How Nonbank Lenders’ Small Business Encroachment Threatens Community Banks

A new trend has emerged as small businesses across the U.S. seek capital to ensure their survival through the Covid-19 pandemic: a significantly more crowded and competitive market for small business lending. 

Community banks are best-equipped to meet the capital needs of small businesses due to existing relationships and the ability to offer lower interest rates. However, many banks lack the ability to deliver that capital efficiently, meaning:

  • Application approval rates are low; 
  • Customer satisfaction suffers;  
  • Both the bank and small business waste time and resources; 
  • Small businesses seek capital elsewhere — often at higher rates. 

When community banks do approve small credit requests, they almost always lose money due to the high cost of underwriting and servicing them. But the real risk to community banks is that large players like Amazon.com and Goldman Sachs Group are threatening to edge them out of the market for small business lending. At stake is nothing less than their entire small business relationships.

Over the past few years, nonbank fintechs have infiltrated both consumer and business banking, bringing convenience and digital delivery to the forefront. Owners of small businesses can easily apply for capital online and manage their finances digitally.

Yet in 2018, only 11% of small banks had a digital origination channel for small business lending. In an age of smartphones, community banks still heavily rely on manual, paper-based processes for originating, underwriting and servicing small business loans. 

It was no surprise, then, when Amazon and Goldman Sachs announced a lending partnership geared toward third-party merchants using the retail giant’s platform. Soon, invited businesses can apply for a revolving line of credit with a fixed APR. Other major companies like Apple and Alphabet’s Google have also debuted innovative fintech products for consumers —it’s only a matter of time before they make headway into the small business space.

A 2016 Well Fargo survey found that small business owners are willing to pay more for products and services that make their lives easier. It makes sense that an independent retailer that already sells on Amazon would be more inclined to work with a lender that integrates directly into the platform. If your small business lending program isn’t fully online, customers will take the path of least resistance and work with institutions that make the process easier and more seamless.

Serving small business borrowers better
The issue isn’t that small businesses lack creditworthiness as prospective customers. Rather, it’s that the process is stacked against them. Small businesses aren’t large corporations, but many banks apply the same process and requirements for small credit requests as they do for commercial loans, including collecting and reviewing sophisticated financials. This eliminates any chance of profit on small credit requests. The problem is with the bank’s process — not its borrowers.

The solution is clear cut:

  • Digitize the lending process so customers don’t have to take time out of their busy day to visit a branch or speak with a loan officer. Note that this includes more than just an online application. The ability to collect/manage documents, present loans offers, provide e-contracts and manage payments are all part of a digitally-enabled lending process.
  • Incorporate SMB-specific credit criteria that accurately assess creditworthiness more effectively, like real-time cash flow and consumer sentiment.
  • Take advantage of automation without giving up control or increasing risk. For example, client notifications, scoring and application workflow management are all easy ways to save time and cut costs.
  • Free up lending officers to spend more time with your most-profitable commercial customers.

These changes can help turn small business customers into an important, profitable part of your bank. After all, 99% of all U.S. businesses are considered “small” — so the ability to turn a profit on small business lending represents significant upside for your bank. 

With better technology and data, along with a more flexible process, community banks can sufficiently reduce the cost of extending capital to small businesses and turn a profit on every loan funded. Next, banks can market their small business loan products to existing business customers in the form of pre-approved loan offers, and even gain new business customers from competitors that push small business borrowers away. 

Think about it: small business customers already have a deposit relationship at your bank. Community banks have this advantage over the likes of Amazon, Goldman Sachs, Apple and others. But when time is limited, small businesses won’t see it that way. By rethinking your small business lending process, it’s a win for your bank’s bottom line as well as a win in customer loyalty.

Is Your Bank Ready for Loan Review 2.0?

Lending institutions face unique challenges in 2020.

Leading up to 2020, regulators and industry professionals voiced growing concerns related to the easing of underwriting, prolonged increasing of commercial real estate values, risk tolerance complacency, and how much longer the good times could continue — which the ongoing public health crisis answered.

Covid-19 propelled businesses and borrowers into a liquidity crisis like most have never experienced. Economists already have identified the start of a recession, but many lending institutions find themselves determining if — or when — the liquidity crisis has transitioned to a credit crisis

The third and fourth quarters of 2020 will be most telling. Never has a bank’s loan review function been more important.

