2020’s Growth All-Stars

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Low interest rates pressured net interest margins in 2020, but they also produced outsized growth for banks with a strong focus on mortgage lending.

“From a nominal — that is, not inflation-adjusted perspective — [2020] was the biggest year in the history of the [mortgage] industry, and it was driven heavily by the fact that mortgage rates fell to 2.5%” for customers with good credit history, says Douglas Duncan, senior vice president and chief economist at Fannie Mae. Single-family mortgage originations totaled $4.54 trillion, he says. Almost two-thirds were mortgage refinancing loans; the remaining loans were used for purchases. His tally represents an estimate — the U.S. government doesn’t calculate total mortgage loan volume.

But Duncan’s estimation is reflected in the countless press releases I’ve read from banks boasting record mortgage volume — and revenues — over the past few months. And mortgages are a major factor that fueled 2020 growth for the fastest-growing banks.

Using data from S&P Global Market Intelligence, Bank Director analyzed year-over-year growth in pre-provision net revenue (PPNR) at public and private banks above $1 billion in assets to identify the banks that have grown most quickly during the pandemic. We also included return on average assets, calculated as a three-year average for 2018, 2019 and 2020, to reward consistent profitability in addition to growth. The analysis ranked both factors, and the numeric ranks were then averaged to create a final score. The banks with the highest growth and profitability had the lowest final scores, meaning they ranked among the best in the country.

Among the best was eighth-ranked $2.4 billion Leader Bank. President Jay Tuli credits low interest rates with driving outsized growth at the Arlington, Massachusetts-based bank. Its sizable mortgage operation helped it to take advantage of demand in its market, roughly doubling mortgage volume in 2020 compared to the previous year, says Tuli.

“With rates coming down during Covid, there was a big surge in mortgage demand for refinances,” explains Tuli. Most of those mortgage loans were sold on the secondary market. “That produced a substantial increase in profitability.”

Mortgage lending also significantly lifted revenues at Kansas City, Missouri-based NBKC Bank, according to its chief financial officer, Eric Garretson.

The $1.2 billion bank topped our ranking, and it’s one of the two banks in this analysis that have become specialists of sorts in banking-as-a-service (BaaS). The other is Celtic Bank Corp., which is also a Small Business Administration lender that funded more than 99,000 Paycheck Protection Program loans.

NBKC’s BaaS program grew in 2020, says Garretson, though “this was dwarfed by the increase in revenue from mortgage lending.” Right now, NBKC focuses on deposit accounts, allowing partner fintechs to offer these accounts under their own brand, issue debit cards and deliver similar banking services. Lending products are being considered but aren’t currently offered, says Garretson.

As the financial technology space continues to grow, the opportunities should increase for banks seeking to partner with fintech companies, says Alex Johnson, director of fintech research at Cornerstone Advisors. Banks like NBKC and Celtic Bank Corp. have developed the expertise and skills needed to partner with these companies. They also have a technology infrastructure that’s fintech friendly, he explains, allowing for easy integration via standard, defined application programming interfaces (APIs) and a microservices architecture that’s more modular and decentralized. Put simply — a good BaaS bank will have the same tech capabilities as its fintech client.

“There’s a very clear model for how to do this, and there’s growing demand,” says Johnson. “One thing that tends to characterize banks that do well in the banking-as-a-service space are the ones that build a specialization in a particular area.” These banks have a track record for building these products, along with the requisite processes and contracts.

“When a company comes to them, it’s as easy [a process] as it could possibly be,” says Johnson. “The more of that work they do, the more that ripples back through the fintech ecosystem. So, when new fintech companies are founded, [and venture capitalists] are advising them on where to go — they tend to point to the banking-as-a-service partners that will work well.”

Top 10 Fastest-Growing Banks

Bank Name/Headquarters Total Assets (millions) ROAA
3-year avg.		 PPNR growth YoY Score
NBKC Bank
Kansas City, MO		 $1,207.5 7.93% 67.52% 14.67
Plains Commerce Bank
Hoven, SD		 $1,129.9 3.97% 86.75% 15.33
The Federal Savings Bank
Chicago, IL		 $1,076.2 7.66% 60.37% 19.67
Northpointe Bank
Grand Rapids, MI		 $3,685.5 2.58% 73.24% 25.00
Celtic Bank Corp.
Salt Lake City, UT		 $4,704.8 4.22% 55.87% 28.00
Union Savings Bank
Cincinnati, OH		 $3,586.3 2.75% 56.76% 29.67
North American Savings Bank, F.S.B.
Kansas City, MO		 $2,470.9 2.71% 58.57% 30.67
Leader Bank, N.A. $2,419.6 2.46% 61.63% 32.67
Waterstone Financial
Wauwatosa, WI		 $2,198.0 2.41% 59.23% 38.00
BNC National Bank
Glendale, AZ		 $1,225.7 2.13% 71.44% 39.33

