What #Banking Trend Will Have the Greatest Impact on Your Bank?

This was the question posed to Bank Profitability students as part of the Oregon Bankers' Association's Executive Development Program (EDP). These were up-and-coming bankers, the future leaders of our industry, identifying industry trends that will have the greatest impact on their bank, in no particular order. 

1. Interest Rates

So many financial institutions had a positive GAP (assets that are maturing or repricing within one year minus liabilities that are maturing or repricing within one year) during the Fed's ambitions five quarter rate hike from zero to 5.25%, meaning that they were asset sensitive and their net interest margins should have expanded. And then what happened in 2004-06 happened again. Depositors woke up and thought "what is my bank paying me?" And our cost of funds chart looked like the trail lift at Breckenridge. The Fed has paused for nearly a year now, and it was our experience in 2006-07 that bank cost of funds continued to increase as the market closed the delta between what someone could earn in a money market mutual fund and a bank account. Cost of funds is leveling off now. But not until $1 trillion went from banking to money markets. Will NIM compression continue, as it did last year (see chart from American Banker)? Will bankers reposition their balance sheet to be liability sensitive so NIMs will improve with falling rates? And will their ALCO reports accurately predict what will happen? Time will tell and it is weighing heavily on bankers' minds as the most impactful to their banks' success. And with our industry still heavily dependent on net interest income for revenue, I think they are right.

2. Consumer Demographics and Changing Customer Demands

Remember all the pre-pandemic talk about millennials? You couldn't go to a conference without every presenter having millennial this or millennial that on their slide decks. They are digital native, meaning they never knew life without the Internet. We've been able to ignore them because, well, they didn't have big borrowing needs nor did they have any money in their deposit accounts. Besides what was needed to buy some Keystone Light and Vlad for this weekend's party. Now the oldest millennial is 43 (see table by Statista). They have cars, houses, and are nearing their peak earning years. They are starting businesses and inheriting money from The Greatest Generation and Baby Boomers. In other words, great bank clients with high lifetime values. In fact, there are segments of millennials that have always had high lifetime values. That's why Sofi went after them at the end of college, focusing on the engineering majors and leaving the English majors to others. High lifetime value. Now we have to tailor what we do, how we do it, and how we differentiate to these young whippersnappers that never had to scroll through library microfilm when researching a college paper. Our tortoise approach worked when Baby Boomers controlled the wealth. EDP students fear it will work no longer. 

3. Shadow Banking

This trend seemed very specific to current commercial lender anxiety today. Because of our current liquidity situation, where depositors now carry lower average balances per account, the aforementioned trillion that went to money market accounts, and our bond portfolios being underwater, nearly every banker is hunting for deposits. As part of that full-court press, commercial lenders are being asked for higher and stricter compensating balances from borrowers. Experienced borrowers are feeling the pinch from the multiple banks they deal with. And, according to some EDP students that are lenders, are turning to the shadow banking market that do not have deposit demands. Such as direct lending funds, and insurance companies. Shadow Banking refers to banking-like operations that take place outside of the mainstream banking industry. Shadow bank lending is similar to bank lending but is not subject to the same regulations, and compensating deposit balace requirements. Typical shadow banking entities are bond funds, money market funds, finance companies, and special purpose entities. Business Research Insights estimates the worldwide shadow banking system to be over $53 trillion in 2021 and believes it will grow to $85 trillion by 2031, a 5% compound annual growth rate (see table). Although shadow banking mostly serves larger corporations, think money market funds buying commercial paper, bankers fear the trend will continue going downstream to more traditional community bank customers.

4. Commercial Real Estate Uncertainty/Vacancy Rates

Nineteen point six percent of office space is vacant at year end 2023, according to Axios.com (see chart). Vacancy reached a record high in the fourth quarter and surpassed previous peaks last reached in 1992. Office buildings are emptying around the U.S., as companies continue to adapt to the new norms of remote and hybrid work by shrinking their real estate footprint. Although large office towers in big cities are not usually part of a community financial institution loan portfolio, smaller commercial real estate in urban areas and throughout suburbia and rural markets are. Commercial rents are projected to decrease by a small amount this year, while borrowing costs will escalate as those that borrowed in the low interest rate environment of 2017-19 have their loans coming due, some at twice the rates of their maturing loan, putting pressure on debt service coverage ratios. Rents are lower, borrowing costs are higher. Do bankers make exceptions to policy, ask borrowers to kick in more equity, or push borrowers out of their bank? There's better news for multi-family and warehouse lenders, as these sectors of CRE are doing just fine. But bankers should be preparing for a devaluation of the collateral used by their borrowers to determine how best to manage this emerging situation.

