Industry Insights

June 17, 2019
CECL Status Check: How Prepared is Your Financial Institution?
By Rick Martin, Product Manager, Financial & Risk Management Solutions, Fiserv

It’s already clear that the effect of CECL – the Financial Accounting Standards Board’s (FASB) Current Expected Credit Loss standard – will be far-reaching. The CECL accounting standard, which requires banks and credit unions to record expected losses whenever they make a new loan (at the time of origination or purchase), is scheduled to go into effect as follows:

- Q1 2020 (March 31) for SEC-filing public organizations
- Q1 2021 (March 31) for non-SEC-filing public organizations
- Q1 2022 (March 31) for non-public business entities
- Q1 2022 (March 31) for credit unions

Despite these fast-approaching effective dates, many financial institutions do not have the historical data in place to calculate life-of-loan losses as required by this new credit loss model. Consequently, it may come as no surprise that financial institutions are working at a breakneck pace to prepare themselves for CECL. As financial institutions ramp up to this new standard, considering these following seven tasks will not only help them ensure they have the right data (and enough of it), but also save time and money down the road.

Driving CECL Implementation by Committee
By now, financial institutions should have implementation committees in place, with responsibilities assigned along the three main categories: operational, credit and compliance. These committees should include senior leaders from finance, accounting, lending, risk, operations/IT, compliance and retail.

Beyond the essential to-do lists, institutions should assign responsibility for integrating systems and processes across the organization and re-evaluating growth strategies.

Selecting a Methodology
Financial institutions have a great deal of flexibility when it comes to selecting a methodology for evaluating expected credit loss. In fact, the only requirement is to choose a method that is appropriate and practical – one that can reasonably estimate the expected collectability of financial assets and be applied consistently over time. The right choice depends on the type and size of loans issued by the institution (for instance, car loans versus mortgages) and other internal and external factors. In other words, different methods for different asset groups.

Compiling the Data
Compiling all of the data necessary to comply with CECL often represents the most challenging, time-consuming aspect of the process. For financial institutions, gathering the right historical data is a staggering task.

Begin by learning what data is required for CECL compliance and compare it to existing data to identify gaps. How will missing data be acquired to fill the gaps? Define how data from external or internal sources can be used. Look to external or aggregated sources from peer institutions. Institutions can also extrapolate through historical analysis of data within their organization. Determining how to put processes in place to capture the necessary data going forward is paramount.

Applying Economic Forecasts to Loans
Moving from the incurred-loss model to an expected-loss model will force financial institutions to consider how to apply economic forecasts to the valuation and protection of loan portfolios. Economic forecasts can provide valuable insight into future performance. For instance, unemployment rates could indicate shortfalls on car loan repayments or other short-term loans, while regional growth factors could positively affect repayment/refinancing of home loans, mortgages and longer-term loans.

Once the external data best suited to a loan portfolio has been assessed and gathered, forecasts can be developed to provide an advanced look at loan performance and reserve requirements.

Storing and Managing Data
Data management, retention and storage should also be considered when adapting to CECL standards, and many institutions are assessing their IT systems and planning investments to meet current and future requirements. Going forward, they’ll also need to put the right systems in place to gather data, and develop governance strategies to ensure its retention. By combining data from financial accounting and risk management systems, it can be managed and analyzed in a meaningful way.

Gaining a Strategic Advantage
Fortunately, all of this data preparation can provide a competitive advantage for financial institutions. CECL requirements mark the first time this much data has been aggregated at the individual financial instrument level. And once that history – that instrument-level data – is captured, good things can happen. It can reveal valuable insights and trends that can help the institution improve decision-making around credit risk, interest rates and profitability.

For instance, look at demand for different types of loans over time, or other key factors. Data can be pooled and correlated by collateral or type – including mortgages, auto loans, credit cards and more – and further segmented by cost center, loan officer, FICO score or geography. Practical analysis of such a historical amount of instrument-level data provides a solid foundation for financial institutions to understand their markets and metrics. This includes how portfolios behave and where potential opportunities lie.

