Preparing to Be There for Your Community

The fallout from COVID-19 will likely take some time to stabilize. The personal and social costs are already significant, and neither is independent of economic and business disruptions.

Especially impacted are the businesses on Main Streets everywhere that are served by community banks. Community banks will be essential to any recovery, so it is important that they take steps now to ensure they’re positioned to make a difference.

The Challenge Of A “New Normal”
Financial markets were in “price discovery” mode this spring, but that phase is unlikely to last for long. If Treasury rates rise from their current levels, banks are likely to do well with their traditional models. But if they remain low, and spreads eventually stabilize to 2019 levels, nearly every institution will encounter pressure that could undermine their efforts to be a catalyst for Main Street’s recovery.

Bank Director’s recent piece “Uncharted Territory” warned that the experience of past financial crises could mislead bankers into complacency. Last time, dramatic reductions in funding costs boosted net interest margins, which helped banks offset dramatically higher loan losses. The difference today is that funding costs are already very low — leaving little room for similar reductions.

Consider asset yields. Even without significant credit charge-offs, community bank profitability could face headwinds. Community banks entered 2020 with plenty of fuel to support their thriving Main Streets. Their balance sheets had been established for a Treasury rate environment that was 100 basis points higher than today’s. If rates settle here for the next couple of years and existing assets get replaced at “new normal” levels, yields will fall and net interest margins, or NIMs, could take a hit.

Banks could have trouble “being there” for their communities.

Where do the current assets on banks’ balance sheets come from? They were added in 2018, 2019 and the first quarter of 2020. If we assume a fixed rate loan portfolio yields somewhere around 300 basis points over the 5-year swap rate at closing (which averaged about 1.75% over 2019), and floating rates loans yield somewhere around 50 basis points over prime day to day, we can estimate banks’ first quarter loan yields at perhaps 4.75% fixed-rate and 5.25% prime-based.

Prime-based yields have already dropped for the second quarter and beyond: They are now earning 3.75%. Fixed-rate loans continue to earn something like 4.75%, for now.

Banks that can quickly reduce funding costs might, in fact, see a short-term bump in net interest margins. If they can stave off provision expenses, this might even translate into a bump in profitability. But it will not last.

If Treasury rates remain at these historic lows and spreads normalize to 2019 levels, current balance sheets will decay. Adjustments today, before this happens, are the only real defense.

Banks’ fixed rate loans will mature or refinance at much lower rates — around 3.50%, according to our assumptions. Eventually, banks that enjoyed a 3.50% NIM in 2019 will be looking at sustained NIMs closer to 2.50%, even after accounting for reduced funding costs, if they take no corrective steps today. It will be difficult for these banks to “be there” for Main Street, especially if provision expenses begin to emerge.

Every community bank should immediately assess its NIM decay path. How long will it take to get to the bottom? This knowledge will help scale and motivate immediate corrective actions.

For most banks, this is probably a downslope of 18 to 30 months. For some, it will happen much more rapidly. The data required may be in asset and liability management reports. Note that if your bank is using year-end reports, the intervening rate moves mean that the data in the “100 basis points shock” scenario from that report would represent the current rates unchanged “baseline.” Reports that do not run income simulations for four or more years will also likely miss the full NIM contraction, which must be analyzed to incorporate full asset turnover and beyond.

Times are hectic for community banks, but in many cases commissioning a stand-alone analysis, above and beyond standard asset-liability compliance requirements, is warranted.

Then What?
The purpose of analyzing a bank’s NIM timeline is not to determine when to start taking action, but to correctly size and scope the immediate action.  All the levers on the balance sheet— assets, liabilities, maybe even derivatives — must be coordinated to defend long-term NIM and the bank’s ability to assist in Main Street’s recovery.

The Small Business Administration’s Paycheck Protection Program lending is fully aligned with the community bank mission, but it is short term. Banks must also plan for sustainable net interest income for three, four and five years into the future, and that planning and execution should take place now. The devised NIM defense strategy should be subjected to the same NIM decay analysis applied to the current balance sheet; if it’s insufficient, executives should consider even more significant adjustments for immediate action.

The economic environment is out of bankers’ control. Their responses are not, but these require action in advance. Banks can — and should — conduct a disciplined, diagnostic analysis of their NIM decay path and then correct it. This interest rate environment could be with us for some time to come.

The Powerful Force Driving Bank Consolidation


margins-8-16-19.pngA decades-old trend that has helped drive consolidation in the banking industry can be summarized in a single chart.

