Profits Over Growth

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The last few weeks have been a whirlwind for banking. As bank stock indices plummet and investors make bets about which bank will fail, I’m headed to one of Bank Director’s most important conferences. 

But the agenda isn’t packed with discussion about investor and depositor panic. Experience FinXTech on May 9-10 in Tampa, Florida, is for bankers and technology company leaders who want to make connections and learn from each other. Still, the news headlines will be on people’s minds. I’m thinking about how the new environment is going to impact banks and technology companies. Two years ago, a consultant to tech companies said to me, “The last five years have found that you don’t have to be profitable to be a company.” 

Tech founders focused on growth, not profitability; and once they had market share, they went public or sold to a bigger company, taking their billions in equity to retire at 30 on an island in the Caribbean.

The times are changing.

Some banks may pull back on planned tech implementations. I think some fintechs will be forced to sell.  Venture capital deals fell 60% in value in the fourth quarter of 2022 compared to a year prior, according to the news site PitchBook. Banks are choosing a vendor or partner while also considering the company’s financial stability. Banks don’t want their partners and vendors to disappear or be gobbled up by larger companies that disinvest in the platform.

But the current environment is not all bad for partnerships, either. In a contrast from two years ago, fintech founders tell me they’re concentrating on profitability these days and not just growth. The good news is that fintechs in general have gotten leaner, more focused and driven to create successful partnerships. 

Bankers still need to act like private detectives and investigate those fintechs. Bank Director Managing Editor Kiah Lau Haslett explores due diligence in Bank Director’s recently released FinXTech report, “Finding Fintechs.” But I’m convinced a group of fintechs focused on bank success — rather than growth for its own sake — can only be good for banks.

How Banks Can Win the Small Business Customer Experience

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In the first stages of the pandemic, it became apparent that many banks were unable to effectively meet the needs of their small business customers in terms of convenience, response time, fast access to capital and overall customer experience. Innovative financial technology companies, on the other hand, recognized this market opportunity and capitalized on it.

Bankers recognize the importance of providing their business banking customers with the same fast and frictionless digital experience that their consumer retail banking customers enjoy. So, how can banks ensure that they are competitive and continue to be relevant partners for their small business customers?

The reality of applying for most business loans below $250,000 is a difficult experience for the applicant and a marginally profitable credit for the bank. Yet, the demand for such lending exists: the majority of Small Business Administration pandemic relief loans were less than $50,000.

The key to making a smooth, fast and convenient application for the borrower and a profitable credit for the lender lies in addressing the issues that hinder the process: a lack of automation in data gathering and validation, a lack of automated implementation of underwriting rules and lack of standardized workflows tailored to the size and risk of the loan. Improving this means small business applicants experience a faster and smoother process — even if their application is declined. But a quick answer is preferable to days or weeks of document gathering and waiting, especially if the ultimate response is that the applicant doesn’t qualify.

But many banks have hesitated to originate business loans below $100,000, despite the market need for such products. Small business loans, as a category, are often viewed as high risk, due to business owners’ credit scores, low revenues or lack of collateral, which keeps potential borrowers from meeting banks’ qualifications for funding.

Innovative fintechs gained the inside track on small business lending by finding ways to cost-effectively evaluate applicants on the front-end by leveraging automated access to real-time credit and firmographic and alternative data to understand the business’ financial health and its ability to support the repayment requirements of the loan. Here, much of the value comes from the operational savings derived from screening out unqualified applicants, rerouting resources to process those loan applications and reducing underwriting costs by automating tasks that can be performed by systems rather than people.

To make the economics of scale for small dollar business lending work, fintechs have automated data and document gathering tasks, as well as the application of underwriting rules, so their loan officers only need to do a limited number of validation checks. Adopting a similar approach allows banks to better position themselves to more cost effectively and profitably serve the borrowing needs of small business customers.

Although some fintechs have the technology in place to provide a faster, more seamless borrowing experience, many lack the meaningful, personal relationship with business owners that banks possess. They typically must start from scratch when onboarding a new loan customer, as opposed to banks that already own the valuable customer relationship and the existing customer data. This gives banks an edge in customizing offers based on their existing knowledge of the business client.

While consumer spending remains strong, persisting inflationary pressures and the specter of a recession continue to impact small businesses’ bottom lines. Small business owners need financial partners that understand their business and are nimble enough to help them react to changing market dynamics in real time; many would prefer to manage these challenges with the assistance of their personal banker.

