How Open Banking Will Revolutionize Business Lending

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There has been much chatter about open banking over the last couple of years, and for a good reason. If it stays on its current growth trajectory, it could revolutionize the financial services sector worldwide, forcing changes to existing business models.

At this stage, many business bankers, and the small commercial clients they serve, are not ready to move to an open banking system. Banks have traditionally enjoyed a monopoly on their consumers’ financial data — and they do not want to lose it. Small business owners might worry that their data is shared with financial services providers other than their banks.

Open banking can seem risky, but it offers benefits to both lenders and borrowers. 2022 could be an excellent opportunity for this perception to catch up to reality and make open banking the norm in the business lending space.

Open banking is a banking practice that uses application programming interfaces (APIs) to give third-party providers access to consumer financial data. This access allows financial institutions to offer products that are tailor-made to consumers’ needs. This approach is more attractive than other ways that consumers have traditionally aggregated their financial data. For instance, screen scraping transfers screen display data from one application to another but can pose security risks. Optical character recognition (OCR) technology requires substantial human resources to read PDF documents to extract information. And data entry is both time-consuming and has a high likelihood of errors.

Using APIs addresses many of the problems that exist with other data aggregation methods. The data is transmitted directly — no need to share account credentials — eliminating the security risk inherent with screen scraping. And since there is no PDFs or data entry involved, bankers do not need to use many resources to check the accuracy of the data.

Still, bankers may wonder: Why do we need to move to an open banking system?

Business lending works today, but there is significant room for improvement. The main issue is the lack of centralized data. Lenders do not have enough data to approve loans to creditworthy borrowers or identify other products the client could receive. On the other side, small business owners endure a slow and cumbersome process because they must provide their data to each lender, one by one. An open banking system allows lenders to offer borrowers better terms and creates an easier application process for borrowers.

Misconceptions could complicate adoption. In an Axway survey, half of the respondents did not think that open banking was a positive development. They had concerns about the constant monitoring of financial activity (33%), losing control over access to their financial data (47%) and financial institutions using their data against their interests (27%).

But open banking gives consumers more control over their financial data, not less. Since open banking is a new concept, there is a significant gap between perception and reality. There is, understandably, a hesitancy among the public to share their data, which emerges when consumers are directly asked about it. But as services like Personal Capital and Credit Karma clearly show, consumers will overwhelmingly opt for open banking services because they can use their financial data to gain via more straightforward analysis or track their spending.

This is the promise of open banking in the business finance space. Small business owners want to focus their attention on non-administrative tasks and connecting their financial data to services that bring them faster access to capital with less paperwork is a clear benefit they are excited to get.

Services like Plaid and Envestnet Yodlee connect customer data directly with financial institutions and are widespread in the small business lending market. More than half of small business owners already choose to use these services when applying for financing, according to direct data reported by business lending companies.

Banks, on the other hand, will need to make a couple of adjustments to thrive in an open banking ecosystem. They will need to leverage the bevy of consumer financial data they have to offer more customizable financial products, as the system’s open nature will lead to more competition. To analyze all that data and provide those customer-centric products, banks should consider using a digital lending platform, if they aren’t already. Open banking is set to disrupt the financial services sector. Financial institutions can set themselves up for sustainable success by embracing the movement.

Banks Increasingly Use Sub Debt to Raise Capital

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2015 is set to become the third year in a row that total capital raised among U.S. banks has increased—on track for more than $140 billion issued by year-end. The recent boon in capital raising activity generally is attributed to the simultaneous increase in public bank stock values. The effect of market values on the decision to raise capital should not be discounted; however, capital demand has continued despite the market’s recent volatility and perceived weakness. Why has this trend continued?

The confluence of three factors, in particular, within the banking industry have helped fuel capital demand and have shifted demand for different forms of capital, including an increased demand for subordinated debt. First, the interest rate on Troubled Asset Relief Program funding has increased to 9 percent for most banks that still hold TARP funds. Second, participants in the Small Business Lending Fund have experienced—or will soon experience—an interest rate hike on those funds to 9 percent or more. Third, banks that deferred interest payments on trust preferred securities in the wake of the financial crisis must determine how to repay the deferred interest after five years or risk default. Each of these factors is prompting banks to consider capital alternatives.

The Rise of Subordinated Debt
Subordinated debt has become the darling form of capital for community banks (i.e., those banks less than $10 billion in assets). Thus far in 2015, subordinated debt has comprised 30 percent of all capital raised by community banks—up from 24 percent in 2014 and 7 percent in 2013. Why has this form of capital become so popular?