On May 8, interagency guidance was released on credit risk review systems. The guidance was well-timed given the pandemic but wasn’t impulsive, as the regulatory agencies began their review process in October 2019. The guidance focused on two key pieces of the puzzle needed for effective credit risk systems: a solid credit administration function and independent credit review.

The guidance highlighted the importance of a loan review policy and how it should incorporate the following areas:

  • Qualifications of credit risk review personnel.
  • Independence of credit risk review personnel.
  • Frequency of reviews.
  • Scope of reviews.
  • Depth of reviews.
  • Review of findings.
  • Communication and distribution of results.

These policy areas are highlighted to help drive a successful function that provides the right level of independent challenge to the organization on issue identification, risk rating accuracy/timeliness, policy adherence, policy depth, trends, and management effectiveness. Independently reporting these observations to the board and all stakeholders provides an in-depth independent assessment to help verify the strength of internal controls and the timeliness of grading. It also provides assurance that management’s reporting and allowance levels are reasonable.

Fast forward one month to June 2020, and loan review was top of mind for these same regulatory agencies, which released “Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Financial Institutions” (FDIC PR-72-2020). This guidance looked to address the unique challenges to consider when conducting safety and soundness assessments in these unprecedented times.

The guidance memorialized how examiners will consider the unique, evolving, and potentially long-term nature of the issues confronting institutions and exercise appropriate flexibility in their supervisory response. It speaks specifically to credit risk review (loan review) by stating the following:

Credit risk review. Examiners will recognize that the rapidly changing environment and limited operational capacity might temporarily affect an institution’s ability to meet normal expectations of loan review (such as a schedule or scope of reviews). Examiners will assess the institution’s support for any delays or reductions in scope of credit risk reviews and consider management’s plan to complete appropriate reviews within a reasonable amount of time.

Classification of credits. The assessment of each loan should be based on the fundamental characteristics affecting the collectability of that particular credit, while acknowledging that supporting documentation might be limited and cash flow projections might be highly uncertain.

Loan portfolios are a lending institution’s lifeblood. Portfolios drive earnings but also can be the largest threat to an institution’s ongoing viability. In this rapidly moving environment, it is key to have a loan review function that is up to the challenge.

Operating an effective loan review function
Large- and medium-sized financial institutions often opt to maintain an in-house loan review department. While this decision makes sense for some institutions, establishing and maintaining an effective and credible internal loan review operation can present significant challenges.

Credit department responsibilities have grown increasingly complex in recent years, not only due to regulatory demands but also because of a rapidly changing credit environment and new types of credit products. With these heightened expectations, loan review functions are being pressured by regulators and external auditors to raise the bar. Is it time to step back and assess whether your loan review function has adjusted to the changing environment and the products you offer?

Answer these questions to help take a step back and determine if your institution has a robust loan review function that not only meets the demands of the regulatory guidance but is built to meet the demands of the future as well.

Helping Customers When They Need It Most

Orvin Kimbrough intimately understands the struggles shared by low-to-moderate income consumers. Raised in low-income communities and the foster care system, he also worked at the United Way of Greater St. Louis for over a decade before joining $2.1 billion Midwest BankCentre as CEO in January 2019. “[Poverty costs] more for working people,” he says. “It’s not just the financial cost; it’s the psychological cost of signing over … the one family asset you have to the pawn shop.”

His experiences led him to challenge his team to develop a payday loan alternative that wouldn’t trap people in a never-ending debt cycle. The interest rate ranges from 18.99% to 24.99%, based on the term, amount borrowed (from $100 to $1,000) and the applicant’s credit score. Rates for a payday loan, by comparison, range in the triple digits.

The application process isn’t overly high-tech, as applicants can apply online or over the phone. The St. Louis-based bank examines the customer’s credit score and income in making the loan decision; those with a credit score below 620 must enroll in a financial education class provided by the bank.

Industry research consistently finds that many Americans don’t have money saved for an emergency — a health crisis or home repair, for example. When these small personal crises occur, cash-strapped consumers have limited options. Few banks offer small-dollar loans, dissuaded by profitability and regulatory constraints following the 2008-09 financial crisis.

If the current recession deepens, more consumers could be looking for payday loan alternatives. Regulators recently encouraged financial institutions to offer these products, issuing interagency small-dollar lending principles in May that emphasize consumers’ ability to repay. 

Everybody needs to belong to a financial institution if you’re going to be financially healthy and achieve your financial aspirations,” says Ben Morales, CEO of QCash Financial, a lending platform that helps financial institutions automate the underwriting process for small-dollar loans.