The challenge for bankers is crafting and executing their small business lending strategy: whether to develop better business banking technology and capabilities in-house, buy and interface with a third-party platform or partner with an existing fintech.

Better serving business customers by integrating a digital, seamless experience to compliment the personal touch of traditional banking positions financial institutions to compete with anyone in the small business lending marketplace. With the right strategy in place, banks can begin to win the small business customer experience battle and more profitably grow their small business lending portfolios.

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.

How Fifth Third Crafts Successful Bank-Fintech Partnerships

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From the start, Eric White anticipated the solar lender he launched in 2013 would eventually be owned by a bank. But it wasn’t until last fall that he settled on the $207 billion Fifth Third Bancorp in Cincinnati, Ohio.

The bank announced on Jan. 19 that it would acquire Dividend Finance for an undisclosed amount and closed the deal in May, with White, its founder and CEO, continuing to run the business.

White recalled two moments that made him feel certain his company had found its ideal buyer — the first was last fall when a group of Fifth Third’s top executives visited the fintech’s San Francisco’s headquarters for an initial meeting and the second was not much later when he met Ben Hoffman, Fifth Third’s chief strategy officer.

“It starts with people,” White says. “You have to like the people who are on the other side of the table from you before you get on the same side of the table as them.”

Hoffman echoed that, saying Fifth Third has come up with a couple of heuristics that help it determine whether it wants to pursue a partnership with a particular fintech. One is the way it assesses the entrepreneurs at the helm.

“We look at the leadership team and we ask, ‘Are these people that we could see filling other roles in the bank? Not because we intend to take them off mission — quite the opposite. When we bring these leaders in, it’s about empowering them to continue doing the thing that they’re incredibly passionate about and great at,” Hoffman says.

Not all bank-fintech partnerships turn into acquisitions, nor does Hoffman intend them to. And not all acquisitions start out as partnerships. Fifth Third and Dividend Finance had not worked together prior to striking their deal.

But Fifth Third’s introspective question serves as “a real test for cultural fit,” Hoffman says. “If there isn’t another real job on the org chart that you think these individuals could do, how can you expect them to understand us, and how can you expect us to really understand them, and to appreciate each other?” 

Ensuring a Cultural Fit
In anticipation of rising interest rates, White began seeking prospective bank buyers for Dividend Finance late last year. His prerequisite was that the banks had to be experienced with indirect lending, as his company is a point-of-sale lender that partners with contractors nationwide to provide their customers with financing for solar and other home improvement projects.

White says Fifth Third’s long partnership with GreenSky – a point-of-sale lender that offers home improvement loans through merchants – gave him comfort. Fifth Third invested in and began collaborating with GreenSky starting in 2016. (Goldman Sachs acquired the fintech in March.)

“Indirect lending is a very different model than direct lending. Some banks just don’t get it, and Fifth Third did,” White says.

But it was in that first meeting with Fifth Third, as then-President Tim Spence talked about how he had previously worked at technology startups and as a strategy consultant, when White first felt a sense that this bank stood out from the other contenders. Spence had been lured away from Oliver Wyman, where he focused on helping banks — Fifth Third among them — with their digital roadmaps. (He succeeded Greg Carmichael as Fifth Third’s chief executive officer in July.)

“Hearing Tim introduce himself and give his background was an eyeopener in and itself. He doesn’t come from a traditional bank executive background,” White says. “So, it was a different and a very refreshing perspective. It was very exciting for us.”

Hoffman made just as strong an impression on White when they met later on, further reassuring him that Dividend Finance had found “a perfect cultural fit” in terms of management philosophy and the long-term goals of both sides.

Hoffman previously worked with Spence as part of the Oliver Wyman team that advised Fifth Third and other banks; he followed Spence to the bank side in 2016. Hoffman’s mandate has evolved over the years, but one facet of his duties is overseeing Fifth Third’s fintech activities. White gives Hoffman rave reviews, calling him “one of the most creative thinkers that I’ve come across in my entire career.”

With the people test passed, the most salient selling point for White was “how the bank thinks about technology and product.”

In his perspective, too many banks are stuck in “archaic approaches” to managing growth and innovation. But Spence’s answer when asked why he decided to work at a bank in Cincinnati “really stuck with me,” White says. “He viewed Fifth Third as a platform to combine the best elements of traditional banking along with the opportunity to infuse innovation and a technology-driven approach to product development and organizational management.”

