Industry Insights

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.

INTRODUCTION TO PRICING
“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.

However, the landscape is different for financial institutions post-2008. Today, there are fewer institutions and a small number of new banks opening3. With lower-than-average interest rates persisting for more than a decade and tighter regulations around many of the fees that financial institutions grew to depend on, the environment is more challenging than ever. Also, new competitors such as fintech players are putting additional pressure on consumer demand.

Over the last few years, a favorable shift in the financial services environment has occurred. With steadily rising interest rates, a booming economy and successful efforts in regulatory relief for the industry, financial institution profitability and stock prices have soared. Consequently, a focused and communicable pricing strategy is important. As industry revenues rise, pricing inefficiencies have a bigger financial impact on unprepared institutions. Even in a favorable market, a critical part of any pricing strategy looks at how consumer behavior changes based on pricing variations – also known as the price elasticity of demand.

PRICING STRATEGIES
Pricing is critical and frequently not well understood. Warren Buffet states, “Price is what you pay. Value is what you get.” Many financial institutions do not have a specific pricing strategy, and pricing decisions are often handled as a guessing game. At best, financial institutions review the market occasionally and price with the competition, which establishes a reactive rather than a proactive strategy. Each financial institution faces a different cost structure and a different set of objectives that influence pricing decisions. For example, the risk profile of one financial institution is very different from another, with different strengths and weaknesses, which of course impacts pricing. Pricing should also be factored into long-term strategy and the overall goals of the institution. What follows are brief overviews of some common pricing strategies.

Product-Based Pricing
The most common and basic pricing strategy is to differentiate products based on price. If a similar product costs more than another, there needs to be a compelling reason for consumers to consider the more expensive product. This is where financial institutions often fall short, in creating perceived value.

Many times the only difference in a cheap/free checking account and a more expensive account is one pays interest and the other does not. With interest rates so low for so long, there is minimal perceived value in the more expensive account. In a recent study by Deloitte, accounts paying interest only affected consumer choice by 12%4. As noted above, financial institutions must create a value proposition if they use price as a differentiator.

Risk-Based Pricing
Risk-based pricing is commonly used in the lending function. In its most basic form, a borrower with a lower credit score is deemed a higher risk than one with a higher score, so the borrower is offered a higher interest rate to compensate for the additional risk.

As financial institutions advance their pricing and product mix, risk-based pricing progresses onto the deposit side of the balance sheet. If a prospective customer is considered a higher risk, products such as second chance checking offer a way for the financial institution to still profitably do business with this prospective customer, even though he or she poses a higher risk.

Relationship-Based Pricing
The general proposition of a relationship pricing model is giving pricing discounts when a high-volume or highly profitable customer opens a new account. Inversely, this strategy often requires pricing premiums for low-volume or unprofitable customers opening a new account. This type of pricing is tricky, however, as it is possible to lose out on new business due to the higher pricing premiums. Another risk is that discounts to current consumers get excessive, causing the profitability of a valuable customer to erode.

REGULATORY IMPACT ON PRICING
Nothing has a bigger impact on pricing strategies in the financial services industry than the alphabet soup of various regulatory agencies. The CFPB, NCUA, FDIC, etc., limit many areas where financial institutions earn revenue. While this paper is not intended as a regulatory discussion, pricing cannot be mentioned without recognizing the regulatory gorilla in the room.

Between the CARD Act of 2009, the Consumer Financial Protection Act of 2010 (Dodd-Frank) and the changes to Regulation E in 2010, the entire industry was burdened with new regulations that dramatically reduced revenue. These three regulations materially changed the way financial institutions earned revenue and impacted the pricing of certain services. Financial institutions are still dealing with the ramifications from these regulations today.

NSF and Regulation E
As part of Dodd-Frank, Congress transferred the regulatory burden of Regulation E to the Consumer Financial Protection Bureau (CFPB). During 2010 and 2011, the CFPB changed how Regulation E transactions are assessed overdraft fees. Consumers cannot be charged overdraft fees on one-time/everyday ATM or debit card transactions if the consumer did not affirmatively consent (opt-in) to participate in the overdraft program.