QCash connects to a bank’s core systems to automate the lending process, using data-driven models to efficiently deliver small-dollar loans. The whole process takes “six clicks and 60 seconds, and nobody has to touch it,” Morales says. QCash uses the bank’s customer data to predict ability to repay and incorporates numerous factors — including cash-flow data — into the predictive models it developed with data scientists. It doesn’t pull credit reports.

Credit bureau data doesn’t provide a full picture of the customer, says Kelly Thompson Cochran, deputy director of FinRegLab and a former regulator with the Consumer Financial Protection Bureau. Roughly a fifth of U.S. consumers lack credit history data, she says, which focuses on certain types of credit and expenses. The data is also a lagging indicator since it’s focused on the customer’s financial history.

In contrast, cash flow data can provide tremendous value to the underwriting process. “A transaction account is giving you both a sense of inflows and outflows, and the full spectrum of the kind of recurring expenses that a consumer has,” says Cochran.

U.S. Bancorp blends cash flow data with the applicant’s credit score to underwrite its “Simple Loan” — the only small-dollar loan offered by a major U.S. bank. The entire process occurs through the bank’s online or mobile channels, and takes just seven minutes, according to Mike Shepard, U.S. Bank’s senior vice president, consumer lending product and risk strategy. Applicants need to have a checking account with the bank for at least three months, with recurring deposits, so the bank can establish a relationship and understand the customer’s spending behavior.

“We know that our customers, at any point in time, could be facing short-term, cash-flow liquidity challenges,” says Shepard. U.S. Bank wanted to create a product that was simple to understand, with a clear pricing structure and guidelines. Customers can borrow in $100 increments, from $100 to $1,000, and pay a $6 fee for every $100 borrowed. U.S. Bank lowered the fee in March to better assist customers impacted by the pandemic; prior to that the fee ranged from $12 to $15.

Since the loan is a digital product, it’s convenient for the customer and efficient for the bank.

Ultimately, the Simple Loan places U.S. Bank at the center of its customers’ financial lives, says Shepard. By offering a responsible, transparent solution, customers “have a greater perception of U.S. Bank as a result of the fact that we were able to help them out in that time of need.”

Avoiding Pitfalls of Covid-19 Modifications for Swapped Loans

Many banks are modifying commercial loans as they and their commercial borrowers grapple with the economic fallout of the Covid-19 pandemic.

Payment relief could include incorporating interest-only periods, principal and interest payment deferrals, and/or loan and swap maturity/amortization extensions. While modifications can provide borrowers with much-needed financial flexibility, they also risk creating unintended accounting, legal and economic consequences.

Don’t forget the swaps
Lenders need to determine whether there is a swap associated with loans when contemplating a modification. Prior to modification, lenders should coordinate efforts with their Treasury or swap desk to address these swapped loans, and ensure that loan and swap documentation are consistent regarding the terms of the modification.

Develop realistic repayment plans
Lenders need to consider how deferred obligations will be repaid when creating a temporary payment deferral plan. The lender may need to offer an interest-only period so a borrower can repay the deferred interest before principal amortization resumes, or deferred interest payments could be added to the principal balance of the loan. Lenders also should consider whether the proposed modification will be sufficient, given the severity of the borrower’s challenges. The costs associated with amending a swapped loan may convince a lender to offer a more substantive longer-term deferral, rather than repeatedly kicking the can down the road with a series of short-term fixes.

Determine whether swap amendment is necessary
The modified loan terms may necessitate an amendment of the associated swap. It may be possible to leave the swap in place without amendment if you are only adding an interest-only period, as long as the borrower is comfortable with their loan being slightly underhedged. But if you are contemplating a full payment deferral, it typically will be desirable to replace the existing swap transaction with a new forward-starting transaction commencing when the borrower is expected to resume making principal and interest payments.

Understand bank or borrower hedge accounting impact of loan modifications
Lenders often hedge the value of their fixed-rate loans or other assets through formalized hedging programs. A popular strategy has been to designate these swaps as fair value hedges using the shortcut method.

This method requires that the economic terms of the asset, such as amortization of principal and timing of interest payments, precisely match those of the hedge. A mismatch due to a loan payment deferral would cause the lender to lose the hedge’s shortcut status. The lender’s hedging program potentially could maintain hedge accounting treatment using the more cumbersome long-haul method if that mismatch scenario was contemplated in the hedge inception documentation.

