Responding to Uncertainty by Focusing on Bank Fundamentals

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In the face of a novel environment and great economic uncertainty, community banks should focus on their fundamentals — and their customers.

That’s the message from speakers throughout the first day of Bank Director’s 2023 Acquire or Be Acquired conference. More than 1,700 attendees started off Sunday with an overview of the challenging economic landscape, coupled with encouragement that there are opportunities for nimble operators.

“No way do I believe that size alone is a determinant of success,” says Tom Michaud, CEO of investment firm Keefe Bruyette & Woods, in the conference’s opening session. “Size hasn’t ensured success. Some of the finest banks I know are under $5 billion in assets.”

It all comes down to execution, and there is reason for banks to be cautious. It’s not clear if the economy will go into a recession or land softly, although Michaud says his firm is projecting a “softer” landing for 2023 and single-digit loan growth. The Federal Reserve has raised rates at a pace that most bankers have never experienced — a dramatic turnabout two years after the industry was deluged with $2 trillion of stimulus spending to address the coronavirus pandemic. But even with the prospect of slower growth, Michaud advises banks to keep their balance sheet clean and find opportunities to build capital. 

“An industry that is catching its breath but remains profitable is a good place to be,” he says.

For now, this rapid whipsaw is the new normal in banking. Ahead of the conference, former Comptroller of the Currency Gene Ludwig told Bank Director that one truism in banking from the last half-century is that “the ups and downs come more frequently, and probably more severely, in shorter periods than they have in the past.” Technology and globalization have accelerated the pace of change, and banks need to be prepared for the volatility. 

Ludwig speaks from experience. In addition to serving as comptroller in the 1990s, he founded IntraFi, a reciprocal deposit network formerly known as Promontory Interfinancial Network, and is now a managing partner of Canapi Ventures, a bank-focused venture capital fund that invests in financial technology companies.

Having seen a variety of economic and credit cycles, Ludwig advised management teams to operate their institutions for the long haul and resist the noise of one quarter or the next. For the former comptroller, this comes down to the fundamental focus on customers, community and deposits. “Is what I am doing, and how I’m operating, best for my customer? Am I doing that in fundamentally a safe and sound manner?”

Increasingly, low-cost deposits are an important aspect of those customer relationships. Technology has made it easier for deposits to move, creating competition for those once-sticky funds. “Bankers that cultivate good customer relationships and use modern tools are able to have more stable and lower cost funding than banks that don’t,” Ludwig said, adding that banks have a variety of methods and tools to encourage existing companies to keep their deposits. 

The environment has shifted from unprecedented levels of liquidity flowing into banks to outflows. Total deposits in the banking industry declined for the second consecutive quarter, down 1.1%, or $206 billion, from the second quarter of 2022 to the third quarter, according to the Federal Deposit Insurance Corp. Driving the shift were accounts with balances above $250,000.  

“Banks in general are going to have to start thinking about funding loans as they go along,” Michaud told Bank Director ahead of the conference. “Previously, they had this reservoir of excess funding that made it easy to make an incremental loan. Now they’re going to have to fund it marginally, and that’s why we’re seeing deposit costs rise.”

Many institutions consider themselves “relationship lenders,” but Mac Thompson, founder and president of analytics firm White Clay, points out that many bankers struggle to quantify the depth of their customer relationships. That is one imperative for community bankers to grasp ahead of a potential recession.

“Who is using your liquidity, who is using your capital and what are you getting paid for it?” he says during a lunchtime presentation. Relationship managers should know the answer to those questions by analyzing a customers’ loans and deposits. Thompson urges banks to focus on bringing customers’ operational accounts to the bank — the accounts that pay their bills — because those accounts may be harder to move in response to interest rates. 

Customer loyalty goes both ways in relationship banking, and Michaud said this is one approach banks leverage when navigating the uncertain environment. 

“Now’s the time for banks to be there for their best customers,” he said, especially as access to credit tightens. “Typically when they are, their best customers tend not to forget it.” 

Increased Regulatory Scrutiny Renders Credit Furnishers Vulnerable

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Rising consumer debt, the potential specter of recession and an intensified regulatory focus on credit reporting and disputes management are creating a perfect storm for companies that provide credit, including banks.

And yet, from my vantage point as an expert in credit dispute operations technology, I see troubling gaps in how furnishers conduct their credit dispute management operations. Weak credit dispute management will be a liability for banks. My advice to leaders of operational risk and portfolio operations business lines? Shore up your operations now before the inevitability of a rising tide of disputes overwhelms you.

Some effects of a slowing economy that hint at a potential recession are already affecting consumer pocketbooks. Rising consumer prices continue to curtail spending as consumers prioritize groceries and gas over other expenses, most notably debt repayment.

Add spiraling interest rates to that mix, and it should come as no surprise that consumer debt has ballooned to new highs that surpass pre-Great Recession levels. This comes as the job market is expected to eventually trend downward and tools that cash-strapped consumers use, like buy now, pay later, become more popular. These worrisome indicators all point to a significant reboot in the consumer credit score cycle. Here’s what that shift looks like:

  • Lenders look to adjust credit risk.
  • Loan pricing tightens.
  • Interest rates increase as credit scores decrease.
  • Cost of funds increases for consumers with lower credit scores.
  • Consumers take a greater interest in their credit score.
  • Furnishers see dispute volumes increase.
  • Consumers get frustrated and turn to credit repair organizations (CROs).

Yes, we’ve been down this road before and weathered it. But this time could be different.

A Renewed Focus on the FCRA
What is unique to this 2022 cycle, compared to the last cycle that spanned 2009 to 2014, is the notable change in the federal government’s interest in consumer protection. During the last cycle, fewer consumers had the savviness or empowerment to understand credit reporting and scores; additionally, the Consumer Financial Protection Bureau had just been created. Today however, the CFPB is strong, established and primed to act.

