Putting the "Community" Into Community Banking

Community banking has almost achieved Kleenex or Xerox fame, being generalized to the point of meaninglessness. PNC ($557 billion in total assets) calls itself a "Main Street Bank."  Citadel Credit Union's website is CitadelBanking.com. 

One of my Navy division officers once told me, "Be careful pointing fingers, because the rest are pointing back at you." And the dilution of what it means to be a community bank has been diminished not just by interlopers pretending to be sheep in wolf's clothing, but also regulators, and unfortunately, community banks themselves. The so-called fingers pointing back at us. We have not done a good job explaining what a community bank is.

Here is what @Victaurs said about a community bank on his or her substack:

"A community bank in the U.S. is generally defined as a depository or lending institution that primarily serves businesses and individuals in a small geographic area. These banks emphasize personal relationships with their customers and often have specialized knowledge of their local community and customers. They tend to base credit decisions on local knowledge and nonstandard data obtained through long-term relationships, rather than relying solely on models-based underwriting used by larger banks."

There are attributes that community banks should yell loudly from the rooftops. Because "buy local" has the greatest impact if you deposit your hard-earned money locally. Because a community bank:

- Lends 70%-80% of every dollar you deposit within your community to businesses that need capital and people that need homes.

- Donates almost exclusively to local non-profits in the communities it serves such as food pantries, affordable housing initiatives, and local youth sports organizations.

- Leaders from community banks are typically leaders in your communities, on school boards, Rotary clubs, and libraries.

- Community banks assess a borrowers' ability and willingness to pay loans back based on more than financials laid out in spreadsheets, but also based on local knowledge of the borrower, business, and markets.

- A community bank thinks your business and personal banking needs are important. Think back to the pandemic when small businesses couldn't get their big bank on the phone. They called community banks. Why? Because those businesses weren't "small" to them. 

For some reason, we have not been able to break through the public's perception that a community bank is somehow less than a big bank. Less safe and secure. Fewer products. Low tech. None of which are usually true. So why do people perceive that it is true? Again, the other fingers are pointing back at us.

What To Do

My first recommendation to distinguish a community bank from others (big banks, fintechs, other financial intermediaries), is to improve our messaging as to content and frequency. In today's digital world, we don't need a Capital One ad budget to deliver our message to our target audience early and often. I'm in a swing state and I receive political messages daily via ads, content (paid and free), and old-school direct mail. When I traveled to California recently, I got none of this, telling me that you don't have to plaster ads across large geographies. Just the geographies where we operate. This can really elevate the importance of bank marketing from what James Robert Lay of the Digital Growth Institute said: "financial marketers have been viewed internally as ‘kids who play with paint and crayons." It matters where people and businesses bank. But only if people and businesses know why it matters.

My next recommendations come from past posts because I believe now as I did then, that community banks can elevate their importance to the communities they serve. They can matter more. They would be missed if they were not there.

Build a small business banking platform. I asked Google Gemini AI who were the top 5 market cap firms in the S&P 500 and what year did they start. The response:

The top 5 companies in market capitalization in the S&P 500 as of October 2024 are:

Apple: Founded in 1976   

Microsoft: Founded in 1975   

Alphabet (Google): Founded in 1998

Amazon: Founded in 1994   

Nvidia: Founded in 1993

All started as small businesses. In addition to extraordinary founders with awesome business ideas, all needed seed capital and loans. And now they employ hundreds of thousands of people. Community banks can increase their participation in what may be the next Amazon. I wrote two articles on how they can do this. The first, Build Your Own Small Business Loan Platform confesses to a seldom discussed blind spot in how community banks build communities: they only like lending with real estate as collateral. In that post I described a bank that had several alternatives on how a community bank can make capital available to small businesses, only a couple of which would actually be on the bank's balance sheet if those loans were outside of the bank's risk appetite. It could be started today and deployed in a matter of months, if a bank chooses to do it.

Small businesses don't need loans early in their existence. They need capital. That is why I wrote Shark Tank twelve years ago. I hatched this idea prior to writing about it and bounced it off of the CEO of a New York bank when he was Chairman of the ABA. His response: "Jeff, that isn't banking." But I have not given up on the idea because there are new Bill Gates and Jeff Bezos out there who don't need loans because they don't have the cash flow yet to service loans. But they need capital.  And those who can be significant employers in your communities may not be lucky enough to get the attention of p/e firms. But a local angel fund run by the community bank? Heck I bet you could get the big banks to be an investor in it.

Another idea is to build a Financial Wellness Center (FWC) as a profit center to serve the needs of the low-mod income families in your markets. I'm talking beyond CRA. I'm talking impact. Help people go from Low to Mod, Mod to Middle, and so on. And do so profitably. I suggested how to do this in my recent article Financial Wellness as a Profit Center. Sure there are others doing it for altruistic reasons. Without using profit as your goal posts, you will have an activity that begs for resources and is a drain to the bottom line. Instead, build one that supports itself and is a beacon of hope in your communities. 