As it facilitates risk analysis into interest rates, liquidity, credit, market and regulatory capital, additional data for loans and credit helps forecast and reduce losses. In addition to generating more accurate budget projections, using this data to inform strategic decisions can help lead to lower overall risk and better managed return for every stakeholder, including borrowers.

Making Technology Do the Work for You
Making progress on CECL implementation is more urgent than ever considering the fast-approaching deadline. The best bet for financial institutions to meet the deadline and be positioned to strategically leverage all of that required data is to turn to a consultative vendor with the right CECL technology. Utilizing these resources can have a financial institution up and running with a CECL solution in as little as two months.

Consider these five factors when investigating CECL technologies: data management; methodology; reporting; technology integration; and strategic guidance and expertise. Having the right solution not only ensures compliance and minimizes reserve requirements, but also provides insight into data for strategic value over the long term.

Regardless of the ultimate choice, it is crucial for institutions to accelerate their implementation plans so they can approach the coming deadline with confidence.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Rick Martin is a product manager in the Financial & Risk Management Solutions division at Fiserv. He has more than twenty years of experience in banking and financial technology, and educates financial institutions on ensuring compliance with CECL and other standards and regulations.

May 20, 2019
White Paper:
Pricing and Elasticity in Financial Institutions: What happens when pricing changes?

By Matthew E. Speed, Vice President, Ceto and Associates

Summary: The financial services industry employs several methods of making pricing decisions on its products and services. While there is not an agreed-upon industry best practice for how products and services are priced, pricing inefficiencies cause a detrimental effect on income. Furthermore, various regulations in the industry significantly impact pricing strategy and must be taken into consideration.

“The single most important decision in evaluating a business is pricing power,” Warren Buffet, CEO Berkshire Hathaway1. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”

The above statement is true regardless of the industry, which is why it is often quoted. The financial services industry, specifically banks and credit unions, have struggled over the last several decades with pricing. As the industry grew more competitive, giving everything away became commonplace. This “strategy” worked during times of higher interest rates and less regulation around fee income, which is why new banks opened at a rate of over 100 institutions per year from 2000 to 20072.

Read More >

May 6, 2019
The Road to Higher Profits
By Alec Hollis, Director, ALM Strategy Group, ALM First Financial Advisors, LLC

Banks want to achieve above-average profitability. Profitable growth is a critical element to success as an organization. Long-run commercial viability occurs when an organization delivers value to its constituents in a profitable and sustainable manner. But how do banks get that way? Are there distinguishing characteristics of high-profit banks?

The year 2018 was a blockbuster one for the banking industry, thanks in large part to the Tax Cuts and Jobs Act (TCJA). The industry earned $236.7 billion in 2018, a whopping 44.1% improvement over the $164.3 billion in 2017, and return on assets (ROA) was 1.35% – its highest point in over seven years. According to the FDIC’s Quarterly Banking Profile, the 44.1% increase in full-year net income would have only been an estimated 13.5% given a normalized tax rate.

Drawing conclusions from the FDIC’s published data, it’s clear that asset size is a factor to profitability. Medium and larger banks have a much higher profit advantage over smaller banks. For example, banks under $100 million in assets have a ROA disadvantage of 33 basis points (bps) to the industry’s 1.35%, much of which can be attributed to scale that results in greater efficiency. However, the discussion of size and performance recalls the chicken-and-egg conundrum; or as statisticians would put it, correlation does not imply causation.

The effectiveness of an institution’s management team shapes its performance, and hence its size. Growth for the sake of growth is no substitute for profits. The wrong incentives related to growth could lead to uncontrolled increases in operating expenses and a loss of a competitive advantage. Rather, management teams should focus on delivering value in a profitable manner. Growth then becomes a natural byproduct, which can bring scale and further improvements in efficiency.

To view performance outside of the traditional confines of asset size, we created a bank screener to profile high-profit banks. To start, we filtered out the largest of banks, removing banks above $20 billion in assets and other unrepresentative specialty banks.