Even prior to the war in Ukraine and inflation materialized, CFPB Director Rohit Chopra had already begun laying out his thesis on stronger consumer credit protections — one that includes a far more intentional focus on credit furnishing and dispute provisions within the Fair Credit Reporting Act, or FCRA. The CFPB has clearly signaled that FCRA adherence is its top priority and that this time around, furnishers will be held to account.

Efficiency will protect and help your bank manage the increased volume of disputes expected in an era of stronger consumer credit protections. Let’s examine where those disputes are coming from. Disputes originating from credit repair organizations are the top concern for credit providers. A poll from a recent Consumer Data Industry Association conference shows that 74% of the respondents identified CROs as the “biggest pain point” in their operations. Additionally, the market size for these services is expected to grow by 9.5% this year.

That’s a clear signal for every organization to shore up its credit dispute management and credit furnishing today. Organizations need to be able to demonstrate accurate furnishing standards and adherence, produce relevant policies and procedures that encapsulate reasonable investigation for credit reporting disputes and, above all, adequately demonstrate evidence that “what was said would be done and what was actually done” match. To do anything else is to unnecessarily invite increased regulatory scrutiny at a time when credit furnishers are most vulnerable.

How well prepared is your bank for this increased regulatory scrutiny? If you’re not sure, reach out to a trusted expert to help evaluate and implement the technology and regulatory guidance needed to help accurately and efficiently resolve credit reporting issues before they become disputes.

Banking During a Time of Uncertainty

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The following feature appeared in the fourth quarter 2022 edition of Bank Director magazine. It and other stories are available to magazine subscribers and members of Bank Director’s Bank Services Membership Program. Learn more about subscribing here.

For John Asbury, CEO at Atlantic Union Bankshares Corp., a $19.7 billion bank headquartered in Richmond, Virginia, concerns about the direction of the U.S. economy have a familiar feel to them. It was just two years ago that Asbury and the rest of the banking industry were staring into the abyss of an economic catastrophe caused by the Covid-19 pandemic.

The U.S. economy shrank 31.2% in the second quarter of 2020 when the country was put into lockdown mode to fight the pandemic. And while the economy made a dramatic recovery, growing 38% the following quarter, it was a time of great uncertainty for the nation’s banks as they dealt with an unprecedented set of economic and operational challenges.

For bankers like Asbury, it’s déjà vu in 2022.

“Once again we find ourselves in a period of great uncertainty — which is a familiar place to be,” says Asbury. This time the economic challenges come from a sharp rise in inflation, which came in at 8.5% in July — well above the Federal Reserve’s target rate of just 2%. The Fed clearly misread this sudden increase in inflation, thinking it was driven primarily by supply chain disruptions coming out of the pandemic, and now is trying to catch up with a fast-moving train.

Year to date through September, the Fed’s rate setting body — the Federal Open Market Committee — raised the federal funds rate five times, including three successive rate increases of 75 basis points each, bringing the upper limit of the target rate to 3.25%. It’s been a long time since the Fed raised interest rates by such a substantial margin in so short a time. The FOMC was scheduled to meet again in November and December, and Federal Reserve officials indicated in September that rates could reach 4.4% by year-end.

During the early days of the pandemic, the Federal Reserve also pumped money into the economy through a policy tool called quantitative easing, where it bought long-term securities from its member banks. Earlier this year, the Fed began to reverse that policy to reduce liquidity in the economy, which should help boost interest rates.

The result has been a dual economic outlook, with the immediate future looking more promising than it has in years — but with the longer-term prospects clouded by the threat of inflation and the Federal Reserve’s determination to bring it to heel. Rising interest rates are generally a boon to most banks, but there is a threshold point at which higher rates can lead to a prolonged economic downturn — which is not good for banks or most other companies.

“It remains to be seen what [the Fed] will do when push comes to shove but at least for now, it looks like they’re more concerned about reining in inflation than any of the effects — like a slowdown — that such actions could cause,” says R. Scott Siefers, managing director and senior research analyst at the investment bank Piper Sandler & Co.

The challenge for banks is plotting a course through such a confusing landscape. Do they push for loan growth at the beginning of an economic slowdown of unknown depth and duration, or adopt a more conservative posture toward credit? Should they compete for deposits as funding costs inevitably go up, or be content to let some of their excess funding run off? And lurking in the background is the risk that the Federal Reserve ends up tipping the economy into a deep recession as it seeks to choke off inflation.

By a traditional definition, the U.S. economy has already entered a shallow recession. The country’s gross domestic product, which is the monetary value of all goods and services produced in a specific time period, was -1.4% in the first quarter and -0.9% in the second quarter. Recessions are generally thought of as two quarters of economic contraction, but a variety of factors and data are part of that consideration. The Business Cycle Dating Committee, which is part of the National Bureau of Economic Research, is the group that declares when the U.S. is in recession and has yet to declare this current cycle one.

By other measures, however, the economy is doing surprisingly well. The country’s unemployment rate in August was just 3.7% — down from a peak of 13.2% in May 2020 — and the economy added over 500,000 new jobs in July and another 315,000 in August. In another piece of good news, August’s inflation rate was 8.3%, down from 8.5% in July and 9.1% in June, offering a glimmer of hope that the Fed’s rate hikes are beginning to work.

And in many respects, the experience of bankers on the ground is also at odds with the economic data. “What I’ve found myself saying as I speak to our clients and to our teams is that I feel better than I do when I simply read the financial press,” says Asbury. “Despite all the uncertainty, we’re actually in a pretty good place at the moment. Asset quality remains very benign. We see no end in sight to that, which is one of the more astonishing aspects of the whole pandemic, continuing even to now. Liquidity is still very good. We would have expected to see more deposit runoff than we have. It’s really all about business and consumer sentiment, which seems to be going up and down … The reality is that we’re in a pretty good spot.”