My last idea on how to distinguish a community bank from all others is: Adopt a higher purpose. Community financial institutions, in my experience, donate 4%-8% of pre-tax profit to local charities in the communities they serve. They sprinkle their giving here and there and do social media posts talking about it. But what if they focused effort and resources for championing a cause. For example, Bombas Socks donates a pair of socks to a homeless shelter each time you buy a pair from them. As their business model grew, they began donating other clothing items most in need at shelters. What could your higher purpose be?  Perhaps you can marry the Financial Wellness Center idea to your higher purpose: Elevate the financial well-being of every community we are in. And then create measurables to see how you are doing. Wouldn't it be a great selling point to keep your top-performing employees and attract others? Would customers stay with you longer and not demand the best price? Would your community be better off with you in it?  

Make no mistake, I already believe that community banks are critical to the success of their communities and feeding the American Dream of entrepreneurship and home ownership. I offer my suggestions to take that strategic advantage to the next level. Make your institution indispensable and you will be unbreakable.

~ Jeff

   

  

Guest Post: Financial Markets and Economic Update- Third Quarter 2024

Financial Markets Update – Third Quarter 2024

I had a fantastic September traveling to France and Luxembourg with my sisters.  We joined my dear friend, Elisabeth, Thanks GIs Association, and other American families for the dedication ceremony of a new monument to the 11^th Infantry Regiment, who fought in the Dornot-Corny battle along the Moselle River in 1944 for their freedom.  My Uncle, Stephen W. Jaworski, was killed in action during these battles just south of Dornot.  We spent quality time with our French friends/family.  We joined Thanks GIs for lunch with the Mayor of Noveant, who surprised us with a posthumous Medal of Honor award to Stephen from the town.  It was another emotional day, and later we visited Stephen’s gravesite at the Luxembourg American Cemetery to honor him.  These were powerful, emotional events and I will always be proud to represent Stephen, our family hero.

Where is the Recession?

I’ll start this subject again this quarter by saying I believed we would get recession by now; my timing has been horribly early and wrong.  All the signals have been there for two years; the index of leading economic indicators has been down 27 of the last 28 months, consumers are using borrowing to get them through as inflation ravages household budgets, and an inverted yield curve, which is generally a precursor of recession, lasted about two years.  Interestingly, the 10-year to 2-year Treasury spread, which was -37 basis points at June 30^th, turned positive in September after 26 months and is now +23 basis points.  The 10-year to 3-month Treasury spread is still inverted, as short-term rates wait for more Fed action.  The spread was -101 basis points at June 30^th and is still widely negative at -81 points today.  Remember, it is the re-steepening of the yield curve after a prolonged period of inversion that heralds recession and Fed easing.

You wouldn’t know we have recession risk when stocks are rampaging; markets crashed for a day on August 5^th but recovered in mere days.  Year-to-date, the S&P 500 is up +21%, Nasdaq is up +23%, and the DJIA is up +12%.  But unemployment took a turn for the worse with July’s numbers, reported in August and some economists point to the Sahm Rule (recession occurs when the unemployment rate rises +.5% in a short period), with the unemployment rate at 4.2% in August being +.8% over the low in 2023 of 3.4% to say recession could be starting.  I’ve been suspicious of the fictional payroll numbers and equally unreal JOLTS report.  In August, the BLS announced that they would cut 818,000 jobs from the payroll reports of the past 12 months as part of their benchmark revision process.  It’s the largest since 2009!  The pool of available workers is high again at 12.75 million persons and the unemployed now total 7.1 million.  Full-time jobs are down -1,021,000 in the past 12 months while part-time jobs, likely without benefits, are up +1,055,000.  Payroll and household job growth has weakened considerably since July.

Gold is signaling concern as it trades at new highs, currently $2,658 per ounce.  Safe havens are not always bonds.  Anticipated slowdowns in the economies of the US, China, and Europe led to oil prices declining to $68.64 per barrel and gas prices declining to $3.22 per gallon, according to AAA.

GDP

The latest Federal Reserve projections from September for GDP are for +2% growth this year and next year, despite 2Q24 GDP being +3.0% and the Atlanta Fed GDP Now being +2.9% for 3Q24.  By the way, Chairman Powell called 2% GDP growth “solid.”  It’s sad that we have lowered our standards.  The Fed and many others believe (or maybe they hope) that we will have a soft landing.  This is a familiar refrain.  Before every recession since 1980, economists and market participants believed the economy would have a soft landing; in fact, the elusive soft landing was achieved only once since then- in 1996 by Maestro Greenspan.  More than likely, the US will experience a weak recession…if the Fed keeps lowering rates.