Borrowers who have taken variable rate loans may have entered into swaps to gain synthetic rate protection. Restructuring  a hedge to defer payments alongside the loan’s deferred payments could jeopardize an accounting-sensitive borrower’s hedge accounting treatment. It is possible for the borrower to reapply hedge accounting under the amended terms, although the restart has additional considerations compared to a new un-amended hedge. If hedge accounting is not restarted, the derivative’s valuation changes thereafter would create earnings volatility per accounting rules. While borrowers should be responsible for their own accounting, lenders’ awareness of these potential issues will only help client relationships in these uncertain times.

Take stock of counterparty derivative exposure
As interest rates plunge to record lows, many lenders have seen their counterparty exposure climb well above initially-approved limits. Hedge modifications may further exacerbate this situation by increasing or extending counterparty credit exposure. We recommend that lenders work with their credit teams to reassess their counterparty exposure and update limits.

Accounting guidance also requires the evaluation of credit valuation adjustments to customer swap portfolios. Lenders should ensure that their assumptions about the creditworthiness of their counterparties reflect current market conditions. These adjustments could also have a material impact on swap valuations.

Hope for the best, plan for the worst
Hopefully, loan modifications will give borrowers the opportunity to regain their financial footing. However, some may face continued financial challenges after the crisis. Lenders should use the modification process to prepare for potential defaults. Loan deferments or modifications should provide for the retention of the lender’s rights to declare a default under the loan documents and any swap agreements. The lender, through consultation with its credit team, may want to take this opportunity to bolster its position through the inclusion of additional guarantors or other credit enhancements.

The economic fallout from the global pandemic continues to have a profound impact upon borrowers and lenders alike. Adopting a thoughtful approach to loan modifications, especially when the financing structure includes a swap or other hedge, may make the process a little less disruptive for all.  

Loan Growth: Curation, Credit Monitoring

SavvyMoney.pngOne community bank is using a fintech to deepen lending relationships with customers and help them monitor and improve their credit score.

Watford City, North Dakota-based First International Bank and Trust wanted to offer customers a way to proactively monitor their credit and receive monthly or incident-related alerts about any changes — without needing to use external vendors, granting external access to accounts or even paying for it. It chose to partner with SavvyMoney, which provides customers with their credit scores and reports alongside pre-qualified loan offers from within the bank’s online and mobile apps.

The fruits of the relationship were one reason the fintech was awarded the Best Solution for Loan Growth at Bank Director’s 2020 Best of FinXTech Award in May. CommonBond, a student loan refinancer, and Blend, which offers banks an online, white-label mortgage processing solution, were also finalists in the category.

In exploring how it could help customers improve their credit score and manage their finances, First International knew some customers were already using similar services through external websites. But the $3.6 billion bank wanted to convey that it had invested time and IT resources to ensure SavvyMoney’s validity, accuracy and status as a trusted partner, says Melissa Frohlich, digital banking manager. The SavvyMoney feature takes about 45 seconds to activate once a customer is logged in, and the customer experience is the same in the mobile app or website.

“From the fraud standpoint, we definitely recommend to our customers that … they use SavvyMoney because it’s free to them,” Frohlich says. “Especially with all the breaches that happen, it’s a good way for them to self-monitor their credit.”

The bank also uses the platform to share specialized credit offers along with a customers’ loan information and credit score, which it crafts using public records and extends based on internal criteria. It has launched two credit card balance transfer offers since rolling out the product two years ago. The fintech offers First International a way to “slice and dice” data to truly target customers with customized offers, as opposed to “throwing out a fishing line and hoping someone bites,” she says.

Launching the offers takes “very little” time to implement and consists of updating a term sheet, whipping up bank graphics and sending out a simple email blast. The first offer netted more than $190,000 in balance transfers — all from one email campaign.

“It was just very, very little work for us with pretty significant impact, without a ton of manpower or money that we had to put into it,” Frohlich says.

The balance transfer offer included messaging about how much customers would save with the new interest rate. If First International wanted to offer auto loan refinancing, it could input different rates based on the year of the vehicle and loan term.

First International was drawn to SavvyMoney in part because it had an existing relationship with a variety of core providers. That’s key, given that SavvyMoney connects to a bank’s core to pull in personal customer information from online and mobile banking sources. And because it would be sharing customer data, First International spent several months conducting due diligence, combing through SavvyMoney’s system and organization controlsreports and speaking with both its core and the fintech.