In simple terms, banks facing rate hikes on TARP, SBLF, and/or repayment of trust preferred securities have taken advantage of the low interest rate environment to raise capital on more favorable terms. Furthermore, the interest expense paid on subordinated debt is tax-deductible and it generally qualifies as Tier 2 capital on a holding company consolidated basis. In other words, newly issued sub debt can enable banks to reduce debt service requirements, increase regulatory capital, and preserve current ownership interests that otherwise could be diluted by raising common equity.

And as banks have become more creditworthy and investors have raised funds dedicated to community bank sub debt investments, the interest rate on sub debt has steadily declined: the median coupon for sub debt issuances in 2015 is approximately 5.25 percent, down from 7 percent in 2011. 

You’ve Decided to Issue Sub Debt…Now What?
The process of issuing sub debt for most banks is straightforward. Investment bankers generally know investors with an appetite for sub debt and can provide banks with preliminary term sheets relatively quickly. For banks with more than $1 billion in assets, it could make sense to obtain a bond rating from a rating agency; the process generally takes four to six weeks and can be a great marketing tool when raising capital. A solid rating helps banks achieve better terms and opens the door to new potential investors, such as insurance companies, plus it gives investors added comfort in their own assessment of the deal.

Investor demand for sub debt will continue to increase as long as interest rates remain low and bank balance sheets remain strong. Banks considering a future capital raise should understand the benefits of sub debt and seriously consider it while the market is ripe.

What Bank Boards and Management Need to Know about M&A in 2013

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Freechack_and_Laufenberg.pngJohn Freechack, chairman of the financial institutions group at Barack Ferrazzano Kischbaum & Nagelberg, and Allen Laufenberg, managing director of investment banking at Stifel Nicolaus Weisel, answered some timely questions about mergers and acquisitions at a recent Bank Director conference.

Where are we compared to a year ago?

Bank valuations have improved slightly but they’re still not great, said Laufenberg. Healthy institutions above $1 billion in assets are now trading above book value, improving their ability to become acquirers. The economic outlook is still positive but sluggish. The number of “problem” institutions on the Federal Deposit Insurance Corp.’s list is no longer north of 800, but it is still above 600. Still, there are more buyers in many markets than a year ago. Some markets had only two or three potential acquirers a year ago but now have five or six.

What is an important quality for an acquirer these days?

Patience. Your favorite targets and their boards may need time to digest the fact they need to sell. Many banks will need to raise capital or make tough decisions in the coming years. Dividends will increase on stock sold originally through the Troubled Asset Relief Program or Small Business Lending Fund. Sellers do not want to feel forced to sell. They want to feel they are selling on their own terms. You may need more retained earnings to persuade your regulators that you can be an acquirer.

What steps should you take if you’re interested in being an acquirer?

This is a fabulous time to do planning, and many banks are focused on strategic planning and organic growth, even if they think they will sell in the next two to three years, said Freechack.  Regulators are more willing to discuss getting banks off of regulatory orders and resolving those problems for good, he said. Have those discussions with your regulator now.

Freechack_and_Laufenberg_2.pngWill you need to or be able to raise capital in the foreseeable future?

One aspect of strategic planning is figuring out if you will need capital in the future, either to grow or become an acquirer, for example. What sources of capital might you need? Regulators love common equity but it has been difficult to raise and can dilute existing shareholders. Preferred stock has been popular lately, Laufenberg said. There is a perception that management and directors have been “tapped out” and are no longer willing to put more money into the bank. That was two or three years ago and might not be the case today.

How should you approach other banks about an M&A discussion?

Get a preferred target list of banks together and involve your independent board members in the discussion of strategy and acquisitions. Be careful about how you treat these potential sellers. Don’t hire away their second in command (and possible successor to the current CEO)and expect them to be nice to you later on. Don’t approach boards and management with a pitch that sounds like you know they have a troubled bank or will have a retiring CEO in the next year or two. That can turn people off.  Regulators need to know what you are planning but they might not be of help too early in the planning process.

Banks (don’t) like Small Business Lending Fund

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smb-loan.jpgI previously wrote about the Small Business Lending Fund in this blog, but the fund drew as much interest as raw broccoli at a children’s birthday party.

Congress created the $30 billion fund to provide capital to banks and increase lending to small business, but as of Monday, a little more than 600 banks applied for only $8.6 billion, according to Treasury spokeswoman Colleen Murray.

Those numbers disguise the fact that about 2,000 banks are S corporations or mutual companies and haven’t had a chance to apply yet because the Treasury hasn’t given them a term sheet.