It gave White confidence that Fifth Third would not make the mistake that he believes other banks sometimes do, which is “trying to make the fintechs conform to the way that the bank has operated historically and in doing so, stripping out the qualities that make that fintech successful.”

White says his confidence has only grown since the acquisition. At Fifth Third, his title is Dividend Finance president, and he operates the business with a comfortable level of autonomy, reporting to Howard Hammond, executive vice president and head of consumer banking.

Ensuring a Strategic Fit
Fifth Third has partnerships with about a dozen fintechs at any given time and, over the past year and a half, has acquired two niche digital lenders outright, Dividend Finance, in the ESG space, and Provide, in the healthcare space. (ESG stands for Environmental, Social and Governance, and is often used to refer to the components of a sustainability-minded business approach.)

ESG and healthcare are two categories that align with Fifth Third’s own areas of focus, in accordance with a rule Hoffman follows when choosing fintechs of interest, whether for partnerships or acquisitions. He considers this rule — the fintech must help the bank improve on its existing strategy — key to helping ensure a partnership will eventually produce enough of a return to make Fifth Third’s investment of time, effort and money worthwhile.

As a result of the Dividend Finance acquisition, Fifth Third is actively assessing whether to increase its sustainable finance target. The bank had set a goal two years ago that called for achieving $8 billion of lending for alternative energy like solar, wind and geothermal by 2025.

“The things that we do with fintech are things that we were going to do one way or another. We’re not taking on incremental missions. We’re just pursuing those missions in different form. So, that framing completely changes the analysis that we’re doing,” Hoffman says.

Other banks might have to look broadly at competing priorities to decide between partnering with a specific fintech or tackling some other important initiative. But Fifth Third engages in a different thought process.

“It’s not, if we decide to partner with Provide, or should we acquire Dividend Finance, what will we not do?” Hoffman says.

Instead, Fifth Third asks, does this accelerate the timeframe for achieving a goal the bank has already set for itself?

“These partnerships are successful when they are aligned to our strategy and they accelerate, or de-risk, the execution of that strategy, as opposed to being separate and apart from the core ambitions of the franchise,” Hoffman says.

Assessing the Priority Level of Partnering — for Both Sides
Beyond that, any proposed partnership also needs to be “a top five priority” for both the fintech’s leadership and the relevant Fifth Third business line.

Hoffman advises other banks against the common approach of setting up a “tiny” partnership for the two sides to get to know each other with the idea of taking things to the next level when the time is right. “The likelihood of the timing ever being right, is very, very low,” he says. Those relationships often end up as distracting “hobbies” rather than ever escalating to the priority level necessary to add value for both sides and pay off in a meaningful way.

His insight is informed by experience. Hoffman leads Fifth Third’s corporate venture capital arm, which makes direct minority investments in fintechs. Given recent regulatory changes, it also participates as limited partners in several fintech-oriented venture capital funds.

His team is responsible for nurturing Fifth Third’s fintech partnerships, offering strategic insight and facilitating access to resources within the bank.

“As you can imagine, with some of the early-stage companies that we invest in, it’s six partners and an idea. Meanwhile, we have 20,000 people and branches and a half-dozen regulators and all of that. So, we provide a single point of contact to help sort of incubate and nurture the partnership until it reaches a level of stability and becomes a larger business,” Hoffman says.

“We work hard, as the partnerships mature, to stabilize the operating model such that the handholding, the single point of contact, becomes less necessary.”

That transition typically happens as the fintech gets better integrated into the day-to-day operations of the core business with which it is partnering, whether consumer banking, wealth management or another area in the bank.

Delivering Above and Beyond
With Provide, a digital lending financial platform for healthcare practices, the bank was an early investor, taking a lead role in a $12 million funding round with the venture capital firm QED Investors in 2018.

Fifth Third began funding loans made on the platform about two years later, with the amount increasing over time to the point where it was taking about half of Provide’s overall loan volume, the largest share among the five participating banks.

Through the Fifth Third partnership, Provide also expanded its offerings to include core banking and payments services, which are now used by more than 70% of the doctors for whom the fintech provides acquisition financing nationwide.

In announcing the agreement to buy Provide in June 2021, Fifth Third says the fintech would maintain its brand identity and operate as an independent business line.