Frohlich says the actual implementation took about a month and was as straightforward as flipping a switch to activate the capability in customer accounts. She continues to work with her representative at SavvyMoney to add or change loan offers.

“They have probably the best integration that I’ve seen with Fiserv from a third party or a fintech, out of any other product that Fiserv doesn’t own,” she says. “The actual implementation was the best that I’ve ever taken part in.”

SavvyMoney can also integrate with the bank’s new loan platform that was slated for a March launch, a fact that Frohlich didn’t know when the bank selected either. Loan applications submitted through SavvyMoney will feed into the software’ auto decision-making.

“That will be a game changer for us, then we will heavily start doing more promotions,” she says.

Even after the bank switched cores, it has been able to keep SavvyMoney given its vendor relationships with other cores. “There have been other solutions, that now that we’re moving to a different platform, that I could consider,” Frohlich says. “But to be honest, our experience has been so great with SavvyMoney that I have no reason to look elsewhere.”

How Peoples Bancorp Prevailed Through PPP

“You only learn who has been swimming naked when the tide goes out,” wrote Warren Buffett in his 2004 annual letter.

He was referring to operations that trade derivatives. You don’t really know the value of what you hold in opaque markets, he explained, until it’s tested in hard times.

The same can be said about banking.

Rarely has the industry faced an environment as acute as today.

The scope and speed of this downturn are without modern precedent,” said Federal Reserve Chairman Jerome Powell earlier this week. It’s “significantly worse than any recession since World War II.”

It’s hardly an exaggeration to say that bankers bear much of the burden of saving the economy from oblivion. “If doctors and nurses are first responders to those who are sick,” says Robyn Stevens, chief credit officer at Peoples Bancorp, “bankers are the first responders for businesses, communities and economies.”

Stevens would know.

Within its three-state footprint spanning Ohio, West Virginia and Kentucky, Peoples was the top-performing bank in the first round of the Paycheck Protection Program measured by dollars of PPP loans approved per assets.

“A culture is tested when times get tough,” says Ryan Kirkham, general counsel at the $4.5 billion bank based in Marietta, Ohio. “You find out whether it is real or just lip service. We passed the test.”

The success of Peoples in the first round of PPP reveals a flaw in one of the principal narratives that has emerged from the unfolding crisis — that banks with the most advanced technology were the ones best positioned to manage the onslaught of loan applications.

It’s not that Peoples Bank hasn’t invested in technology in recent years, because it has. But the secret to its success in the first round of PPP was simple elbow grease.

Personnel from the top of the bank to the bottom volunteered to enter data into the Small Business Administration portal to process customer loan applications.

“Banks had to decide whether they were going to do it automated or whether they were going to do it manually,” says CEO Chuck Sulerzyski. “Peoples tried an automated approach but then opted for manual.”

“Many of our most senior executives have done data entry until 8, 9, 10, 11, 12 at night,” he adds. “We did over 100 of these loans on Easter Sunday. And when they shut banks over $1 billion out from 6 p.m. to midnight one evening, we had a couple dozen people volunteer to work midnight to 4 a.m. putting in the entries.”

This success reflects a culmination of a decade’s worth of effort, spearheaded by Sulerzyski, who joined the bank from KeyCorp in 2011.

The 62-year-old CEO spent the previous four decades working up the corporate ladder at multiple prominent banks. He worked at Citibank during the Walter Wriston era. He was at Chemical Bank when Walter Shipley was CEO. And he spent eight years at Bank One, working closely with President Don McWhorter and CEO John B. McCoy.

Sulerzyski has been there and done that, in other words. One lesson he’s learned along the way has been the importance of culture and customer relationships. It’s a lesson that has paid off in spades over the past three months.

“From a competitive standpoint, a lot of the large banks struggled with PPP,” Sulerzyski says. “One of the large regionals couldn’t do any loans the first few days. Another one started, but then had to shut down. Each of the bigger banks we compete against had their own degree of difficulties with this. Because our customers were well taken care of, CPAs and attorneys started referring business to us and it kind of snowballed on itself.”

Sulerzyski’s team speaks in single voice on this.

Our commitment to our communities and the importance that plays resonates with our employees,” says Thomas Frawley, senior vice president, consumer lending. “They start the call as a banker and end the call as a counselor, listening to the fears of our customers while assuring them that we are going to do our best to help them.”