In 1995, the industry’s net interest margin, or NIM, was 4.25%, according to the Federal Reserve Bank of St. Louis. (NIM reflects the difference between a bank’s cost of funds and what it earns on its assets, primarily loans.) Twenty years later, the margin dropped to a historic low of 2.98%, before gradually recovering to 3.30% last year.

NIM-chart.png

The vast majority of banks in this county are spread lenders, making most of their money off the difference between what they pay for deposits and what they charge for loans. When this spread narrows, as it has since the mid-1990s, it pinches their profitability.

The decision by the Federal Reserve’s Federal Open Market Committee to reduce the target range for the federal funds rate by 25 basis points in August will likely exacerbate this by reducing the rates that banks can charge on loans.

“For most banks, net interest income [accounts for] the majority of their revenue,” says Allen Tischler, senior vice president at Moody’s Investor Service. “A reduction in [it] obviously undermines their ability to generate incremental earnings.”

There have been two recessions since the mid-1990s: a brief one in 2001 and the Great Recession in 2007 to 2009. The Federal Reserve cut interest rates in both instances. (Over time, lower rates depress margins, although banks may initially benefit if their deposit costs drop faster that their loan pricing.)

Inflation has also remained low since the mid-1990s — particularly since 2012, when it never rose above 2.4%. This is why the Fed has been able to keep rates so low.

Other factors contributing to the sustained decline in NIMs include intermittent periods of intense competition and rate cutting between banks, as well as the emergence of fintech lenders. Changes over time in a bank’s the mix of loans and securities, and among different loan categories, can impact NIMs, too.

The Dodd-Frank Act has exacerbated the downward trend in NIMs by requiring large banks to carry a higher share of low-yielding liquid assets on their balance sheets, which depresses their margins. This is why large banks have contributed disproportionally to the industry’s declining average margin – though, these institutions can more easily offset the compression because upwards of half their net revenue comes from fees.

Community banks haven’t experienced as much compression because they allocate a larger portion of their balance sheets to loans and do most of their lending in less-competitive markets. But smaller institutions are also less equipped to combat the compression, since fees make up only 11% of the net operating revenue at banks with less than $1 billion in assets, according to the Office of the Comptroller of the Currency.

The industry’s profitability has nevertheless held up, in part, because of improvements to operating efficiency, particularly at large banks. The corporate tax cut that went into effect in 2018 plays into this as well.

“If you recall how banking was done in 1995 versus today … there’s just [greater] efficiency across the board, when you think about what computer technology in particular has done in all service industries, not just banking,” says Norm Williams, deputy comptroller for economic and policy analysis at the OCC.

The Fed’s latest rate cut, combined with concerns about additional cuts if the escalating trade war with China weakens the U.S. economy, raises the specter that the industry’s margin could nosedive yet again.

Tischler at Moody’s believes that sustained margin pressure has been a factor in the industry’s consolidation since the mid-1990s. “That downward trend does undermine its profitability, and is part of the reason why the industry has consolidated as much as it has,” he says.

If the industry’s margin takes another plunge, it could drive further consolidation. “The industry has been consolidating for decades … and there’s no reason why that won’t continue,” says Tischler. “This just adds to the pressure.”

There were 11,971 U.S. banks and thrifts in 1995. Today there are 5,362. Given the direction of NIMs, it seems like we may still have too many.

Bridging the Gap Between Digital Convenience and In-Branch Expertise


digital-11-16-18.pngFor decades, banks needed to add new locations to grow, pushing the number of U.S. branches to a peak in 2009. Following the financial crisis, some banks started to close branches in an effort to lower their costs in the face of declining net interest margins and rising regulatory costs. Along the way, lenders realized they could maintain their deposit levels with fewer locations in a digital world where customers often prefer mobile apps and ATMs.

In fact, over the past two decades, banks have purposefully discouraged customers from visiting their lobbies. Beyond simply driving customers to automated channels such as online banking, mobile apps, and chatbots, some banks have even gone as far as charging their customers fees whenever they use tellers or lobby-related activities.

Digital tools are now being used by almost all bank customers regardless of whether they value in-person interactions or not. However, great banking still needs great relationships, especially for complicated transactions.

Today there are nearly 90,000 bank branches in the United States. Last year, according to a survey by PricewaterhouseCoopers, 46 percent of banking customers said the only way they interacted with their bank was exclusively through digital channels, up from 27 percent in 2012. How do we justify keeping 90,000 bank branches open to support the less than 50 percent of clients who still need to visit a branch for those complicated transactions?