Daniel Titcomb oversees Provide as its president and reports to Kala Gibson, executive vice president and chief corporate responsibility officer. (Gibson had oversight of business banking when Titcomb came on board and, though he’s in a new role as of March, continues to work with Provide.) Under Fifth Third’s ownership, Titcomb, who co-founded the fintech with James Bachmeier III in 2013, envisions being able to fuel loan growth and offer expanded services that help make starting and running a healthcare practice easier for doctors.

Since its launch, Provide has originated more than $1 billion in loans, largely through “practice lending,” which enables healthcare providers to start, buy or expand their practices. Its average loan size is $750,000.

Titcomb cited “a shared belief” in bank-fintech partnerships as one reason the early relationship with Fifth Third proved to be a success. “We both had a view of the future that didn’t include one destroying the other,” he says.

Years ago, fintechs and banks were often wary of each other — even adversarial — with banks being labeled by some as “dumb pipes,” the implication being that they were unable to keep up with nimble and innovative startups and were useful merely for product distribution to a larger customer base, Titcomb says. But he always found Fifth Third to be thoughtful and strategic, defying those stereotypes.

Though selling his business was scary, he says, “it was a lot less scary than it could’ve been,” given the established relationship.

Still, “we had to get comfortable and confident that they weren’t going to encourage us to spend less on technology,” he added. “Any time you enter into an agreement like that, you hope, but you don’t know.”

Titcomb says he is thrilled that the consistent feedback from Fifth Third since he joined has been: “You run this business the way you think it should be run.”

“It’s a relief,” he says.

Given outcomes like those experienced by White and Titcomb, Fifth Third has become known in fintech circles as a strong partner that delivers on its promises. Hoffman works hard to maintain that reputation—a competitive advantage.

“These companies have options, and some of those options are very compelling,” Hoffman says, adding that his goal is to make sure Fifth Third is “the partner of choice” for the fintechs it targets. That only happens, he says, if their experience after signing a deal aligns with what he says beforehand.

Count an enthusiastic Titcomb among those who attest that it has. “They have delivered above and beyond,” Titcomb says.

Getting the Most out of the Profitability Process

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The banking industry is increasingly using profitability measurements and analysis tools, including branch, product, officer and customer levels of profitability analysis.

But a profitability initiative can be a considerable undertaking for an organization from both process and cultural perspectives. One way that institutions can define, design, implement and manage all aspects of a profitability initiative is with a profitability steering committee and charter — yet less than 20% of financial institutions choose to leverage a profitability steering committee, according to the 2020 Profitability Survey from the Financial Managers Society. Over the past 30 years, we have found that implementing a profitability process inherently presents several challenges for institutions, including:

  • Organizational shock, due to a change in focus, culture and potentially compensation.
  • Profitability measurement that can be as much art as it is science.
  • A lack of the right tools, rules and data needed.
  • A lack of knowledge to best measure profitability.
  • A lack of understanding regarding the interpretation and use of results.
  • An overall lack of buy-in from people across the organization.

The best approach for banks to address and overcoming these challenges is to start with the end in mind. The graphic below depicts what this looks like from a profitability initiative perspective. Executives should start from the top left and let each step influence the decisions and needs of the subsequent step. Unfortunately, many organizations start at the bottom right and work their way up to the left. This is analogous to driving without a destination in mind, or directions for where you want to go.

The best way for banks to work through the above process, and all the related nuances and decisions, to ensure the successful implementation of a profitability initiative is by creating and leveraging a profitability steering committee and related charter. There are three primary components of a profitability steering committee and charter. The first task for the committee is to define the overall purpose and scope of the profitability initiative. This includes:

  • Defining the goals of the steering committee.
  • Outlining the governance of the initiative.
  • Defining how the profitability results will be used.

The committee’s next step is to define the structure of the profitability process, including:

  • The employees or roles that will receive profitability results, based on the decisions to be made, the results they will identify, any needed metrics and reports and any examples of reports.
  • The tool selection process, including determining whether an existing tool exists or if the bank needs a new tool, documenting system/tool requirements, creating the procurement process details and ownership of the tool.
  • Deciding and documenting governance concerns that relate to profitability rules, including identifying the primary owner of the rules, the types of rules needed (net interest margin, costs, fees, provision or capital), the process for proposing and approving rules, any participants in the process and any education, if needed.
  • Identifying the data needs and related processes for the initiative, such as the types of data needed, the sources and process for providing that data, ownership of the data process and the priority and timelines for each data type.