“We have several associates who are working day and night,” says Ann Helmick, director of enterprise risk management. “They are doing this for the good of the client. For most, there will not be a personal gain.”

“It is easy to come up with a mission, vision and values. And when times are good, it can be easy to live by those values,” says Jason Phipps, regional president. “It is when a company or person faces adversity that you find out who a person or who an organization really is.”

One can argue all day long about the importance of scale and technology, and how it could soon be a principle competitive differentiator in banking. But technology is only a tool to help bankers ply their trade. The soul of any organization, and the true source of performance, lies instead in the people who run it.

“Bankers may have got a bad rap during the last crisis,” says Stevens, “but ours have been heroes during this one!”

Beyond PPP: Supporting Small Business Through the Covid Crisis

In the first wave of the Small Business Administration’s Paycheck Protection Program, West Des Moines, Iowa-based Bank Iowa Corp. closed around 400 loans totaling $72 million, according to CEO Jim Plagge. When we spoke — just a few days before the SBA re-opened the portal for another $320 billion of PPP loans — the $1.4 billion bank was prepared to submit another 75 or so applications.

The bank’s branch teams — which are split to encourage social distancing and minimize the impact if someone were to get sick — have also taken to ordering takeout every day to support local restaurants that have been particularly hard hit. “[We’re] just trying to support them,” he says.

This desire to support the 23 communities it serves inspired Bank Iowa’s “Helping Hand” program, which is accepting nominations to assist local organizations, small businesses and nonprofits. The bank’s goal is to serve at least one need in each of its seven regions. “We’re only as strong as the communities we serve,” says Plagge. “So, we’re just trying to help where we possibly can.”

Banks play a vital role in supporting their communities, one we’re seeing played out across the country as bankers put in extra hours to help customers, especially small businesses that keep towns alive. Bank Iowa, like many financial institutions, recognizes that supporting small businesses can’t be limited to the SBA program — PPP loans have proved difficult to obtain, and they don’t make sense for some companies that still need help.

Bank Iowa reached out immediately to borrowers to understand the impact of the coronavirus crisis for each one, says Plagge. The bank has deferred loan payments, restructured debt and set up working capital lines. Bankers have also been a shoulder to cry on.

“[We’re] trying to be there to help our clients talk through the difficulties they’re facing,” says Plagge. “Hopefully we can offer some advice and encourage them along the way.”

Relationships matter. “We typically see that business banking account managers get good scores for being courteous, knowledgeable and responsive,” says Paul McAdam, a senior director, regional banking in the financial services practice at J.D. Power. Small business owners will be even more sensitive to their banker’s response in today’s desperate environment, asking: “‘Do I feel like I’m connecting with them? Do they understand my needs and what I’m going through right now?’”

In addition to building long-term relationships, supporting small businesses now could help banks reduce later damage to their loan portfolios. But unfortunately, tough decisions will be required in the coming months. Plagge says Bank Iowa has started stress testing various sectors. With agriculture comprising a significant portion of the loan portfolio, they’re examining the impact of a reduction in revenue for ag producers.

“Our goal will be to try to work with every borrower and see them through this,” Plagge says. “But we also know that may not be possible in every case.”

David K. Smith, a senior originations consultant at FICO, advises banks to segment their portfolio, so lenders understand which businesses they can help, and which pose too great a risk. Does the business have a future in a post-Covid economy? “You can only help so many without sinking your portfolio,” he says.

But banks should also look for ways to keep relationships alive. “As small businesses go out of business, there’s an entrepreneur there … that person who lost this company is going to be on the market creating another company soon,” says Smith.

After the crisis, this could lead to a wave of start-up businesses — which banks have typically hesitated to support. “They’re going to have to rethink policy, because [of] the sheer number of these that are going to pop up,” says Smith. Some businesses won’t fail due to poor leadership; they simply couldn’t do business in an abnormal environment, given shelter-in-place and similar orders issued by local governments. “Bankers will have to appreciate that to a certain degree and figure out a solution, because it will help bring the economy back faster,” he says.

When Rates are Zero, Derivatives Make Every Basis Point Count

It’s been one quarter after another of surprises from the Federal Reserve Board.

After shocking many forecasters in 2019 by making three quarter-point cuts to its benchmark interest rate target, the data-dependent Fed was widely thought to be on hold entering 2020. But the quick onset of the coronavirus pandemic hitting the United States in March 2020 quickly rendered banks’ forecasts for stable rates useless. The Fed has acted aggressively to provide liquidity, sending its benchmark back to the zero-bound range, where rates last languished from 2008 to 2015.