5. Regulation and the Political Environment

"Last month, the CFPB reported how banks have become more dependent on these fees to feed their profit model on checking accounts. In 2019, bank revenue from overdraft and non-sufficient funds fees surpassed $15 billion with the average cost of each charge between $30 to $35. But that's not the only product where large financial institutions feast on their customers through fees. In 2019, the major credit card companies charged over $14 billion each year in late fees with an average charge of around $35. And when buying a home, there's a whole host of fees tacked on at closing where borrowers feel gouged."

~ Rohit Chopra, CFPB Director, January 26, 2022

"I am pleased to support this adoption (of required climate disclosures) because it benefits investors and issuers alike. It would provide investors with consistent, comparable, decision-useful information, and issuers with clear reporting requirements."

~ Gary Genslar, SEC Chairman, March 6, 2024

"The CFPB and other regulatory bodies will use the disclosures required by Rule 1071 of the Dodd-Frank Act as a cudgel to pressure bankers to lend to politically favored small businesses or to not lend to politically disfavored small businesses."

~ Jeff Marsico

6. Technology Advancement and Generative Artificial Intelligence

In the third quarter of 2023, the total operating expense to operate a branch was 47% direct cost: branch salaries and benefits, lease expense, etc. and 53% indirect costs: operations, IT, human resources, etc. This is a hefty burden to put on a branch that is competing with branchless banks that don't incur the direct costs and can pass that on to depositors in the form of higher interest rates. Bankers must get serious about driving down the cost of the pistons, carburetors, and batteries of running a bank. Technology offers opportunities to do just that. Additionally, customer acquisition is another significant cost to financial institutions. Technology and Generative AI could dramatically lower those costs. As well as compliance, fraud, credit, reconciliations, reporting, and other risk mitigation that is currently performed in a resource intensive way. The opportunity to lower costs without escalating risks, in fact likely lowering risks, is near. EDP students think this could have a significant impact on their banks. 

7. Branch Consolidation

Community financial institutions are caught in this place where they want to demonstrate commitment to the communities where they operate yet can't figure out how to do it profitably in certain locations. Large financial institutions simply consolidate their branches. Community bankers still consider this as a sign of weakness to the market, lack of commitment to its leaders and residents, and admission to a mistake to enter the market in the first place. This, of course, was a Bank Profitability course, and when staring in the face of hard data, namely a branch's income statement showing perpetual red ink, it becomes more difficult to justify keeping the branch open with those soft reasons such as not supporting the community. I got news for you, if you can't operate a branch profitably and you are satisfied that the reason is not because of poor execution by your bank, perhaps the community doesn't support you.

~ Jeff

Commercial Real Estate or Business Lending: Which Is Better?

Me: Commercial Real Estate loans are the most profitable product in a community bank's arsenal and have been through various interest rate environments.

Bank Senior Lender: Not when you consider the whole relationship.

True, it is more likely that a traditional business borrower has a full relationship with their bank than a typical commercial real estate (CRE) borrower. In a world of limited resources, which should you dedicate resources to pursue? This was the conversation I had with a senior lender of a client at the Massachusetts Bankers' Association annual convention.

And after that conversation, I sat in my hotel room thinking about the right answer. Since I rely heavily on data, I poured through my firm's product profitability reports that aggregates the answers from all of our clients. What does a "full relationship" mean? I thought, business loan plus a business checking account. The much sought after "operating account." How do these products perform through different interest rate environments?  

The charts below show the pre-tax profits as a percent of the total product portfolio during different rate scenarios compared to the Fed Funds Rate.