Ira Robbins, chairman and CEO at Valley National Bancorp, a $54.4 billion regional bank headquartered in Wayne, New Jersey, offers a similar assessment. In addition to New Jersey, the bank also does business in New York, Alabama and Florida. And a bank’s experience during an economic downturn may depend on its geographic location, because not all regions of the country are affected equally. “I’m sitting in Florida today, and it doesn’t feel like a recession here at all,” says Robbins in a recent interview. The economy might fit the traditional definition of a mild recession, but that doesn’t seem to bother him very much.

“I really don’t think it’s all that relevant to be honest with you,” he says. “When I look at the behavior of our consumers and commercial customers, we would say we’re not in a recession based on activity, based on spending habits, based on the desire to still have capital investments. When it comes to commercial endeavors, the economy still feels very, very strong.”

Valley National is a large residential lender, and Robbins says that the rise in interest rates has chilled the mortgage refinancing market and made it more difficult for first-time home buyers looking for an entry-level home. “But general activity in the purchase market is still very strong,” he says. “The Florida market is still on fire for us. Prices really haven’t abated yet. And the demand is still very strong in the market from a residential perspective.” Commercial real estate activity, including multi-family housing, is also booming in Florida thanks to the continued influx of people from out of state, according to Robbins. “We still have many of our borrowers — developers — looking to this footprint to grow,” he says. “And the rise in interest rates really hasn’t impacted their desire to be in this market.”

Valley National is also seeing a lot of multi-family development in the Jersey City, New Jersey market, where the bank is an active lender. “We have an environment where the supply hasn’t kept up with demand for a long time,” Robbins says. “Irrespective of what’s going on in the interest rate environment, there’s still a lot of people demanding newer product that just isn’t available to them today.”

If Asbury and Robbins see the current economic situation from a glass-half-full perspective, Tim Spence, CEO at $207 billion Fifth Third Bancorp in Cincinnati, Ohio, sees it as half empty. Spence has chosen to position the bank more conservatively given the economy’s uncertain outlook going into 2023. “We’ve elected to be more cautious as it relates to the outlook than many others have been,” he says. That caution has manifested itself in tougher expense control, “paring around the margins in terms of the lending activity” and using swaps to protect the bank’s net interest margin should the Fed end up cutting interest rates in the future, Spence explains.

While the U.S. economy may be slowing down, there are other factors that should buoy the industry’s profitability through the remainder of 2022. Most banks benefit from a rising rate environment because they can reprice their commercial loans faster than market competition forces them to reprice their deposits.

Deposit costs have yet to increase upward even as interest rates have shot up dramatically, and there is still a lot of liquidity in the country’s banking system. Siefers points to Fed data that deposits grew 0.6% in the first half of the year and remarks in an email exchange that he’s “been surprised at how resilient the deposit balances were. The conventional wisdom is that commercial balances have been looking for other homes, while consumer [deposits] have [gone] higher. Net/net, very little movement in total balances.”

One of the dichotomies in the economy is the industry’s strong loan growth despite the evidence of a slowdown. Citing Federal Reserve data, Siefers points out that loans excluding Paycheck Protection Program loans grew 5.5% in the first half of the year. While it might seem counter-intuitive that loans would grow while the economy is cooling off, Tom Michaud, CEO of investment bank Keefe, Bruyette & Woods, says that many commercial borrowers have been returning to the loan market after staying out during the early days of the pandemic. “The government took much of the role of lending out of the industry’s hands with the Paycheck Protection Program and other support elements,” he says. “And then after Covid started, most middle market corporations didn’t see any reason to increase borrowing a lot until they had a better feeling about the economy.”

The industry’s asset quality has also remained at historically low levels and along with the Fed’s interest rate hikes, has created what Siefers calls a “Goldilocks environment” with rising margins, strong loan growth and benign credit trends.

This will likely lead to higher profitability in the latter half of the year. “You’re going to see a significant expansion in bank net interest margins in the third and fourth quarters — the likes of which we’ve probably not seen in a couple of decades, because you’re going to have the cumulative impact of the May, June and July rate hikes flowing into the third and fourth quarters,” says Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities.

The dichotomy between low deposit costs and higher rates won’t last forever, of course. David Fanger, a senior vice president at Moody’s Investors Service, says that deposit rates typically move very little during the first 100 basis points in rate hikes when the Federal Reserve begins to tighten its monetary policy. And even when they do begin to move upward, it’s never on a one-to-one basis. “Even at the end of the [last] rate hike cycle, deposit rates increased only 30% of the increase in [the federal funds rate],” says Fanger. Once deposit rates do begin to rise — certainly in 2023 if not later this year as the Fed continues its tight monetary policy — that will probably cut into the expanding net interest margin that most banks are currently enjoying, although Fanger does not expect the industry’s margin to contract unless loan growth drops significantly.

What probably will change, however, is a decline in the industry’s liquidity level as banks decide not to compete for excess funds that seek out higher rates than they are willing to pay. Through a combination of federal stimulus legislation like the CARES Act, passed in March 2020 during the Trump administration, and the American Rescue Plan Act, passed in March 2021 during the Biden administration, along with $800 billion in PPP loans that banks originated and the Fed’s quantitative easing policy, trillions of dollars were pumped into the economy during the pandemic. Much of this money ended up on banks’ balance sheets at historically low interest rates. (The federal funds rate in May 2020 was 0.05%.) As rates rise, some of the money will start looking for a higher return.

“I don’t think banks are going to manage their companies just for the absolute level of deposits,” says Michaud. “I believe they’re going to manage their deposits as the market becomes more competitive for deposits relative to the size of their loan portfolio or what they believe is the size of their core bank. Some banks even started doing that in the second quarter. They were happy to let deposits run out of the bank, and they were more willing to focus on their core deposits.”