During those seven years of zero percent interest rates, banks learned two important lessons:

  1. The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
  2. Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.

The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about  funding/liquidity and realize meaningful savings in the process.

To illustrate: A bank looking to access the wholesale funding market might typically start with fixed-rate advances from their Federal Home Loan Bank. These instruments are essentially a bundled product consisting of liquidity and interest rate protection benefits; the cost of each component is rolled into the quoted advance rate. By choosing to access short-term funding instead, a bank can then execute an interest rate swap or cap to hedge the re-pricing risk that occurs each time the funding rolls over. Separating funding from rate protection enables the bank to save the liquidity premium built into the fixed-rate advance.

Some potential benefits of utilizing derivatives in the funding process include:

  • Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
  • In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
  • Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
  • In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
  • Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.

Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs. 

While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help a board and management team separate facts from fears and make the best decision for their institution.

With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.

Banking on the Fly at Atlantic Union

When the rapidly spreading COVID-19 virus forced CEO John Asbury to send most of Atlantic Union Bankshare Corp.’s 2,000 employees to work from home, it gave him the chills.

After all, the Richmond, Virginia-based bank is hardly a digital-only enterprise. It has a branch-centric strategy that emphasizes face-to-face customer service. And like most traditional companies, it has lots of people working in big offices.

To Asbury’s immense relief, everyone has quickly adapted to the demands of running a $17.6 billion institution with a distributed workforce. “A month ago, it was quite candidly terrifying, the notion of moving the company to a virtual status,” he says. “But I have to tell you, at this point we’re actually pretty comfortable with it.”

Ninety percent of Atlantic Union’s employees are now working from home, including Asbury and the bank’s senior management team.

As it turned out, working remotely was not the only challenge that Asbury and the bank’s employees would find themselves facing in the early days of the pandemic. Soon thereafter, a second challenge came in the form of an opportunity that hardly anyone was ready for — not just at Atlantic Union but throughout the banking industry.

The Small Business Administration’s Payroll Protection Program, included in a $2.2 trillion stimulus bill passed in late March, was designed to funnel $349 billion in loans to hard hit small businesses that have been forced to close as part of a broad nationwide lockdown intended to curb the virus’ spread. But almost no one was prepared to take loan applications on the program’s April 3 start date, least of all the SBA.

Many banks, including some of the country’s largest, were slow to engage because of their uncertainty about various details in the hastily rolled out program. Asbury, however, decided that Atlantic Union owed it to its small business customers in Virginia, North Carolina and Maryland to quickly embrace the program and help them get funded.

“I think we all feel the weight of our responsibility,” Asbury says. “I never thought we would be an economic first responder. I never thought we would be at the scene of the crash, and here we are. You cannot say to your customers, ‘Sorry, it’s just too much work,’ or ‘Sorry, we just can’t go fast enough,’ or say, ‘Well, we’re going to do this for a privileged few, because the others aren’t worth it.’”

And yet for all of Asbury’s determination to respond quickly, there were many problems that had to be solved along the way. For starters, the bank did not have the right technology to handle the large volume of loan applications that it expected to receive. It had recently licensed an automated workflow solution to build an online account opening system, but the bank’s new head of digital technology concluded that it wasn’t the right solution for account opening. Asbury says she quickly negotiated a credit with the vendor and chose a different technology instead.

“The team literally, in a matter of days, was able to repurpose the solution and stand up an online application web portal and an automated workflow system, which is essentially a virtual assembly line,” Asbury says. Many of the bank’s employees worked 12 hour days and weekends to have the system up and running by April 3. “To be able to build this automated assembly line … recognizing that everyone working on it is sitting in their homes, is unbelievable,” he adds.

Another challenge was the SBA’s failure to provide lenders with a standard note agreement, one reason why some large banks were slow to engage in program. If a bank doesn’t use the SBA’s standard agreement, the agency won’t guarantee the loans. Asbury decided the bank couldn’t afford to wait for the SBA to resolve that issue, so he took a risk. “We used our best educated guess to create our own note, in the spirit of the agreement, and we began to fund,” he says. The agency later said it was okay for banks to use their own note agreements.