So the answer, from a straight pre-tax profit perspective, is commercial real estate in more recent times and a rising rate environment. In the falling rate environment period between the third quarter of 2007 until the fourth quarter of 2008, when the Fed Funds Rate dropped from 5.25% to zero, you can see from the chart that business checking did quite well in the early quarters because of the lag effect of falling rates on the profitability of non-term deposits. Having a Fed Funds Rate of 5.25% bolsters deposit profitability, as the chart demonstrates. By the time the FF hit zero at the end of 2008, CRE was the last product standing. It would have been more profitable if not for the heavy loan loss provisioning as the economy teetered. Zero rates bolsters the value of loan products as funding costs decline.

But what of the relationship? Take a more normal rate scenario at the end of 2018, when FF stood at 2.50%. The math is in the tables below.

All data are from my firm's product profitability database.

CRE still wins. Why? Two reasons, in my opinion: average balance per account, and operating expense per account. Banking is mostly a spread business, and if you are generating the same spread through a $216,732 balance account versus a $589,949 average balance account, as they were in 2018, then the larger balance account wins. Especially if it takes a similar effort to originate and maintain the account.

In spite of these numbers, I agree with my client that the total relationship commercial loan and business checking customer is more valuable. Just not necessarily more profitable. And banks should determine their "why" and set about to change it.

In the above case, there are multiple levers to press. Lever one, increase the average balance of commercial loans to drive greater spread dollars. This could be through industry specialization, focusing on those that carry greater average balances or utilize their lines of credit with greater frequency. It could be through cost by automating decisioning for smaller loans or, for example, using AI to perform annual reviews or do them bi-annually for loans that meet certain criteria. 

Another consideration to improving the profitability of commercial loans is to perform a risk-based equity allocation. I understand this is financial alchemy, but most of our clients allocate more capital to the business loan because it has less reliable collateral. But commercial loans, if analyzed for total risk (not just credit risk), also are typically less risky for interest rate and liquidity risks. A bank that takes a complete view of the risk and therefore the equity needed to support each product type might determine that a commercial loan might require less capital than a CRE loan. 

Deposit profitability suffers in a zero rate environment because we are simply not generating enough spread to cover costs. But in a more normalized environment, such as 4Q18, it was profitable and profits were trending better. The pre-tax ROA might not look great. Because there is little credit risk to the product it requires little equity to account for interest rate, liquidity, and operational risk. This creates a stellar PT ROE, the best of the three products measured here.

So even though CRE remains the most profitable product to a community bank, it is not necessarily the most valuable. But we have work to do.

~ Jeff

Bank Customer Lifetime Value

Who are your target customers? Answer: XYZ

Why are they your target customers? Answer: They are our most profitable customers.

May I see your profitability reports that show this? Answer: *crickets*

Is "most profitable" the right answer? Aside from my skepticism that the financial institution actually calculates who their most profitable customers are. But in doing profitability reporting for decades, I feel comfortable saying that most commercial-focused financial institutions' most profitable customers are commercial real estate investors. Not small mom-and-pop real estate investors. The ones with the big balances.

Targeting them would likely yield a very profitable bank. But would it be a valuable bank? It is highly competitive in the large commercial real estate space. Not only are there community financial institutions chasing that business, but large banks, conduits, insurance companies, loan brokers, etc. The competition is, well, not very "blue ocean" like (compete where the competition isn't). 

I'm not down on commercial real estate. Any balanced balance sheet should have its fair share of investor CRE to boost profits. But to boost value, I ask again, who are your target customers?

In comes what experts deem "lifetime value" (LTV). Can we categorize, and generalize, customer segments to predict what segment delivers the greatest LTV? Because if we consider spot profitability, we should target CRE. It is likely the reason why so many bank balance sheets have concentrations in this product. 

Let's take a doppelganger customer segment: Recent college graduates with high earnings potential. We're not talking philosophy majors here. I already have enough of them fumbling my coffee order. I'm talking the docs, engineers, accountants, cyber security, et al. The customers that SoFi targeted out of the gate.

See the table below for our recent engineering major grad, who is working as a junior engineer for an environmental engineering firm. Four years after becoming our bank's customer, he/she breaks out on his/her own. 