From there, our high-profit benchmark (HPB) contains banks with the following criteria:
- ROA and ROE higher than the industry in four out of the past five years
- A higher ROA today than five years ago
- Non-performing assets not greater than 1.20% of assets (double the industry’s aggregated figure)

Of the 5,406 institutions reporting according to the FDIC, 575 banks were included in the HPB, representing about 11% of the total number of banks. These are institutions without excessive credit losses and a strong track record of performance over the past five years. The asset size distribution is very similar to the broader industry, indicating high-profit banks across all asset sizes are represented. However, the skew is more towards the larger side, as the average asset size is $873 million in the HPB compared to $670 million on average for banks less than $20 billion in assets. In our findings, the factors these high-profit banks share are expense control, leverage and balance sheet structure.

How High-Profit Banks Do It
Expense control is one factor that leads to higher profits, and arguably the most important one. Operating overhead stands out as the most statistically significant factor in profitability, as HPBs posted 2.57% of average assets in non-interest costs and a 50.38% efficiency ratio – both significantly lower than the numbers of their similarly-sized peers. HPBs also have lower interest costs and higher net interest margins (NIMs). On the other hand, non-interest income and fee income don’t seem to be key factors; HPBs seem to earn less in these diversified sources of income relative to larger banks. Overall, HPBs outpaced the broad industry by a wide margin last year, generating a 1.81% ROA and 16.03% ROE.

Leverage also stands out, but more so when comparing to banks on the smaller side. Larger banks tend to make better use of economically cheaper debt relative to high-cost owners’ capital. Interestingly, HPBs have higher capital ratios than the broader industry – including the largest banks – but risk-based capital ratios are about the same. This indicates HPBs are more likely to utilize risk-based capital, which leads us to the next point.

Balance sheet structure influences performance, at least for the time being when credit performance is strong. Loan-to-deposit and loan-to-asset ratios are significantly higher than the broader industry. HPBs also have higher deposit-to-asset ratios, perhaps giving them a cost of funds advantage.

Ultimately, profitability is a result of many factors. Market forces are certainly a big part of this discussion – once again, think back to 2018’s tax tailwind. A bank’s financial statement performance, however, suffers from the drawback that it is not risk-adjusted. That is the purpose of asset-liability management (ALM) – to increase profits by reducing risks that may adversely impact profitability. Should market forces move unfavorably, efficient, well-run banks will be the best positioned to survive.

Figure 1: The Index of High-Profit Banks Compared to the FDIC's Compiled Data

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

As a Director for the ALM Strategy Group at ALM First Financial Advisors, Alec Hollis performs asset liability management strategy research for financial institutions, implements firm-wide ALM modeling procedures and assists in the execution of client balance sheet hedging programs.

April 22, 2019
The Growing Push for Financial Literacy
By Robert Segal, CEO, Atlantic Capital Strategies, Inc.

The Massachusetts legislature approved a bill in January that requires state education officials to establish financial literacy standards for students in kindergarten through grade 12. The goal is to train students in skills that will help them become financially self-supporting adults, with topics that include understanding loans, renting or buying a home, saving for college and investing for retirement.

“Financial institutions have said that when they interact with young customers, they’re seeing a lot of young people not fully grasping everything from what credit cards are to compound interest to just general costs once they’re out of high school and college,” said Massachusetts State Senator Jamie Eldridge, who sponsored an original version of the bill.

Also in January, New Jersey Acting Governor Sheila Oliver signed a law that requires the state Board of Education to include financial literacy instruction in the curriculum for students in grades six through eight in public schools across the state. The new law says the lessons should equip students with tools for “sound financial decision-making,” with content covering budgeting, savings, credit, debt, insurance and investments.

“Financial responsibility is an important acquired and learned life skill, and with the increasing financial challenges millennials face, it is a skill that must be a necessary part of our educational curriculum,” said Oliver.

John Pelletier, director of the Center for Financial Literacy at Champlain College in Vermont, reported that only five states received an “A” grade for providing the appropriate financial education for students. He further noted that studies continue to show that financial literacy is linked to positive outcomes like wealth accumulation, retirement planning and avoiding high-cost alternative financial behavior like payday lending and paying interest on credit card balances. Conversely, he says, financial illiteracy was partly to blame for the Great Recession, and that in order to minimize the impact of any future recession or financial crisis, Americans must be educated in personal finance.

