting all of their reporting requirements are not going to get dinged simply for banking a high-risk business, says Paul Dunford, cofounder and vice president of knowledge at Green Check Verified, a technology provider focused on the cannabis sector.  

“In the world that we live in, cannabis banking is based on precedent,” Dunford says. “Every year you see more and more financial institutions willing to express an interest because it’s been happening for a while. We hear stories about people banking cannabis, and people are not getting their charters revoked. The horror stories are not coming true.” 

Broadly speaking, banks serving the cannabis industry tend to stick to offering deposit products to those customers. Far fewer have gotten comfortable actually lending to cannabis businesses, in large part because the industry lacks accepted underwriting standards and banks cannot collateralize a controlled substance, Dunford says. But those banks that do lend to cannabis businesses can usually command higher interest rates on the loans.  

“We see good fee income associated with these accounts,” Repanich says, noting that mortgage income has declined as interest rates have increased, and non-sufficient funds and overdraft fees are under pressure by regulators like the Consumer Financial Protection Bureau. “Some of our banks are providing loan facilities to the industry, and they’re usually getting a better than average yield.”

Directors and executives contemplating whether cannabis might complement their bank’s business model should weigh the risks and benefits, and clearly define the geographic area they’re willing to serve, Silvia says. They should also consider exactly what services their bank will and will not provide; some banks are not comfortable offering wire services, for example. It’s also important to get buy-in from the compliance staff who would be handling the day-to-day operations associated with those accounts.  

“It’s very difficult to dip your toe in one of these higher risk areas,” says Silvia. “You either jump in head first, or you stay out because the cost of putting together the risk management is not insubstantial.”  

Regardless of a Recession, Banking Technology Makes Sense

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No bank wants to be Southwest Airlines Co.

Investing in technology with recession clouds brewing might seem counterintuitive. But as Southwest’s crisis over the 2022 winter holidays showed, technology shortcomings can incur enormous costs in the short-term and in the future.

The company has estimated that its scheduling system meltdown will cost it as much as $825 million. Customers disparaged the airline and executives received a pay cut. Southwest had been investing in customer-facing technology. But the back-end limitations of its operations technology hampered the company’s ability to handle the most basic customer service for airlines: safely getting customers where they needed to be in the wake of a winter storm.

Community banks face downside risks from inflation, rising interest rates and continued geopolitical uncertainty. As a result, bank executives may be inclined to delay or cut spending on technology that can help their institutions grow or be more efficient. Southwest’s experience shows that would be a mistake. According to Forrester data, firms pursuing technology-driven innovation grow three to four times faster than industry averages. Institutions that undertake multi-year efforts to make digital technology a priority recognize digital acceleration is a way to:

  • Permanently reduce the cost of doing business.
  • Improve customer and employee experience.
  • Outperform competitors ahead of a looming downturn.

Bank executives facing pressure to downshift their digital efforts in the name of cost reduction should remember the following lessons from Southwest’s experience:

  1. Back-office failures directly affect customer experiences. Southwest prioritized technology spending on customer experience gains over back-end improvements, such as a digital way for flight crews to report their locations and availability. As a result, crews spent time manually calling in to report their locations, rather than helping solve customers’ problems. Delays or cuts in spending on technology that would make bank lending more efficient, for example, could mean longer loan turnaround times for customers.
  2. Systems fail at the worst time. Systems usually buckle under stress, rather than when it’s convenient — whether the system is a complex staffing solution or basic spreadsheets tracking loans in the pipeline. On the other hand, the Paycheck Protection Program demonstrated how institutions that had invested in technology earlier could capitalize on that opportunity faster than those that did not. If the economy downshifts, banks may be too busy putting out figurative fires to assess vendors and initiate technology that would help them manage lending and credit at scale during and after any recession.
  3. Viewing technology as a near-term cost, instead of a long-running investment that drives growth, ultimately hurts the organization. Forrester notes that Southwest apparently “budgeted for technology on an ‘allocative efficiency’ basis, focusing on optimally allocating costs to meet current demand. In doing so, it appears to have largely neglected ‘productive efficiency,’ or focusing on maximizing future outcomes given current cost constraints.”

