Will Regulators’ Actions Stem Deposit Runs, Banking Crisis?

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Bank regulators rolled out several tools from their tool kit to try to stem a financial crisis this week, but problems remain. 

The joint announcements followed the Friday closure of Silicon Valley Bank and the surprise Sunday evening closure of Signature Bank. 

Santa Clara, California-based Silicon Valley Bank had $209 billion in assets and $175 billion in deposits at the end of 2022 and went into FDIC receivership on March 10; New York-based Signature Bank had $110 billion in assets and $88.6 billion in deposits at the end of 2022 and went into receivership on March 12. Both banks failed without an acquiring institution and the FDIC has set up bridge banks to facilitate their wind downs.

Bank regulators determined both closures qualified for “systemic risk exemptions” that allowed the Federal Deposit Insurance Corp. to cover all the deposits for the failed banks. Currently, deposit insurance covers up to $250,000; both banks focused mainly on businesses, which carry sizable account balances. About 94% of Silicon Valley’s deposits were uninsured, and 90% of Signature’s deposits were over that threshold, according to a March 14 article from S&P Global Market Intelligence.

The systemic risk exemption means regulators can act without Congressional approval in limited situations to provide insurance to the entire account balance, says Ed Mills, managing director of Washington policy at the investment bank Raymond James. 

The bank regulators also announced a special funding facility, which would help banks ensure they have access to adequate liquidity to meet the demands of their depositors. The facility, called the Bank Term Funding Program or BTFP, will offer wholesale funding loans with a duration of up to one year to eligible depository institutions that can pledge U.S. Treasuries, agency debt and mortgage-backed securities and other qualifying assets as collateral. The combined measures attempt to stymie further deposit runs and solve for the issue that felled Silicon Valley and Signature: a liquidity crunch. 

In a normal operating environment, banks would sell bonds from their available-for-sale securities portfolio to keep up with liquidity demands, whether that’s deposit outflows or additional lending opportunities. Rising rates over the last five quarters means that aggregate unrealized losses in securities portfolios grew to $620 billion at the end of 2022 — losses many banks want to avoid recording. In the case of Silicon Valley, depositors began to pull their money after the bank announced on March 8 it would restructure its $21 billion available-for-sale securities portfolio, booking a $1.8 billion loss and requiring a $2 billion capital raise. 

“The BTFP will be an additional source of liquidity [borrowed] against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress,” the Federal Reserve said in its release on the facility. Importantly, the pledged collateral, such as U.S. Treasurys, will be valued at par. That is the “most beneficial portion” of the program and eliminates the discount many of these securities carry given their lower yields, Mills says. 

The hope is that banks pledge their underwater bonds to increase their liquidity should deposits begin to leave their institution. One concern, then, is that banks hesitate to use it as a sign of weakness, Mills says. But he says, “conversations about impacts to earnings and impacts to reputation are secondary to solvency.”

Former Comptroller of the Currency Gene Ludwig tells Bank Director that he appreciates the steps the regulators took, and of President Joe Biden’s messaging that accompanied Sunday’s actions. 

“I realized that for the regulators, because of the speed and the need to react quickly and over a weekend, there was a lot of wood to chop,” he says. “ It takes time, but I think they reacted with vigor.”

Although he wasn’t at the FDIC, Ludwig’s career touches on the importance of deposit coverage. In addition to serving as comptroller in the 1990s, he founded and later sold IntraFi, a reciprocal deposit network. He encourages banks to at least establish lines to the BTFP, since the application and transfers can take time.

It remains to be seen whether regulator actions will be enough to assuage depositors and the broader public. Banks have reportedly borrowed $11.9 billion from the new facility and another $152.8 billion from the discount window, according to a Bloomberg article published the afternoon of March 16. However, the facilities don’t fully address the problem that most banks are carrying substantial unrealized losses in their bond books — which may only continue to grow if the Federal Open Market Committee continues increasing rates.

“This announcement was about stemming the immediate systemic concerns, but it absolutely did not solve all of the banks’ woes,” Mills says.