In 2011, other recommendations were made to the financial services industry to further protect consumers. De minims limits and daily fee caps were recommended and subsequently adopted by most financial institutions in order to avoid any compliance concerns. All told, these revisions to how financial institutions process and collect fee income on overdrafts dramatically reduced revenue across the industry.

Durbin Amendment
Also a part of Dodd-Frank, the Durbin Amendment drastically impacted debit card interchange income, one of the primary non-interest revenue streams for financial institutions. The amendment capped interchange fees for debit purchases for institutions with more than $10 billion in assets. The cap, which took effect on October 11, 2011, cut the average interchange fee for covered banks from $0.50 per transaction to $0.24 per transaction. According to a paper published by the George Mason Economics department, this decreased interchange revenue for affected institutions as much as $6-$8 billion per year5.

CARD Act
One of the most sweeping reforms in the financial services industry in recent years is the CARD (Credit Card Accountability Responsibility and Disclosure) Act of 2009. This regulation was passed to protect consumers in the extension of credit under an open-ended revolving credit plan. It effectively did away with practices such as double cycle billing, universal default and other revenue-generating tactics.

The CFPB was given control over late fees, limiting them to a maximum of either the payment amount, or the annually reviewed fee level allowed. Additionally, many modifications to interest rate structure on credit cards were made. Even with this additional regulation, the industry still considers credit cards a valuable line of business, and the market remains extremely competitive for these accounts, despite regulation changes significantly reducing revenue.

Regulatory Impact to Pricing Other Services
As previously described, regulations dramatically impacted the industry’s profitability, which is why over the last ten years the industry has adjusted pricing in other areas to help offset the costs of these regulations. The leading trend is discontinuing “free checking” products. Without the revenue generated by services such as debit cards and overdrafts, free checking is a highly unprofitable product, especially for larger institutions6.

Other impacts of regulatory costs are consistently rising fees for other products and services, and an overall more expensive experience for the consumer. For example, unprofitable services like notarizations, which were once free, are now associated with fees. Financial institutions are also trying to offset costs by migrating consumers away from paper statements and assessing fees if they refuse to adopt electronic statements.

WHAT IS PRICE ELASTICITY?
Economics Refresher
The law of demand states that when the price of a good or service rises, consumers tend to buy less of it; conversely, when the price of a good or service falls, consumers tend to buy more of it. However, the law of demand does not tell how much more, or less, consumers tend to buy. For some goods, the quantity demanded changes considerably when the price changes; for others, the impact is negligible.

This is where the price elasticity of demand is relevant. It is a measure of how sensitive, or responsive, consumers are to a change in price. For any good or service, the price elasticity of demand measures how much the quantity demanded by consumers responds to a change in the price of that good or service. The real question then becomes, “Do products and services in the financial services industry have elastic or inelastic demand?”

Financial Services Industry
When looking at any industry, variables that affect demand must be taken into account. This is especially true in the financial services industry. Due to rapid changes experienced over the last 10 years and competition from outside the industry, consumer behavior has been impacted.

As alternatives to banking (especially payment options) come to market, demand for certain products and services change, regardless of the price. A great example of this is safe deposit boxes; price has little to do with the falling demand that financial institutions see for this service. The market has changed, and many of the important documents that people kept in a safe deposit boxes are now digital. Increasing or decreasing the price of safe deposit boxes minimally impacts this product’s future demand.

FINANCIAL SERVICE FEES: ELASTIC OR INELASTIC?
There is a surprising dearth of information related to fee and service charge pricing research in the financial services industry. It seems financial institutions pay close attention to pricing elasticity around interest rates, as they should, but there is little, if any, attention paid to elasticity of the fee and service charges that make up a large percentage of a financial institution’s non-interest income.