The world’s best banker, Chase’s Jamie Dimon, recently warned about a scenario that is worse than recession; he says not to discount the possibility of stagflation like the 1970s, with slow growth, rising inflation, and rising unemployment.  I would add that we should not discount the possibility of inflation falling far below Fed targets if they remain stubbornly tight.

The Fed

I was not surprised at the 50 basis point cut in the Fed Funds rate in September.  I’ve continually complained that the Fed Funds rate was too high.  I think it came down to the Fed regretting that they did not cut rates in July (as all hell broke loose with unemployment right after that), so they are playing catch-up.  But I ask, in what universe does a 5% Fed Funds rate make sense?  Short-term Treasury yields and SOFR rates are all in the 4s, one-year to 10-year Treasuries all have 3 handles, and very long-term Treasuries are in the low 4s.  But a 5 handle on Fed Funds?  Even bankers disagree, as the FF effective is 4.83%, toward the lower end of the 4.75% to 5.00% range.  So yes, we’re happy with the first 50 basis points two weeks ago, but there is a lot more work to do.  I think the Fed will “catch up” again and do 50 basis points in November.  That FOMC meeting occurs after Election Day, so they won’t get any political questions.  And 2025?  The Fed themselves project the rate cutting phase will continue through the year.

Inflation

Everybody hates inflation!  Thankfully, inflation continues to head down toward Fed targets, albeit slowly for some measures.  Fed targets are based on the BEA reported PCE and core PCE numbers, published monthly and quarterly.  The most recent monthly report for August had PCE at +2.2% y-o-y and core PCE at +2.7% y-o-y.  From the GDP report, 2Q24 PCE was +2.5% and core PCE was 2.8%, both y-o-y.

In terms of CPI, August was +2.5% y-o-y and core CPI was +3.2% y-o-y.  Remember that CPI historically is higher than PCE by +.5%, so 2.5% would be a good goal to have on CPI.  Core CPI is stubborn and declining more slowly than expected.  Before we celebrate too much, can you say “supply chain issues?”  We have the threat of dock workers going on strike October 1^st at ports along the east coast of the US and across the Gulf coast to Texas.  What would this disruption mean especially since there is so much need in states like Florida, North Carolina, and Tennessee after Hurricane Helene destroyed so many communities with massive rain and flooding.

Chairman Powell stated that wage growth is not contributing to inflation.  He also called the labor market “solid,” but we will forgive him for that one.  The figure was +3.8% y-o-y for August.  Remember that wages can increase in a 2% inflation target environment and, if productivity is decent (historically +1.5%), can grow +3.5% on average.  2Q24 productivity was +2.5% and 1Q24 was +.4%, making the y-t-d average +1,5%, precipitating Powell’s comments.  The wage growth percentage for August is getting closer to this goal.

The inflation narrative really is broken down into two parts:  the level of the inflation index and the marginal rate of change.  The level of CPI is up +19.7% since the end of 2020, including food +21.8%, shelter +22.7%, and energy +33.8%.  It is the level of CPI, with no decline in sight, that frustrates consumers the most.  Victory in getting the marginal change down to a low level does not reduce their grocery, housing, utility, and energy bills.  High prices have pushed consumers to turn to credit cards to take care of everyday needs; credit card balances outstanding have ballooned to $1.34 trillion with an average rate of 23%, and more telling, a delinquency rate of 9%.

Restrictive Fed

Was Fed Funds at 5.5% restrictive?  Yes!  Let’s have a look:

FF less CPI of 2.5%= 3.0%; FF less core CPI of 3.2%= 2.3%; FF less PCE of 2.5%= 3.0%; FF less core PCE of 2.8%= 2.70%; FF less nominal GDP 2Q23 of 5.5%= 0.0%; 1Q24 of 4.6%= 0.9%; FF less nominal GDP 4Q23 of 4.8%= 0.7%.

Not to be forgotten are two other key elements in this tightening cycle- QT and M2.  QT continues at a pace of $60 billion sales or runoff per month from the Fed’s balance sheet.  To date, the balance sheet is down $1.5 trillion from its peak.  It’s hidden tightening in that $1 trillion of QT is believed to be the equivalent of +100 basis points of tightening.

M2 continues its slight growth, according to the H.6 Money Stock report.  In August, M2 grew by +2.0% y-o-y compared to July +1.3% y-o-y.  Between December, 2022 and March, 2024, M2 declined on a y-o-y basis, which was the first time that has happened since 1931 to 1933.  Don’t go there; I think the Fed was trying to offset wild government spending but decided not to risk it anymore.  Milton Friedman suggested that M2 growth should equate to output, or nominal GDP.  That’s been 4% to 5%, so M2 is restrictive and far away from equilibrium.

