Finding Opportunities in a Rising Interest Rate Environment

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Over the course of a year or so, the Federal Reserve has raised short-term interest rates more than 475 basis points.

Bankers with a portion of their balance sheet assets invested in fixed income securities are all too aware of the “Finance 101” lesson of the inverse relationship between interest rates and the market value of fixed income securities. While the recent Fed actions certainly have negative implications for parts of the bank’s balance sheet, they also have some positive ones.

For instance, banks with available liquidity have some great buying opportunities currently in the market. In addition to obviously investing in government securities with durations on the short end of the yield curve, the cash value yields on certain types of bank owned life insurance, or BOLI, are currently the highest they have been in at least 15 years.

Regulators allow banks to use BOLI to offset the cost of providing new or existing employee benefits. Part of the way BOLI offsets these employee benefit costs is by providing compelling cash value rates of return, which are generally provided by life insurance carriers that carry high credit quality. Another benefit of BOLI is that most types have cash values vests on a daily basis — the cash value doesn’t reduce in a rising interest rate environment. This eliminates the mark-to-market risk associated with other assets on the bank’s balance sheet, such as fixed income securities or loans.

Other higher yielding, high credit quality opportunities are also currently available in the market. Many of the same high credit quality life insurance carriers that offer BOLI have begun offering, or are creating, a guaranteed investment certificate or GIC. GICs are sometimes referred to as a financial agreement or FA. The GIC works much like a certificate of deposit, where the purchaser deposits money with the offering entity — in this case, the life insurance carrier — and earns interest on the deposited money. Much like a CD, the money must be deposited for a fixed length of time and interest rates vary according to the duration. GICs are nothing new; insurance companies themselves have been investing in them for decades.

Another interesting development over the last few months is the ability for banks to invest in a collateralized loan obligation, or CLO. A CLO is a single security that is backed by a pool of debt. As a floating-rate security, it offers income protection in varying market conditions while also minimizing duration. Additionally, CLOs typically offer higher yields than similarly rated corporate bonds and other structured products. We have also seen CLO portfolios added as investment options of private placement variable universal life BOLI designs to provide a bank with additional benefits. This structure has the advantage of giving bank owners the ability to enhance the yield of assets that are designated as offsetting employee benefit expenses. The advantages of this type of structure are obvious in the current inflationary environment.

So while the actions of the Fed have certainly added challenges to the typical banks’ balance sheet, for those institutions who are well positioned, it has also created numerous opportunities.

5 Key Areas Where Banks Can Implement Automation Solutions

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As automation has become more widely available to the financial services industry, banks need to take advantage of automated solutions to streamline manual systems and processes and maintain a competitive edge.

But they would be mistaken to seek out automation only for a solution to a specific problem; rather they should take a holistic approach to automation and craft a strategy that incorporates automation in a variety of ways that could potentially improve many functions of their business. While commercial, off-the-shelf software exists for specific automation use cases, banks need to understand how automation fits into their broader business strategy and how to weave it throughout the organization’s processes. This allows leadership teams to understand where a customized approach is necessary and where turnkey solutions may be suitable.

There are five specific areas that banks should assess for automation readiness and efficiency gains.

1. Customer experience. A frictionless customer experience is a standard expectation in many industries; banking is no exception. In the past, if a customer wanted to open a deposit account at a bank one month and take out a loan the following month, the bank might require two interactions with two different employees to gather data from that customer. But there are process enhancements that can automate and streamline these processes to remove the redundancy and enhance the customer experience.

Automation can streamline the intake and digital cataloging of customer information, pulling that data together into a single place and data set that employees from various functions of the bank can query and use. The consistency of information makes the experience more palatable for the customer, and more efficient for employees.