The Center asserts that high schoolers are the prime candidates for financial education for the following reasons:

- The number of financial decisions an individual must make continues to increase, and the complexity of financial products continues to grow;
- Many students do not understand that one of the most important financial decisions they will make in their lives is choosing whether they should go to college after high school;
- Most college students borrow to finance their education, yet they often do so without fully understanding how much debt is appropriate for their education;
- Children are not learning about personal finance at home, with a 2017 T. Rowe Price survey noting that 69% of parents are reluctant to discuss financial matters with their children;
- Employee pension plans are disappearing and being replaced by defined contribution retirement programs, which impose greater responsibilities on young adults to save and invest.

It seems most Americans would agree with the study’s conclusions. The National Foundation for Credit Counseling’s (NFCC) “2017 Consumer Financial Literacy Survey” reports that 42% of adults gave themselves grades C, D or F with regard to their personal finance knowledge; 27% have not saved anything for retirement; 32% have no savings; 60% do not have a budget; and 22% do not pay their bills on time.

In a 2015 report, the FINRA Investor Education Foundation revealed that vast improvement in credit behavior resulted from state-mandated personal finance education. The study evaluated the effect on credit scores and delinquencies over a three-year period in the states of Georgia, Idaho and Texas. Individuals in school during the third year following the inception of the program showed greater benefits from personal finance instruction, with credit scores increasing by 10.89 points in Georgia, 16.19 points in Idaho and 31.71 points in Texas, while ninety-day-plus delinquencies dropped nearly 2% in all three states by the third year. FINRA found that if a rigorous financial education program is carefully implemented, it can improve the credit scores and lower the probability of delinquency for young adults.

The data suggest that financial literacy is more than just a “feel-good” exercise. According to most research, consumers who understand the basics of personal finance are more profitable for the banks and credit unions that provide them with financial education. Individuals who participate in these programs tend to be open to advice from that institution and generally say they’re likely to bring business to them.

The FDIC has shown that partnerships with non-profit organizations and local government agencies are key components in outreach efforts. The FDIC stresses that a well-executed strategy is mutually beneficial to banks, their community partners and consumers. Across the nation, a number of depository institutions work with established groups from the local community to provide financial education. This builds trust and, in turn, educates consumers about the benefits of using banking services and the lasting advantages that a banking relationship offers in gaining access to other financial products.

Promising opportunities exist for banks that are considering developing continuing, sustainable relationships with consumers. Financial institutions not yet participating may wish to explore partnering with various state agencies and/or non-profit organizations in to order to support their customer base and ensure the long-term viability of their communities.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Robert Segal is the founder and CEO of Atlantic Capital Strategies, Inc., which provides investment advisory services for financial institutions. He has over 35 years of experience in the banking industry, having worked in several community banks with roles in mortgage banking sales, trading and ALM. Bob is also currently a Director-at-Large on the FMS Board of Directors.

April 8, 2019
Is Your Shadow IT Compromising Your Growth and Compliance?
By Joe Galletta, Sales Manager – Americas, ClusterSeven

With the financial crisis behind us and the much-debated rollback of some Dodd-Frank Act regulations underway, the focus of many financial institutions has finally shifted from managing compliance to managing the business. Issues such as cost management, optimizing business performance and the need for innovation have once again come to the fore.

The emphasis now is firmly on building the business across areas such as portfolio management, risk management and product development. Central to these goals are the models banks use to manage their business, and the technology they use to deliver the output of these models – typically spreadsheets, databases and visualization tools.

Regulators are “on the case”
Of course, the wide and varied use of models – together with the tools, calculators and the technology infrastructure that supports them – brings its own challenges. Unmonitored and uncontrolled, models can themselves pose risk factors that regulators are increasingly noting. The Current Expected Credit Losses (CECL) accounting standard is one such example where model management is a fundamental requirement for which institutions need to demonstrate full control and transparency. The FDIC too has its model risk management framework for financial institutions with assets over $1 billion, affecting around 700 banks in the U.S.