While it’s possible that the inflation rate peaked in June, Michaud doesn’t expect the central bank to begin lowering the fed funds rate anytime soon. “I think, if anything, the Fed is going to wait to see the outcome from their policy actions to ensure that inflation has gone back down to the level that they wish to see,” he says.

Asbury is of the same mind. “There have been lots of studies that suggest that if the Fed backs off too quickly, that will be a bad thing,” he says. “So, I don’t think rates are coming down anytime too soon.”

In fact, in late summer, there was a disconnect between the fed funds futures market and information coming out of the Federal Reserve. Activity in the futures market implied that the Fed would cut rates next year, even though messaging coming out of the central bank strongly suggested otherwise. The Fed’s summary of economic projections, which includes its dot plot chart that reflects each Fed official’s estimate of where the fed funds rate will be at the end of each calendar year three years into the future, suggests that the median rate will be 4.4% at the end of this year and 4.6% at the end of 2023.

And in a speech at the Federal Reserve Bank of Kansas City’s annual policy symposium in Jackson Hole, Wyoming, in late August, Federal Reserve Chairman Jerome Powell warned that “[r]educing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth and softer labor conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.”

Translation: If it takes a recession to bring the inflation rate back down to 2%, so be it.

Inflation has several direct effects on bank profitability. Like most other industry sectors, banks have seen their employment costs rise in a tight job market. “We’ve had to make adjustments, and we continue to look at what needs to be done to remain competitive for front line, client-facing teammates,” says Asbury. “The war for talent is raging.” Valley National also gave raises that went into effect in June, 5% to those making less than $65,000 a year, and 3.5% for those earning between $65,000 and $75,000 a year. “Those are permanent raises,” says Robbins. “It’s going to cost us almost $5 million a year in increased salary expense. So, we have to do a much better job on the revenue side to make sure we’re generating enough to support those expenses.”

The sharp rise in interest rates has also led to an increase in bond yields, which has impacted those banks that over the last two years used their excess deposits to invest in lower yielding securities. This has resulted in unrealized losses in their accumulated other comphrensive income — or AOCI — line. While these losses are not charged against a bank’s net income or its regulatory capital if the securities are being held for investment rather than trading purposes, they still impact its tangible common equity capital ratios “and industry observers watch that,” says Michaud.

But the biggest impact of inflation is how it drives the Federal Reserve’s monetary policy. Rising interest rates help fatten the industry’s net interest margin, but they also hike the debt service costs for corporate borrowers as their loans reprice higher. And some of those companies may end up defaulting on their loans in a longer, deeper recession.

As bankers look at the uncertainty hanging over the economy going into 2023, it’s important to give increased attention to customer communication and credit risk analysis. “Banks that have underwriting processes that have survived through multiple economic cycles and that are extremely client-centric will do better,” predicts Poonawala at Bank of America Securities.

“This is an appropriate time to step up communication with the client base, and we are doing that,” says Asbury. “You also have to run sensitivity analyses in terms of the impact of higher borrowing costs. We do this in the normal course of underwriting. Even when rates were at absolute historic lows, we still made credit decisions [by] running scenarios of higher rates and their capacity to service debt and repay in a higher rate environment. That’s just good banking.”

For his part, Robbins sees no need to pull Valley National back from its core commercial borrowers, even with the economy cooling off. “Seventy percent of our commercial origination comes from recurring customers,” he says. “Many of them have been through interest rate environments that have historically been much higher. Their ability to operate in this type of environment isn’t something that really concerns us.” Interest rates would have to go much higher before many of the bank’s core borrowers, particularly in an asset class like multi-family housing, where the demand for new product is high, would pull back from the market, Robbins says.

The larger risk occurs when banks stray beyond their comfort zone in search of yield or volume.

“Because we’ve been in a declining net interest margin environment, banks have been stretching to get into new geographies or asset classes they don’t have any real experience with,” Robbins says. And in an economic downturn, “banks that have done that but haven’t done it in the proper way are going to have real challenges,” he adds.

The difference in perspective may be more nuanced than truly material, but Spence at Fifth Third takes a more cautious view of the future beyond 2022. “From our point of view, it is a challenging environment to understand because the Fed has never had to move at the pace it has,” he says. “We’re coming off 15 years of zero or near-zero interest rates, and an environment where central banks were the largest bond buyers in the world. Now all of a sudden, they’re bond sellers.” Factor in the continued supply chain challenges that were initially driven by the pandemic but are now being accentuated by the war in Ukraine, along with a tight labor market, and it’s a very uncertain time.

Spence outlines three steps that Fifth Third has taken to address this uncertainty. First, the bank is spending even more time thinking about concentration risk. “Are we lending to sectors of the economy … that are going to be more resilient in any environment?” he says. On the consumer side, that has meant more emphasis on super prime customers and homeowners, and less on subprime borrowers even though they pay higher rates. And on the commercial side, that translates into greater focus on commercial and industrial loans to provide inventory financing, equipment purchases and working capital, and less emphasis on commercial real estate and leveraged lending.

Second, Fifth Third has used various hedging strategies to protect its balance sheet for a time when the Fed eventually loosens its monetary policy and begins to lower rates. Spence says the bank has added $10 billion in fixed-rate swaps to build a floor under its net interest margin for the next 10 years.

And finally, the bank is prepared for a scenario in which the Fed has to drive interest rates much higher to finally curb inflation. “In that case, nothing is more important than the quality of your deposit book,” says Spence, who believes that Fifth Third has a strong core deposit franchise.

Spence worries much less about the consequences of being too conservative than being too reckless. “In a business like ours that’s susceptible to economic cycles, the single most important thing that you can do is ask yourself what happens if I’m wrong,” he says. “From my point of view, if we are wrong, then we gave up a couple of points of loan growth in a given year that we can just get back later.”