It’s also possible that those tailored actions may be insufficient for certain institutions that resemble Silicon Valley Bank or Signature Bank. Clifford Stanford, an Atlanta-based partner of law firm Alston & Bird and a former assistant general counsel at the Federal Reserve Bank of Atlanta, remembers how bank failures and weakness would come in waves of activity during the Great Recession and afterward. 

“There’s a lot of unknowns about who’s got what holes in their balance sheet and who’s sitting on what problems,” he says. “Every board of every bank should be asking their management right now: Do we have this problem? If we do have a risk, how are we hedging it? What sort of options do we have to backstop liquidity? What’s our plan?”

A Tax Savvy Solution for Addressing Liquidity Needs

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Supernova Technology’s Loan Operations Manager, Austin Mead, recently shared trends, and insights that he has seen during tax time, as well as tips on how banks can support their clients as they navigate what solutions are available to them for paying their tax bill.

There is a growing trend of clients expecting more from their financial advisor. The share of investors looking to simplify their financial relationships by having banking and wealth management under one roof has risen from 13% in 2018 to 22% in 2021, according to consultancy McKinsey & Co. It’s increasingly important that banks take a holistic approach and have a wide range of solutions. Clients are looking for more than investment advice; they are looking for proactive tax planning, estate planning and debt planning, to name a few.

A Trending Solution for Taxes
Mead recalls the record number of service requests and new lines or draws that Supernova saw the last couple of years during tax time, particularly last year. “We saw about 50% of all draw requests being used for tax payments from April 1 to April 18.” Since 2020, each tax season has gotten busier and busier for his team. “New lines and balances were growing daily due to the reactive demand for a securities-based line of credit or SBLOC, which was mostly driven by capital gain tax obligations.”

Mead says he’s concerned about the down market but was still optimistic since Supernova data is still showing a steady increase for the first several weeks of the year — though not quite as high as last year.

Typically, in a down market, many advisers encourage their clients to hold on to their investments and ride it out verses selling them off, staying true to investing for the long-term strategy. Regardless of what strategy a client may have, if a client has liquidity needs, securities-based lending has been a trending solution banks can recommend at tax time. When talking about the measures Supernova’s partners put in place to ensure their clients avoid elevated risk, Mead says lending partners have proactive credit policies in place to hedge against their clients falling into a collateral call. Advisers are also in close communication with their clients through the adviser and client portals.

“Advisers can have educated conversations with their clients about where their portfolio stands versus the outstanding loan balance. Having insight to advance rates on certain securities plays a huge role in those conversations around rebalancing, paying down the loan, and even raising cash,” he says.

Mead says the top three most common reasons clients open or use a line during tax season is general liquidity, followed by strategic ways to avoid capital gains from the market and capital gains from real estate sales over the past few years. After the beginning of the year, there is a steady increase for line openings and/or usage through Tax Day, but he says the most active time period was April, leading up to Tax Day.

As Mead says, since the beginning of the year, there has been a steady, weekly increase in line opening and usage. It’s important banks start having conversations early with clients to ensure they are prepared for Tax Day and have access to liquidity when they need it.

Commit to Process and Framework in the New Year

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The challenging last three years have done nothing but reinforce our belief that the best-performing community banks, over the long run, anchor their balance sheet management in a set of principles — not in divining the future.

They organize their principles into a coherent decision-making methodology that evaluates all capital allocation alternatives across multiple scenarios, over time, on a level playing field. Unfortunately, however, far too many community bankers rely on forecasts of interest rates and economic conditions, which are then engraved into budgets, compensation programs and guidance provided to stock analysts and asset-liability providers.

If we’ve learned anything recently, it’s that nobody can predict rates — not even the members of the Federal Open Market Committee. A year ago, its median forecast for fed funds today was approximately 0.80%; the reality of 4.50% is 370 basis points above this “prediction.”

Even slight differences between predicted and actual rates can result in significant variances from a bank’s budget, which can pressure management towards reactive strategies based on near-term accounting income, liquidity or capital. We’ve long argued that this approach will usually accumulate less reward, and more risk, than proponents ever expect.