Hence, while financial institutions are keen to focus on developing and driving the business forward, effective compliance management remains an imperative. And judging by historical events, compliance appears to be a moving goal post.

Shadow IT a risk
Shadow IT (e.g., databases, development environments, management information systems and spreadsheets) today is extensively used to manage numerous business processes, in parallel with and integrated with corporate IT applications. In fact, these applications, especially spreadsheets, are often the preferred business and regulatory compliance modelling tool due to their ease of use and flexibility. They are powerful enough to run complex calculations and are easy to connect so that data seamlessly flows between the various models, tools and calculators, as well as the processes they support. Perhaps this is why these applications often start as a tactical fix for a business issue, and eventually become so embedded into a business-critical process that they can’t be easily removed.

Regulators are increasingly recognizing the importance of shadow IT to key business processes at banks and credit unions. There is nothing wrong with this as such, but it does mean that institutions need to have suitable visibility and controls in place. Without these controls, there’s no getting away from the operational, regulatory and reputational risks the unfettered use of these tools pose.

For example, a fat-fingered data entry can cause outcomes to be skewed. A lack of version control means that there can be multiple versions of the same file or spreadsheet in use at the same time, which can seriously impair decision-making and critical reporting. This can be exacerbated if these applications are linked to other applications, replicating the same problems across the business almost instantaneously. From a compliance standpoint, such situations can cause inadvertent misreporting, resulting in severe regulatory fines. Recently, a regulator in the UK imposed a $37 million fine on UBS for a decade of transaction misreporting errors, serving as a reminder of the potential risks involved – and a fine like this doesn’t begin to quantify the reputational risk involved.

From a business perspective, the impact can be equally serious. Poor quality information can lead to missed opportunities, or give an unrealistic view of potential returns on an investment. It can also expose an institution to contractual breaches or other issues that drive reputational risk.

A risk-sensitive approach to managing shadow IT
These shadow IT challenges can be overcome by taking a risk management led approach to its usage. At its core, it requires establishing a framework for “business as usual” shadow IT management, which should include:

Creating a comprehensive inventory of the shadow IT tools and processes is an obvious place to start.

2. Risk-based tiering
Not all the tools and processes will be equally materially important to the business. Based on a defined criteria and the institution’s appetite for risk, tiering the shadow IT processes and models helps identify the ones that pose the most operational, regulatory, compliance and reputational risk to the business.

3.Understanding the data connections
Especially for high-risk processes, identifying and understanding the data linkages and lineages across the landscape is crucial to ensuring data quality and accuracy – and thereby integrity – of the processes and models.

4.Managing and monitoring
Based on a shadow IT user policy, the business-critical models and processes can then be monitored and managed for version and change control, as well as review, approvals and authorizations, to ensure that the data is accurate and can hold up to scrutiny at all times.

Institutions often resort to manual processes to govern their shadow IT estate, but despite the best will in the world, they’re fighting a losing battle due to the vast expanse and complexity involved. Achieving full transparency for an estate (to the stringent requirements of auditors and regulators) that is complex and grows organically due to lack of controls is next to impossible to achieve manually.

Therefore, automation is often the preferred solution for taking care of everything end-to-end. From scanning the IT infrastructure to locate the spreadsheets and other files to exposing the underlying data sources and relationships across the landscape to risk-checking the critical files and models, automation can help to provide continuous monitoring and control without being a drain on resources. In doing so, it also presents a reliable and demonstrable way to assure stakeholders – including senior management, auditors and regulators – that the institution’s shadow IT is subject to the same level of scrutiny that its enterprise IT is.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Joe Galletta has over three decades of experience in business development and partner management, with extensive work with financial services organizations, banks, asset managers and insurers.

March 25, 2019
Banking M&A 2019: The What and the Why
By Neil Dhar, Partner and Head of Financial Services, PwC

In all of 2017, there were $33 billion in announced deals among U.S. banking and capital markets firms. After six weeks in 2019, we had already passed that level.

What’s going on?