Speaking of government spending, the deficits are out of control, at a projected -$1.9 trillion for fiscal 2024 compared to -$1.7 trillion in 2023.  Debt outstanding is $35.3 trillion, or 121.7% of GDP as of 2Q24; when the debt to GDP ratio exceeds 90% for over five years, the negative effect on GDP is about -33% of trend.  Interest expense on debt will now top $1 trillion per year, or $3 billion per day.  Ridiculous!  Given the habit of our government of printing tons of money to hand out like candy, I am afraid of what they’ll do when we have recession.  Maybe Jamie will be right.

What does it all mean?  Recession signals are around but not impacting us yet.  Stocks, bonds, and data can all turn on a dime.  Short-term rates should continue to decline, with the Fed having some catch-up to do.  Inflation is headed down, at least the marginal change part.  Long-term rates have some room to decline, which includes mortgage rates, which are about to drop below 6%- finally!  No one will move out of their home when they have a low-rate mortgage.  The average mortgage rate in the US is 3.78%, so don’t expect too much from housing.  Unemployment is the wild card.  If it keeps getting worse, the Fed will respond more aggressively.  Those affected in many states by Hurricane Helene will have a huge task in front of them to rebuild their homes, roads, bridges, and communities after last week’s flooding and devastation.  Give them the strength to do so.

I appreciate all of your support!  Thanks for reading!  DLJ 09/30/24

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy recently retired from Penn Community Bank where she worked since 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Disclaimer:  This publication is provided to you solely for educational and entertainment purposes.  The information contained herein is based on sources believed to be reliable but is not represented to be complete and its accuracy is not guaranteed.  The expressed opinions, views, and estimates are those of the author as of this date and are subject to change without notice.  The author cannot provide investment advice but welcomes all comments.

Embracing Change or Chasing Shiny Objects: 4 Criteria to Distinguish Between Them

So often we struggle with the noise surrounding the banking industry. “Change or die!” “Get bigger or get out!” “If you don’t have an AI strategy you’re already behind!” How do we create a financial institution that embraces change without chasing shiny objects?

I have ideas in the below video.

Financial Wellness as a Profit Center for Financial Institutions

So many financial institutions list "financial literacy" or customer "financial wellness" as one of their higher purposes. Which makes immeasurable sense given how defined benefit pension plans are now the exception and households are left to fend for themselves when it comes to their own financial wellness. 

And by objective measures they are not doing too well. According to a 2023 Payroll.org study, 78 percent of Americans live paycheck to paycheck, meaning if they miss a paycheck they would have trouble paying their bills.  That is up 6 percent from the prior year. 

Further, in 2022, only about 46% of households reported any savings in retirement accounts. Twenty-six percent had saved more than $100,000, and 9% had more than $500,000. This was why my firm did a recent This Month in Banking podcast with our friends from CentSai as our guests on how promoting financial literacy can help financial institutions perform better. You read that right. 

The need for someone, anyone to help Americans become first financially sound and then financially free was driven home by Anne Shutt of Midwestern Securities, presenting Creating a Financial Oasis at a recent banking conference I attended. Anne said that only 14 percent of respondents of a recent survey said their financial institution helped them with their financial wellness. 

I contend that financial institutions should serve a higher purpose other than maximizing profit to benefit shareholders. But in serving your communities, employees, customers and shareholders, profit should be your yardstick in a stakeholder driven, higher purpose financial institution. And right now, financial literacy is executed for the benefit of one, maybe two constituencies, at the expense of the others. To create alignment, I propose a different path.

Make financial wellness a profit center. Like a branch. Assign personnel to it. Like a branch. Instead of branch manager, assistant branch manager, and three universal bankers, staff with two financial coaches, and a financial wellness assistant. 

When we onboard new customers, as part of our Know Your Customer, determine their financial well-being. Ask if they would like, as part of being a customer of the bank and for a small quarterly fee (perhaps... might waive this as the Financial Wellness Center (FWC) builds its customer base) they can opt-in to improve their financial well-being. If they opt yes, then their account, balances, spread, fees are part of the balances and revenue streams of the FWC. 

In addition, we can market to existing customers that struggle financially based on observable criteria, human judgment, or generative AI. At first, this center will bleed red ink. So do new branches. Even some mature branches that banks refuse to close. But red ink should not be the goal, as many altruistic, CRA-driven community initiatives are.

The challenge is that those most in need of the FWC will likely carry low balances and are in the Cash Flow & Basic Needs or the Financial Safety rungs in the chart below, presented by Anne. Low balances per account have a strong correlation to low profits, as spread represents so much of profit in community financial institutions. Revenues are generally driven by balances, where expenses are driven by number of accounts. Not a great mix for the FWC.

But we don't have a physical facility, like a branch. Although the FWC might have to absorb or incur some sort of internal transfer payment to branches servicing their accounts. That said, there would be less expenses than a branch that would have more employees and physical plant than the FWC. The FWC would likely have more fees, as lower average balances and the need for a financial coach probably equates to more insufficient funds charges, etc. This has consistently been the case when we measure the profitability of higher versus lower average balance accounts in our profitability outsourcing service. And there would be those coaching fees. 