The following case studies review detailed fee and service charge alterations that took place at multiple community-sized financial institutions (under $10 billion in assets) over the last several years. Detailed transaction data is compiled from before the changes were implemented and after they took effect. This allowed the following analysis to be done around elasticity of specific fees at the institutions. Institutions selected have disparate geographic locations and customer bases, as well as types of fee changes. The nature of this research required a limited sample size to keep the results manageable.

Case Study 1 – Wire Transfer Fees
Wire transfer fees are one of the most ubiquitous fees assessed by financial institutions. Because there is quite a bit of time and effort that goes into sending a wire for a customer, most institutions assess a fee for this service. Since it is so prevalent, this fee makes an appropriate subject for review in an analysis on elasticity. With the rise of the fintech industry, third-party payment platforms and same-day ACH services, there are a number of alternatives to sending a wire these days. Given this environment, if financial institutions raise the cost of sending a wire, how will that affect the demand for this service?

In this analysis, the financial institution made a substantial change to its international wire fee, doubling the fee from $20 to $40. Throughout the industry, this fee increased dramatically over the last few years due to Dodd-Frank changing how costs are disclosed to consumers. While costs are increasing for this product, most of the alternatives listed above work for sending funds in the U.S., but are not capable of sending same day funds overseas. The lack of alternative options is why the average demand over a six-month tracking period is fairly consistent pre- and post-change. As seen in the chart below, average volume post-change of 140 wires per month is very close to the original annualized monthly baseline of 133 wires per month.

While the average over the time period is similar before and after the change, demand does appear to be dropping over time. It is possible since the fee increase was so large (100%) that users of the service found alternative methods of sending funds overseas. Another cause is that consumers are willing to send funds in a less rapid method due to the higher cost. Elasticity of demand for this service is higher than many bank services, since there are alternatives available with a similar cost. In the long term, the demand for this service will continue to drop as consumers migrate to alternatives.

Figure 1: International Wire Fee


Case Study 2 – ATM Surcharges
Another fee prevalent throughout the financial services industry is the ATM surcharge, a fee assessed for using an ATM that does not belong to the customer’s financial institution. A substantial amount of industry research shows that while ATM usage is stable or even falling in some mature markets, most continue to see an increase. In the U.S., for example, where an increase in surcharges contributed to a decline in withdrawal volumes over a number of years, transaction levels actually rose slightly in 2015. Since ATM networks are expensive to build out and maintain, it is not surprising that financial institutions attempt to recoup some of those costs from users.

While ATM networks are expensive, they are also quite prevalent in the majority of markets, so alternatives to ATMs are readily available. Therefore, this fee has a high degree of elasticity if the fee goes above what is common in the local market. The financial institution in this analysis had an ATM surcharge that was significantly below market, at $1.50. The market average was $3.00, and the financial institution decided to raise the ATM surcharge to $2.50, a 66.7% increase. As seen in the chart below, the change in the surcharge had a temporary impact on transactions.

The financial institution’s transactions dropped from the average of 3,259 per month to an average of 2,269 per month during a five-month tracking period – a 30% reduction in volume. The drop was dramatic immediately after the fee increase, as users searched for alternatives. However, demand eventually began to return to previous levels, as consumers realized the institution was still priced below market.

Figure 2: ATM Surcharge


Case Study 3 – Credit Card Late Fee
Credit card late fees are a common fee that many consumers encounter in the management of their financial lives. They are also highly regulated fees, with limitations placed on them by the CFPB. Current credit card late fee limitations for 2019 are $28 for an initial late payment and $39 for subsequent late payments in a six-month period.

Due to the high degree of regulation around this particular fee, it is interesting how many institutions do not consider it a competitive issue, but instead just follow the regulations as to what they are allowed to charge. That said, late fees on credit cards are a sizable generator of fee income and cannot be ignored.

