Anxieties and Opportunities in Commercial Banking

Jim Young: Hi and welcome to The Purposeful Banker, the podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, director of content at PrecisionLender, and I'm joined again today by Dallas Wells, our EVP of Strategy. Today, we're going to take a little bit of a break from our recent series of discussions about primacy and commercial deal collaboration and we're going to go back to really what I consider our tried and true episode model, which is essentially Jim gets confused by what he's seeing in the commercial banking industry, and then Dallas patiently helps him make sense of it. So Dallas, welcome back to the show. I'm sure you're already wishing that you had talked Jason Carr into coming on this episode as well.

 

Dallas Wells: Oh no, of course not. I'm thrilled to be here and have another one of these discussions with you.

 

Jim Young: You guys can't see Dallas on the other end of this Zoom and know that there was almost no authenticity behind that. All right. So there are quite a few things actually that have been confusing me lately, some of which are based on, I think just conflicting information and others are just, I'm not even sure exactly where to start. So actually let's start with that.

In her most recent commercial banking update for July, Anna-Fay Lohn found that bankers are currently pricing 10 year commercial fixed rate deals cheaper than five year ones.

 

Now at first blush, I mean, Anna-Fay I had this discussion like, okay, well let's check the data, because surely that must be something there, but it wasn't. And Anna-Fay noted that actually, no, this is corroborating what she's been hearing anecdotally. She'd been hearing this for a bit, so she decided to check in on it to see whether that was really happening because in one of the conversations she related, there was a banker who said, "Yeah, I'm pretty indifferent about the rates on our five year and 10 year loans." Yeah. Help me make sense of that please.

 

Dallas Wells: Well, so I mean, we see this occasionally. So, there are inversions in the curve.

 

Jim Young: Yeah, I was about to say, but I also didn't know inversion-

 

Dallas Wells: I pulled it up just to double check and see how far apart those two points are on the curve, and it's about 50 basis points. So the curve is flattish in that portion of the curve. But I think what you're seeing here is just the negotiating power of strong borrowers right now. So a little bit of that is probably going to be credit quality. You're more likely to make a 10 year deal to a strong borrower versus a five year deal maybe as a borrower you're keeping on a little tighter leash. So some of that could be quality issues, but it's also just that rates are cheap and borrowers know they have some leverage because of all the liquidity out in the industry. Everybody wants to make deals to any willing borrower, and so they can shop these, and this is what happens a little bit.

 

Some of this is also just bankers squinting at that saying, "Yeah, it's a 10-year fixed rate deal, but it's not going to be around for 10 years." These things tend to have a much shorter average life than maybe you would expect, especially over the last few years, as rates have come down, and again, all the liquidity has showed up. These deals will get refinanced or rolled over pretty quickly, so you don't actually have to live with that 10-year fixed rate for all that long, but contractually it's there. That's interest rate risk in a nutshell is bankers are saying, "I'm willing to take that risk just to get a good viable loan on the books." So a little bit of just desperate times. I think you've got bankers that just desperately need the loan volume, so you do what you've got to do to get it on the books.

 

Jim Young: All right. So you use the word desperate times and that's excellent. I don't know if it's intentional or not, but it's good foreshadowing because that is going to be part of our conversation coming up here in a minute. But also I will say I had some sort of dark humor with it when I said to Anna-Fay, "Well, this almost looks like the tactic of a banker who doesn't plan to be in the industry five years down from now."

 

Dallas Wells: Yeah.

 

Jim Young: Which again, when we're talking and will foreshadow a little bit for some of our conversations about community banks and that sort of thing, and whether do you think your community banks is going to be swallowed up in four or five years and just becomes a bigger bank's problem on their portfolio. But let's go to another thing that confused me, and I realize this could end up being a four hour podcast if we go to all the things that confuse Jim, but relating another conversation with one of our clients, in which they basically said, "Well, we were doing the whole thing, again with a deal collaboration, talking about the need to really push cross-sell, beyond just the loans, et cetera." And they said, "Well, yeah, but a little worried about what that cross-sale could do to the NIM."

 

And I'll just say, is that as bad as it sounds? Again for me, but can you again, give me some context, maybe soften this one a little bit, give me a rational reason for why that should be something ... Isn't that the point? I thought that's the whole conceit here, gaining here part of cross-sell, I thought.

 

Dallas Wells: Yeah. I think what you're hearing is that deep seated panic, especially from some community bankers. So community banks are still margin driven machines. Their earnings are driven by credit spreads on loans, and as those spreads have just gotten tighter and tighter and tighter, that lifeblood is getting a little thin and it doesn't leave a lot of revenue for things like investing in all the technology that the bankers are hearing from every direction is necessary for their survival.

 

So they are hesitant to put in place any strategy where it says, "Well, we'll trade some margin for some fee income." They've been burned by that so many times that eventually, a pattern emerges and a smart banker will say, "Yeah, I'm not going to fall for this again, where I give away some of the loan spreads in hopes that someday I get made whole on fee income, and maybe it never shows up or maybe I would've gotten it anyway and I didn't have to discount the loan to get it."