The committee’s final step focuses on the communication and training needs for the profitability initiative, including defining:

  • A training plan for stakeholders.
  • A communication plan that includes how executive will support for the initiative, a summary of the goals, decisions that need to be made, and any expectations and timelines, as well as details of the process, as needed.
  • An escalation process for handling questions, issues or disputes, and the role that committee members are expected to play in the escalation process.
  • The help and support, such as personnel and documents. that will be available.

Additional Best Practices
When creating a profitability steering committee and related charter, we have found it helpful to consider the following items as appropriate:

  • If profitability results will be included as part of individual or team incentive compensation, be sure to work through the necessary details, such as process flows, additional reporting, required integration points and data flows, dispute management, additional education and training, among others.
  • Consider aligning any metrics, approaches and reporting structures if the budgeting and planning process forecasts profitability.
  • Document plans for assessing the profitability initiative over time.
  • Finally, keep it suitably simple. Expect to be asked to explain the initiative’s approaches, details and results; the bank can always increase the precision and/or complexity over time.

Inflation, Interest Rates and ‘Inevitable’ Recession Complicate Risks

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What is the bigger risk to banks: inflation, or the steps the Federal Reserve is taking to bring it to heel?

Community banks are buffeted by an increasingly complicated operating environment, said speakers at Bank Director’s 2022 Bank Audit and Risk Committees Conference in Chicago, held June 13 to 15. In rather fortuitous timing, the conference occurred in advance of the Federal Reserve’s Federal Open Market Committee’s June meeting, where expectations were high for another potential increase in the federal funds rate. 

On one hand, inflation remains high. On the other hand, rapidly increasing interest rates aimed at interrupting inflation are also increasing risk for banks — and could eventually put the economy into a tailspin. Accordingly, interest rates and the potential for a recession were the biggest issues that could impact banks over the next 12 to 18 months, according to a pop up poll of some 250 people attending the event.  

Brandon Koeser, a financial services senior analyst at audit and consulting firm RSM US, said that inflation is the “premier risk” to the economic outlook right now. He called the consumer price index trend line “astonishing” — and its upward path may still have some momentum, given persistently high energy prices. Just days prior, on June 10, the Bureau of Labor Statistics announced that the CPI increased 1% in May, to 8.6% over the last 12 months. 

Koeser also pointed out that inflation is morphing, broadening from goods into services. That “rotation” creates a stickiness in the market that will be harder for the Federal Reserve to fight, increasing the odds that inflation persists.

It is “paramount” that the economy regain some semblance of price stability, Koeser said. In response, central bankers are increasing the pace, and potential size, of federal fund rate increases. But jacking up rates to lower prices without causing a recession is a blunt approach akin to “trying to thread a needle wearing boxing gloves,” he said.

While higher interest rates are generally good for banks, an inflationary environment could dampen loan growth while intensifying interest rate and credit risk, according to the Federal Deposit Insurance Corp.’s 2022 Risk Review. Inflation could lead consumers to cut back on spending, leading to lower business sales, and it could make it harder for borrowers to afford their payments.

At the same time, banks awash in pandemic liquidity added longer-term assets in 2021 in an attempt to capture some yield. Assets with maturities that were longer than three years made up 39% of assets at banks in 2021, compared with 36% in 2019, according to the FDIC. Community banks were even more vulnerable. Longer-term assets made up 52% of total assets at community banks at the end of 2021.

Managing this interest rate risk could be a challenge for banks that lack institutional knowledge of this unique environment. Kyle Manny, a partner at audit and consulting firm Plante Moran, pointed out that many banks are staffed with individuals who weren’t working in the industry in the 1980s or prior. He shared an anecdote of a seasoned banker who admitted he was “caught flat footed” by taking too much risk on the yield curve in the securities portfolio, and was now paying the price after the fair value of those assets fell. 

And high enough rates may ultimately send the economy into a recession. In Koeser’s poll of the audience, about 34% of audience members believe a recession will occur within the next six months; another 36% saw one as likely occurring in the next six to 12 months. Koeser said he doesn’t think it’s “impossible” for the central bank to avert a recession with a soft landing — but the margin for error is getting so small that a downturn may be “inevitable.”

Banks have limited options in the face of such macroeconomic trends, but they can still manage their own credit risk. David Ruffin, principal at credit risk analytics firm IntelliCredit, a division of Qwickrate, said that credit metrics today are the most “pristine” he had seen in his nearly 50 years in the industry. Still, the impact of the coronavirus pandemic and inflation could hide emerging credit risk on community bank portfolios. Kamal Mustafa, chairman of the strategic advisory firm Invictus Group, advised bankers to dig into their loan categories, industry by industry, to analyze how different borrowers will be impacted by these countervailing forces. Not all businesses in a specific industry will be impacted equally, he said.