2. Credit approval and loan operations. A typical commercial loan application and approval process can require the loan applicant to submit a significant number of documentation items and pieces of information to the bank. Using an automated tool to gather, process and organize that information can significantly cut the cycle time for the loan application, approval and origination process. Additionally, an automated process on the front end enables the loan operations process on the back end of a transaction to be more efficient and seamless, as employees can access all of the electronically obtained information in an organized format.

Automated solutions for credit and loan operations — one example of which is highlighted in this case study — can result in better information for banks and quicker decisions for applicants. Banks can use automated solutions to integrate with credit bureaus or other data providers via application programming interface (API), and apply credit policies throughout underwriting.

3. Data management. Most banks have numerous data sets that can be queried separately but not all together. What this can mean from a lending perspective is that a bank may have a commercial loan system, a retail loan system and a credit card system; all of those systems could have different outputs, which could make it difficult to analyze data and have a holistic and meaningful view of the customer’s relationship, profitability and risk profile.

Organizations should explore how automation solutions may improve their existing infrastructure and make their data more relevant and useful by enabling real-time reporting to build a more complete profile of the customer.

4. Automation tools can vastly improve the intake and data maintenance process required to comply with Know Your Customer (KYC) regulations. Automation can replace manual process during customer onboarding and ongoing monitoring and verification efforts. Compliance automation creates a uniform process and data set that the bank can use throughout the customer lifecycle, rather than on an as-needed basis, when onboarding is completed or when monitoring items arise.

5. Streamlining the audit function. As we highlight in this case study, automation can help a bank’s internal audit department “spend less time gathering data and scoping audits and more time on fieldwork such as testing hypotheses, assessing risk management, and reaching conclusions using a datacentric approach.” In that specific case, a bank used an intelligent automation solution to identify gaps and pain points in how it quantified risk during the audit planning process, accelerated its planning process and incorporated various data sources, such as consumer complaints and regulatory standards, into the audit plan.

Automation can improve virtually any function of a bank’s business, but organizations may find it daunting to determine where or how to begin implementing such solutions. Discussing options with a third-party advisor can help bankers craft a valid and thorough automation strategy that incorporates all the advantages of automated capabilities that might be relevant and available. This strategic approach maximizes efficiencies for the bank, while providing a best-in-class customer experience.

In the Search for Efficiency, Rethink Cash Management

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Despite the rise in digital payment options, cash persists as a payment method in the United States. Between October 2019 and October 2021, circulating currency in the United States increased by $423 billion, according to the Federal Reserve Bank of San Francisco. Also, cash accounted for 20% of all payments and continues to be a primary option for a substantial portion of the population.

Even as cash continues to be a vital payment tool, handling it is a headache for banks. Branch managers manually count, log and balance cash, which leaves banks vulnerable to safety issues and cash leakages due to criminal activity or miscalculations. Bankers must evaluate their cash management processes to save time and money.

What is often overlooked, or taken for granted in the cash management process, is the time it takes a bank to move, count and manage cash. Every time cash moves — from the vault to the teller, teller to teller, or teller to vault — it must be counted and balanced. If even $1 is missing, staff can spend hours counting and recounting.

Cash handling costs are rising and are estimated to account for 5% to 10% of bank costs, even as cash use declines, according to McKinsey & Co. Why? Cash distribution, maintenance and processing require expensive manual labor. Depending on the institution, a single branch will need to handle hundreds of transactions and teller-to-teller exchanges a day and, of course, opening and closing counts of cash. From cash vault to end-of-day tally, the process relies on the precision and accuracy of each count. Say your branch has a counting error. This single error from manual labor can add significant time to your staff’s day. Additionally, manual cash handling is vulnerable to counterfeit currency, tracking errors and theft.

Banks are examining every expense for greater efficiencies as the economic environment potentially turns. It’s critical that they assess the technology budget and balance sheet to ensure their investments go as far as possible. There are a proliferation of cash counting and handling processes that banks implement, but these tend to only oversee one part of the overall cash management process. Banks also often grapple with outdated technology, which is vulnerable to outages or cannot automate simple tasks.