There are many factors that underlie any given transaction. But there are also some broad themes at work in the market, and we expect them to continue for the foreseeable future. Whether you’re a would-be acquirer or a potential target, this is a good time to review some trends and consider how they might apply to your own institution. In fact, two recently announced transactions – the $28 billion proposed merger between BB&T Corporation and SunTrust Banks, and the $3.6 billion combination of Chemical Financial Corporation and TCF Financial Corporation – say a lot about where the industry may be heading.

Innovation and digital capabilities
For several years now, the largest U.S. banks have grown significantly faster than their regional competitors. We believe this trend is due to two factors: a sustained push to develop strong digital capabilities at scale, and more successful, better-funded marketing efforts. Some of the strongest customer growth in retail is being driven by millennials and older, wealthier clients; PwC analysis shows that both of these groups tend to be especially responsive to digital and marketing strengths.

Between 2011 and 2014, the biggest U.S. banks accounted for nearly two-thirds of deposit growth and virtually all the net growth in debit cards, which is a good proxy for consumer checking accounts. Given their scale, these players can significantly out-invest other banks in brand marketing, data analytics and digital products and services. The converse is also true: financial institutions that don’t, or can’t, invest to achieve digital capabilities at scale are finding themselves at an ever-greater disadvantage. With both of these deals, the banks involved cited their desires to invest in innovation and digital capabilities as a strategic reason for the deals.

Favorable deal economics
Higher-priced deals typically require aggressive synergy and growth targets to create attractive returns. Our research has shown that more than 50% of banks fail to achieve their growth-adjusted cost synergy targets. However, recent deals referred to as “mergers of equals” (MOEs) have found a sweet spot, where both sides structure a deal with book value multiples and targets that might reward all stakeholders.

Recent transactions are setting a new standard for attractive bank deals. In 2018, bank transactions averaged above 1.8x a target’s tangible book value (TBV), and as high as 3.2x. At around 1.7x, the BB&T-SunTrust and Chemical-TCF mergers represent great prices for strong organizations. These deals appear to have been priced reasonably, and this increases their chances of generating the desired return on investment.

Further, when banks link up, they typically announce that they will see synergies (cost savings) ranging from 10-45% of the acquired bank’s non-interest expense. Our experience with bank integration shows that synergy targets in the 20-30% range tend to be conservatively achievable. Synergies greater than 30% usually require rationalizations of branch networks, products and operations that are far more ambitious, and therefore harder to accomplish. In the first transaction, the banks have announced a target of 29% of SunTrust’s non-interest expense. In the second, they are aiming for 18% of TCF’s non-interest expense. We believe that if other banks can create deals with relatively low TBV multiples and achievable synergy targets, we are likely to see many more similar transactions in the market.

Regional, digital tie-ups
MOEs traditionally bring together complementary strengths, such as uniting a strong commercial bank with a strong community bank franchise, distinctive product sets or adjacent territory. If both firms in a transaction can effectively distribute their combined product portfolios across their combined geographies, they may boost top-line revenue. Digital capabilities may provide an additional path to these kinds of synergies: the new variable in bank M&A.

Receptive investors
The total number of U.S. banking deals has remained relatively flat for awhile. Despite equity markets getting increasingly skittish, shareholders have reacted well to these transactions; the MOE deals have traded up on announcement. With such optimistic responses from investors, we’re likely to see more of these types of transactions in the year ahead.

No deal is a slam dunk. Integration issues associated with change management, data and technology can limit the payoff from a deal that looks good on paper. These challenges may be harder for MOEs relative to outright acquisitions, because the two firms often have comparable processes and teams. Leveraging the best of both cultures, choosing what to preserve, aligning and retraining everyone to follow a new operating model and a set of desired behaviors, thinking through location strategy, transparency around how people and communities will be affected: these all require work. But when MOE deals are integrated properly, there can be winners on both sides of the transaction – as well as shareholders, customers and employees.