In addition, I find it plausible, even likely that a bank with an FWC designed to improve their customers' financial well-being will include some account ornamentation, such as credit score monitoring, lower my bills services, etc. that the bank can charge a fee for service. 

I don't think the FWC could achieve the same level of profit as some of the bank's larger branches, commercial lending center(s), or mortgage department (during good times). The FWC could strive to achieve some pre-tax profit number as a percent of average deposits of, say, 50 basis points for a bank that strives to achieve over a one percent ROA. In addition to that accountability metric, the FWC could ensure all of their clients are on the bank's personal financial management tool, and gauge improvements in customers' net worth as a sign of success. Lastly, the FWC could use improvement in customers' credit score as objective evidence of success. 

And when customers elevate to Accumulating Wealth or higher in the chart above, they can graduate from the FWC with a natural referral to our wealth group. Because right now, wealth groups are not seeking many customers at or below the Accumulating Wealth level. They just can't make any money doing it. So we let customers seek other alternatives and hope we win them back when they have $500,000 or more in investible or bankable balances.

Financial Wellness Centers can work. But we have to elevate beyond altruism and CRA and migrate to profit to make it a viable line of business to our financial institution.

~ Jeff

Guest Post: Financial Markets and Economics Update - Second Quarter 2024

Financial Markets Update – Second Quarter 2024

A dream vacation!  I went with family and friends to Holland and Belgium during peak tulip season during April.  It was so beautiful and lots of fun.  We saw so many fabulous places, including Amsterdam, Kinderdijk and its windmills, Keukenhof Gardens, Brussels, Bruges, and Antwerp.  We learned how Holland keeps the floodwaters away.  It was my first vacation in decades where I did not have work waiting on my desk when I got home.   Also, my family and I got to spend three days in Hershey last week watching the excitement on the children’s faces as they moved from ride to ride and played in the water parks.  For me, this is what my retirement is all about.  That and getting consumed by Euro 2024 and Copa America soccer and of course, the Phillies.

Where is the Recession?

I think I’ve spent too much time reading and studying economics.  The time-honored indicators that so many of us review for signals of recession continue on, month after month, and yet their ability to project recession has not turned into reality.  Take, for instance, the inverted yield curve.  In July 2024, we will mark two years of inversion between the 10-year Treasury and the 2-year Treasury yields.  It is already the longest inversion on record, surpassing the 624-day inversion ending in 1978.  The spread currently stands at -37 basis points.  At times, the spread exceeded -100 basis points.  The 10-year Treasury versus the 3-month Treasury spread, which turned negative in October 2022, is now -101 basis points.  So, after 18 months to 2 years later, where is the recession?  Some say it will appear when the curve re-steepens and some say it is coming soon.

And what about the index of leading economic indicators?  For this cycle, the LEI first had a negative monthly reading in April 2022.  Other than a slight positive of +.2% in February 2024, when the Conference Board gleefully announced that there would be no recession, the index has been negative for 27 months and is down a cumulative -15.1%.  So where is the recession?  I think we have to wait.  We know the Conference Board measures three factors with the LEI, including duration, depth of the decline, and diffusion indices; but, seriously, two of three are screaming watch out below.  The same Conference Board reversed course and now says there is a “fragile outlook,” making themselves look ridiculous as the LEI continued its descent.

And what about tight Fed policy leading to weaker growth, especially if they hold rates too high for too long?  We have many examples, notably 2000-2001, 2006-2008, and 2019, when restrictive rates impaired growth and recession followed.  Between March 2022, and July 2023, the Fed increased rates by 525 basis points, with Fed Funds at 5.50% ever since.  Are they restrictive?  Yes, when Fed Funds is above inflation and above nominal GDP growth.  Note all of the following:

FF less CPI of 3.3%= 2.2%; 

FF less core CPI of 3.4%= 2.1%; 

FF less PCE of 2.8%= 2.7%; 

FF less core PCE of 3.7%= 1.80%; 

FF less nominal GDP 1Q24 of 4.5%= 1.0%; 

FF less nominal GDP 4Q23 of 5.1%= .4%.  

We’ve seen slowing from this restrictive policy but not recession.

And what of QT?  The Fed was allowing $95 billion of Treasuries and MBS to roll off of its balance sheet but reduced the total to $70 billion starting in May.  It seems to be an acknowledgement that they must reduce this restrictive policy and that easing is coming soon as money supply was being impacted too much.  But I will get to money supply later.