Technology can provide the answer. There are times when banking customers need to work with someone in person, but it’s expensive staffing branches with specific experts who are often underutilized. On top of that, branches are often only open during business hours, a particularly inconvenient time for those of us who are working their day job during those exact same hours and find it difficult to sneak off to the bank.

We think the solution to this problem is a Virtual Banking Expert©—which is a physical system with a video feed and specialized work-station touch-screen that allows anyone to privately interact with an expert at almost any time. This allows customers to work with specialized tools on highly secure channels in their local branches while keeping their personal information private and not requiring that they miss valuable work hours. This also means banks can now bring the benefits of a physical branch to their customers as long as there is a secured room accessible via account-holder cards, biometric security measures, and proper physical safety.

It simply isn’t cost effective to staff physical branches with experts who are available for the occasions when customers need to leverage their specialized skills. According to research by the technology company CACI International, the typical consumer will visit a bank branch just four times a year by 2022, compared to an average of seven times today. However, through the use of new technology like the Virtual Banking Expert© kiosk solution, that highly valuable and skilled banker can service customers at multiple locations remotely, privately and securely, providing a tremendous cost savings to the bank. Even the most heavily trafficked branches with experts on staff would be able to remote-in to other branches.

The consumer financial industry is changing–and a digitally evolving customer base continues to push the limits of what banks can do with increasing demands for convenience and ease. But I don’t believe we’re anywhere close to cutting humans out of banking transactions. In fact, as the CEO of a public computing company, I can tell you that is not our goal. We just think the role of humans is going to get a little more personal and less transactional. It’s easy to make those interactions more convenient and affordable for all parties involved. And as more and more customers demand flexibility and options when it comes to how they do business—whether it’s in-person, online, over the phone or through a live chat–it’s more important than ever to get ahead of this growing trend.

Feeling the Flat Yield Curve Squeeze?


interest-rate-6-26-18.pngInvestors have always sought better returns for greater risk. Longer investment horizons are associated with a higher amount of risk driven by uncertainty. In the fixed income markets, this translates to higher yields for longer maturities to compensate investors for the risk, thus creating what is called the yield curve. The yield curve has a positive slope in a normal market. The curve can also be flat or even inverted, which typically indicate transitionary periods in the market. That said, interest rate troughs usually do not last more than seven years, and central banks normally do not pump trillions of dollars into global markets as they have over the last several years. With protracted recovery and extreme monetary policy measures, this dreaded flat yield curve seems to be here for a while.

Banks’ primary earning power is largely driven by net interest margin, which is impacted by the shape of the yield curve and the ability to manage interest rate risk. It is prudent to perform non-parallel rate simulations on a regular basis, and regulators require this type of analysis. These simulations should be reviewed with management and saved for future use. Given the protracted flat yield curve environment, banks are feeling margin compression. If you have not done so, it may be time to retrieve these reports, understand if and where risk is impacting your balance sheet and manage your margin accordingly.

There are a number of ways a flat yield curve can negatively impact interest rate margins. Liquidity pressure is often at the top of the list in a rising rate environment. We have seen seven upward moves in the target fed funds rate since the bottom of the recovery, a total of 175 basis points. Depositors are hungrily pursuing newfound interest income. Most banks have had to follow suit and raise deposit rates. On the asset side of the balance sheet, fixed-rate loan yields have remained relatively stagnant. A typical rate on a 20-year amortizing 5-year balloon, owner-occupied commercial real estate loan in the $1-million to $5-million range was priced around 4.75 percent during the bottom of the rate trough.

As deposit rates have risen, banks have had difficulty in pricing the yields on loans of this type much above 5 percent. A third pressure point is the investment portfolio. During a normal yield curve environment, institutions with asset-sensitive balance sheets could earn income by borrowing short-term liabilities and investing at higher yields further out on the curve. Given the tightness of spreads along the curve where typical banks invest, there is minimal advantage to implementing this type of a strategy.

Since the issue of margin compression driven by the flat curve is a top concern for those who manage interest rate risk, the better question is what to do about it. Most bankers know it is present but many avoid the potential ramifications. The non-parallel simulation is an important exercise to understand the implications over the next year or so. The bank may even want to consider running a worst-case scenario simulation around an inverted curve as well. From there some strategic deposit pricing can be implemented.

One strategy may be either maintaining a short duration, and hopefully, inexpensive deposit or locking in funds for longer terms, pending balance sheet needs. Locking in longer term funding will come at a cost to the net interest margin unless the curve inverts. The interest rate risk simulation will help answer those types of questions. It is also a good time to look at a loan pricing model. This would help determine whether to continue to compete on price or pass on deals until margins improve. There is even a level that where banks should turn down business. It is important to understand the price point that becomes dilutive to earnings. Finally, there is a point that one stops taking duration risk in the investment portfolio, stays short and prepares to take advantage of future opportunities while reducing price risk.