Community banking is challenging, but it needn’t be bewildering. The following decision-making principles can clarify your path and energize your execution:

Know where you are.
Net interest income and economic value simulations in isolation present incomplete and often conflicting portrayals of a bank’s risk and reward profile. To know where your bank is, hold yourself accountable to all cash flows across multiple rate scenarios over time, incorporating both dividends paid to a horizon and the economic value of the bank at that horizon. This framework produces a multi-scenario view of returns to shareholders , across a range of possible futures. Making capital allocation decisions in the context of this profile is everything; developing and consulting it is far more inspiring and leverageable than a mere asset-liability exercise.

Refuse to speculate on rates.
Plenty of wealth has been lost looking through the wrong end of the kaleidoscope. Nobody can predict rates with any utility — not economists, not even the FOMC. Make each marginal capital allocation in the context of your shareholder return profile, avoiding unacceptable risk in any scenario while seeking asymmetric reward in others. The idea is to stack the deck in the bank’s favor, not to guess the next card.

For example, imagine your institution is poised to create more shareholder wealth in rates down scenarios than up, a common reality in the current environment. Should you consider trading some of this for outsized benefits in the opposite direction, or not? Assess potential approaches across multiple scenarios: compare short assets versus long liabilities, test combinations or turn the dial through simple derivative strategies to asymmetrically adjust returns or create functional liquidity.

Price options appropriately.
Banks sell options continually, but seldom consider their compensation. They often price loans to win the business, rather than in comparison to wholesale alternatives, and they often forgo enforceable prepayment penalties. Less forgivably, many banks sell options too cheaply in their securities portfolios, in obtaining wholesale funding or in setting servicing rates. Know who owns each option the bank is short, and determine whether it is priced appropriately by comparing it to possible alternatives and measuring the impact on the bank’s forward-looking return profile.

Evaluate risk and regulatory positions.
To make capital allocation decisions prospectively, principle-based decision-makers assess their risk and regulatory positions prospectively as well. The bank’s enterprise risk management platform should offer an objective assessment of its current capital, asset quality, liquidity and sensitivity to market risk positions, and simulate these on a prospective basis also. The only way to determine if a strategy aligns with management’s specific risk tolerance is to have clarity and confidence in its pro forma impact on risk and regulatory positions. For many, establishing secured borrowing lines and reviewing contingency funding plans in 2023 will be prudent steps.

These principles are timeless — only the conclusions they lead to will vary over time. Those institutions that have already woven them into their organizational fabric are facing 2023 and beyond with confidence; those adopting them now for the first time can soon experience the same.

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.

Why Some Savers Don’t Pay Down Debt

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In an era of rising interest rates, it would make good financial sense for consumers to pay off costly credit card debt before stashing money in a low-interest savings account. But a new paper from the Federal Reserve Bank of Boston finds many consumers acting irrationally. These so-called “borrower-savers,” as Fed economists term them, carry revolving credit card debt while simultaneously holding liquid assets in their bank accounts. Understanding their motivations for doing so could help bankers identify new opportunities to connect with their customers. 

Based on 2019 survey data, Boston Fed economists identify 42% of respondents as borrower-savers, meaning they carry $100 or more in revolving credit card debt while also holding at least $100 in liquid assets, defined as cash, money in checking and savings accounts, or prepaid cards. 

Just 40% of these consumers have liquid assets that exceed their credit card debt. The average borrower-saver carries around $5,400 in liquid assets and nearly $6,400 in revolving credit card debt, according to the researchers. On the whole, borrower-savers are financially worse off than savers, who pay down revolving credit card debt every month. 

“On the surface it would seem like there is a paradox here. You get paid a fraction of a percent on your deposits in the bank … That’s nothing compared to the interest rate that credit cards charge,” says Joanna Stavins, a senior economist and policy advisor with the Boston Fed. “If you have money in the bank, why not pay down that credit card debt?” 

But scratch the surface, and that behavior actually starts to make a lot more sense: Researchers also find that over 80% of consumers’ monthly bills need to be paid out of a bank account and can’t be charged to a credit card. 

Still, that imbalance between savings and paying down pricier debt is one of those quirks of human behavior that has myriad implications for banks. For those banks not in the credit card business, it could mean an opportunity to sell their customers on cheaper consolidation loans. It could also represent an opportunity to build goodwill with customers by offering assistance with managing bills or automating savings. 