 

But that goes back to the conversation we've been having of primacy, and are you using credit to become the primary bank or are the credits just being shopped, and you're just basically putting in a bid and the lowest rate wins? That's a real critical thing that community banks have to get their arms around, is making sure that they are really doing relationship banking, and that if you are doing that, you actually really get paid for it. That means that fair credit spreads, but also if you are going to grow the relationship, maybe you trade some of that for that very lucrative fee income. That also presupposes that you've got those services to sell for that fee income. Treasury management has kind of become the holy grail for these commercial relationships. It's where all the big profits come from, but that takes some serious investment.

 

And that's where all the technology, innovation is happening right now is in that payments and account management space. And can you keep up? Can you realistically keep up and actually be able to provide a service that you can charge for? So I think that's what you're hearing, is some anxiety about all those things swirling around of do I actually have services I can sell to make up for the fact that I just gave away some credit for an uncomfortably tight spread?

 

Jim Young: Yeah. I guess along those lines, particularly for some of the bigger ones in the community where they've got that separate silo of treasury, do I know when I'm making this concession, that those guys aren't making the concession the opposite direction on this?

 

Dallas Wells: Exactly, yeah.

 

Jim Young: As well. So, I told you we were moving away from deal collaboration and primacy, but-

 

Dallas Wells: You can't get away from it, yeah.

 

Jim Young: You can't get away from it.

 

Dallas Wells: We suck you back in every time.

 

Jim Young: Exactly. Just when I thought I was out. But you've used a few words here that quite frankly are spiking my heart rate a little bit. You've used this phrase desperate times, panic and anxiety. So, desperate times, is that a fair description for where we are right now? Or maybe is there a little bit of overreaction?

 

Dallas Wells: Well, so industry consolidation is not a new thing. That's been happening certainly since the early '80s, but it actually has picked up the pace a little bit. So post financial crisis, if you look over the last 15 years, and actually FDIC had some handy charts that just focused on the last 10 years, so that's what I'll use. But in the last 10 years, a third of bank charters have gone away, and that actually probably undersells a little bit what's actually been happening, where the industry just gets, month by month, quarter by quarter, more and more top heavy. So the top four banks in the country now have about 40% of the assets and they make up about 40% of the earnings.

 

So when you look at the industry and you say, is it time to panic? No. We had record earnings last quarter, except that 40% of those accrued to four banks, and JP Morgan in particular had a massive quarter. So as those four banks go, so goes the industry. And if you extend that down to, the classic definition of community banks would be anything under 10 billion in assets. Under 10 billion is like 97% of the bank charters at this point. Those 97% of the banks though only have 15% of the assets and 15% of the earnings. So that's where there's two worlds here. There's the big banks, and there's some consolidation happening even in the big regionals, where the big regionals are becoming even bigger regionals. So you've got the top four who can't really acquire anything and they're just massive and they're doing their thing. And then below that from the five to 12 range in size, those are now starting to pair up. So it's getting really, really top heavy, and that's just a different world.

 

And those banks are, ultimately they're all chasing the same deals. A middle market commercial borrower is going to have their local community bank that they can deal with and then they're always going to have one of those big banks in town with some sort of presence for them too. So the products are the same. They do compete with each other. But man, internally, you're talking about two very different worlds and two very different discussions happening. So for those small banks, there's a lot of them that clearly are not seeing bright sunny days ahead, so they're selling while times are good and they can sell. And for those that are trying to stick it out, they are wrestling with that, how much can we realistically invest and lean into this and make ourselves a viable, ongoing concern? And how much of our business model is really at threat from the big banks on one end and from the fintechs and whatever you want to call the online competition from the other direction? It's a tough spot to be in.

 

Jim Young: Okay. All valid. Then you sent me this article before we podcasted from American Banker titled From Florida to California: Bank Startups Are Surging. So just to that point where it feels like we're saying everybody out of the pool, we've got people suddenly enthusiastically jumping into this pool. So what are those guys ... I guess de novo is the term I think a lot use. Seeing that community banks aren't right now. I thought about our good old analogy friend, the pendulum. Are there people out there saying actually, maybe this whole consolidation of community banks and feeling that there's not a place for them has been overdone, and now there actually is a window of opportunity there?

 

Dallas Wells: Yeah. So first of all, there's some stuff to discuss there, but let's start with some context. So the grand total of de novos in the pipeline is somewhere in the teens. I don't remember the exact number, but it's less than 20.

 

Jim Young: 16, I think. Yeah. But yeah, fair.

 

Dallas Wells: So the consolidation that's happening is dwarfing the rate of de novos. And for quite a while, the industry held steady, where yes, there was consolidation. Bank of America was in the process of becoming Bank of America by rolling up a whole bunch of banks. But while that was happening, there was also this steady creation of new de novo banks. So as the local bank would get rolled up into a bigger one, there was this opportunity for local business people to put together a new charter and say, "Hey, we're the friendly community bank who knows you by name," and all that kind of stuff, in contrast to the Bank of America that maybe buys the branch and then guts it of local staff and local presence. So that dynamic was there for a long time, and then through the financial crisis, it just went away. There just weren't new charters.