Parts of the economy are suffering, including housing from high rates affecting affordability, weak housing starts and a 30-year low for existing home sales with low inventories keeping home prices higher than normal.  Manufacturing is weak.  Consumer spending and retail sales are declining this quarter as people cope with high inflation, especially on food prices.  Retail store closings have escalated as sales weaken and retail theft skyrockets.  Both consumers and businesses are paying high interest rates on their increasing debt balances.  One of the components of the LEI which is up strongly is the S&P 500 stock market index, by +14.5%.  Rallies in the Magnificent 7 stocks and Artificial Intelligence’s transformational potential mean that we may not get a recession signal yet from stocks.

So there is still no recession, although I stubbornly refuse to remove it from my forecast.  Rates that are kept too high for too long will not lead to anything good.  Signals from the yield curve and leading indicators dampen the outlook.  In my mind, recession should have already happened.  So I am obviously not accounting for existential or even psychological factors that are delaying the inevitable.

Real GDP.

Chairman Jerome Powell recently called economic growth “strong” in his press conference.  I hope he was not looking at the first quarter at 1.4%.  OMG!  Or maybe he was looking at the notoriously volatile Atlanta Fed’s GDP Now projection for the second quarter of 2.2%.  It’s a sad day when GDP growth of 2% or less is “strong.”   Of course, that’s what we lived through from 2010 to 2020.  Regardless, the FOMC projection for GDP is 2.1% for 2024 and 2.0% for 2025 and 2026.

My favorite banker, Jamie Dimon, recently called his economic outlook “cautiously pessimistic.”  He has been worried for such a long time; remember when he said in 2022 that there would be a storm, or even a hurricane that would hit the economy.  I have shared this same view with him.  And interestingly, he must now be thinking about retirement, because when asked how much longer he will stay at Chase, he did not respond with his traditional “five years,” but said “less than five years.”

With recession in many people’s projections, but not appearing on the horizon yet, we have to navigate our boats as best we can.  GDP is projected at 2% for an extended time.  I think it could be lower.  If we look at out-of-control federal government spending, budget deficits, and ever-increasing debt, it is having an impact on our growth potential.  Debt-to-GDP at the end of the 1Q24 was 122.3%; studies show that debt levels greater than 90% of GDP (which we’ve had since 2010) lead to a severe reduction in GDP.  Debt service payments for the government are accelerating at an unsustainable pace.  Lower GDP means lower inflation but it may also mean lower tax receipts.  Maybe the roller coaster in Treasury yields will come to a stop and we will see lower long-term rates.  The 10-year Treasury has been quite volatile in 2Q24, starting at 4.20%, peaking at 4.65% in April, and ending at 4.35%.  The 2-year Treasury started at 4.62%, peaked at 5.01% in April, and ended at 4.72%.

Money Supply M2

The 16-month streak of declining M2 money supply has been broken, when April and May showed slight year-over-year increases of +.2% each month, following declines of -1.0% in March, -1.9% in February, and -2.2% in January.  M2 had been declining on a y-o-y basis since December 2022 and this was the first time since the 1930s where we saw M2 fall.  We are still far below the long-term average M2 growth of 6% to 6.9%, which approximates nominal GDP growth.

In the past 150 years, excluding the current 2022-2024, M2 has declined only four times on a y-o-y basis, in 1878, 1893, 1921, and 1931-1933.  These four instances led to recession/depression and high unemployment.  I’m not sure about this time, but I think it was necessary to offset the massive federal deficit spending so that inflation could fall.

Let me repeat Milton Friedman’s quote and add more to it: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output (GDP).”  He made this quote in 1963, referring to persistent inflation, not short-term supply shocks.  Maybe everyone will forgive the Fed and people like myself in 2021 for initially thinking inflation would be “transitory” because of supply shocks.   We were wrong and quickly realized it because M2 was growing so much faster than GDP.  Not until mid-2022 did CPI peak at +9.1% y-o-y and start its deceleration in pace.  But now think of Friedman’s quote in reverse; if the quantity of money drops more than output, should we not see disinflation?

Misconceptions about Fed Inflation Targets

The Fed’s targets for inflation of 2% apply to PCE and core PCE.  The Fed does not target CPI.  I repeat, they do not target CPI, but they inherently consider it.  Prior analyses have shown that CPI tends to exceed PCE by .5%, due to the different construction of the underlying indices.  If the inflation target is 2% for PCE, CPI can be 2.5%.  

The Fed does not target wage growth per se.  Did anyone catch Powell’s comment during the press conference in June that linked inflation and productivity to arrive at acceptable wage growth.  I’ve written about this several times; if PCE is 2% and productivity averages 1.5% (as it has for long periods of time), then wage growth can be 3.5% and can co-exist with a 2% PCE inflation target.