Ron Shevlin, managing director and chief research officer with Cornerstone Advisors, notes that younger generations could be likelier to use technology to get a handle on their finances. “I think that resonates especially with a lot of younger consumers who have had it drilled into them that they have to be better at managing their finances,” Shevlin says. “You get somebody who’s 25; those habits have not been ingrained yet. And so the technology, the tools, and I think more importantly, the philosophies and approaches to managing their finances have not been solidified yet.”  

For most banks, offering the right solutions will have them working with their digital banking provider or another third party. Fintechs such as Plinquit work with community banks to help their customers set savings goals and earn rewards for achieving them, according to Bank Director’s FinXTech Connect platform. 

The Boston Fed’s paper doesn’t delve into the effect of higher incomes on saving and borrowing behaviors. Or in other words, the researchers could not say that higher income enables consumers to start saving more and avoid carrying a credit card balance in the first place. Yet, savers tend to have higher incomes, averaging about $98,000 per year compared to less than $76,000 for borrower-savers. On average, savers hold about five times more liquid assets compared to borrower-savers, as well as higher credit limits and lower mortgages due to more equity in their homes. And just a third of borrower-savers could cover a $2,000 emergency expense using liquid assets, compared to two-thirds of savers.

The proportion of borrower-savers fell from 42% to 35% in 2020, note the Boston Fed researchers, likely due to pandemic-related federal assistance programs as well as increased saving by people who kept their jobs but cut back on spending. 

With the employment picture still relatively strong, borrower-savers are generally in decent shape at the moment. But Stavins notes that many of the borrower-savers studied in the paper also have other kinds of debt; she worries how the picture could change if economic conditions further deteriorate. 

The imbalance between savings and spending could worsen. “What I’m worried about,” she says, “is that people are going to start relying on credit card debt more as the economy gets potentially worse.”  

Liquidity Observations for Banks as 2022 Closes

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Investors must recognize that banks should generate and expand their revenues through the credit cycle, which covers and includes whatever problems and losses that may occur.

The increase in spread revenue and expansion of net interest margin was a significant theme from earnings reported after June 30, and will be for the rest of 2022. Yes, some deposit outflow has started; it seems natural for liquidity to decline from record levels reached throughout the earliest wave of the coronavirus pandemic. Recall: deposits increased more than 40% at all banks regulated by the Federal Deposit Insurance Corp. between December 2019 to March 2022.

At Janney, we’re focused on measuring how banks can tap funding sources beyond traditional deposit gathering. One important measure of a bank’s ability to borrow are “pledged” securities, which are pledged as collateral to another entity, such as the Federal Reserve or Federal Home Loan Banks. These securities are well below pre-pandemic levels, and slightly above their totals in the first quarter of 2022. By region, banks in the Mid-Atlantic have the highest percentage of securities already pledged; as a group, banks over $50 billion in assets had the lowest percentage of pledged securities. We also performed a distribution analysis that showed most banks have between 0% and 50% of securities pledged.

Banks of all asset sizes rely on the Federal Home Loan Bank system for contingent liquidity via credit lines and borrowings called “advances,” which effectively serve as wholesale funding and are an alternative to brokered deposits. To borrow from the FHLB, banks must post collateral in the form of certain types of securities, such as Treasurys, agency-backed securities and certain private label and municipal securities, or loans, generally first-lien mortgages, home equity lines of credit, certain commercial real estate loans and some farm loans. The banks are then subjected to internal risk-ratings that determine an ultimate borrowing capacity amount. The risk-ratings and limits differ among the 11 individual FHLBs, but we know from FHLB guidance that most banks are subjected to a 25% maximum borrowing limit.

Our analysis used FDIC call report data to pull all the individual security and loan categories eligible as collateral. We then applied the FHLBs’ haircuts to the collateral values in these various categories to determine total potential collateral. Finally, we subtracted already pledged securities and existing FHLB borrowings, which banks disclose in their call reports, to the typical maximum 25% borrowing limit to determine the remaining availability.