Once Atlantic Union began submitting loan applications, the SBA’s “E-Tran” electronic loan processing system kept crashing under the torrent of submissions it was receiving from lenders throughout the industry. The bank had 30 people who manually keyed in data, and is implementing automated technology to import the application data and upload it into the E-Tran system, which will greatly shorten the application process. “We think we can get the cycle time down to one minute for one loan, and that’s really important,” Asbury says.

The bank had 400 employees working full time on the program, including Asbury’s own administrative assistant who was approving loans. Through April 15, 5,717 Atlantic Union customers had been approved for loans totaling $1.42 billion. The program is now out of funds, although the bank has decided to continue accepting application in the hope that Congress will provide additional funding.

The pandemic proved to Atlantic Union that it is both resilient and innovative, traits that will benefit it long after the COVID-19 crisis has passed. “It’s going to cause us to be more courageous,” Asbury says. “I don’t mean we’re going to be hasty [or] impulsive, but I think that we’re going to be able to make big decisions more confidently, and frankly quicker as we’ve proven we can do it.”

LIBOR Changes On the Horizon for Syndicated Loans on Bank Books

LIBOR-9-2-19.pngAlthough the shift from LIBOR to a new reference rate is several years away, banks should start preparing today.

Syndicated loans make up only 1.7% of the nearly $200 trillion debt market that is tied to the London Interbank Offered Rate (LIBOR), a figure that includes derivatives, loan, securities and mortgages. But many banks hold syndicated loans on their balance sheets, and will be directly affected by efforts to replace LIBOR with a new reference rate.

In 2014, federal bank regulators convened the Alternative Rates Reference Committee (ARRC) in response to the manipulation of LIBOR by banks during the financial crisis. In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice to replace LIBOR in USD derivative and other financial contracts.

Shifting from LIBOR to SOFR requires various moving pieces to converge as well as addressing legacy issues for existing contracts tied to LIBOR. The ARRC was reconstituted in 2018 with an expanded membership that includes regulators, trade associations, exchanges and other intermediaries, and buy side and sell side market participants. The group now oversees the implementation of the Paced Transition Plan and coordinates with cash and derivatives markets as they address the risk that LIBOR may not exist beyond 2021. This includes minimizing the potential disruption associated with LIBOR’s potential phase-out and supporting a voluntary transition away from LIBOR.

In April 2019, the ARRC released proposed fallback language that firms could incorporate into syndicated loan credit agreements during initial origination, or by way of amendment before the cessation of LIBOR occurs.

Contracts need recommended fallback language to provide consistency across products and institutions. The definition of LIBOR, the trigger events that would require use of the fallbacks and the fallbacks themselves vary significantly — even within the same product sets. Additionally, existing contractual fallback language was originally intended to address a temporary unavailability of LIBOR, like a glitch affecting the designated screen page or a temporary market disruption, not its permanent discontinuation. Until recently, fallback language rarely addressed the possibility of the permanent discontinuance of LIBOR. As a result, legacy fallback language could result in unintended economic consequences or potential litigation.

The ARRC recommends contracts have two sets of fallback language for new originations of U.S. dollar-denominated syndicated loans that reference LIBOR. Syndicated loan fallback provisions try to balance several goals of the ARRC: flexibility and clarity.

  1. Hardwired Approach:” This approach uses clear and observable triggers and successor rates with spread adjustments that are subject to some flexibility to fall back to an amendment if the designated successor rates and adjustments are not available at the time a trigger event becomes effective.
  2. Amendment Approach:” This approach is meant to offer standard language, which provides specificity with respect to the fallback trigger events and explicitly includes an adjustment to be applied to the successor rate, if necessary, to make the successor rate more comparable to LIBOR. It also includes an objection right for “Required Lenders.” In the Amendment Approach language, all decisions about the successor rate and adjustment will be made in the future.

As the market continues to prepare for LIBOR’s eventual exit, there are several steps that BancAlliance recommends that banks take to prepare for this transition:

  1. Quantify, document and monitor exposure to loans in your portfolio with LIBOR-based pricing.
  2. Ensure that executives are familiar with the current LIBOR fallback language in the individual credit agreements within the portfolio.
  3. Be mindful should any amendments occur to your existing portfolio, as SOFR’s acceptance grows in the marketplace.
  4. Continue observing new originations to see how fallback language is being drafted, and any other structural changes with regards to LIBOR.
  5. Review ARRC pronouncements and market-related current events to ensure your institution is up to speed on the latest news and changes with respect to LIBOR.