2024 State of Commercial Banking Preview

Cheryl Brown

In this episode of The Purposeful Banker, Jim Young and Gita Thollesson discuss some of the takeaways from Q2’s State of Commercial Banking 2024 Market Analysis.

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Transcript

Jim Young

Hi, and welcome to The Purposeful Banker, the leading commercial banking podcast brought to you by Q2, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young. Welcome to the show.

It's that time of year when we hold our annual State of Commercial Banking webinar. To give you a preview of what's in store, we have Gita Thollesson, manager of Q2 Strategic Advisory Services and one of our resident experts on applying the proprietary data from Q2 PrecisionLender to identify market trends. Welcome back, Gita.

Gita Thollesson

Thanks, Jim. Good to be with you. It's been a couple of years since you and I have done one of these together.

Jim Young

It has. I'm excited to talk about this and, as usual, I'll have to reign myself in from revealing too much of what you're going to be talking about in the webinar, which, by the way, will be on February 8th and we will have a link to where you can sign up for the webinar in our show notes. But I'm going to want to talk to you about everything that's in the report and you'll have to rein me in and make sure that we give people a little bit of a preview without giving away the whole story.

Gita Thollesson

Sounds good. Will do.

Jim Young

Alright, so first off, let's back up. For those who are not familiar with the State of Commercial Banking, can you explain just a little bit more about this report? How many years has it been now that we've been doing it and sort of what the thinking was behind it?

Gita Thollesson

Yeah, so this will actually be our sixth State of Commercial Banking report and webinar. The first one was in January of 2019, so this will be the sixth one that we're doing. And it's really meant to be a retrospective on what's transpired in commercial banking over the past year: where we're sitting today, how things are looking on a going-forward basis, as well. And clearly this year has been quite different from prior years, so the themes have been different, but it's still the same overall goal to take that 10,000-foot view on the commercial banking market and show folks what our data is saying about the market.

Jim Young

That segues right into my next question, which is about the data. Can you tell our listeners about where you're pulling from, what sources, and then also maybe a little bit about, for those who have been regular State of Commercial Banking attendees in the past, what might be a little bit different in terms of data for this year?

Gita Thollesson

Yeah, absolutely. So there are several sources of data that we use. There's some public information—Fed FDIC data—that we like to look at to provide some context around the market. I think as one example, this year we're looking at volume, pulling some Fed data as well as our own proprietary information, but looking at it with a very different lens.

So in the past, we used to report, almost interchangeably use the terms “loan volume,” and “loan demand” because typically when you saw overall volume increasing, that was a signal that loan demand was getting stronger. We're no longer calling it loan demand anymore because now we're starting to see that banks are pulling back. So we're looking at the same metrics around volume, but now it's perhaps viewed with a different lens as more of an indication of supply contractions. But then on the proprietary side, we have multiple sources of data that we're tapping into.

So we have over 150 commercial banks and credit unions that are running the PrecisionLender platform, and from those institutions, we really have fantastic visibility into what's happening in the market. There are two distinct sources of data that we're using for this report. One is a database of actual commercial relationships. So our clients are feeding to us the full commercial relationship—that's credit, it's commercial deposits, and then it's ancillary fee-based business, the treasury services, corporate card, and so on—and so we're getting that data typically on a weekly basis from the system of record. It's a good reflection of what's actually happening out there.

But then the second data source that we're using is a data source based on what folks are actually putting into the PrecisionLender platform. So as RMs are working through deals, as they're exploring pricing and structure and relationship, we have visibility into what they're contemplating. So those deals may not have closed yet, they may not close for another couple of months, but it's a fantastic forward-looking indicator of what they're thinking. Is pricing going up is what's happening in terms of just activity and volume? But then the related piece to that is for clients that are using the PrecisionLender platform, we also have visibility into what executive management is planning and thinking because we can see what management is putting in terms of assumptions to drive RM behavior. So things like cost of funds and liquidity premiums and FTP credit on deposits. So we can see a lot of that information, and really for the first time in this report, we're really tapping into that management-level information to see where folks are headed from a strategic point of view.