So while banks can’t control the environment, they can at least understand their own loan books. 

3 Questions to Optimizing Debit Card Profitability in a Deal

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As the banking industry shrinks each year, CEOs often ask what they should look out for to improve profitability during and after a merger or acquisition. There is one area that is all too often overlooked: debit card profitability.

As an ever-growing source of demand deposit account revenue, debit card portfolios require detailed profit and performance analyses to optimize return. Done correctly, the efforts can be extremely fruitful. But there are a few things acquiring banks should keep an eye on when evaluating any acquisition target’s debit card profitability, to learn what is working for them and why.

Three items to consider when entering the M&A process:
1. Know thyself. To accurately gauge the impact of acquiring another bank’s cardholders, prospective buyers should first know where their own institution stands. How much is your bank netting per transaction, or per debit card outstanding? Every bank must know how much money is to be made when they issue a debit card to their customer. This concept is simple enough and is considered the basics of nearly all business, but putting it into practice can prove difficult without the proper knowledge base. Know your institution’s performance before the acquisition, as well as where your institution should to be after.

2. Dissect the income. If an analysis of interchange income reveals that your bank, as the acquirer, is making less interchange income per purchase than the acquired institution, find out why. The acquisition target may have better interchange rates because of a better network arrangement or even just better network agreement terms. This evaluation should not only apply to the networks or the foundation of interchange earning. Oftentimes, the acquired institution has done a better job of marketing and getting their cards into customers’ hands for use. Bigger does not necessarily mean better when it comes to debit card profitability. Choose the arrangement and agreement terms from either institution on electronic funds transfer (EFT) processing, PIN network and card brand that is most profitable.

3. On expenses, timing can be everything. While the acquiring bank often has better pricing on processing expenses, they don’t always — especially on EFT. Most bankers know to evaluate the acquired institution’s contracts to determine buyouts, deconversion and termination penalties and get a general glimpse at the pricing. But there is a present need for a pricing deep dive across all contracts in every single deal — especially when considering a merger of equals or an acquisition that really moves the needle.

Further, this evaluation should not stop at traditional data processing contracts, like core and EFT. It must consider card incentive agreements. Executives should study the analytics around buyout timing on both institutions’ card brands, along with the interchange network agreements. Consider the termination penalties, but also the balancing effect of positive impact, to incentive income of the acquirer’s agreements. Although the bank cannot disclose details of the acquisition, they can keep the lines of communication open with card vendors. There will be a sweet spot of timing in the profit optimization formula, and the bank will want an open rapport with their card-critical vendors.

Debit cards as a potential profit center are often overlooked in the merger and acquisition process, which tends to be geared toward share price and the details of the buyout. However, it is valuable for acquirers to review debit cards in context of the combined bank’s long-term success of the bank, not just focusing on the deposits retained and lost when it comes to income consideration.

A Third Option for Banks Considering M&A

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“When you come to a fork in the road, take it.” – Yogi Berra, American baseball legend

Clearly, Yogi Berra didn’t quite see the fork in the road as a binary choice. The industry has seen more than 250 bank acquisitions over the past few years, and experts predict M&A activity could ramp up in 2022 as deals that were put on hold due to the Covid-19 pandemic finally come to fruition. But rather than exploring paths that could lead banks to either be a buyer or seller in a transaction, what if there was another option? A door number three, like in “Let’s Make a Deal.”

Bankers could embrace Yogi’s wisdom; that is, they could take a pass on buying or selling while opting for continued independence as a high-performing bank. Without being naive nor blind to the imminent wave of M&A activity, there are an abundance of strategic options and partnerships banks can employ to maintain independence and fuel growth.

As anyone who has been on either side of the M&A equation knows, absorbing and combining banks is a messy business full of complexity, unforeseen challenges and risk. Institutions that expect to be involved in a transaction would be well advised to consider alternate service delivery models for some of their existing lines of business to reduce M&A friction.

At the same time, digital transformation continues to be a recurring theme for the industry. What is your bank’s digital strategy? Is your bank curating the right digital experience for your customers? Is your bank exploring strategic partnerships that can streamline the back office while leveraging the customer-facing tech?