As you can see, the Total LTV in the top table shows a pretty profitable customer, and likely customer segment. But if you look at the spot profitability in Year 1 of the bottom table, our doppelganger customer doesn't look so attractive. Profits actually decrease in years two and three. THIS is why estimating LTV of identifiable customer segments is so important to strategic decision making in financial institutions. Not only must we calculate LTV by segment, but we must also compare to external data to ensure there are enough of these "households" in our markets so we can build critical mass.

There are business models that span the country for their targeted customer segments. In addition to the already mentioned SoFi, Live Oak Bank comes to mind. They started as an SBA shop focused on business segments that were recession proof, like dentists and veterinarians. And searched the entire country for them.

Most of us are geographic focused. But that doesn't mean we shouldn't build our infrastructure: the people, technology, and physical locations, to differentiate ourselves with those customer segments that deliver superior LTV and are in abundant supply in the markets we choose to serve.

Do you calculate LTV?

~ Jeff

And don't forget my book: Squared Away-How Can Bankers Succeed as Economic First Responders. 

Ten percent of author royalties go to K9sForWarriors.org, who work to bring down the suicide rate among our veterans. 

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Thank you!

Bank Lending: Shifting Emphasis from CRE to C&I

Although bank commercial real estate (CRE) lending has been more profitable than commercial and industrial (C&I or Business Loans), both now AND immediately after the financial crisis, regulatory CRE guidelines are causing financial institutions to consider a switch of emphasis to Business Lending.

Here are my thoughts on how to do so.

Your thoughts?

~ Jeff

What's With Regulator Agita Over Bank Commercial Real Estate Lending?

Anxiety, anxiety, anxiety. The recovery from the Great Recession is eight years running. Ample time to look down the road towards our next recession. And regulators are getting anxious. Anxious about commercial real estate (CRE) concentrations. 

Last December, Astoria Financial Corp. and New York Community Bancorp called off their planned merger. Why? They couldn't get regulatory approval. Both institutions were over the CRE concentration guidelines, so putting them together would exacerbate this risk, so the regulatory thinking must have been.

Today, I read an American Banker article on how a multi-billion dollar bank is going to ramp up its business lending. Why? Reading between the lines, this bank is likely over the CRE guidance levels, and were probably getting grief from their regulators about it.

To remind readers, in 2006 the OCC, Federal Reserve, and FDIC issued joint interagency Guidance on Concentrations in Commercial Real Estate Lending. They need a marketing person to title their reports. Maybe sub out an economist or two.

To summarize, banking institutions exceeding the concentration levels should have in place enhanced credit risk controls, including stress testing of CRE, and may be subject to further supervisory analysis. Whatever that means.

The CRE concentration tests are as follows:

1.  Construction concentration criteria: Loans for construction, land, and land development (CLD) represent 100% or more of a banking institution's total risk-based capital.

2.  Total CRE concentration criteria: Total nonowner-occupied CRE loans (including CLD loans), as defined in the 2006 guidance (“total CRE”), represent 300% or more of the institution’s total risk-based capital, and growth in total CRE lending has increased by 50 percent or more during the previous 36 months.

The OCC did an excellent analysis of the impact of this guidance in 2013. If you have some free time to read it, I encourage you to do so.

The upshot of the analysis, in my opinion, is that the risk can be further limited to CLD lending, more so than straight, plain vanilla CRE lending that is so common in community financial institutions. See the chart below from the OCC report for net charge-offs during the Great Recession.

To be balanced, and not a news media outlet, it is true that banks that grew CRE fast, i.e. over the guidance levels mentioned above, regardless if in the CLD or straight plain vanilla categories, were more likely to fail during the period measured. But isn't fast growth by itself an indicator of increased risk of failure, regardless of the loans that fueled the growth? Risk mitigants tend to lag growth, especially fast growth. And success is the great mollifier to risk managers that wish to take away the punch bowl when the party's rockin'.

So, yes, fast growth leads to greater failures. But that's why fast growth is riskier, and tends to reap greater rewards for stake holders. Look at technology companies. Their shareholders are highly rewarded for fast growth. And they take on greater risk, because earnings have yet to materialize.