Although a flat yield curve is not a new market phenomenon, it is currently impacting bank margins and may continue to for the next year or longer. Our Balance Sheet Strategies Group recommends banks consider the use of a detailed, non-parallel simulation to assess the current market and how to position the balance sheet moving forward. In addition to optimizing the interest rate position going forward, this will also help preserve and potentially enhance the interest margin. Every five basis points saved or earned on a $250-million balance sheet will equate to $125,000 in interest rate margin.

How Strategic Plans for Community Banks Should Change


strategy-5-21-18.pngThe commercial banking industry is undergoing a structural transformation. The Federal Reserve’s response to the recession in the last decade has had a continuing, unanticipated impact on community banks. Yet most banks are relying on legacy strategic planning tools and processes that won’t allow them to see – and solve – upcoming problems.

Quantitative easing (QE) pumped funds in the marketplace (deposits), while banks contended with an extended low interest rate environment. Moving forward, as QE is reversed, deposits will be withdrawn while interest rates gradually rise. Already, the largest banks are sucking up the best deposits, which will leave community banks scrambling for funds.

All banks do strategic planning. Most banks tend to extrapolate accounting data to generate pro forma reports and analysis. Prior to 2008, this process worked well, and many consulting firms and banks developed analytical tools and processes to help in strategic planning.

But dependence on these traditional strategic planning tools and processes is risky. Accounting statements camouflage critical data that is relevant to bank pro forma performance and strategic planning. This data may not have mattered prior to the recession, but it is essential in today’s banking environment.

The monetary policy of the last decade has led to hidden time bombs in banks’ balance sheets, masked by traditional financial reporting and ignored by most market analysts. Unfortunately, the inevitable rising rate environment will expose this harm, blindsiding most bank management, investors and shareholders.

Year to date, declining gross loan yields have been offset by declining cost-of-funds (primarily deposits) and an increase in the supply of these deposits. During this extended post-recession period, net interest margins (NIMs) have remained relatively strong, creating a pattern of reasonable earnings, year after year. Unfortunately, in a rising rate environment this process will reverse itself.

Many banks will attempt to use the ALCO process to mitigate these trends. Unfortunately, ALCO is primarily a short-term tuning process, not a long-term strategic tool. It is not designed to solve long-term gross yield and cost-of-funds issues. Given that the “Normalization Period” will extend for several years, corrective actions using ALCO may serve to further aggravate the long-term situation.

Community banks need to focus on methods designed to meaningfully change the mix, rate and duration of their asset portfolios. They must also recognize that deposits, whose availability and pricing have been taken for granted for several years, will be of increasing importance in the years to come.

Community banks need to be prepared to move away from their dependence on traditional analytics that cannot identify, quantify and provide solutions to these unprecedented problems in the U.S. community banking market.

Given the slow turnover rate of loan portfolios, any real change in a bank’s assets and their composition by type, rate and maturity can only be accomplished through the merger and acquisition (M&A) M&A process. Similarly, improving loan-to-deposit ratios and deposit composition can only be truly accomplished through M&A.

But many banks are not even including an M&A scenario in their strategic planning exercises. And that is a big mistake. While there is no guarantee that an appropriate target exists, or, if it exists, that it is available for sale at the appropriate price, it is imperative that community bank management explore this possibility thoroughly before resigning themselves to more traditional and less effective approaches to solving the upcoming problems.

Banks that successfully use M&A in an appropriate manner have an extraordinary opportunity to separate themselves from the pack.

For banks that are prepared to explore the M&A option, CEOs and boards should realize that times have changed. Traditional M&A valuation techniques and dependence on ratios such as multiple-to-book and payback period are no longer relevant and generally misleading.

It is necessary to analyze in depth, not only the fixed and floating interest rates built into a target’s loan portfolio, but also the individual duration and maturities of their loan portfolios as they extend into the future. Traditional accounting systems tend to obscure this critical data, and the commonly used extrapolations of GAAP financial statements generally lead to misleading and erroneous conclusions.

The increasing value of deposits needs to be quantified in the appropriate manner. Again, traditional techniques for valuing deposits are either too short-term oriented or based on methodologies used in entirely different economic environments, rendering their conclusions meaningless.

M&A can be a powerful catalyst to solve problems in today’s complicated banking environment. It does not have to tie up too much bank time or management resources, if it is done correctly with the right analytics.