Mortgage is an ideal candidate for this due to the level of complexity, compliance risk and volatility it inherently poses. Merging two mortgage operations into a cohesive unit or injecting mortgage operations into an institution where it did not previously exist can be massive undertakings that only add to the difficulty of completing a merger or acquisition.

Regardless of what side of the M&A transaction a bank is on, a mortgage offering helps banks find scale to drive technology or other investments, expand their geography, acquire new customers and grow revenue. Offering this foundational financial product cost-effectively through an outsourced fulfillment partner allows banks to progress on those goals by eliminating what could be a significant source of potential friction.

Outsourcing back-office mortgage operations also provides substantial benefits to both potential acquirers and acquirees. From an acquirer’s perspective, a fulfillment service maximizes their mortgage profitability and portability, enabling them to seamlessly extend their operations into the target bank without the hassle of integrating systems or solving for staffing issues. Acquirers can immediately enhance the franchise value of its acquisition by introducing mortgage services and begin generating an entirely new revenue stream without establishing new operational infrastructure.

On the flip side, partnering with a mortgage fulfillment provider can enhance the attractiveness of banks looking to sell. Outsourcing mortgage fulfillment enables banks to reduce the overhead and expenses required to maintain a full-fledged mortgage operation in-house, which can improve the liabilities side of the balance sheet, making them a more financially attractive acquisition target.

Outsourcing mortgage also enables banks to stabilize their staffing needs, avoiding the industry’s traditional “hire-and-fire cycle” of staffing up during high volume periods to keep up with demand and severely reduce staff when volume inevitably slows. Outsourcing the labor-intensive fulfillment portion of the mortgage process allows prospective sellers to redeploy their internal resources and ensure maximum staff retention post-M&A.

Improving scale, efficiency, profitability and stakeholder value are always the objectives for any bank, whether they engage in M&A or choose to stay independent. Regardless of strategy, outsourcing mortgage fulfillment using innovative technology can be a critical strategy for banks looking to grow their product offerings and revenue in the short term while setting themselves up for sustainable high performance.

It’s tempting to aim for the fences with a grand slam when it comes to digital transformation. But maximizing the profitability of a key product segment like mortgage could be a nice, achievable win.

Should More Community Banks Be B Corporations?

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Banks face a highly competitive landscape filled with thousands of other banks, credit unions and financial technology companies. Could proving your values be a powerful way to differentiate your institution in such an environment? A 2021 Edelman survey found that 61% of consumers will advocate for brands they trust, and 86% expect them to “act beyond their product or business,” wrote Richard Edelman, CEO of the global communications firm. “[B]rands will need to operate at the intersection of culture, purpose and society.”

Sunrise Banks, a $1.9 billion community development financial institution (CDFI) based in St. Paul, Minnesota, aspires to be “the most innovative bank empowering financial wellness,” says Bryan Toft, its chief revenue officer. That mission “attracts customers [who] really care about those values,” he says. “Passionate employees are attracted to it as well, who work hard and want to make a difference because of that mission, as opposed to a paycheck.” In addition to its community bank footprint around St. Paul, Sunrise also offers a banking-as-a-service platform, choosing partner fintechs through a “social filter” that considers how those companies align with its mission.

Toft views this as a competitive advantage, not one that detracts from profitability. Sunrise Banks’ quarterly return on assets averaged 1.22% from March 2018 through Sept. 30, 2021. Performance during this period was fueled by commercial loan growth, new fintech relationships and fee income through the Paycheck Protection Program.

Certifying as a B corporation, Toft says, was a natural fit for the bank. These businesses are redefining what it means to run a successful enterprise, according to B Lab, which certifies B corporations. B Lab likens its certification to Fair Trade USA’s standard for coffee, providing a way to assess and verify a company’s social and environmental impact. The nonprofit has certified more than 4,600 companies worldwide and 1,691 B corporations in the U.S., including ice cream manufacturer Ben & Jerry’s and clothing retailer Patagonia. Eleven of these B corporations are U.S. banks. Becoming a B corporation doesn’t guarantee higher profits; few reported an ROA on par with Sunrise as of third quarter 2021.

B corporations must score a minimum 80 points on B Lab’s “B Impact Assessment,” a tool the nonprofit developed to “measure, manage, and improve a company’s positive impact performance” in the following areas:

  • Governance, including mission, ethics and transparency.
  • Workers, including health, wellness and safety, and career development.
  • Community, including economic impact, civic engagement and diversity, equity and inclusion.
  • Environment, including the company’s impact on air, water, land and biodiversity.
  • And customers, including products and services as well as data privacy and security.