Jim Young

Just speaking from someone working with Anna-Fay Lohn this year on some of these Market Updates, some really interesting cases in which sometimes what banks were doing and their tactics didn't totally match up with some of the more public funding curves and that sort of thing out there. But again, got to check myself and not reveal too much of the report here.

Let's take a step back again here on the timeline here, this time since last year, a lot has really happened. The rate hikes and that sort of thing seem to have slowed down. But even so, hearing a lot of bankers say that 2024 could be a tough year or maybe euphemistically a challenging year. If you had to write sort of one headline about this year's report, what would it be?

Gita Thollesson

So I'd say that the 2023 headline would probably be something like: 2023, Expect the Unexpected. And the reason I would say that is if you think back to what we were talking about this time last year, the market was not looking like what it ultimately panned out to be. So beginning of last year, we were in a spot where we were starting to lose some deposits. We were starting to see those outflows. Banks were all over that; they were starting to raise rates and we thought, "OK, this is going to slow down. This is going to stop. Things will return to normal." And at the same time, there were a lot of signals that the economy was poised to slow down, and so the feeling was that even these incessant rate hikes would very soon come to an end and, if anything, the Fed was hard to reverse course, so everything was going to sort of return back to normal.

Obviously we all know that that didn't quite happen. We had a bit of a stronger economy than we had anticipated that kept the rate hikes going until the summer, and the deposit outflows didn't slow down. If anything, they accelerated and ultimately culminated in a couple of pretty sizable bank failures, and so really when you think about the unexpected, I think maybe a better way of saying it, it's not so much about expecting the unexpected, it's more about being prepared for the unexpected. So if you look at what happened with those couple of banks that really struggled during the spring, they had just an abundance of uninsured deposits and they had sort of taken a lot of their excess deposits from that period of excess liquidity and they parked those funds into held to maturity security, so highly illiquid securities.

So they weren't prepared for the unexpected. When the unexpected happened and deposits started to flow out of the system, they really couldn't liquidate those securities fast enough. And so who knows what 2024 will bring? Maybe it'll be better, and some folks are predicting some relief from the Fed. Some are saying it's going to be higher for longer. But whatever happens, we just need to be prepared and be able to pivot quickly as needed.

Jim Young

Throw in there, too, a presidential election toward the end of the year, which I'm sure we’ll probably have more unexpected for that one, as well.

Before I dive into the data, just one more sort of thing, again, having done these for six years and seeing sort of like sometimes you go into a year and you take a look back at what happened and you look forward and say, “This is what could be out there for 2020 the next year.” I'm sort of curious, though, from the lens of it's been four years now, hard to believe, since COVID hit the U.S., we had the shelter in place and PPP and all that sort of thing. What are some of the things when you look back in those four years with 2020 hindsight and look back at how the commercial banking market responded to everything that's happened during that time period that stick out to you that are of interest?

Gita Thollesson

Yeah, I think the repercussions from the pandemic are still being felt in today's market. So, separate from PPP, all the federal stimulus, I'd say the one thing that stands out to me when I think back to where we were and what happened, and this isn't specific to commercial banks as much as to businesses overall, it's just the resilience that U.S. businesses showed in terms of reinventing themselves, coming up with new operating models on the fly. I remember that when we first heard the announcement that we couldn't gather in a room with more than 10 people, you remember that? And so you start to think, "Well OK, I can't go to work tomorrow. I can't go to a restaurant. I can't get on a plane. I can't go shopping. I can't do anything." And at that point, it really started to feel like we were headed for another Great Depression. Not even a recession, but a depression.

And it was just so hard to even fathom how we'd come out of it and, separate from what the government did in terms of stimulus, I mean companies started to develop new operating models and so we had, all of a sudden, you could still conduct business, just do it via Zoom or Teams. Instead of traveling to see customers, you did it that way instead of going to a restaurant, you had DoorDash and Uber Eats instead of shopping in a mall. You had online shopping, which existed before, but never was really used to this degree. So that was really just remarkable how probably all of the stimulus that was injected into the system wasn't even really needed because companies were able to figure out a way of staying afloat and turning a profit.