This particular fee was reviewed due to the large data set provided by the financial institution. The original data was six months of late payment fees assessed. Fairly substantial adjustments of $5 and $10 to the fee amounts were implemented, and the results tracked for ten months. As demonstrated in the chart below, new annualized fee volumes were 98% of the original annualized volumes, post implementation.

This trend is a perfect example of a highly inelastic fee. There were large changes to the fee structure, increasing the cost to consumers by 20% on average, but the volume of transactions remained flat over the monitoring period. This is also an area where it is not possible to price the fee out of the market, since the upper range of the fee is controlled by the CFPB.

Figure 3: Credit Card Late Fee Volume


Case Study 4 – NSF Fees
Non-sufficient funds (NSF) and overdraft fees continue to be a significant percentage of financial institutions’ non-interest revenue. Changes to Regulation E in 2010 dramatically changed how financial institutions managed these fees, and industry revenue from NSF/OD dropped due to new regulations. NSF fees are still a hot-button topic with regulators, but there are not currently any regulations in place to cap or limit this fee. While most financial institutions are cautious in this area, the fee has continued to increase over the last few years, partially to offset the changes to regulations that hurt income.

For this analysis, detailed data was used due to a longer period of tracking available than most of the data sets. The initial data included a blend of income and transactional data for the year, so it had to be averaged monthly to do a comparison. This financial institution also made some very large changes to the fee structure of the NSF/OD fee, with the average fee increasing by about 33%. The baseline for transactions before the fee changes on an annualized basis was 620,484, or 51,707 per month. Transaction volumes post-fee change were tracked for six months due to the high variability in the month-to-month volumes, as seen below.

While there is a good deal of variability in the monthly transaction data, comparing the average volumes before and after the changes reveal that the financial institution experienced a drop in transaction volume of about 7.5% over the six-month period. Compared to the 33% fee increase, there does not appear to be a high degree of elasticity in NSF/OD fees for this institution.

Figure 4: NSF/OD Volumes


Macro Data – NSF/OD Fees
This analysis takes a broader look at NSF/OD fees, due to the high industry scrutiny they receive. Taking a detailed look at data from 14 banks and credit unions that increased these fees in the last several years, only four showed potential decline in transaction counts for this fee, with the highest drop of 7.5% discussed above. Overall, the 14 financial institutions averaged fee increases of almost 11%, while also increasing average volume of transactions by more than 6%.

The data around these fees has some variability, as most institutions only provided data for several months before and after the fee change. NSF/OD volume varies significantly from month to month, as shown in the above analysis, and annual volumes were not available for most institutions. While the analysis does not suggest that increasing the fee increases the volume, it is obvious that the fee increases are not causing volume to go down, as they would if there was strong elasticity of demand. Once adjustments are made for average deposit growth of 5-7% – which according to S&P Global7 was the average annual deposit growth for community banks in 2018 – the average NSF/OD transaction volumes are flat after the fee increases.

Figure 5: NSF Fee Volumes: Six Credit Unions and Eight Banks


CONCLUSION
Pricing significantly impacts profitability. Unlike other areas such as growing market share or reducing operating costs, changes to pricing directly impacts the bottom line. The reality is that price optimization creates more value than a financial institution expects from overall reduction in variable costs or fixed costs, or an increase in volume. According to PwC, changing price by 1% impacts profitability more than increasing volume (growth) or reducing costs (efficiency) by a similar amount8.

Since pricing is vital to profitability, it is critical to have an understanding of which products’ and services’ demands are closely related to price. Through many analyses, it is apparent that price is always going to be a critical factor in a consumer’s buying decision. But as long as financial institutions are fairly priced when compared to the market, small changes to pricing have a negligible impact on demand, while providing a considerable impact to profitability.



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

About the Author

Matthew Speed has more than 16 years of experience encompassing virtually every aspect of banking, with particular expertise in the areas of retail banking, commercial banking, capital markets and wealth management activities. As a Vice President for the Consulting Services Group at Ceto and Associates, he focuses on increasing profitability for banks and credit unions through identifying revenue gaps.