What to Do Instead of Cutting
As bank boards and leaders consider their technology budget and expenditures, remembering Southwest’s lessons can help guide their investments. They should narrow their focus to vendors set up to meet their needs and provide the appropriate return on investment. For example, a bank looking to purchase software to process and analyze loans may encounter systems designed for larger banks. In their evaluations of lending software, they should consider:

  1. How long will implementation take? Smaller financial institutions often have small staffs, so implementing new technology quickly is critical.
  2. Does the loan system foster cross-functionality to support staff with more generalized roles who wear multiple hats?
  3. Does the bank need to make adjustments to the technology before using it, or can it use “out-of-the-box” standard templates and reports to get them up and running?
  4. Is the technology capable of processing the various loan types offered by the community financial institution?
  5. Can the lender maintain control of the relationship throughout the process? For example, many community banks want the flexibility to either have a lender start a loan request in the branch, or let the customer enter key information and documentation at their convenience.
  6. Does the software provide straightforward summaries of individual deals and portfolio-wide summaries for greater collective visibility into the pipeline?
  7. Will the community financial institution have to switch vendors if it grows substantially, or can the software partner handle the transition?

Community financial institutions are vital to the communities they serve and need to be able to respond quickly to meet borrowing and other demands of their customers. Continuing or pursuing technology investments regardless of the economy will help the community and the bank thrive.

Deposit Costs Creep Up Following Rate Increases

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Safeguarding Credit Portfolios in Today’s Uncertain Economic Landscape

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Rising interest rates are impacting borrowers across the nation. The Federal Open Market Committee decided to raise the federal funds rate by 75 basis points in its June, July and September meetings, the largest increases in three decades. Additional increases are expected to come later this year in an attempt to slow demand.

These market conditions present significant potential challenges for community institutions and their commercial borrowers. To weather themselves against the looming storm, community bankers should take proactive steps to safeguard their portfolios and support their borrowers before issues arise.

During uncertain market conditions, it’s even more critical for banks to keep a close pulse on borrower relationships. Begin monitoring loans that may be at risk; this includes loans in construction, upcoming renewals, loans without annual caps on rate increases and past due loans. Initiating more frequent check-ins to evaluate each borrower’s unique situation and anticipated trajectory can go a long way.

Increased monitoring and borrower communication can be strenuous on lenders who are already stretched thin; strategically using technology can help ease this burden. Consider leveraging relationship aggregation tools that can provide more transparency into borrower relationships, or workflow tools that can send automatic reminders of which borrower to check in with and when. Banks can also use automated systems to conduct annual reviews of customers whose loans are at risk. Technology can support lenders by organizing borrower information and making it more accessible. This allows lenders to be more proactive and better support borrowers who are struggling.

Technology is also a valuable tool once loans is classified as special assets. Many banks still use manual, paper-based processes to accomplish time consuming tasks like running queries, filling out spreadsheets and writing monthly narratives.

While necessary for managing special assets, these processes can be cumbersome, inefficient and prone to error even during the best of times — let alone during a potential downturn, a period with little room for error. Banks can use technology to implement workflows that leverage reliable data and automate processes based directly on metrics, policies and configurations to help make downgraded loan management more efficient and accurate.

Fluctuating economic conditions can impact a borrower’s ability to maintain solid credit quality. Every institution has their own criteria for determining what classifies a loan as a special asset, like risk ratings, dollar amounts, days past due and accrual versus nonaccrual. Executives should make time to carefully consider evaluating their current criteria and determine if these rules should be modified to catch red flags sooner. Early action can make a world of difference.

Community banks have long been known for their dependability; in today’s uncertain economic landscape, customers will look to them for support more than ever. Through strategically leveraging technology to make processes more accurate and prioritizing the management of special assets, banks can keep a closer pulse on borrowers’ loans and remain resilient during tough times. While bankers can’t stop a recession, they can better insulate themselves and their customers against one.

3 Ways to Help Businesses Manage Market Uncertainty

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Amid mounting regulatory scrutiny, heightened competition and rising interest rates, senior bank executives are increasingly looking to replace income from Paycheck Protection Program loans, overdrafts and ATM fees, and mortgage originations with other sources of revenue. The right capital markets solutions can enable banks of all sizes to better serve their business customers in times of financial uncertainty, while growing noninterest income.