The bottom line? Median net FHLB borrowing capacity has incrementally declined in the second quarter of 2022 by a miniscule 0.2%, and still stands at a strong 23% — only 2 percentage points below the 25% maximum and 2 percentage points above pre-pandemic levels of 20.9% in the fourth quarter of 2019. Regionally, banks in West tended to have the highest capacity, while their neighbors in the Southwest had the lowest; by asset size, banks below $1 billion in assets tended to have the most capacity and the largest banks had the lowest remaining capacity, primarily due to existing borrowings. Finally, another distribution analysis shows most banks currently have full capacity at 25%.

We combined the two concepts of pledged securities and estimated FHLB borrowing capacity to reinforce that numerous banks still enjoy high borrowing capacity, with low levels of pledged securities. We are confident that financial institutions nationwide have superb “dry powder” to fund near-term growth opportunities for new loans and franchise expansion.

We also observed that brokered funding is quite low. The average use of brokered CDs to total deposits has dropped over the past decade, to currently about 4% to 5% of total deposits. This is another available tool for banks today to fund balance sheet growth, as interest rates and underlying spread revenues are much improved. Investors should keep in mind that brokered deposits are less expensive than FHLB funding currently. In fact, about 67% of banks reported no brokered funds at the end of June. If deposits decline as banks deploy excess liquidity, brokered deposits could be a key incremental tool to generating higher revenues that allow financial institutions to “earn through the credit cycle” — a critical concept all investors should be able to grasp. Fortunately for banks, plenty of liquidity capacity exists. The critical question is, “How will banks access and deploy their available liquidity?”

Banks Inherited a Wholesale Balance Sheet During the Pandemic. Here’s What to Do.

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Bank managements and directors must recognize how cash has changed significantly over the past seven quarters, from the fourth quarter of 2019 to the third quarter of 2021. The median cash-to-earning assets for all publicly traded banks has grown to 10% in recent quarters, up from 4% pre-pandemic. This is a direct impact of the Covid-19 pandemic on deposit flows from government stimulus and the reluctance to deploy cash in a time of historically low interest rates.

The result is a healthy “wholesale” balance sheet that is separate and distinct from banks’ normal operations. This must be factored into growth plans for 2022 and 2023. We think it may take several quarters to properly deploy the excess liquidity. Investors already demand faster loan growth and their tolerance towards low purchases of securities may wane. The pressure to take action on cash is real, and it should be seen as an opportunity and certainly not a curse. We see excess cash as a high-class problem that can be met with a successful response at all banks.

We expect financial institutions will become far more open about their two balance sheet positions in the near future. First, let’s talk about the “normal” operation with stated goals and objectives on growth (e.g. loans, earnings per share and returns on tangible equity). Next, segment the “wholesale” balance sheet, which contains the cash position and any extra liquidity in short-term securities. Using our industry data above (10% cash in earning assets, up from 4% pre-pandemic), a $3 billion community bank has $300 million in cash instead of the usual $120 million it carried two years earlier — this establishes a $180 million wholesale position. Company management should directly communicate how this separate liquidity will be used to enhance earnings and returns in future quarters. Likewise, boards should stay engaged on how this cash gets utilized within their risk tolerance.

Late in the fourth quarter of 2021, certain company acquisitions disclosed the use of excess cash as a key rationale of the deal. An example is Ameris Bancorp, whose executive team stated in its December 2021 purchase of Balboa Capital that the transaction was funded by excess cash. Back in May 2021, Regions Financial (which is neutral-rated by Janney) acquired EnerBank with a home improvement finance strategy that would deploy its liquidity into new loans. Regions has since completed additional M&A deals with the same explanation. Many more small M&A transactions seem likely in 2022 using cash deployment as an underlying theme.

It has been my experience for three decades as an equity analyst that banks miss chances to explain their strategy in a succinct yet powerful manner. Remaining shy under the pretense of conservatism does not generally reward a higher stock valuation. Instead, banks who are direct and loud about their strategy (and then execute) tend to be rewarded with a stronger stock price. Hence, it is a far better idea to express a game plan for cash and a bank’s distinct “wholesale” balance sheet.

The current cash positions (which produced little to no earnings return in prior quarters) are now a superb opportunity to make a difference with investors. We encourage banks to be direct on how they will utilize excess cash and liquidity separate from their existing operations. The Janney Research team estimates banks can generate nearly a 10% boost to EPS by 2023 from managing excess cash alone. This is separate from any benefit from higher interest rates and Federal Reserve policy shifts that may occur.