The Return of the Credit Cycle

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It has been like waiting for the second shoe to fall.

The first shoe was the Covid-19 pandemic, which forced the U.S. economy into lockdown mode in March 2020. Many banks prepared for an expected credit apocalypse by setting up big reserves for future loan losses — and those anticipated losses were the second shoe. Sure enough, the economy shrank 31.4% in the second quarter of 2020 as the lockdown took hold, but the expected loan losses never materialized. The economy quickly rebounded the following quarter – growing an astonishing 38% — and the feared economic apocalypse never occurred.

In fact, two and a half years later, that second shoe still hasn’t dropped. To this day, the industry’s credit performance since the beginning of the pandemic has been uncommonly good. According to data from S&P Global Market Intelligence, net charge-offs (which is the difference between gross charge-offs and any subsequent recoveries) for the entire industry were an average of 23 basis points for 2021. Through the first six months of 2022, net charge-offs were just 10 basis points.

Surprisingly, the industry’s credit quality has remained strong even though U.S. economic growth was slightly negative in the first and second quarters of 2022. The Bureau of Economic Analysis, which tracks changes in the country’s gross domestic product, had yet to release a preliminary third quarter number when this article published. However, using its own proprietary model, the Federal Reserve Bank of Atlanta estimated in early October that U.S. GDP in the third quarter would come in at 2.9%.

This would suggest that the industry’s strong credit performance will continue for the foreseeable future. But an increasing number of economists are anticipating that the U.S. economy will enter a recession in 2023 as a series of aggressive rate increases this year by the Federal Reserve to lower inflation will eventually lead to an economic downturn. And this could render a significant change in the industry’s credit outlook, leading to what many analysts refer to as a “normalization of credit.”

So why has bank loan quality remained so good for so long, despite a bumpy economy in 2022? And when it finally comes, what would the normalization of credit look like?

Answering the first question is easy. The federal government responded to the pandemic with two major stimulus programs – the $2.2 trillion CARES Act during President Donald Trump’s administration, which included the Paycheck Protection Program, and the $1.9 trillion American Rescue Plan Act during President Joe Biden’s administration — both which pumped a massive amount of liquidity into the U.S. economy.

At the same time, the Federal Reserve’s Federal Open Market Committee cut the federal funds rate from 1.58% in February 2020 to 0.05% in April, and also launched its quantitative easing policy, which injected even more liquidity into the economy through an enormous bond buying program. Combined, these measures left both households and businesses in excellent shape when the U.S. economy rebounded strongly in the third quarter of 2020.

“You had on one hand, just a spectacularly strong policy response that flooded the economy with money,” says R. Scott Siefers, a managing director and senior research analyst at the investment bank Piper Sandler & Co. “But No. 2, the economy really evolved very quickly on its own, such that businesses and individuals were able to adapt and change to circumstances [with the pandemic] very quickly. When you combine those two factors together, not only did we not see the kind of losses that one might expect when you take the economy offline for some period of time, we actually created these massive cushions of savings and liquidity for both individuals and businesses.”

The second question — what would a normalized credit environment look like? — is harder to answer. Ebrahim Poonawala, who heads up North American bank research at Bank of America Securities, says the bank’s economists are forecasting that the U.S. economy will enter a relatively mild recession in 2023 from the cumulative effects of four rate increases by the Federal Reserve — including three successive hikes of 75 basis points each, bringing the target rate in September to 3.25%. The federal funds rate could hit 4.4% by year-end if inflation remains high, and 4.6% by the end of 2023, based on internal projections by the Federal Reserve.

“There’s obviously a lot of debate around the [likelihood of a] recession today, but generally our view is that we will gradually start seeing [a] normalization and higher credit losses next year, even if it were not for an outright recession,” Poonawala says. While a normalized loss rate would vary from bank to bank depending on the composition of its loan portfolio, Poonawala says a reasonable expectation for the industry’s annualized net charge-off rate would be somewhere between 40 and 50 basis points.

That would be in line with the six-year period from 2014 through 2020, when annual net charge-offs for the industry never rose above 49 basis points. And while loan quality has been exceptional coming out of the pandemic, that six-year stretch was also remarkably good — and remarkably stable. And it’s no coincidence that it coincides with a period when interest rates were at historically low levels. For example, the federal funds rate in January 2014 was just 7 basis points, according to the Federal Reserve Bank of St. Louis’ FRED online database. The rate would eventually peak at 2.4% in July 2019 before dropping back to 1.55% in December of that year when the Federal Reserve began cutting rates to juice a sagging economy. And yet by historical standards, a federal funds rate of even 2.4% is low.

Did this sustained low interest rate environment help keep loan losses low during that six-year run? Siefers believes so. “I don’t think there’s any question that cheap borrowing costs were, and have been, a major factor,” he says.

If interest rates do approach 4.6% in 2023 — which would raise the debt service costs for many commercial borrowers — and if the economy does tip into a mild recession, the industry’s loan losses could well exceed the recent high point of 49 basis points.

“There is a case to be made that a recession could look a bit more like the 2001-02 [downturn] in the aftermath of the dot-com bubble [bursting],” says Poonawala. “You saw losses, but it was an earnings hit for the banks. It wasn’t a capital event.”

That recession lasted just eight months and the decline in GDP from peak to trough was just 0.3%, according to the National Bureau of Economic Research. The industry’s net charge-off ratio rose to an average of 107 basis points in 2002 before dropping to 86 basis points in 2003, 59 basis points in 2004 and bottoming out at 39 basis points in 2006.

This same cyclical pattern repeated itself in 2008 — the first year of the financial crisis – when the average net charge-off rate was 1.30%. The rate would peak at 2.67% in 2010 before declining to 68 basis points in 2013 as the economy gradually recovered.