I would like to take issue with the implicit pressure on financial institutions for going over the 300% guidance levels for plain vanilla CRE. Note that the guidance says AND 50% growth over the past three years. But is that how it is being examined and enforced? Or are examiners, and perhaps bankers, pulling back on bread and butter lending, seeking loans where they have less experience or there is riskier collateral?

The below two charts tell a story. The Great Recession lasted from the fourth quarter 2007 through the second quarter 2009, according to the National Bureau of Economic Research.

For the below chart, I took every bank and savings bank, not federal thrifts because during this time they still filed TFRs versus Call Reports, and therefore their loan categories were different. But look at the asset classes that were on non-accrual during this period. How significant was CRE lending to the souring of bank loan portfolios?

The following chart is from my firm's profitability outsourcing service. It shows the pre-tax profit as a percent of the loan portfolios measured. We perform this service for dozens of community banks. CRE lending remained more profitable and stable then C&I portfolios, which seems to be the asset class banks try to increase to offset the risk of CRE concentrations and raising the ire of their examiners.

CRE not only remained profitable during the Great Recession, but more profitable and more stable than C&I. Indeed, even today, CRE is the most profitable community banking product. If you wondered why community banks feast on it, there ya go!

I don't want to suggest that banks continue packing on CRE and relegate C&I to the back burner. C&I loans are typically smaller than CRE, are more difficult to underwrite, and require more resources to monitor. Yet the pricing we see in our product profitability service does not show bankers getting paid for these challenges. C&I spreads were very close, and in some institutions inferior, to CRE spreads. Also, there are an increasing number of technology solutions that can reduce resources needed to more profitably deliver C&I loans to the market.

So, don't let this blog post motivate you to double down on CRE, and turn your back on C&I. What do your customers demand? What is the trend in your market? How can you reinvigorate economic vitality into your communities?

Don't let regulatory guidance or the inefficiency in your lending processes answer those questions. Let your markets and customers do the talking.


~ Jeff

Why Are Bank Net Interest Margins Under Pressure?

Industry analysts are beating the drum of net interest margin (NIM) decline. Irrational pricing by competitors is often cited in strategy sessions.

But in picking through the numbers, there appears to be something else at work. Factually, NIMs were actually greater in 2013 than in 2007 for Bank and Thrifts, according to the financial institutions included in SNL Financial's Bank & Thrift Index (2.91% in 2007 versus 2.94% in 2013). But NIM has been on the decline since 2010 when it stood at 3.31%.

Is it irrational pricing by the competition? I think all bankers will attest that at the forefront of the financial crisis, credit spreads worked their way back into pricing decisions. Banks were not only more cautious about the quality of the credit, but the yield on the loan too. And this partially explains why the NIM rose from 2007-2010. But has irrational loan pricing driven the NIM south since that time? The below chart shows differently.

                        Source: The Kafafian Group, Inc.

The largest loan categories on bank balance sheets actually showed spread gains during this period, until they finally began to wane in 2013.  This analysis measures loan spreads by taking the actual yield of the loan portfolios, and charging a transfer price for funding the loans using a market instrument with the same repricing characteristics. In plain English, it removes interest rate risk from the spread, often called co-terminous spread. 

How do we explain rising loan spreads, combined with decreasing NIMs? Well one reason can be the reduced benefit of deposit repricing. Financial institutions have benefited by the significantly reduced funding costs brought about by the historically low Fed Funds rate. But that benefit has been mostly exhausted. Leaving re-pricing of loans to be offset by, well, nothing.

The second culprit behind NIM decline since 2010 is the continued decline in loan to deposit ratios (see chart). Perhaps you hear talk of this in your FIs senior management meetings over the last couple of years. "We don't need more deposits because we have no place to put them." "We have tons of cash to lend." Etc.

But loan pipelines are getting fuller as the tortoise-like economic recovery grows deeper roots. With many FIs still mopping up excess liquidity, competition remains strong for those "good" credits, whatever that means. Presumably it means borrowers who will pay you back. This will continue to put pressure on NIMs. Once rates rise, there will likely be additional pressures as the least liquid FIs start pricing up their deposits to keep funding their pipeline. 