Outlining a cash strategy in 2022 and 2023 is a critical way to differentiate the bank’s story with investors. Bank executives and directors must take advantage of this opportunity with a direct game plan and communicate it accordingly.

Banks Face a New Regulatory Environment: From Overdrafts to Fair Lending

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Regulatory risk for banks is evolving as they emerge from the darkest days of the pandemic and the economy normalizes.

Banks must stay on top of regulatory updates and potential risks, even as they contend with a challenging operating environment of low loan growth and high liquidity. President Joseph Biden continues to make progress in filling in regulatory and agency heads, and financial regulators have begun unveiling their priorities and thoughts in releases and speeches.

Presenters during the first day of Bank Director’s Audit & Risk Committees Conference, held on Oct. 25 to 27 in Chicago, provided insights on crucial regulatory priorities that bank directors and executives must keep in mind. Below are three of the most pressing and controversial issues they discussed at the event.

IRS Reporting Requirement
While politicos in Washington are watching the negotiations around Biden’s proposed budget, bank trade groups have been sounding the alarm around one way to pay for some of it.

The proposal would require financial institutions to report how much money was deposited and withdrawn from a customer’s bank account over the course of the year to the IRS in order to help the agency identify individuals evading taxes or underreporting their income. Initially, the budget proposal would require reporting on total inflows and outflows greater than $600; in subsequent iterations, it was later pushed to $10,000 and would exclude wage income and payments to federal program beneficiaries. It has the support of the U.S. Department of the Treasury but has yet to make its way into any bills.

Like all aspects of the spending bill, the budget proposal is in flux and up for negotiation, said Charles Yi, a partner at the law firm Arnold & Porter, who spoke via video. Already, trade groups have mounted a defense against the proposal, urging Biden to drop it from considerations. And a critical senator needed for passage of a bill, Sen. Joe Manchin (D-W.V.), came out against the proposal; his lack of support may mean Congressional Democrats would be more apt to drop it.

But if adopted, the informational reporting requirement would impact all banks. Banks would have to report a much greater volume of data and contend with potential data security concerns.

“Essentially, you’re turning on a data feed from your bank to the government for these funds and flows,” said Arnold & Porter Partner Michael Mancusi, who also spoke via video.

Overdrafts Under Pressure
Consumer advocates have long criticized overdraft fees, and regulators have brought enforcement actions against banks connected to the marketing or charging of these fees. Most recently, the Consumer Financial Protection Bureau settled with TD Bank, the domestic unit of Canada-based Toronto-Dominion Bank, for $122 million over illegal overdrafts in 2020. And in May, Bank of America’s bank unit settled a class lawsuit brought by customers that had accused it of charging multiple insufficient fund fees on a single transaction for $75 million.

Pressure to lower or eliminate these fees and other account fees is coming not just from regulators but from big banks, as well as fintech and neobank competitors, said David Konrad, managing director and an equity analyst at the investment bank Keefe, Bruyette & Woods. Banks have rolled out features like early direct deposit that can help consumers avoid overdrafts or have started overdraft-free accounts. These institutions have been able to move away from overdraft fees because of technology investments in the retail channel and mobile apps that give consumers greater control.

But insufficient funds fees may be a significant contributor of noninterest income at community banks without diverse business lines, and they may be reticent to give it up. Those banks may still want to consider ways they can make it easier for consumers to avoid the fee — or choose when to incur it — through modifications of their app.

Fair Lending Scrutiny Continues
Many regulatory priorities reflect the administration in the White House and their agency picks. But Rob Azarow, head of the financial services transactions practice at Arnold & Porter, said that regulators have heightened interest in fair lending laws — and some have committed to using powerful tools to impact banks.

Regulators and government agencies, including the Consumer Financial Protection Bureau and the U.S. Department of Housing and Urban Development, have stated that they will restore disparate impact analysis in their considerations when bringing potential enforcement actions. Disparate impact analysis is a legal approach by which institutions engaged in lending can be held liable for practices that have an adverse impact on members of a particular racial, religious or other statutorily protected class, regardless of intent.