Harnessing technology can eliminate redundancies, automate manual processes, reduce labor expenses and streamline workflows. These changes can also improve staff retention at the crucial frontline level, a huge issue for banks. In a competitive employment environment, eliminating inefficiencies and creating a positive work environment is a priority for banks looking to retain staff. Rather than counting cash by hand or dealing with an unexpected recycler outage, bank executives can leverage solutions that enable their tellers, frontline branch staff, and regional managers to worry less about cash management and focus more on customer experience.

Economic uncertainty means banks need to make tough cost-cutting decisions while thinking about investing in operational efficiency and aligning innovation. To meet employee needs, banks should transform each level of branch operations, especially in the cost centers, such as cash handling. Reimagining branch operations and improving the employee experience and bank operations through automated technologies can help unlock new workflows and solutions.

Fortunately, strategic investments in high-return technology with advanced capabilities can offer immediate benefits. Automating labor-intensive processes and increasing cash visibility at enables banks to save time, leverage scarce resources and focus on creating unique customer experiences, while eliminating pain points and redundant work. As banks further automate mundane tasks, they can optimize staffing levels and maximize profits while serving customers better. By implementing specialized technology to count, dispense and manage cash, banks can improve their accuracy and reduce the costs associated with manual cash handling — ensuring that staff are using both the procedures and technology that best meets clients’ needs with the greatest efficiency.

Why Mutual Banks Won’t Sell

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Two Massachusetts banks hope to preserve their mutual status for years to come by merging their holding companies now, in an example of how M&A tends to be a different story for mutual institutions.

Newburyport Five Cents Bancorp and Pentucket Bank Holdings recently received board approval to merge into a single holding company. The combined organization, with $2.5 billion in assets, will likely get a new name, Newburyport CEO Lloyd Hamm told a local news outlet. Meanwhile, $1.5 billion Newburyport Five Cents Savings Bank and $947 million Pentucket Bank will maintain their separate brands.

“We definitely want to emphasize it’s not a merger of the banks, and we will likely select a new name for the co-branded holding company,” Hamm told The Daily News in Newburyport. The new organization also plans to change its bylaws in order to make it more difficult for a future leadership team to take the company public. “This is ensuring mutuality for decades to come,” Hamm said.

All employees of the two banks will keep their jobs, and executives intend to invest more in technology, training and talent, and increase charitable giving under the combined holding company. No branch closures are planned as part of the deal.

According to data from S&P Global Market Intelligence, there have been just three combinations of mutual banks in the past five years, including the deal between Newburyport Bank and Pentucket Bank, which was announced in December 2022.

The dearth of mutual bank M&A essentially comes down to numbers: The U.S. had just 449 mutual institutions at the end of 2021, according to the Federal Deposit Insurance Corp., out of 4,839 total banks. In some respects, mutual banks may more closely resemble credit unions than public or privately held banks, though credit unions have been more actively acquiring FDIC-insured institutions, accounting for 56 deals over the past five years. Mutual banks have no shareholders and are effectively owned by their depositors. Any profits they generate are returned to their depositors in some fashion, for example, in the form of lower rates on mortgages. Last year, the FDIC approved the first de novo mutual bank to launch in over 50 years, Walden Mutual in Concord, New Hampshire.

Because mutual banks don’t have shareholders, they don’t need to always focus on the next, most profitable move, says Stan Ragalevsky, who has worked extensively with mutual banks as a partner with K&L Gates in Boston.

“If you’ve been sitting on the board of a small [mutual] bank, you realize there’s a lot of changes going on in banking, but you also think ‘We’re making money. We may not be making 80 basis points, but we’re making 45 basis points,’” Ragalevsky says. “They feel comfortable that they’re doing the right thing.”

Some of those sentiments showed up in Bank Director’s 2023 Bank M&A Survey: 77% of mutual bank executives and directors participating in the survey say they’re open to M&A but focus primarily on organic growth. Just 12% want to be active acquirers, compared to 23% of all respondents.