Will deposit rates rise faster than the loans those deposits will fund? Time will tell. 

Do you think NIMs will continue to decline, even when rates rise?

~ Jeff

Real Estate: Love it or hate it?

Economists and government officials continue to cite lack of lending activity as a key contributor to our economic malaise. At the same time, I keep hearing from bankers about the lack of credit-worthy borrowers and regulatory pressure regarding the quality of the bank loan portfolio. I am also seeing a rise in bank cash positions and a decline in business loan (C&I) portfolios (see chart). As I understand it, government officials (excluding regulators) want banks to lend, banks have the cash to lend, bankers are hesitant to lend, and regulators would just as soon have you hire another compliance officer and purchase a U.S. Treasury.

Much of the standoff revolves around real estate secured lending. There is little doubt that bankers like real estate as collateral for loans. Countless bank CEO's, senior lenders, and bank directors tell me so. This preference resulted in real estate assets (including mortgage-backed securities) representing 44.1% of total assets at March 31, 2010 (see link below).

Regulators are slightly schizophrenic on the subject. They imposed limitations on the amount of non-owner occupied commercial real estate (CRE) a bank should carry, and they link the value of the loan to the value of the collateral backing it. How will these conflicting views on real estate work itself out over the near term?

What I suggest regulators consider is collateral alternatives. Our current slump, which started at the end of 2007 was real estate driven. When sub prime and similar loans began to default, other borrowers began tightening their belts and began to de-leverage, leading to a recession. Pundits spoke confidently and often about prime mortgages and CRE being the next shoe to drop. The result was a decline in real estate values (see table below).

Amidst all of the calamity, the median home price in the U.S. dropped 24% from 2007 through the first quarter 2010. It makes you wonder what has happened to the values of alternative collateral such as vehicles, inventory, or receivables? Are these more reliable? One regulator, on a panel at a banking conference, told a tale of a recent conversation he had with his regional director. A bank this regulator examined was increasing the level of CRE on its books beyond the 300% of capital target. The regional director voiced his concern, to which the examiner responded "what alternative to real estate as collateral should I suggest?" He didn't hear from his boss on the subject again.

Bankers, on the other hand, should study carefully the direction of the national and their regional economies. What segments are growing? Do these segments typically have real estate to offer as collateral?

Let me offer a story. Let's say Ted owns an environmental engineering firm that he started five years ago. He used his own money and a home equity loan to get it going. Today he has $2 million in revenue, $200k in capital, and 10 employees headquartered in a leased office. An opportunity presents itself to pick up five new employees. However, Ted projects the growth will put him in the red for two years. He would like to get a loan from his bank but doesn't want to use his home as collateral because he is not confident he has enough equity and his wife was none-too pleased about doing it the first time.

Would your bank lend to Ted? Let's take the story further, assuming the firm secured a C&I loan from a bank. Now the economy goes in the tank and the firm has a pretty bad year. He puts some additional equity in the business to get them through, but when submitting his financials to the bank, the loan now doesn't cash flow. Will the bank write down the loan at the behest of regulators or on their own accord? Will they encourage Ted to refinance with another bank? Or will the bank see Ted through this difficult period?

If you're a regulator reading this, my guess is you would make the bank take a larger provision and/or write down the loan. If you're a banker reading this, my guess is you wouldn't make that loan without real estate as collateral. But we have to ask ourselves how long we can continue to lend to commercial building owners while avoiding lending to the businesses, like Ted's, within the building? It's those businesses that are likely to drive our economy in the future.

This has been an unusually long post. So I must summarize. Real estate continues to be a reliable source of collateral to lend against, even considering the recent downturn. Regulators should take note. But the businesses likely to fuel the U.S. economy into the future may not have real estate to offer as collateral. Bankers should take note and be prepared to finance them.

- Jeff

FDIC: Quarterly Change in C&I Loans

http://tinyurl.com/25rz9a

FDIC: Real Estate Assets as % of Total Assets
http://tinyurl.com/27go23m

National Association of Realtors: 1st Quarter 2010 Median Sales Price of Existing Family Homes
http://tinyurl.com/2692z7x