Economic and geopolitical conditions have created significant market volatility. According to Nasdaq Market Link, since the beginning of the year through June 30, the Federal Reserve lifted rates 150 basis points, and the 10-year Treasury yielded between 1.63% and 3.49%. Wholesale gasoline prices traded between $2.26 and $4.28 per gallon during the same time span. Corn prices rose by as much as 39% from the start of the year, and aluminum prices increased 31% from January 1 but finished down 9% by the end of June. Meanwhile, as of June 30, the U.S. dollar index has strengthened 11% against major currencies from the start of the year.

Instead of worrying about interest rate changes, commodity-based input price adjustments or the changing value of the U.S. dollar, your customers want to focus on their core business competencies. By mitigating these risks with capital market solutions, banks can balance their business customers’ needs for certainty with their own desire to grow noninterest income. Here are three examples:

Interest Rate Hedging
With expectations for future rate hikes, many commercial borrowers prefer fixed rate financing for interest rate certainty. Yet many banks prefer floating rate payments that benefit from rising rates. Both can achieve the institution’s goals. A bank can provide a floating rate loan to its borrower, coupled with an interest rate hedge to mitigate risk. The bank can offset the hedge with a swap dealer and potentially book noninterest income.

Commodity Price Hedging
Many commercial customers — including manufacturers, distributors and retailers — have exposure to various price risks related to energy, agriculture or metals. These companies may work with a commodities futures broker to hedge these risks but could be subject to minimum contract sizes and inflexible contract maturity dates. Today, there are swap dealers willing to provide customized, over-the-counter commodity hedges to banks that they can pass down to their customers. The business mitigates its specific commodity price risk, while the bank generates noninterest income on the offsetting transaction.

International Payments and Foreign Exchange Hedging
Since 76% of companies that conduct business overseas have fewer than 20 employees, according to the U.S. Census Bureau, there is a good chance your business customers engage in international trade. While some choose to hedge the risk of adverse foreign exchange movements, all have international payment needs. Banks can better serve these companies by offering access to competitive exchange rates along with foreign exchange hedging tools. In turn, banks can potentially book noninterest income by leveraging a swap dealer for offsetting trades.

Successful banks meet the needs of their customers in any market environment. During periods of significant market volatility, businesses often prefer interest rate, commodity price or foreign exchange rate certainty. Banks of all sizes can offer these capital markets solutions to their clients, offset risks with swap dealers and potentially generate additional income.

How High Inflation, High Rates Will Impact Banking

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In the latest episode of The Slant Podcast, former Comptroller of the Currency Gene Ludwig believes the combination of high inflation and rising interest rates present unique risks to the banking industry. Ludwig expects that higher interest rates will lead to more expensive borrowing for many businesses while also increasing their operating costs. This could ultimately result in “real credit risk problems that we haven’t seen for some time.”

While the banking industry is well capitalized and asset quality levels are still high, Ludwig says the combination of high inflation and rising interest rates will be a challenge for younger bankers who have never experienced an environment like this before.

Ludwig knows a lot about banking, but his journey after leaving the Comptroller of the Currency’s office has been an interesting one. After completing his five-year term as comptroller in 1998, Ludwig could have returned to his old law firm of Covington & Burling LLP and resumed his legal practice. Looking back on it, he says he was motivated by two things. One was to put “food on the table” for his family because he left the comptroller’s office “with negative net worth – [and] it was negative by a lot.”

His other motivation was to find ways of fixing people’s problems from a broader perspective than the law sometimes allows. “I love the practice of law,’’ he says. “It’s intellectually satisfying.” But from his perspective, the law is just one way to solve a problem. Ludwig says he was looking for a way to “solve problems more broadly and bring in lawyers when they’re needed.” This led to a prolonged burst of entrepreneurial activity in which Ludwig established several firms in the financial services space. His best known venture is probably the Promontory Financial Group, a regulatory consulting firm that he eventually sold to IBM.

Ludwig’s most recent initiative is the Ludwig Institute for Shared Economic Prosperity, which he started in 2019. Ludwig believes the American dream has vanished for many median- and low-income families, and the institute has developed a new metric which makes a more accurate assessment of how inflation is hurting those families than traditional measurements such as the Consumer Price Index — which he says drastically understates the impact.

Ludwig hopes the Institute’s work gives policymakers in Washington, D.C., a clearer sense of how desperate the situation is for millions of American families and leads to positive action.

This episode, and all past episodes of The Slant Podcast, are available on Bank Director, Spotify and Apple Music.

Student Loans Come Due

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

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

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

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

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

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

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

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

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

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

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

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