Furthermore, all of the 20 mutual participants say their bank’s board and management would not be interested in selling within the next five years, compared to 52% overall. When asked why they were unlikely to sell, many refer back to their institution’s mutual status and a wish to maintain an independent banking option in their communities.

Compared with deals involving publicly held banks, mutual bank deals also tend to be driven by the board more than the management, Ragalevsky adds. While board members may be motivated to some degree by personal self interest — retaining a board seat, for example — “there’s also a sense of commitment to the community,” he says.

Additionally, many prospective mutual bank sellers may be constrained by a lack of like-minded buyers. This very reason is partly why $1.4 billion Cooperative Bank of Cape Cod, based in Hyannis, Massachusetts, is unlikely to sell anytime soon, says CEO and Chair Lisa Oliver.

“We don’t sell, because there’s nobody to buy [us]. We’re owned by our depositors in a non-stock kind of way. If anything, it would be a merger for lack of succession planning, if that were really critical,” Oliver says. “But there are plenty of potential candidates that can be hired to become CEOs of a small bank.”

Some also argue that mutuals’ independent streak is, to some degree, woven into their history. Many mutual banks, particularly in the Northeast, trace their roots back over 100 years, when they were initially founded to provide banking services for poor and working class families.

“The mutual bank movement has been one of the greatest, most successful social and business experiments,” Ragalevsky says. “Mutual banks were formed to improve people’s lives — they weren’t formed to make money. They were formed to improve people’s lives, and they’ve done that.”

Steps for Managing and Leveraging Data

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Does your institution rely on manual processes to handle data?

Institutions today generate vast amounts of data that come in different forms: transactional data such as deposit activity or loan disbursements, and non-transactional data such as web activity or file maintenance logs. When employees handle data manually, through mouse and keyboard, it puts your institution at risk for inefficient reporting, security threats and, perhaps most importantly, becoming obsolete to your customers.

Take a look at how data is moved through your organization. Exploring targeted improvements can result in actionable, timely insights and enhanced strategic decision-making.

First, focus on areas that may have the biggest impact, such as a process that consumes outsized amounts of time, staff and other resources.

What manual processes exist in your institution’s day-to-day business operations? Can board reporting be streamlined? Do directors and executives have access to meaningful, current data? Or should the institution explore a process that makes new opportunities possible, like improving data analytics to learn more about customer engagement?

Build Your Data Strategy
Crawl — The first step toward effectively managing data is to take stock of what your bank currently has. Most institutions depend on their core and ancillary systems to handle the same information. Various inputs go into moving identical data, like customer or payment information, from one system to another — a process that often involves spreadsheets. The issue of siloed information grows more prominent as institutions expand their footprint or product offering and adopt new software applications.

It’s helpful for directors and executives to ask themselves the following questions to take stock:

  • What is our current data strategy?
  • Does our data strategy align with our broader institution strategy?
  • Have we identified pain points or areas of opportunity for automation?
  • Where does our data reside?
  • What is missing?
  • In a perfect world, what systems and processes would we have?

Depending on complexity, it is likely a portion of the bank’s strategy will look at how to integrate disparate systems. While integration is an excellent start, it is only a means to an end in executing your bank’s broader digital strategy.

Prioritize ROI Efforts and Execute
Walk — Now that the bank has developed a plan to increase its return on investment, it is time to execute. What does that look like? Executives should think through things like:

  • If I could improve only one aspect of my data, what would that be?
  • What technical skills are my team lacking to execute the strategy?
  • Where should I start: build in-house or work with a third party?
  • Are there specific dashboards or reports that would be transformational for day-to-day business operations and strategic planning?
  • What digital solutions do our customers want and need?

Enable Self-Service Reporting
Run — The end goal of any bank’s data strategy is to help decision-makers make informed choices backed by evidence and objectivity, rather than guesswork and bias.