Employment

In my last newsletter, I wrote that I had real reservations about the employment report.  Now I feel vindicated.  In his press conference, Chairman Powell expressed the same doubts about the employment report and the birth/death ratio applied to small businesses, which accounted for over half of all jobs added in the establishment report in the past twelve months.  Since April 2023, the B/D ratio accounted for 1.9 million, or 56%, of all new jobs.  In the May 2024 report, payrolls rose by 272,000 jobs, which included 231,000 jobs added for the B/D ratio in the face of declining business formation.  It’s ridiculous.

Look at the contrast between establishment (payrolls) and household surveys since February 2024 and the number of unemployed and pool of available workers:

Payrolls May +272,000, April +165,000, March +310,000, February +236,000; total +983,000

HH survey May -408,000, April +25,000, March +498,000, February -184,000; total -69,000

Unemployed May 6,649,000, April 6,492,000, March 6,429,000, February 6,458,000; chg +191,000

Pool AW May 12,366,000, April 12,129,000, March 11,872,000, February 12,130,000; chg +236,000

The unemployment rate now stands at 4.0% in May, up from a low of 3.4% in 2023.  The payroll numbers get the headlines, with almost 1 million jobs added in 4 months, but look deeper.  Household jobs are down and the unemployed and pool of available workers (unemployed plus those not in the labor force who want a job) are growing and the unemployment rate is on the rise.   Thankfully, the unemployment rate is calculated from the household survey, not the fictitious payroll numbers.  They are almost as fictitious as the JOLTS reported job openings.  Additionally, full-time jobs are down 1 million to 133.3 million in the past year, while part-time jobs are up 1.5 million to 28.0 million.  So, you tell me, is this a strong labor market?  Should I keep recession in the forecast?

End of an Era

In June, there was another end of an era for one of our rate indices.  Just like LIBOR was kicked to the curb, now FNMA discontinued posting its historical daily required net yields for 30- and 15-year mortgages on June 3rd, claiming that many market participants didn’t use them.  But what about the ones who did?  To me, they were worth tracking as an indicator of the mortgage whole loan versus MBS market spread.  Gone is the history back to 1985, too.  Very sad.

Summer is here.  May you all enjoy wonderful dream vacations!

I appreciate all of your support!  Thanks for reading!  DLJ 06/30/24

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy recently retired from Penn Community Bank where she worked since 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

Disclaimer:  This publication is provided to you solely for educational and entertainment purposes.  The information contained herein is based on sources believed to be reliable but is not represented to be complete and its accuracy is not guaranteed.  The expressed opinions, views, and estimates are those of the author as of this date and are subject to change without notice.  The author cannot provide investment advice but welcomes all comments.

Regulators War on Banking

Last year I wrote a Forbes Finance Council article What's Missing in the CFPB's War on Junk Fees? That war was being waged against overdraft fees. I stated that comparing the fee assessed on an overdraft to the cost of processing one is like comparing the cost to manufacture a pill to the cost of the medication. It is short-sighted to isolate overdraft fees from the total cost to originate and maintain a checking account. If the CFPB was so concerned about fees charged by banks, perhaps they should perform an analysis of over regulation that is a key contributor to fees charged by banks.

Regulators must not have read that article. Because they have since expanded their war to include, among other things, debit interchange. Oliver Wyman said this in their Impact of Simultaneous Regulatory Proposals in Retail Banking: 

"The Fed proposes under Reg II to decrease the maximum allowed debit interchange fee from $0.22 + 5 basis points to $0.157 + 4 basis points for issuers above $10 billion in assets. With a 2021 average ticket of $46.26, Reg II would decrease the average interchange transaction by ~28%. Debit interchange is a significant component of checking accounts non-interest income (around 50% according to data from payment card publication Nilson Report). Therefore, the proposed rule has a more significant impact on the profitability of low-balance checking accounts due to banks' relatively higher reliance on non-interest income for these consumers (versus high-balance checking accounts that rely more on interest income). Additionally, this may lead banks to start charging for fraud losses to recoup lost revenue - under Regulation E, banks are able to charge $50 for fraud losses to the customer, however, most banks cover those losses for their customers."

I should point out that when the Durbin Amendment of the Dodd-Frank Act (2010) capped interchange fees, it did not result in any measurable benefit to the consumer. Why take a second bite at the apple?

In my Forbes article, I demonstrated that banks' reaction to downward pressure on fee income, be it overdrafts or other fees, was to increase their average deposits per account. Meaning that they started focusing on more affluent customers that tend to carry higher balances so they can offset the fee decline by driving more spread through the account. 

Yet here they go again. And Oliver Wyman is what I believe to be correctly assuming that banks will make moves to cover the revenue shortfall from debit interchange mandated by Reg II. What do regulators think will happen?

When I look at the average cost per retail checking account, be it interest bearing or non-interest bearing (see chart, courtesy of The Kafafian Group performance measurement), I see consistency in operating cost per account.