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:

1.Visibility
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.

FIGURE I: NET INTEREST MARGIN AND CORE SPREAD 1


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.

8 BEST PRACTICES FOR CREATING FRANCHISE VALUE LATE IN THE ECONOMIC CYCLE

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.

COMMUNICATE PROACTIVELY WITH ALL STAKEHOLDERS


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.


February 11, 2019
Is Your Financial Institution Prepared to Meet Clients' Technology Expectations?
By Joseph Lowe, Commercial Lending Marketing Manager, Abrigo

Ultimately, all financial service institutions – large, small, community, national or alternative lenders – share one common goal: to meet customer expectations.

But it’s 2019 – customer expectations for banking have shifted toward digital platforms, and community bank leadership is on notice. According to the American Bankers Association’s (ABA) 2018 Community Bank CEO Priorities report, which surveyed 440 community banks, 71% of respondents planned to offer digital processes for small business lending last year, and 57% planned to offer digital processes for consumer lending.

Whether or not those respondents ultimately made good on their goals, it’s apparent that technology disruption is top of mind for community bank CEOs. From quicker loan decisions to streamlined credit analysis to customized workflows, financial technology offers a competitive advantage when it comes to internal banking processes. Perhaps more importantly, however, customer-facing technology is increasingly becoming an expectation among banking customers, putting pressure on banks and credit unions to quickly adopt tech solutions or risk becoming irrelevant.

According to Salesforce, 57% of consumers say it’s critical for companies to provide an easy-to-use mobile experience

Offering mobile banking in an effort to attract Millennials is a popular strategy, as 62% of consumers in this demographic do most of their banking on a phone. But it’s important to remember that Baby Boomers, Generation Xers and Generation Z are equally important to keep in mind as well, as mobile phone ownership across all generations has increased dramatically over the past seven years. For example, the Pew Research Center found that the share of Americans with a smartphone has jumped from 35% in its first survey in 2011 to 77% in 2018. Further, Pew also notes that more adults are reaching for their handheld devices for their banking needs as well, with 51% of U.S. adults banking online, and 35% of those individuals doing so from a mobile device.

Large banks caught on to this trend early, with giants like Citi, Wells Fargo and USAA offering account management, money transfer and conversational banking services from the convenience of customers’ pockets. What does this mean for community banks and credit unions? It’s time to catch up. Community financial institutions that want to level the playing field with big banks must offer an optimizable and seamless mobile experience for banking customers, whether it’s something as simple as online account summaries or offering online loan applications.

According to the ABA, 45% of loan applicants complained of long waits for a credit decision

Have you ever wondered how much the glut of business meetings or inefficient processes – such as lenders traveling to client meetings – ultimately cost your financial institution? Over $25 million is wasted per day on meetings, and $37 billion is spent on unproductive meetings each year. It’s become so much of a problem that the Harvard Business Review came up with a calculator that allows management to review how much money is wasted via unproductive meetings.

Automating timely front-end bank processes such as meetings, signatures and data entry through digital loan origination systems can be a time-saving and cost-saving endeavor for community banks, with lending automation helping to reduce loan processing time by over 50%, while also decreasing costs by up to 54%.

But according to the ABA State of Digital Lending report, financial institutions aiming to please consumers still have a lot of ground to make up. Community banks and credit unions can start by simply offering a digital loan origination process in the first place. While several banks have a functioning digital branch, only 50% of banks over $1 billion in assets and 38% of banks under $1 billion in assets offer digital loan origination in some capacity.

In the end, despite the number of customers who continue to visit physical branch locations, over 90% of mobile bank users prefer using their app over walking into nearby branches – which means that offering an easy-to-use online platform for clients will continue to be a vital component of a community institution’s success.


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

Joseph Lowe is the commercial lending marketing manager at Abrigo, a leading technology provider of compliance, credit risk and lending solutions for community financial institutions.





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