Source: S&P Global Market Intelligence. Total assets reflect first quarter 2021 data. Average three-year return on average assets reflects year-end data for 2018, 2019 and 2020 for the largest reporting entity. Year-over-year pre-provision net revenue (PPNR) growth reflects year-end data for 2019 and 2020. Bank Director’s analysis of the fastest-growing banks ranked PPNR growth and average ROAA at banks above $1 billion in assets; scoring reflects an average of these ranks.

Low Interest Rates Threaten Banks — But Not the Way You Think

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The coronavirus pandemic laid bare the struggles of average Americans — middle class and lower-income individuals and families. But these struggles are an ongoing trend that Karen Petrou, managing partner of the consulting firm Federal Financial Analytics, tracks back to monetary policy set by the Federal Reserve since the financial crisis of 2008-09.

In short, she says, the Fed bears some of the blame for the widening wealth gap, which sees the rich getting richer, the poor getting poorer and the middle class slowly disappearing. And that’s an existential threat to most financial institutions.

“The bread and butter of community banks — urban, rural, suburban — is the middle class and the upper-middle class, as well as the health of the communities [banks] serve,” Petrou explains to me in a recent interview. Even for banks focused on more affluent populations, the health of their communities derives from everyone living and working in it. “When you have a customer base that is really living hand to mouth,” she says, “that’s not a growth scenario for stable communities, or of course, [a bank’s] customer base.”

A lot of digital ink has been spilled on inequality, but Petrou’s analysis — which you’ll find in her book, “Engine of Inequality: The Fed and the Future of Wealth in America,” is unique. She explores how misguided Fed policy fuels inequality, why it matters, and how she’d recraft monetary policy and regulation. And she believes the future is bleak for banks and their communities if changes don’t occur.

Her ideas have the attention of industry leaders like Richard Hunt, CEO of the Consumer Bankers Association. “She’s not what I’d consider an activist or someone who has an agenda,” he says. “She is purely facts-driven.”

Central to the inequality challenge is the ongoing low-rate environment. We often talk about the Fed’s dual mandates — promoting maximum employment and price stability — but Petrou points out in her book that setting moderate rates also falls under its purview.

Low rates have pressured banks’ net interest margins for over a decade, but they’ve squeezed the average American household, too. Petrou writes that these ultra-low rates have failed to stimulate growth. They’ve also “made most Americans even worse off because trillions of dollars in savings were sacrificed in favor of ever higher stock markets.”

The Fed’s preoccupation with markets over households, she says, benefits the most affluent.

Low interest rates, as we all know, lower the returns one earns on safer investments, like money market accounts or certificates of deposit. That drives investors to the stock market, driving up valuations. Excepting a brief blip early in the pandemic, the S&P 500, Dow Jones Industrial Average and Nasdaq have all performed well over the past year, despite high unemployment and economic closures.

However, stock ownership is concentrated in the hands of a few. As of the fourth quarter 2020, the top 1% hold 53% of corporate equity and mutual fund shares, according to the Federal Reserve; the bottom 90% own 11% of those shares. Most of us would be better off, Petrou concludes, earning a safe, living return off the money we manage to sock away.

More than 60% of middle-class wealth is tied up in their homes; pension funds account for another 17%. Those have been underfunded, “but even underfunded pensions have a hope of paying claims when interest rates are enough above the rate of inflation to ensure a meaningful return on investment,” she writes.

And while homes account for a huge portion of middle-class wealth, home ownership has actually declined over the past two decades among adults below the age of 65, according to a Harvard University study. The supply of lower-cost homes has dwindled, and banks are reticent to make small mortgage loans, which are costly to underwrite. And for those who already own a home, prices still haven’t reached the levels seen before the financial crisis — in real dollars, they’re not worth what they once were.

And homes aren’t a liquid asset. Middle class Americans used to hold more than 20% of their assets in deposit accounts, but that’s declined dramatically. All told, low interest rates severely punish savers, who actually lose money when one adjusts for inflation.