Azarow says this approach to ascertain whether a company’s actions are discriminatory wasn’t established in regulation, but instead crafted and adopted by regulators. The result for banks is “regulation by enforcement action,” he said.

Directors should be responsive to this shift in enforcement and encourage their banks to conduct their own analysis before an examiner does. Azarow recommends directors ask their management teams to analyze their deposit and lending footprints, especially in zip codes where ethnic or racial minorities make up a majority of residents. These questions include:

  • What assessments of our banking activities are we doing?
  • How do we evaluate ourselves?
  • How are we reaching out and serving minority and low-to-moderate income communities?
  • What are our peers doing?
  • What is the impact of our branch strategy on these communities?

The Coming Buyback Frenzy

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Capital planning is examined as part of Bank Director’s Inspired By Acquire or Be Acquired. Click here to access the content on BankDirector.com.

The banking industry hasn’t been this well capitalized in a long time. In fact, you have to go back to the 1940s — almost 80 years ago — before you find a time in history when the tangible common equity ratio was this high, says Tom Michaud, president and CEO of investment bank Keefe, Bruyette & Woods, during a presentation for Bank Director’s Inspired By Acquire or Be Acquired platform.

That ratio for FDIC-insured banks has nearly doubled since 2008, he says, reaching 8.5% as of Sept. 30, 2020, says Michaud.

A big part of the industry’s high levels of capital goes back to the passage of the Dodd-Frank Act in 2010, the Congressional response to the financial crisis of 2008-09. Because of that law, banks must maintain new regulatory capital and liquidity ratios that vary based on their size and complexity.

During the pandemic, banks were in much better shape. You can see the impact by looking at the capital ratios of just a handful of big banks. Citigroup, for example, had a tangible common equity ratio in the third quarter of 2020 that was nearly four times what it was in 2008, Michaud says.

With a deluge of government aid and loans such as the Paycheck Protection Program, the industry’s losses during the pandemic have been minimal so far. The Federal Deposit Insurance Corp. has closed just four banks, far fewer than the deluge of failures that took place during the financial crisis. So far, financial institutions have maintained their profitability. Almost no banks that pay a dividend cut theirs last year.

Meanwhile, regulators required many of the large banks, which face extra scrutiny and stress testing compared to smaller banks, to halt share repurchases and cap dividends last year, further pumping up capital levels.

That means that banks have a lot of capital on their books. Analysts predict a wave of share repurchases in the months ahead as banks return capital to shareholders.

“The banking industry continues to make money,” said Al Laufenberg, a managing director at KBW, during another Bank Director session. “The large, publicly traded companies are coming out with statements saying, ‘We have too much capital.’”

Investors have begun to ask more questions about what banks are doing with their capital. “We see investors getting a little bit more aggressive in terms of questions,” he says. “‘What are you going to do for me?”

Bank of America Corp. already has announced a $2.9 billion share repurchase in the first quarter of 2021. In fact, KBW expects all of the nation’s universal and large regional banks to repurchase shares this year, according to research by analysts Christopher McGratty and Kelly Motta. They estimate the universal banks will buy back 7.3% of shares in 2021, while large regionals will buy back 3.5% of shares on average. On Dec. 18, 2020, the Federal Reserve announced those banks would again be allowed to buy back shares after easing earlier restrictions.

Regulators didn’t place as many restrictions during the pandemic on small- and medium-sized banks, so about one-third of them already bought their own stock in the fourth quarter of 2020, according to McGratty.

In terms of planning, banks that announce share repurchases don’t have to do them all at once, Laufenberg says. They can announce a program and then buy back stock when they determine the pricing is right.

Shareholders can benefit when banks buy back stock because that can reduce outstanding shares, increasing the value of individual shares, as long as banks don’t buy back stock when the stock is overvalued. Although bank stock prices compared to tangible book value and earnings have returned to pre-Covid levels, the KBW Regional Banking Index (KRX) has underperformed broader market indices during the past year, making an argument in favor of more repurchases.

Robert Fleetwood, a partner and co-chair of the financial institutions group at the law firm Barack Ferrazzano Kirschbaum & Nagelberg LLP, who spoke on the Bank Director session with Laufenberg, cautions bank executives to find out if their regulators require pre-approval. Every Federal Reserve region is different. Regulators want banks to have as much capital as possible, but Fleetwood says they understand that banks may be overcapitalized at the moment.