Innovative institutions have tools that make reporting accessible to all decision makers. In addition to being able to interact with data from multiple systems, those tools provide employees with dashboards that highlight key metrics and update in real time, generating the pulse of organizational performance.

With the combination of self-service reporting and data-driven dashboards, leaders have the means to answer tough questions, solve intractable challenges and understand their institution in new ways. It’s a transformative capability — and the end goal of any effort to better manage data.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader.

The Opportunity in Business Payments

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Nonbank competitors challenge the way banks serve small business clients, who are always on the hunt for efficiency. Banks that address key pain points for those customers have a better shot at winning their business — and their loyalty, says Derik Sutton, chief marketing officer at Autobooks. Payments are a particular obstacle, he says. Financial institutions that can help their small business customers simplify accounts receivable and payable can lock in those relationships in 2023.

Topics include:

  • Competitive Pressure From Apps
  • Overcoming the Cash Flow Gap
  • The Advantage in Payments

Maximizing Profitability Potential Via Push Notifications

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Implementing digital fintech solutions is critical for banks seeking to grow their customer base and maximize profitability in today’s increasingly competitive industry.

To engage account holders, banks must explore digital-first communication strategies and mobile-friendly fintech products. Push notifications are an often overlooked, yet powerful, tool that enables financial institutions to proactively deliver important messages to account holders that earn higher engagement rates than traditional communication methods.

Push notifications are delivered directly through a banking app and sent to account holders’ mobile devices and can provide timely alerts from a financial provider. While push notifications can act as a marketing tool, they can also convey critical security alerts via a trusted communication channel — as opposed to mediums that are vulnerable to hacks or spoofing, such as email or SMS texts. Push notifications can be used for personalized promotional offers or reminders about other financial services, such as bill pay or remote check deposit, transaction and application status updates, financial education and support messaging, local branch and community updates and more.

Banks can also segment push notifications using geo-location technology, as long as customers get permission, to alert account holders at a time, place and setting that is best suited to their needs. Banks can customize these notifications to ensure account holders receive messages notifying them of services that are most relevant to their financial needs.

When leveraged effectively, push notifications are more than simple mobile alerts; they’re crucial tools that can significantly increase account holder engagement by nearly 90%. Push notifications can be more effective in reaching account holders compared to traditional marketing methods like email or phone calls and receive engagement rates that are seven times higher.

Boosting customer engagement can ultimately have a significant impact on a bank’s profitability. Studies show that fully engaged retail banking customers bring in 37% more annual revenue to their bank than disengaged customers. Enhancing ease of use while offering greater on-demand banking services that consumers want, banks can leverage push notifications to encourage the use of their banking apps. Enabling push notifications can result in a 61% app retention rate, as opposed to a rate of 28% when financial providers do not leverage push notifications.

Bank push notifications come at a time when consumer expectations for streamlined access to digital banking services have greatly accelerated. In a study, mobile and online access to bank accounts was cited by more than 95% of respondents as a prioritized banking feature.

This focus forces financial institutions to explore fintech solutions that will elevate their customers’ digital experience. Traditional institutions that fail to innovate risk a loss of market or wallet share as customers migrate to technologically savvy competitors. U.S. account holders at digital-only neobanks is expected to surge, from a current 29.8 million to 53.7 million by 2025.

Banks should consider adding effective mobile fintech tools to drive brand loyalty and reduce the threat of lost business. Push notifications are a unique opportunity for banks to connect with their audience at the right moments through relevant messaging that meets individual account holder needs.

Real-time and place push notifications can also be a way for banks to strengthen their cross-selling strategies with account holders. They can be personalized in a predictive way for account holders so that they only offer applicable products and services that fit within a specific audience’s needs. This customization strategy can drive revenue while fostering account holder trust.