Average real wages haven’t budged in decades — but the costs for everything else have risen, from medical expenses to childcare to education and housing. So, what’s paying for all that if savings yield little and incomes are stagnant? Debt. And a lot of it, at least for the middle class, whose debt-to-income ratio has grown to a whopping 120% — almost double what it was in 1983. For the top 1%, it’s more than halved, to 35% of income.

Middle class households were in survival mode before the pandemic hit, explains Petrou.

“All of the Fed’s monetary-policy thinking is premised on the view that ultra-low rates spur economic growth, but most low-cost debt isn’t available to lower-income households, and most middle-income households are already over their head in debt,” she writes. “Monetary policy has failed in part because the Fed failed to understand America as it bought, saved and borrowed.”

Debt can be wonderful; it can build businesses and make buying a home possible for many. But that dream is disappearing. Coupled with the regulatory regime, low interest rates have changed traditional banking, explains Petrou. Financial institutions are forced to chase fee income, found in wealth management and similar products and services. And lending to more affluent customers makes better business sense.

Petrou wants the Fed to gradually raise rates to “ensure a positive real return.” Combined with other factors, rising rates would “make saving for the future not just virtuous, but successful,” she writes, “giving families with growing wages in a more productive economy a better chance for wealth accumulation, intergenerational mobility, and a secure retirement.”

It won’t fix everything, but it will help middle and lower-income families save for their homes, save for college and even pay down some of that debt.

Petrou is clear — in her book and in my interview with her — that the Fed isn’t ill-intentioned. But the agency is ill informed, she believes, relying on aggregate data that doesn’t reflect a full picture of the economy.

“The economy we’re in is not the one in which most of us grew up,” she says, referring to the baby boomers who form the majority of bank boards and C-suites. The top 10% hold a much greater share of wealth, and that share is growing. The things that many boomers took for granted, she says, are increasingly unattainable, or require an unsustainable debt burden.

College tuition offers a measurable example of how much things have changed. Adjusted for 2018-19 dollars, baby boomers paid an average $7,719 a year to attend a four-year public college, according to the U.S. Department of Education. Generation Z is now entering college paying roughly 2.5 times that amount — contributing to the growing volume of student loans.

“Assuming that [the economy] works equitably because there’s a large middle class means that banks will make strategic errors, misunderstanding their customers and communities,” Petrou tells me. “And that the Fed will make terrific financial policy mistakes.”

Turning to Technology as Margins Shrink

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It’s a perfect storm for bank directors and their institutions: Increasing credit risk, low interest rates and the corrosive effects of the coronavirus culminating into a squeeze on their margins.

The pressure on margins comes at the same time as directors contend with a fundamental new reality: Traditional banking, as we know it, is changing. These changes, and the speed at which they occur, mean directors are wrestling with the urgent task of helping their organizations adapt to a changing environment, or risk being left behind.

As books close on 2020 with a still-uncertain outlook, the most recent release of the Federal Deposit Insurance Corp.’s Quarterly Banking Profile underlines the substantial impact of low rates. For the second straight quarter, the average net interest margin at the nation’s banks dropped to its lowest reported level.

The data shows that larger financial institutions have felt the pain brought about by this low-rate environment first. But as those in the industry know, it is often only a matter of time until smaller institutions feel the more-profound effects of the margin contraction. The Federal Reserve, after all, has said it will likely hold rates at their current levels through 2023.

In normal times, banks would respond to such challenges by cutting expenses. But these are not normal times: Such strategies will simply not provide the same long-term economic benefits. The answer lies in technology. Making strategic investments throughout an organization can streamline operations, improve margins and give customers what they want.

Survey data bears this out. Throughout the pandemic, J.D. Power has asked consumers how they plan to act when the crisis subsides. When asked in April about how in-person interactions would look with a bank or financial services provider once the crisis was over, 46% of respondents said they would go back to pre-coronavirus behaviors. But only 36% of respondents indicated that they would go back to pre-Covid behaviors when asked the same question in September. Consumers are becoming much more likely to use digital channels, like online or mobile banking.

These responses should not come as a surprise. The longer consumers and businesses live and operate in this environment, the more likely their behaviors will change, and how banks will need to interact with them.

Bank directors need to assess how their organizations will balance profitability with long-term investments to ensure that the persistent low-rate environment doesn’t become a drag on revenue that creates a more-difficult operating situation in the future.