When we talk about the normalization of credit, what we’re really talking about is the return of the normal credit cycle, where loan losses rise and fall with the cyclical contraction and expansion of the economy. Banks have experienced something akin to a credit nirvana since 2014, but it looks like the credit cycle will reappear in 2023 — aided and abetted by higher interest rates and an economic downturn.

Safeguarding Credit Portfolios in Today’s Uncertain Economic Landscape

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Rising interest rates are impacting borrowers across the nation. The Federal Open Market Committee decided to raise the federal funds rate by 75 basis points in its June, July and September meetings, the largest increases in three decades. Additional increases are expected to come later this year in an attempt to slow demand.

These market conditions present significant potential challenges for community institutions and their commercial borrowers. To weather themselves against the looming storm, community bankers should take proactive steps to safeguard their portfolios and support their borrowers before issues arise.

During uncertain market conditions, it’s even more critical for banks to keep a close pulse on borrower relationships. Begin monitoring loans that may be at risk; this includes loans in construction, upcoming renewals, loans without annual caps on rate increases and past due loans. Initiating more frequent check-ins to evaluate each borrower’s unique situation and anticipated trajectory can go a long way.

Increased monitoring and borrower communication can be strenuous on lenders who are already stretched thin; strategically using technology can help ease this burden. Consider leveraging relationship aggregation tools that can provide more transparency into borrower relationships, or workflow tools that can send automatic reminders of which borrower to check in with and when. Banks can also use automated systems to conduct annual reviews of customers whose loans are at risk. Technology can support lenders by organizing borrower information and making it more accessible. This allows lenders to be more proactive and better support borrowers who are struggling.

Technology is also a valuable tool once loans is classified as special assets. Many banks still use manual, paper-based processes to accomplish time consuming tasks like running queries, filling out spreadsheets and writing monthly narratives.

While necessary for managing special assets, these processes can be cumbersome, inefficient and prone to error even during the best of times — let alone during a potential downturn, a period with little room for error. Banks can use technology to implement workflows that leverage reliable data and automate processes based directly on metrics, policies and configurations to help make downgraded loan management more efficient and accurate.

Fluctuating economic conditions can impact a borrower’s ability to maintain solid credit quality. Every institution has their own criteria for determining what classifies a loan as a special asset, like risk ratings, dollar amounts, days past due and accrual versus nonaccrual. Executives should make time to carefully consider evaluating their current criteria and determine if these rules should be modified to catch red flags sooner. Early action can make a world of difference.

Community banks have long been known for their dependability; in today’s uncertain economic landscape, customers will look to them for support more than ever. Through strategically leveraging technology to make processes more accurate and prioritizing the management of special assets, banks can keep a closer pulse on borrowers’ loans and remain resilient during tough times. While bankers can’t stop a recession, they can better insulate themselves and their customers against one.

3 Ways to Help Businesses Manage Market Uncertainty

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Amid mounting regulatory scrutiny, heightened competition and rising interest rates, senior bank executives are increasingly looking to replace income from Paycheck Protection Program loans, overdrafts and ATM fees, and mortgage originations with other sources of revenue. The right capital markets solutions can enable banks of all sizes to better serve their business customers in times of financial uncertainty, while growing noninterest income.

Economic and geopolitical conditions have created significant market volatility. According to Nasdaq Market Link, since the beginning of the year through June 30, the Federal Reserve lifted rates 150 basis points, and the 10-year Treasury yielded between 1.63% and 3.49%. Wholesale gasoline prices traded between $2.26 and $4.28 per gallon during the same time span. Corn prices rose by as much as 39% from the start of the year, and aluminum prices increased 31% from January 1 but finished down 9% by the end of June. Meanwhile, as of June 30, the U.S. dollar index has strengthened 11% against major currencies from the start of the year.

Instead of worrying about interest rate changes, commodity-based input price adjustments or the changing value of the U.S. dollar, your customers want to focus on their core business competencies. By mitigating these risks with capital market solutions, banks can balance their business customers’ needs for certainty with their own desire to grow noninterest income. Here are three examples:

Interest Rate Hedging
With expectations for future rate hikes, many commercial borrowers prefer fixed rate financing for interest rate certainty. Yet many banks prefer floating rate payments that benefit from rising rates. Both can achieve the institution’s goals. A bank can provide a floating rate loan to its borrower, coupled with an interest rate hedge to mitigate risk. The bank can offset the hedge with a swap dealer and potentially book noninterest income.

Commodity Price Hedging
Many commercial customers — including manufacturers, distributors and retailers — have exposure to various price risks related to energy, agriculture or metals. These companies may work with a commodities futures broker to hedge these risks but could be subject to minimum contract sizes and inflexible contract maturity dates. Today, there are swap dealers willing to provide customized, over-the-counter commodity hedges to banks that they can pass down to their customers. The business mitigates its specific commodity price risk, while the bank generates noninterest income on the offsetting transaction.

International Payments and Foreign Exchange Hedging
Since 76% of companies that conduct business overseas have fewer than 20 employees, according to the U.S. Census Bureau, there is a good chance your business customers engage in international trade. While some choose to hedge the risk of adverse foreign exchange movements, all have international payment needs. Banks can better serve these companies by offering access to competitive exchange rates along with foreign exchange hedging tools. In turn, banks can potentially book noninterest income by leveraging a swap dealer for offsetting trades.

Successful banks meet the needs of their customers in any market environment. During periods of significant market volatility, businesses often prefer interest rate, commodity price or foreign exchange rate certainty. Banks of all sizes can offer these capital markets solutions to their clients, offset risks with swap dealers and potentially generate additional income.

The Opposite of Blissfully Unaware

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There’s been an increasingly common refrain from bank executives as the United States moves into the second half of 2022: Risk and uncertainty are increasing.