To gain insight on account holders’ financial habits and goals, institutions can track user-level data and use third-party services to tailor push notifications about available banking services for each account holder. Institutions can maximize the engagement potential of each offer they send by distributing contextually relevant messaging on services or products that are pertinent to account holder’s financial needs and interests.

Push notifications are one way banks are moving toward digital-first communication strategies. Not only do push notifications offer a proactive way to connect with account holders, they also provide financial institutions with a compelling strategic differentiator within the banking market. Forward-looking financial institutions can use mobile alerts to strengthen account holder relationships, effectively compete, grow their customer base and, ultimately, maximize profitability.

The War for Talent in Banking Is Here to Stay

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It seems that everywhere in the banking world these days, people want to talk about the war for talent. It’s been the subject of many recent presentations at industry conferences and a regular topic of conversation at nearly every roundtable discussion. It’s called many things — the Great Resignation, the Great Reshuffling, quiet quitters or the Great Realignment — but it all comes down to talent management.

There are a number of reasons why this challenge has landed squarely on the shoulders of banks and organizations across the country. In the U.S., the workforce is now primarily comprised of members of Generation X and millennials, cohorts that are smaller than the baby boomers that preceded them. And while the rising Gen Z workforce will eventually be larger, its members have only recently begun graduating from college and entering the workforce.

Even outside of the pandemic disruptions the economy and banking industry has weathered, it is easy to forget that the unemployment rate in this country was 3.5% in December 2019, shortly before the pandemic shutdowns. This was an unprecedented modern era low, which the economy has once again returned to in recent months. Helping to keep this rate in check is a labor force participation rate that remains below historical norms. Add it all up and the demographic trends do not favor employers for the foreseeable future.

It is also well known that most banks have phased out training programs, which now mostly exist in very large banks or stealthily in select community institutions. One of the factors that may motivate a smaller community bank to sell is their inability to locate, attract or competitively compensate the talented bankers needed to ensure continued survival. With these industry headwinds, how should a bank’s board and CEO respond? Some thoughts:

  • Banks must adapt and offer more competitive compensation, whether this is the base hourly rate needed to compete in competition with Amazon.com and Walmart for entry-level workers, or six-figure salaries for commercial lenders. Bank management teams need to come to terms with the competitive pressures that make it more expensive to attract and retain employees, particularly those in revenue-generating roles. Saving a few thousand dollars by hiring a B-player who does not drive an annuity revenue stream is not a long-term strategy for growing earning assets.
  • There has been plentiful discourse supporting the concept that younger workers need to experience engagement and “feel the love” from their institution. They see a clear career path to stick with the bank. Yet most community institutions lack a strategic human resource leader or talent development team that can focus on building a plan for high potential and high-demand employees. Bank can elevate their HR team or partner with an outside resource to manage this need; failing to demonstrate a true commitment to the assertion that “our people are our most important asset” may, over time, erode the retention of your most important people.
  • Many community banks lack robust incentive compensation programs or long-term retention plans. Tying key players’ performance and retention to long-term financial incentives increases the odds that they will feel valued and remain — or at least make it cost-prohibitive for a rival bank to steal your talent.
  • Lastly, every banker says “our culture is unique.” While this may be true, many community banks can do a better job of communicating that story. Use the home page of your website to amplify successful employee growth stories, rather than just your mortgage or CD rates. Focus on what resonates with next generation workers: Your bank is a technology business that gives back to its communities and cares deeply about its customers. Survey employees to see what benefits matter most to them: perhaps a student loan repayment program or pet insurance will resonate more with some workers than your 401(k) match will.

The underlying economic and demographic trend lines that banks are experiencing are unlikely to shift significantly in the near term, barring another catastrophic event. Given the human capital climate, executives and boards should take a hard look at the bank’s employment brand, talent development initiatives and compensation structures. A strategic reevaluation and fresh look at how you are approaching the talent wars will likely be an investment that pays off in the future.

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.