So as the Wall Street Journal reported last week, the fact that only 7 percent of all banks actually applied by the end of March deadline is not as pathetic as it looks.

The U.S. Treasury has extended the deadline for banks to apply from the end of March to May 16 and will issue term sheets within weeks for S corporations and mutuals, Murray said.

She said the Treasury expects applications for the program to start flowing in, and there’s a real need for capital on the part of small business.

Still, there’s a lot of hesitancy among banks. Those that have Troubled Asset Program Relief capital can refinance into the Small Business Lending Fund and potentially save money on dividends to the government, as long as they increase lending.

But for banks that didn’t have TARP money, there is less of an incentive to apply.

Banks that have CAMELS 4 or 5 ratings aren’t eligible, either.

Plus, “many banks concluded there wasn’t sufficient enough growth opportunities to warrant taking on that type of capital,’’ said Richard Maroney, co-head of investment banking for Austin Associates. Although the dividends banks must pay on the capital start low, they can rise as high as 9 percent for banks that don’t increase small business lending after four and a half years (although banks can repay the capital and avoid the higher dividend).

Plus, bankers are wary the federal government could change the rules on them. There is, indeed, a good amount of political pressure surrounding the program.

Congresswoman Sen. Olympia Snowe, R-Maine, for example, introduced a bill last month saying the program lacked “transparency and accountability.” The bill would make it impossible for the fund to give money to banks that had TARP money.

“I think there is still a taint from TARP,’’ Maroney said. “I had a number of clients who said they were hesitant to deal with the government.”

Small business loan fund seems like a ‘no-brainer’ for bankers

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The Small Business Lending Fund may be that gift from Congress to bankers they never expected.

After months of gridlock, legislators passed a small business bill last September that included $30 billion for small business loans.

Banks with less than $10 billion in assets can apply to the U.S. Treasury for the capital, and then use the money to lend to small businesses, as a way to generate relief for the economy. The reason it is so great for banks is that many of them still are saddled with Troubled Asset Relief Program money (TARP) and they are having a tough time raising capital, especially smaller, community banks.

This new fund will give them a chance to refinance out of TARP, save money in dividends paid to the government, and have the new money count toward Tier 1 capital to satisfy regulators. Even banks without TARP money can apply.

“It’s a no brainer,’’ said Christopher Annas, the president and chief executive officer of Meridian Bank in Devon, Pennsylvania.

His $400 million-asset bank would reduce dividends from $600,000 to $125,000 per year, by refinancing out of TARP into the small business fund.

The dividend rate on the new fund is from 1 percent to 5 percent, depending on how much the bank increases lending to small business. Banks that increase lending by less than 2.5 percent will pay 5 percent dividends on the fund. Banks that increase lending by more than 10 percent pay 1 percent. In contrast, banks must pay TARP dividends of 5 percent, no matter how much they increase lending.

Even the potential drawbacks of the new program seem hard to find. For instance, banks have two years to increase their lending to small businesses before they start paying penalties. With penalties, the rate is no more than 7 percent or 9 percent—and the higher amount is if lending doesn’t increase after four and a half years.

The banks are free to pay back the Small Business Lending Fund money at any time, without penalty.

So if it doesn’t work out, no worries.

“If you don’t need the capital right now, take it, you can use it next year,’’ Annas said.

If a bank is having trouble raising capital, the fund could equate to “deferring your capital raise for two or three years,’’ said Richard Maroney Jr., who co-manages the investment banking division of Austin Associates in Toledo, Ohio, and spoke at Bank Director’s Acquire or Be Acquired conference in Scottsdale, Arizona recently.

With 1 percent to 5 percent dividend rates, “over time, you could say that’s a pretty good cost of funds,’’ he said.

For instance, if a bank takes $10 million in small business lending money, refinances out of TARP and reduces its dividend from 5 percent to 1 percent, that’s a savings of $400,000 per year, Maroney said.

There are some requirements though:

  • Any bank, thrift or bank holding company applying for the funds must have assets of less than $10 billion.
  • The deadline to apply is March 31. However, there is no obligation to take the funds if applying.
  • Each loan commitment can’t be more than $10 million.
  • The loans must be given to businesses that make annual revenues of less than $50 million. Commercial and industrial loans are included. So are owner-occupied real-estate backed commercial loans and agriculture loans. SBA and other government-backed loans are excluded (no double dipping allowed).
  • Reporting requirements include quarterly confidential statements to the U.S. Treasury and a two-page report to the primary regulator.