For now, things are good: Credit quality is strong, consumer spending is robust and loan pipelines are healthy. But all that could change.

The president and chief operating officer of The Goldman Sachs Group, John Waldron, called it “among — if not the most —complex, dynamic environments” he’s seen in his career. And Jamie Dimon, chair and CEO of JPMorgan Chase & Co., changed his economic forecast from “big storm clouds” on the horizon to “a hurricane” in remarks he gave on June 1. While he doesn’t know if the impact will be a “minor one or Superstorm Sandy,” the bank is “bracing” itself and planning to be “very conservative” with its balance sheet.

Bankers are also pulling forward their expectations of when the next recession will come, according to a sentiment survey conducted at the end of May by the investment bank Hovde Group. In the first survey, conducted at the end of March, about 9% of executives expected a recession by the end of 2022 and 26.6% expected a recession by the end of June 2023. Sixty days later, nearly 23% of expect a recession by the end of 2022 and almost 51% expect one by the end of June 2023.

“More than 75% of the [regional and community bank management teams] we surveyed [believe] we will be in a recession in the next 12 months,” wrote lead analyst Brett Rabatin.

“[B]anks face downside risks from inflation or slower-than-expected economic growth,” the Federal Deposit Insurance Corp. wrote in its 2022 Risk Review. Higher inflation could squeeze borrowers and compromise credit quality; it could also increase interest rate risk in bank security portfolios.

Risk is everywhere, and it is rising. This only adds to the urgency surrounding the topics that we’ll discuss at Bank Director’s Bank Audit & Risk Committees Conference, taking place June 13 through 15 at the Marriott Magnificent Mile in Chicago. We’ll explore issues such as the top risks facing banks over the next 18 months, how institutions can take advantage of opportunities while leveraging an environmental, social and governance framework, and how executives can balance loan growth and credit quality. We’ll also look at strategic and operational risk and opportunities for boards.

In that way, the uncertainty we are experiencing now is really a gift of foresight. Already, there are signs that executives are responding to the darkening outlook. Despite improved credit quality across the industry, provision expenses in the first quarter of 2022 swung more than $19.7 billion year over year, from a negative $14.5 billion during last year’s first quarter to a positive $5.2 billion this quarter, according to the Federal Deposit Insurance Corp.’s quarterly banking profile. It is impossible to know if, and when, the economy will tip into a recession, but it is possible to prepare for a bad outcome by increasing provisions and allowances.

“It’s the opposite of ‘blissfully unaware,’” writes Morgan Housel, a partner at the investment firm The Collaborative Fund, in a May 25 essay. “Uncertainty hasn’t gone up this year; complacency has come down. People are more aware that the future could go [in any direction], that what’s prosperous today can evaporate tomorrow, and that predictions that seemed assured a few months ago can look crazy today. That’s always been the case. But now we’re keenly aware of it.”

How to Attract Consumers in the Face of a Recession

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Fears of a recession in the United States have been growing.

For the first time since 2020, gross domestic product shrank in the first quarter according to the advance estimate released by the Bureau of Economic Analysis. Ongoing supply chain issues have caused shortages of retail goods and basic necessities. According to a recent CNBC survey, 81% of Americans believe a recession is coming this year, with 76% worrying that continuous price hikes will force them to “rethink their financial choices.”

With a potential recession looming over the country’s shoulders, a shift in consumer psychology may be in play. U.S. consumer confidence edged lower in April, which could signal a dip in purchasing intention.

Bank leaders should proactively work with their marketing teams now to address and minimize the effect a recession could have on customers. Even in times of economic uncertainty, it’s possible to retain and build consumer confidence. Below are three questions that bank leaders should be asking themselves.

1. Do our current customers rate us highly?
Customers may be less optimistic about their financial situations during a recession. Whether and how much a bank can help them during this time may parlay into the institution’s Net Promoter Score (NPS).

NPS surveys help banks understand the sentiment behind their most meaningful customer experiences, such as opening new accounts or resolving problems with customer service. Marketing teams can use NPS to inform future customer retention strategies.

NPS surveys can also help banks identify potential brand advocates. Customers that rate banks highly may be more likely to refer family and friends, acting as a potential acquisition channel.

To get ahead of an economic slowdown, banks should act in response to results of NPS surveys. They can minimize attrition by having customer service teams reach out to those that rated 0 to 6. Respondents that scored higher (9 to 10) may be more suited for a customer referral program that rewards them when family and friends sign up.

2. Are we building brand equity from our customer satisfaction?
Banks must protect the brand equity they’ve built over the years. A two-pronged brand advocacy strategy can build customer confidence by rewarding customers with high-rated NPS response when they refer individual family and friends, as well as influencers who refer followers at a massive scale.

Satisfied customers and influencer partners can be mobilized through:

Customer reviews: Because nearly 50% of people trust reviews as much as recommendations from family, these can serve as a tipping point that turns window-shoppers into customers.

Trackable customer referrals: Banks can leverage unique affiliate tracking codes to track new applications by source, which helps identify their most effective brand advocates.

3. What problems could our customers face in a recession?
Banks vying to attract new customers during a recession must ensure their offerings address unique customer needs. Economic downturn affects customers in a variety of ways; banks that anticipate those problems can proactively address them before they turn into financial difficulties.

Insights from brand advocates can be especially helpful. For instance, a mommy blogger’s high referral rate may suggest that marketing should focus on millennials with kids. If affiliate links from the short video platform TikTok are a leading source of new customers, marketing teams should ramp up campaigns to reach Gen Z. Below are examples of how banks can act on insights about their unique customer cohorts.

Address Gen Z’s fear of making incorrect financial decisions: According to a Deloitte study, Gen Z fears committing to purchases and losing out on more competitive options. Bank marketers can encourage their influencer partners to create objective product comparison video content about their products.