This is in spite of the average balance per account in interest checking growing 44% between the first quarter of 2007 to the fourth quarter of 2023. The average balance per account of non-interest checking accounts grew 152% during that same period. Banks themselves grew asset size to achieve that holy grail of growth, economies of scale. So why have we not lowered our average operating cost per account in retail checking accounts?

I cannot lay the sole blame at the feet of regulators. In every institution we have served with Process Improvement services we have found onerous processes, inefficient technology utilization, and silos prohibiting greater efficiency and therefore lower average costs per account. But many of those processes were belts and suspenders responses to regulatory scrutiny or the fear of that scrutiny in the bank's next exam. 

If regulators work overtime to keep bank's operating expenses higher than need be through regulatory activism (see recent consent orders to BaaS banks around BSA/AML/OFAC compliance-classic checking account critiques) and keep pretending to be the Champion of the Consumer through price fixing regs like Reg II, expect financial institutions to rightly try to fill that profit hole. Be it through charging other fees or increasing minimum average balances that is suggested in the Oliver Wyman report, or through focusing on more affluent customers that carry higher average balances, as stated in my Forbes article.

Either way, will it end up better for the consumer? Look at how so many banks have significantly curtailed consumer lending. It's not because they don't want to serve their retail customer base with a more robust product offering. It's because regulation increased the cost so much and elevated the risk, that they drove many banks out of it.

Is that what we want?

~ Jeff

We Need a New Funding Strategy

In December 2021, when the Fed Funds Rate stood at 0-25 basis points and prior to the Fed's tightening beginning in the first quarter of 2022, there were $18.2 trillion in domestic deposits, according to the FDIC's Statistics at a Glance. In December 2023, a full three quarters after the Fed paused its tightening of the Fed Funds Rate (QT continued), domestic deposits stood at $17.3 trillion. Nine hundred billion dollars, or 5% of deposits... gone. 

What happened?

Money market total financial assets, according to the St. Louis Fed, went from $5.2 trillion in total assets at December 2021 to $6.1 trillion in December 2023. Not so coincidentally, a $900 billion change.

Read this comment from M&T Bank Corporation's (MTB) fourth quarter earnings release:

"Net interest margin of 3.61% in the recent quarter narrowed from 3.79% in the third quarter of 2023 reflecting the higher costs paid on deposits amidst a continued shift of customer funds to interest-bearing products."

And indeed, MTB did grow deposits during this period. But the industry as a whole, not so much. Nationwide, depositors did switch to interest bearing accounts. But money market mutual funds seemed to be the benefactors of the switch. 

As far as community banks, I look to data gleaned from all of the banks where my firm does profitability outsourcing because we have a level of granularity that the FDIC and most readers do not have. Look at the two average balances per account charts below courtesy of The Kafafian Group.

It is true that the average balance per retail (non jumbo) CD account was higher in the fourth quarter 2023 than the fourth quarter 2021. But it was not materially so. In fact, if I multiplied the change in CD balances per account times the average number of CD accounts for all of our outsourcing clients, it would equate to a positive aggregate change in CD balances per bank of $65.7 million. For retail money market deposit accounts alone, the same math equates to an aggregate decline in those balances of $105 million. Of note there were 11% more CD accounts and 8% more retail money market deposit accounts. 

The outflow of deposits was not driven by a decline in the number of accounts. It was driven by the decline in the average balances of those accounts. The story is similar regarding business deposits (see chart above).

Although financial institutions cost of funds are now stabilizing yet still slightly increasing, it has been one year since the Fed paused its Fed Funds Rate tightening. This was similar to the tightening cycle between 2004 and 2006 when Fed Funds rose again to 5.25%-5.50%. But since the financial crisis came quickly on that cycle's heals, banks cost of funds rose two or three quarters after the Fed paused. Because the Fed then precipitously dropped the Fed Funds Rate to offset the negative economic impacts of the financial crisis. For this tightening cycle, the tail of increasing cost of funds amidst a Fed pause is lasting much longer. Higher for longer.

Most of our deposits are immediately callable. We believe we established relationships with our customers so they won't flee with every rate increase. A relationship is built on trust. And if our deposit strategy was to keep rates as low as possible so long as our depositors didn't notice, we have broken that trust. And they fled. Or we had to apologetically raise their rates to be closer to the market to keep their money. Something we continue to do.

What we can learn from this is there is value in a relationship, if we truly have a relationship where our depositors know our bankers and have someone to call to discuss banking matters. Some self-reflection might be needed here.

And secondarily, we have to assess the value of that relationship or other differentiated value we deliver. And by value I mean how much less than market deposit rates they will accept for that perceived value, which appears to be what they can earn in a money market mutual fund. Maybe it's 50 basis points. Maybe 100. But as we found out, it's not 300 or more.

Our cost of deposits will have to be managed by the strength of our differentiation and the mix of our deposits. Because this cycle proves that customers will flee. They may not close their account. But they will drain it. And we may not even notice it.

~ Jeff