The path forward may be long and difficult, but one thing is certain: Banks that aren’t evaluating digital and innovative options will fall behind. Here are three key areas that we’ve identified as areas of focus.

  • Technology that streamlines the back office. Simply reducing headcount solves one issue in cost management, which is why strategic investments in streamlining, innovating and enhancing back-office processes and operations will become critical to any bank’s long-term success.
  • Technology that improves top-line revenues. Top-line revenue does not grow simply by making investments in back-office technologies, which is why executives must consider solutions that maximize efforts to grow revenues. These include leveraging data to make decisions and improving the customer experience in a way that allows banks to rely less on branches for growth.
  • Technology that promotes a new working environment. As banks pivoted to a remote environment, the adoption of these technologies will lead to a radically different working environment that makes remote or alternative working arrangements an option.

While we do not expect branch banking to disappear, we do expect it to change. And while all three technology investment alternatives are reasonable options for banks to adapt and survive in tomorrow’s next normal, it is important to know that failing to appropriately invest will lead to challenges that may be far greater than what are being experienced today.

Balance Sheet Opportunities Create Path to Outperformance

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How important is net interest margin (NIM) to your institution?

In 2019, banks nationally were 87% dependent on net interest income. With the lion’s share of earnings coming from NIM, implementing a disciplined approach around margin management will mean the difference between underperforming institutions and outperforming ones. (To see how your institution ranks versus national and in-state peers, click here.)

Anticipating the next steps a bank should take to protect or improve its profitability will become increasingly difficult as they manage balance sheet risks and margin pressure. Cash positions are growing with record deposit inflows, pricing on meager loan demand is ultra-competitive and many institutions are experiencing accelerated cash flows from investment portfolios.

It is also important to remember that stress testing the balance sheet is no longer an academic exercise. Beyond the risk management, stressing the durability of capital and resiliency of liquidity can give your institution the confidence necessary to execute on strategies to improve performance and to stay ahead of peers. It is of heightened importance to maintain focus on the four major balance sheet position discussed below.

Capital Assessment, Position
Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses and providing resources to seize opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown.

The rapid changes occurring within the economy are not wholly cyclical in nature; rather, structural shifts will develop as consumer behavior evolves and business operations adjust to the ‘next normal.’ Knowing the breaking points for your capital base — in terms of growth, credit deterioration and a combination of these factors — will serve your institution well.

Liquidity Assessment, Position
Asset quality deterioration leads to capital erosion, which leads to liquidity evaporation. With institutions reporting record deposit growth and swelling cash balances, understanding how access to a variety of funding sources can change, given asset quality deterioration or capital pressure, is critical to evaluating the adequacy of your comprehensive liquidity position.

Interest Rate Risk Assessment, Position
In today’s ultra-low rate environment, pressure on earning asset yields is compounded by funding costs already nearing historically low levels. Excess cash is expensive; significant asset sensitivity represents an opportunity cost as the central bank forecasts a low-rate environment for the foreseeable future. Focus on adjusting your asset mix — not only to improve your earnings today, but to sustain it with higher, stable-earning asset yields over time.

Additionally, revisit critical model assumptions to ensure that your assumptions are reflective of actual pricing behaviors, including new volume rate floors and deposit betas, as they may be too high for certain categories.

Investment Assessment, Position
Strategies for investment portfolios including cash can make a meaningful contribution to your institution’s overall interest income. Some key considerations to help guide the investment process in today’s challenging environment include:

  • Cost of carrying excess cash has increased: Most institutions are now earning 0.1% or less on their overnight funds, but there are alternatives to increasing income on short-term liquidity.
  • Consider pre-investing: Many institutions have been very busy with Paycheck Protection Program loans, and we anticipate this will have a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market.

Taylor Advisors’ Take:
Moving into 2021, liquidity and capital are taking center stage in most community banks’ asset-liability committee discussions. Moving away from regulatory appeasement and towards proactive planning and decision-making are of paramount importance. This can start with upgrading your bank’s tools and policies, improving your ability to interpret and communicate the results and implementing actionable strategies.

Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. You must know where you are to know where you want to go. Start by studying your latest quarterly data. Dissect your NIM and understand why your earning asset yields are above or below peer. Balance sheet management is about driving unique strategies and tailored risk management practices to outperform; anything less will lead to sub-optimal results.

Preparing to Be There for Your Community

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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

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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

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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?

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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

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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.