We expect the trend toward M&A in the community and regional banking sector to continue. Consolidation is a strong path forward for many banks in the sector, especially those that are beginning to invest in customer-focused digital transformation. The BB&T-SunTrust and Chemical-TCF mergers suggest that fairly priced deals with reasonable synergy targets will nearly always attract interest, especially when shareholders believe that the integration is achievable.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Neil Dhar is an experienced partner at PwC who currently serves as the head of PwC’s financial services business, which includes all matters (consulting, tax and audit services) associated with the asset & wealth management, banking & capital markets and insurance sectors. Functionally, he is a seasoned deal consulting professional with over 20+ years of experience advising on over 200 transactions representing billions in transaction value and/or capital.

March 18, 2019
Facing a Pause, Banks Must Stay Vigilant
By Scott Hildenbrand, Principal, Balance Sheet Analysis and Strategy, Sandler O’Neill + Partners

The U.S. economy remains strong, but there are clouds on the horizon. Unemployment is low, wages are rising and inflation appears contained. That said, in January U.S. consumer confidence, presumably sapped by the federal government shutdown and market turmoil, touched its lowest level in over two years. Trade tensions remain high, global growth continues to cool and a hard Brexit could send shockwaves across the Atlantic. We fear that renewed market volatility could feed into the real economy through reductions in consumer spending or business investment, thus hastening a recession.

Against this backdrop, the Federal Open Market Committee has decided to take a breather. Since the announcement, some officials have suggested that the Fed Funds rate could even hold the current range for the rest of the year. So what does a pause mean for U.S. banks?

A pause could prolong the economic cycle, which might translate into higher demand for loans and mute credit costs near-term. Still, since the announcement, the yield curve has remained flat, reflecting a strong bid for quality in these uncertain times, while funding pressures have remained acute.

The key question facing bank managers, investors and regulators is whether a pause will relieve deposit cost pressure at small and medium-sized banks. Unfortunately, we don’t see this happening.

Fundamentally, we believe that deposit costs are more a function of market dynamics than the absolute level of interest rates. Since the Great Recession, the deposit market has become even more concentrated, new entrants have been paying up for share, and technology has empowered consumers to find the best rate and transfer funds with one click – debasing or even disintermediating personal relationships from the deposit-gathering process.

Simultaneously, small and medium-sized institutions have been driving net interest margins by depleting on-balance sheet liquidity (cash and cash equivalents, marketable securities, salable loans). Fast forward to today, the median small or medium-sized bank’s loan-to-deposit ratio is approaching a cycle high while its securities portfolio is plumbing a fresh cycle low. Such low levels of on-balance sheet liquidity force banks to pay up to source or retain the marginal deposit. Structurally, small and medium-sized banks are price takers.

We saw more evidence of this phenomenon in the fourth quarter of 2018. On a year-over-year basis, core spread (yield on loans and leases less the cost of interest-bearing deposits) contracted four basis points to 4.16%. As for the dynamics, the yield on loans and leases advanced 35 basis points to 5.19%, while the cost of interest-bearing deposits rose 39 basis points to 1.04%. Moreover, the spread between core spread and NIM continued to tighten. The challenge is that, without remixing, NIM and core spread should move in relative lock-step, potentially pressuring earnings and profitability metrics.


1 Average yield on loans and leases less average cost of interest-bearing deposits
Sample: Banks with assets between $1 billion and $10 billion at December 31, 2018.
Source: Regulatory data as aggregated by S&P Global Market Intelligence.

In such a challenging operating environment, banks must stay vigilant and focus on the fundamentals.


Strengthen your core. The goal is better banks, not just bigger banks. Banks should focus on improving core pre-tax, pre-provision return on assets (core PTPP ROA; core earnings excludes nonrecurring accruals, such as securities losses or one-time gains). Core PTPP ROA excludes volatile credit metrics and tax strategies, exposing a bank’s true earnings power and allowing for apples-to-apples benchmarking to high-performing and regional peers. Critically, a stronger core PTPP ROA protects earnings and capital from higher credit costs. Of course, we fully appreciate that a bank’s primary responsibility is to deliver a compelling risk-adjusted return on the capital entrusted to it by shareholders. Having said that, we believe that at this point in the cycle, focusing on return on assets (ROA) will drive a higher return on equity (ROE) over the long run.