“We have to look at all aspects of our business,” says Toft. The assessment features 200 questions, he says, and explores questions such as, “What percent of your employees are paid a living wage? How do you support diversity, equity and inclusion? What are some of the things that you measure in terms of environmental impact? … How do you know [that] your products make an impact positively in your customers’ lives?”

The assessment is free and can help a company benchmark its performance in the examined areas.

While the assessment is free to use, certification isn’t. The annual fee charged by B Lab to verify B corporation status ranges from $1,000 to $50,000 or more, based on the company’s revenue. In addition to the initial assessment, B Lab selects a subset of questions for additional documentation, and assessed companies must meet B Lab’s risk standards. And B corporations are legally required to consider all stakeholders; opting to become a public benefit corporation — a legal structure available in most states where a company commits to creating a positive social impact — offers a way to fulfill this requirement.

For $2.5 billion Mascoma Bank, the multi-stakeholder approach aligns with its mutual bank charter. “Our governance does not require us to give primacy to shareholders, because the community is primarily the shareholder,” says Clay Adams, CEO of the Lebanon, New Hampshire-based bank. “We measure ourselves versus peers. How do we maximize profitability but also maximize stakeholder results?”

B Corporation companies must recertify every three years, says Adams, a process he compares to a “kinder, gentler version of a regulatory exam.” Average scores range from 40 to 100 out of 200 possible points, according to B Lab. (The score for each bank appears in the below table.) And companies demonstrate different strengths; both Sunrise and Mascoma scored in the top 5% globally in the governance category in 2021.

Toft and Adams both believe that B corporation values align with community banking values, with customers and employees seeking to do business with banks that do good in their communities.

“Where [customers] put their money matters” to them, says Toft. “A lot of banks do great things in their communities, and this is a way to have a third party verify that. … A lot of banks probably could be certified as B corps, because inherently what they do is all about the mission in their respective community.”

B Corporation Banks

Bank Name/Location Asset Size (000s) Return on Assets (ROA) 9/30/2021 B Corp Start Date B Impact Score
Beneficial State Bank
Oakland, CA		 $1,496,354 1.21% 9/17/2012 158.9
Virginia Community Capital (VCC Bank)
Richmond, VA		 $235,502 1.14% 5/14/2012 149.3
City First Bank, N.A.
Washington, DC		 $1,061,371 -0.20% 4/17/2017 146.8
Sunrise Banks
St. Paul, MN		 $1,882,632 1.16% 6/23/2009 144.2
Spring Bank
Bronx, NY		 $336,177 1.42% 4/13/2016 136.2
Southern Bancorp Bank
Arkadelphia, AR		 $1,967,438 1.00% 9/9/2019 122.3
Amalgamated Bank
New York, NY		 $6,866,385 0.77% 1/11/2017 115.1
Mascoma Bank
Lebanon, NH		 $2,546,655 0.88% 6/28/2017 114.9
Brattleboro Savings & Loan
Brattleboro, VT		 $304,363 0.51% 12/18/2018 96.7
Androscoggin Savings Bank
Lewiston, ME		 $1,371,816 0.57% 1/26/2021 91.1
Piscataqua Savings Bank
Portsmouth, NH		 $338,598 0.43% 5/16/2019 81.1

Source: B Lab, Federal Deposit Insurance Corp.

The B Impact score reflects the most recent score received by the bank in B Lab’s B Impact Assessment; a company can receive a maximum of 200 points. On average, companies score between 40 and 100 points; a minimum of 80 is required to be certified as a B corporation.

Transforming, Optimizing Bank Finance Functions

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Banks can optimize their finance functions to go beyond compliance and drive performance and results. Creating a layer of functionality on top of the general ledger allows executives to apply behavior and risk data with an eye toward improving profitability and forecasting without replacing their core. Will Newcomer, vice president of business development and strategy at Wolters Kluwer, and Bill Collette, managing director of financial services solutions at Wolters Kluwer, share what kind of applications and analytics executives could use to drive measurement, accuracy and accountability. Topics include:

  • Trends in Transformation
  • Uses of Finance Analytics
  • Best Practices for Transformation

Banks can improve measurement, accuracy and accountability by leveraging their existing core and finance functions.