But I think the other piece of it is related specifically to banking. During that period where there was so much stimulus and such cheap financing, so think about PPP at just 1% interest forgivable if you used it for the right reasons, but even if you use it for the wrong reasons or just wanted to keep those funds, 1% is pennies compared to what you'd pay in the bank loan market, and so the impact of that was just so much excess liquidity pumped into the system. There was so much capital that then drove this incredible rise in deposit balances. Banks were sitting on so much capital they didn't know what to do with it, and so that was really sort of an anomaly compared to the typical cycles that we're used to, and then as quickly as that all rose in ‘20 and ‘21, it fell off a cliff in ‘22, ‘23.

It is still the same impact, but essentially what was happening was that rates were continuing to rise as the Fed was trying to combat inflation, deposits started to flow out, and that's all really a longer-term impact of what happened during the pandemic. So we're still kind of feeling the impact of it even now four years later. So it's pretty remarkable and hopefully things will start to normalize in the near future.

Jim Young

Yeah, I was telling someone, we were just going thinking back and I was like, really, it's almost hard for me to believe we were at that point of banks saying, "What am I supposed to do with all this liquidity? Get this out the door,” and now we're 80 degrees different now. So taking a look a little bit, when you sit down, to the end of the year to review this data for a report, you've got an idea of what's happened during the year. But I'm sort of curious, did you find anything in the data that surprised you? And then I guess along that, was it a surprise of, “Wow, that's the opposite of what I thought” or was it more of a, "Well, I expected this, I just didn't expect this to this degree?"

Gita Thollesson

Yeah, I'd say maybe the latter. I'd say specifically what I found most surprising, you mentioned Anna-Fay Lohn, she did some fantastic analysis around deposits. So obviously this year, the focus for a lot of banks has been around how do we grow deposits or at least stem the outflow of deposit hold onto what we have, right? So Anna-Fay did some fantastic analysis where essentially she looked at the variance across financial institutions in terms of their success in growing or maintaining deposits. I was really stunned, first of all, to see just how much variance there is. I wasn't expecting it to be that divergent across institutions to the point that there were some banks that were actually tremendously successful at growing commercial deposits, even against this backdrop of deposits leaving the system. And then you have other banks that maybe followed more the market trend of seeing the slow bleeding or maybe quick bleeding in some cases.

And the other piece of that, and they did some really interesting analysis to try to understand the drivers of those differences, and that was really striking. In effect, everyone sort of thinks, "OK, it's all about how much you're paying for these deposits." So that you'd sort of think, OK, the banks that are more successful, they're probably paying a little bit more to hold onto these deposits, and that's true to some degree. But even more than the rates that they're paying to customers, what she found was that the internal triggers—so the internal FTP credit that bank management is telling their RMs, “Here's how much credit we're going to give you in terms of relationship profitability for these deposits”—that, if anything, turns out to be an even stronger driver of success because, in effect, it's the messaging you're giving your RMs.

And there are cases where banks have very high FTP credit on interest-bearing deposit accounts. Meantime, the actual rates they're paying might be very skinny, and yet those banks are just seeing tremendous success. So that was a real eye-opener to see just how much of a gap there was between FTP credit and cost of funds, as well as how impactful that is in actually expanding deposits in the current environment.

Jim Young

That's fascinating. So if I can put it as I always have to in non-banker terms, it sounds like what you're saying is one of the biggest determinations was how well you incentivize your RM to essentially sell the deposit or to go out there and try to add deposits more so than price, I guess.

Gita Thollesson

And it may not be actual RM incentives. It may not be directly tied to compensation as much as you're encouraging them, you're giving them the signals that if you want to achieve profitability, maybe reach our bank's ROE targets, here's one way to get there and it's actually easier to get there with deposits and with loans and including if it's interest-bearing. So there was a time when banks were really encouraging their RMs to go after core deposits or non-interest bearing deposits. Those are free deposits. They’re presumably worth more to the bank, cheaper source of funds, and now it's actually the case where even interest-bearing deposits have just as high FTP credit as the core deposits. So it's a signal to RMs to go after these accounts.