High levels of capital will help banks grow in the future, invest in technology, add loans and consolidate. For the short term, though, investors in bank stocks may be the immediate winners.

How to Prepare for an Unprecedented Year

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Could anyone have prepared for a year like 2020?

Better-performing community banks, over the long run, generally anchor their balance sheet management in a set of principles — not divination. They organize their principles into a coherent decision-making methodology, which requires them to constantly study the relative risk-reward profiles of various options, across multiple rate scenarios and industry conditions over time.

But far too many community bankers look through the wrong end of the kaleidoscope. Rather than anchoring themselves with principles, they drift among the currents of economic and interest rate forecasts. Where that drift takes them at any given moment dictates their narrowly focused reactions and strategies. If they are in a reward mindset, they’ll focus on near-term accounting income; if the mood of the day is risk-centered, their framework will be liquidity. At Performance Trust, we have long argued that following this approach accumulates less reward, and more risk, than its practitioners ever expect.

Against this backdrop, we offer five decision-making principles that have helped many banks prepare for the hectic year that just closed, and can ensure that they are prepared for any hectic or challenging ones ahead.

  • Know where you are before deciding where to go. Net Interest Income and Economic Value of Equity simulations, when viewed in isolation, can present incomplete and often conflicting portrayals of a bank’s financial risk and reward profile. To know where you are, hold yourself accountable to all cash flows across multiple rate scenarios over time, incorporating both net income to a horizon and overall economic value at that horizon. Multiple-scenario total return analysis isn’t about predicting the future. Rather, it allows you to see how your institution would perform in multiple possible futures.
  • Don’t decide based on interest rate expectations — in fact, don’t even have expectations. Plenty of wealth has been lost by reacting to predictions. Running an asset-sensitive balance sheet is nothing more than making a levered bet on rising rates. So, too, is sitting on excess liquidity waiting for higher rates. The massive erosion in net interest margin in 2020 supports our view that most community banks have been, intentionally or not, speculatively asset sensitive. Banks that take a principle-based approach currently hold sufficient call-protected, long-duration earning assets — not because they knew rates would fall, but because they knew they would need them if rates did fall. As a result, they are in a potentially better position to withstand a “low and flat” rate environment.
  • Maintaining sufficient liquidity is job No. 1. Job No. 2 is profitably deploying the very next penny after that. In this environment, cash is a nonaccrual asset. Banks with a principle-oriented approach have not treated every bit of unexpected “excess liquidity” inflow as a new “floor” to their idea of “required liquidity.” One approach is to “goal post” liquidity needs by running sensitivity cases on both net loan growth and deposit outflows, and tailoring deployment to non-cash assets with this in mind — for instance by tracking FHLB pledgeability and haircutting — and allowing for a mark-to-market collateral devaluation cushion. Liquidity is by no means limited to near-zero returns.
  • Don’t sell underpriced options. Banks sell options all day long, seldom considering their compensation. Far too often, banks offer loans without prepayment penalties because “everyone is doing it.” Less forgivably, they sell options too cheaply in their securities portfolio, in taking on putable advances or when pricing their servicing rates. The last two years were an era of very low option compensation, even by historical measures. Principle-based decision-makers are always mindful of the economics of selling an option; those who passed on underpriced opportunities leading into 2021 find their NIMs generally have more staying power as a result.
  • Evaluate all capital allocation decisions on a level playing field. Community banks, like all competitive enterprises, can allocate capital in just four ways: organic growth, acquisitions, dividends or share repurchases. Management teams strike the optimal balance between risk and reward of any capital allocation opportunity by examining each strategy alongside the others across multiple rate scenarios and over time. This approach also allows managers to harness the power of combinations — say, simultaneously executing a growth strategy and repurchasing stock — to seek to enhance the institution’s overall risk/return profile.

So what about 2021 and beyond? This same discipline, these same principles, are timeless. Those who have woven them into their organizational fabric will continue to benefit whatever comes their way. Those encountering them for the first time and commit to them in earnest can enjoy the same.