Offer realistic home-buying advice to millennials: Millennials that were previously held back by student debt may be at the point in their lives where their greatest barrier to home ownership is easing. Banks can address their prospects for being approved for a mortgage, and how the federal interest rate hikes intersect with loan eligibility as well.

Engage Gen X and baby boomer customers about nest eggs:
Talks of recession may reignite fears from the financial crisis of 2007, where many saw their primary nest eggs – their homes — collapse in value. Banks can run campaigns to address these concerns and provide financial advice that protects these customers.

Banks executives watching for signs of a recession must not forget how the economic downturn impacts customer confidence. To minimize attrition, they should proactively focus on building up their brand integrity and leveraging advocacy from satisfied customers to grow customer confidence in their offerings.

An Audit Expert Explains What’s Changed

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An audit committee seat can one of the biggest challenges — and one of the greatest responsibilities — for a bank director, even without a global pandemic and economic recession. The audit committee sets the tone at the top for the bank. How does its role change in a pandemic? It’s an increasingly important responsibility, says Jon Tomberlin, managing partner in Dixon Hughes Goodman LLP’s financial services practice, participating in a panel discussion focusing on audit matters at Bank Director’s BankBEYOND 2020 experience. “There’s a lot of risk and difficulty in being on the audit committee,” he says. “They are one of the most important elements of the bank.” The audit committee creates and maintains an conditions and expectations that support the integrity of the bank’s financial controls — an environment that may have altered or become strained under the pandemic’s forceful impact or the severe economic fallout. Tomberlin says he sees many roles for audit committee in this turbulent environment, overseeing and challenging the appropriateness of internal controls and management’s risk assessment. Joining Tomberlin in this conversation with Bank Director’s Editor-At-Large Jack Milligan were Michael Ososki, a partner at BKD LLP, and Mandi Simpson, a partner at Crowe LLP. You can access all of the BankBEYOND 2020 sessions by registering here.

Banks Have Started Recording Goodwill Impairments, Is More to Come?

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A growing number of banks may need to record goodwill impairment charges once the coronavirus crisis finally shows up in their credit quality.

A handful of banks have already announced impairment charges, doing so in the first and second quarter of this year. Some have written off as much as $1 billion of goodwill, dragging down their earnings and, in some cases, dividends. Volatility in the stock market could make this worse in the second half of the year.

“It was a very hot topic for all of our financial institutions,” says Ashley Ensley, a partner in DHG’s financial services practice. “Everyone was talking about it. Everybody was looking at it. Whether you determined you did … or didn’t have a triggering event, I expect that everyone that had goodwill on their books likely took a hard look at that amount this quarter.”

Goodwill at U.S. banks totaled $342 billion in the first quarter, up from $283 billion a decade ago, according to the Federal Deposit Insurance Corp.

Goodwill is an intangible asset that reconciles the premium paid for acquired assets and liabilities to their fair value. It’s recorded after an acquisition, and can only be written down if the subsequent carrying value of the deal exceeds its book value. Although goodwill is an intangible asset excluded from tangible common equity, the non-cash charge can have tangible consequences for acquisitive banks. It immediately hits the bottom line, reducing income and, potentially, even capital.

Several banks have announced charges this year. PacWest Bancorp, a $27.4 billion bank based in Beverly Hills, California, took a charge of $1.47 billion. Great Western, a $12.9 billion bank based in Sioux Falls, South Dakota, took a charge of $741 million. And Cadence Bancorp., an $18.9 billion bank based in Houston, Texas, recorded an after-tax impairment charge of $413 million.

Boston-based Berkshire Hills Bancorp announced a $554 million charge during its second-quarter earnings that wiped out all its goodwill. The charge, combined with higher loan loss provisions, led to a loss of $10.93 a share. Without the goodwill charge, the bank would’ve reported a loss of only 13 cents a share.

“The primary causes of the goodwill impairment were economic and industry conditions resulting from the COVID-19 pandemic that caused volatility and reductions in the market capitalization of the Company and its peer banks, increased loan provision estimates, increased discount rates and other changes in variables driven by the uncertain macro-environment,” the bank said in its quarterly filing.

Goodwill impairment assessments begin by evaluating qualitative factors for positive and negative evidence — both internally and in the macroeconomic environment — that could cause a bank’s fair value to diverge from its book value.

“It really is not a one-size-fits-all analysis,” says Robert Bondy, a partner in Plante Moran’s financial services group. “Just because a bank — even in the same marketplace — has an impairment, it’s hard to cast that shadow over everybody.”

One reason banks may need to consider impairing their goodwill is that bank stock prices are meaningfully down for the year. The KBW Regional Banking Index, a collection of 50 banks with between $9 billion and $63 billion in assets, is off by 33%. This is especially important given the deceleration in bank deals, which makes it hard to evaluate what premiums banks could fetch in a sale.

“[It’s been] one or two quarters and overall markets have rebounded but bank stocks haven’t,” says Jay Wilson, Jr., vice president at Mercer Capital. “You can certainly presume that the annual impairment test, when it comes up in 2020, is going to be a more robust exercise than it was previously.”

Banks could also write off more goodwill if asset quality declines. That has yet to happen, despite higher loan loss provisions — and in some cases, banks saw credit quality improve in the second quarter.

The calendar could influence this as well. Wilson says the budgeting process and cyclical cadence of accounting means that annual tests often occur near year-end — though, if a triggering event happens before then, a company can conduct an interim test.

That’s why more banks could record impairment charges if bank stocks don’t rally before the end of the year, Wilson says. In this way, goodwill accumulation and impairment mirror the broader economy.

“Whenever the cycle turns, banks are inevitably in the middle of it,” he says. “There’s no way, if you’re a bank to escape the economic or the business cycle.”