Jim Young

One thing I meant to mention when you were talking about, going back to a little bit of the COVID conversation, I remember sitting in an empty office building during that period and thinking, this can't bode well for the CRE sector, basically, but at the same time I'm wondering if we are going to see or did we see in 2023 sort of eventually the ripple effect of that actually I guess hitting the market so to speak?

Gita Thollesson

Yeah, we are starting to see that. We did a survey recently where we actually asked bank executives where they're starting to see signs of credit stress and within the CRE sector, we broke that out between office buildings and then everything else, and it was actually 100% of the executives said the office sector is starting to see some stress, starting to see downgrades. But a pretty high percentage also said other areas within the commercial real estate market. So I mean there's a ripple effect, right? So if you stop having people commuting to work, then all the commuter foot traffic is going to suffer, and then the related businesses, so retail establishments and other businesses will suffer as well, and so the expectation is that there will be an impact there. And we have looked at our own data to look at downgrades and did see an uptick in downgrades on commercial real estate deals. And a little bit on the C&I side, as well, but definitely more so on the commercial real estate side. So it's coming. It's not severe just yet, but it's really the one area we are seeing a bit of stress.

Jim Young

And then looking forward toward 2024, I know you haven't even had a chance to get the webinar yet, but I'm already starting to think through 2024, what are some of the things you're going to be sort of looking for, watching for, and market updates and that sort of thing that you'll be tracking?

Gita Thollesson

So I think the big unknown right now, and I'm really interested to see where this is going to land, is all of the regulatory changes that are taking place. And so there was just another extension on when the U.S.-proposed regulations will need to get reviewed and they're looking for feedback. Originally, I think it may have been November and now it's January. It's probably going to get pushed out even further, but it'll be interesting to see the impact that that has on the banking market. So is it going to be a case where banks pull back even further on credit because now they've got to hold another 20, 25% capital?
Is it the case that they'll start to pass along those higher costs to customers and sort of price folks out of the market? Is it the case that they're going to take those regulations as-is and actually implement that in terms of their pricing process, which could lead to some interesting outcomes given the disconnect that we're seeing between where those regulations are at least today versus where actual market pricing is? And so it'll be really interesting to see where that shakes out.

And I'd say the other thing, I know we haven't really spoken about the other piece of this paper that's being written by Debbie Smart. I think you're probably going to have another session with Debbie later, but the other piece that she talks about that'll be interesting to see is AI and how AI will impact the banking market. It's impacting all industries, and so it'll be interesting to see where we land on that in the coming year.

Jim Young

Yeah, glad you mentioned Debbie because I did want to mention that she will be presenting basically on this. We talk really about the credit deposit, etc., but she's going to be talking about those things like AI and also payments, those types of areas of commercial banking. And we've mentioned Anna-Fay Lohn's name a couple of times on here. People have read her Market Updates, but she'll be part of the webinar as well.

Gita Thollesson

That's right, absolutely.

Jim Young

That is truly a dream team of talent. So definitely encourage everyone again to register for that webinar on February 8th. We will have the link to it in our show notes. Also, you mentioned about regulatory Basel III. I should note that Steve Collum came on in a previous, if you've missed it, a few shows previous. He came on and walked us through a lot of the intricacies of Basel III and its potential impact, and so definitely encourage you to give that a listen, even if you are not one of the big banks that's dealing with that. Again, the ripple effects of that are going to affect the entire industry.

So Gita, thanks so much for coming on again. Really looking forward to the webinar and to your report and hope to talk to you soon.

Gita Thollesson

Sounds great. Thanks Jim.

Jim Young

Alright, that'll do it for this week's episode of The Purposeful Banker. If you want to catch more episodes, please subscribe to the show wherever you listen to podcasts, including Apple Podcast, Spotify, Stitcher, iHeartRadio. If you prefer a video, you can find us on YouTube, as well. As always, please let us know what you think in the comments and head over to q2.com to learn more about the company behind the content. Until next time, this is Jim Young. You've been listening to The Purposeful Banker.