Align incentives with desired outcomes. Specifically, consider incorporating core PTPP ROA into short and long-term incentive plans. Doing so creates space for forward-looking, franchise-enhancing tactics (a loss trade, liability restructure, branch rationalization, etc.). Also, within short-term and long-term incentive plans, make sure that the weights assigned to loan and deposit origination, fee generation and credit look-backs reflect the institution’s objectives and risk tolerance.

Weaponize the inverted swap curve to reduce funding costs. Recent simplifications to hedge accounting have made hedging much more viable for community banks, and various off-balance sheet strategies are worth exploring due to these changes and market pricing. One such strategy synthetically creates fixed rate funding, reduces funding costs and creates accounting symmetry in other comprehensive income (OCI), protecting GAAP capital from higher rates. Bank managers must have a firm grasp of their off-balance sheet options, and begin the education process well before they project needing to implement.

Create shelf space for higher funding costs through a securities portfolio optimization. Take advantage of the rally in the bond market to optimize the securities portfolio. Loss programs can be tailored to enhance book yield and core earnings. Since most of the unrealized loss is already housed in OCI, GAAP capital ratios should not move meaningfully (though regulatory ratios will decline). As always, managers have to consider the impact on duration, convexity and credit profiles.

Challenge managers to think broadly about their options. For example, numerous public banks have asked whether they should pursue a loss trade or repurchase stock. In our judgement, viewing these two tactics as mutually exclusive is far too restrictive; for the right story and balance sheet, they can be mutually reinforcing. Imagine a scenario in which management announces a share repurchase program with clearly defined earn-back parameters. This signals that the stock is cheap in the current range. In conjunction, management announces a loss program, which will bolster core earnings and profitability metrics. This signals that management is pulling every lever to drive high-quality earnings, which amplifies the signal from the buyback, creating a positive feedback loop.

Price loans for late cycle risk. The Federal Reserve’s Senior Officer Loan Surveys show that banks are reluctant to increase loan rates over cost of funds, with 80% of respondents to the January 2019 survey saying that loan rates over cost of funds remained unchanged or narrowed over the past three months for commercial and industrial loans or credit lines to large and middle-market firms. Furthermore, 90% of banks that reported loosening credit standards cited more aggressive competition from other banks or nonbank lenders as a reason for doing so. In short, banks are letting other institutions dictate their risk-adjusted return parameters. We’ve seen this movie before and we know how it ends: badly. The bottom line is that corporate credit spreads have widened and we’re in the latter innings of the economic cycle, both of which mean that loan pricing models and new loan rates should be adjusted in turn.

Focus on risk-adjusted returns, not accounting designations. Banks often say that they only take credit risk in their loan portfolios. We encourage banks to be more flexible, focusing more on risk-adjusted returns and less on specific instruments. For example, if the board has authorized the purchase of national syndicated loans, an institution should also take a look at high-quality collateralized loan obligations (CLOs). Of course, everything must be done in moderation – we’re simply encouraging flexibility without overly restrictive accounting designations.

Create “self-help” through expense rationalization. As revenue headwinds gain force, cost takeout will become increasingly important to sustain earnings growth. Branch networks remain ripe for review as consumers migrate to digital delivery channels. Once savings are identified, take a hard, honest look at mobile and online budgets. If you’re light, reallocate a portion of the brick and mortar savings, and let the residual fall to the bottom line. Remember that playing catch-up is always more expensive.


At this point in the cycle, it’s back to basics for banks. A critical but often overlooked fundamental business practice is to communicate strategic or tactical shifts, clearly and succinctly, to all stakeholders – customers, regulators, investors and employees. All stakeholders should readily acknowledge that bankers have to navigate the trade-offs among soundness, profitability and growth continuously with no margin for error. They should also acknowledge, in an honest and forward-looking moment, that safety and soundness is the most important leg of the banking stool. So as you weigh your options, make sure that you can explain how your final decisions reinforce your commitment to these essential, mutually dependent principles.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Scott Hildenbrand is a Principal and Chief Balance Sheet Strategist at Sandler O’Neill + Partners, L.P. He heads the Balance Sheet Analysis and Strategy group, which works with financial institutions on asset-liability management, capital planning and investment portfolio funding and hedging initiatives.

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