CFPB: Are They Coming to Get You?

A bank trade association CEO asked me a couple of questions while he was researching an op-ed piece. The edited Q&A is below.

Q. Shouldn't the CFPB work to address the impediments to starting a bank in LMI markets rather than punish community banks who scrambled to serve their customers when the economy shut down?

Author's note: This was probably relating to the late January released statement about the acting director of the CFPB's promise to take aggressive action in response to perceived Covid-19 relief violations, including the policy of some banks to only take PPP applications from pre-existing customers, which may have a disproportionate negative impact on minority-owned businesses.

 

A. The problem stems from the spreadsheet, in my opinion. With deposit spreads so low, branch deposit sizes need to be very large for a branch to be profitable. According to my firm's profitability peer group, a branch with $74 million in average deposits made a mere pre-tax profit of three basis points. That is a fully absorbed number, with support center expenses allocated to it. On a direct cost basis, the branch must be at least $38 million in deposits. Knowing this, very large financial institutions operate branches where they can have greater scale to drive greater profitability, which frequently excludes LMI neighborhoods, creating what is termed "bank deserts."

Another challenge is imposed by the very government that tries to assist LMI households: regulation. The average operating cost to originate and maintain an unsecured personal loan is $287 (again, according to my firm's profitability outsourcing service peer group). And the average balance per account is $3,800. The spread needed to cover the cost alone would be 7.5%. That's not the yield... it's the spread. So if the bank's cost of funds was 1% the yield would have to be 8.5%.

But there's more! The provision for loan loss is 1.25% of that balance. A bank would have to charge a 9.75% yield on an unsecured personal loan just to break even. The operating cost is largely attributable to the distribution through the branch network and regulation. Since a bank can't cut regulation, they trim their branch network to lower those costs. And the obvious bullseyes are on branches that lose money.

Similarly, the annual operating cost per account for a retail checking account is $398. With a 1.89% spread and with 0.91% average fees as a percent of balances, the average balance of a retail checking account would have to be over $14,000 to be profitable. A very high hurdle in an LMI neighborhood. Again, much of the cost per account is driven by branch distribution and regulation. Retail banking is heavily regulated. And it's difficult for financial institutions to operate in neighborhoods that have low average balance loans and deposits. Plus, if an institution charges the high yields on loans to be profitable, or assess the high fees it would need to make the retail checking account profitable, think of the reputation risk they would assume. That is why very few of our clients consider retail banking as the driver of future profitability in strategy sessions. 

Q. Should communities today be concerned by the M&A activity taking place? What advantages or disadvantages do they face when institutions consolidate?

A. If we lose 4% of FDIC-insured institutions per year, which was pre-pandemic pace, we will have ~ 3,300 institutions in 10 years. There are people that believe we are over banked, and look to Canada and Europe as case studies for having fewer, larger banks. There are benefits to scale. The most efficient banks in the U.S. tend to be between $5 billion - $10 billion in total assets.

But there are myriads of examples of very efficient $500 million banks, and technology should make it easier for smaller community banks to deliver relevance-sustaining profitability that enables the bank to invest in its future by remaining relevant to its stakeholders. The really small institutions, however, should consider merging, even if one or two engage in a merger of equals to have the resources to remain relevant. Smaller institutions run the risk of nobody wanting to buy them.

As institutions get larger, and their HQ's get farther away, decisions are made that can be sub optimal to the local area, town, and/or borrower. For example, think of the Credit Analyst in Charlotte evaluating a rural Indiana ag loan to an Amish borrower. What does that write-up look like? We will lose that local flavor to allocating capital by centralizing banking. That is what I fear we will lose by continuing the trend that took us from 15,000 banks in 1990 to less than 5,000 today.

~ Jeff

Money Is Math. And Math Is Color Blind.

Typical conversation at my house:

Me: How much was on the credit card?!?!

Wife: Well, it's because of [reason 1], [reason 2], and [reason 3].

Me: Our checking account doesn't care about the reasons. We pay the amount on the credit card, and it comes out of the checking account. Simple math.

This conversation is amplified for households in low-to-moderate income (LMI) families. So often they have too much month left when they run out of money. Causing them to do inefficient and costly things such as remit late payments and be assessed a late fee, use a high-cost payday lender, or sometimes ignore the bill. The cascade of falling dominoes leads to societal dependencies such as 30 million children relying on the National School Lunch Program for food. 

Nobody described this situation better than John Hope Bryant, an American Banker 2016 Innovator of the Year, in my firm's This Month in Banking podcast three years ago. I encourage you to listen to it for ideas on what your financial institution can do to facilitate economic mobility among LMI families. 

I also penned a TKG Perspectives article on the Community Reinvestment Act, its obvious lack of effectiveness if you consider outcomes instead of activity, and what financial institutions can do to promote economic mobility and community development.

Hint about the podcast and the article: It's not about altruism or box checking. In Bryant's words, "you can do well by doing good."

We tend to be emotional spenders and don't consider the long-term impacts of our decisions. I recall being the "money guy" for my daughter's travel softball team. It was a club team and we had an annual fee. Club teams are important for players that want to be seen by college coaches. 

We estimated our expenses and divided by the number of players to determine the fee. We usually rounded up in case of unanticipated expenses and to help families that may not be able to afford it. One family didn't pay, and after several unsuccessful attempts to contact them, we determined they must not be able to pay. So the rest of the families absorbed that expense.

And then the family showed up to the first tournament with the nicest ride on the team. They made the decision to buy a nice car, and couldn't pay for their daughter's club softball team. I'm sure the emotional excitement of buying that car, and pushing their budget to the limit, might have made sense that day. But imagine if, instead of other parents paying that fee, we kicked the girl off of the team? Had they considered this outcome when asking "can we afford this car?" 

This is where banks can play a constructive role. Had their bank positioned themselves as an advisor, the banker would've counseled the family on cars they could afford, without pushing the family budget to the brink, running the risk of dominoes falling if one thing went wrong, and teaching sound family financial management. Perhaps even set them up on budget monitoring tools and automated savings apps. 

Because we often make foolish financial choices if left to our own devices. Think how many people don't contribute to a 401k minimally to get the full company match? People leave the company match piece (i.e. free money) on the table because they don't want to reduce their pay by their contribution. What bank financial counselor would recommend that?

Financial foolishness is color blind. We all could use a dispassionate advisor. But it's particularly acute among LMI families because of the reasons stated above. 

As John Hope Bryant said in the podcast, in the U.S., the poor can save capitalism. Banks can help make it so.

~ Jeff

Note: If you're interested in my annoying video to my daughters on personal financial management, click here. I still own those shorts.