 

So 16 seems huge because the number's been effectively, it rounds to zero for a very long time. So there is new interest, but it's still a blip compared to the consolidation happening. So, that's the context. But when you read basically the prospectuses of these de novo banks and what's their pitch, what's their appeal, both to investors and to the potential customers in their market, they feel like this consolidation is again creating a void of local market presence. One of the interesting quotes in that article, and I'm sure we'll include that in the show notes, but is this idea that the pandemic actually created this opportunity, or it showed at least that this opportunity was there, where you had all these businesses that were looking for help and they had difficult to use websites or 800 numbers from these big banks that have been consolidated, and they just didn't have that local presence, somebody's cell phone that they could call and get a response and a banker to walk them through this process. So that local appeal is still there.

 

But another interesting aspect of that is, one of the quotes there is that one of the CEOs of these de novo banks saying the branch banking model is dead. We're going to do this, but we don't have to create 20 odd branches to cover our footprint. There's other ways to do this now. And what you have is community banks that have those 20 branches already and what are they supposed to do, close 18 of them? So it's almost where the community banking model is still viable, but the question is, is it easier to start from a clean slate as a de novo or to take this established brand equity and charter and make a whole bunch of hard decisions and reduce branches and staff?

 

One of the other articles in American Banker was about the consolidation of M&T and People's United. They were announcing all the layoff plans in Connecticut for the People's United former headquarters, and it caused quite an uproar of like, hey, wait a second. These are good, important jobs in what is kind of a struggling city. How can you do this? So that kind of headwind faces even a community bank that says, "Hey, we've got three branches in this town. Maybe we only need one. How popular is that decision locally?" And do you undo some of that warm, fuzzy feelings of being the local community banker when you start having to make decisions like that?

 

So I think that's what you're seeing is that there is still the community banking model can be viable, but getting from A to B is tricky, and some folks have just clearly decided it's easier to start from a clean slate. There's no legacy technology contracts. You're not into Jack Henry for eight years and multiple commas in the price to try to undo any of that and you don't have these legacy staffing and branching issues to deal with that the community bankers do. They've got just a harder path to get to maybe what looks like a more viable model going forward. So, that's the hard part.

 

Jim Young: Yeah. And you sort of went into that last question I had, which is if it puts you out there in this position of head of a community bank out there, do you look at it and do you say to yourself, "I've got to either get this bank purchased or I need to find a job at that de novo." I need to stop and find a group of investors and start over, or do you say, "No, there's still a way to do this"? And I don't want to sound too apocalyptic, I guess, with it. You know what I mean? Sometimes I feel like the conversation goes to the point where a lot of me, God, are we being a little bit too doomsday with this? Are there paths forward?

 

Dallas Wells: Yeah, there's paths, but these are the discussions that if they're not happening in your board meetings as a community bank, they should be. You should be having this existential discussion of who are we and where are we headed, because I think there is a window where you can actually make some of these hard decisions. And maybe this sounds a little jaded, but I think you can almost use the pandemic, not necessarily as cover, but as the final nail in the coffin of some of these hard decisions of like, look, we don't need this branch. Nobody comes in anymore. So we're going to make those hard decisions and rip off the band-aid. It's either death by 1000 cuts over the next decade, as you slowly come to the inevitable place where if you're relying on a 375 net interest margin to cover that overhead picture of all the branches and the staff that goes with them, that business model is dead, and it just maybe will take a while to play out.

 

So you can either bleed cash and slowly make those hard decisions or you can just do them all at once, or relatively all at once and move quickly. We've seen a couple of banks do this. Jill Castilla's bank down in Oklahoma did this. They consolidated branches and really reduced their footprint and leaned into some technology investments, and it was short-term pain and long-term gain. They have a viable business model now and a loyal customer base and a great marketing momentum and all kinds of positive things happening there. But it wasn't easy. It wasn't just that Jill got on Twitter and all of a sudden they're the cool new bank in town. There was hard decisions along the way and people that had to be let go and doors that had to be locked.

 

And I think those are the decisions that there's a lot of community bankers, they're just not willing to make those right now. And that's what it's going to take, is really rethinking the business model. Start with the spreadsheet exercise of what actually works, and then you've got to go through the hard human decisions of how to make it actually look like that. But it's the point now where if you don't, maybe there's a de novo in town that can, and you lose the edge that you've got, which is that local presence. Somebody else can do it, only much leaner and more agile. But I think to answer your actual question, de novo banking's really, really hard. It's still a painful route to go. So community banks still do have the upper hand. They still do have a viable future. It's just that there's hard decisions there that need to be made like yesterday. The time is not working in your favor here.

 

Jim Young: Yeah, it's interesting, and I'll close us out on this because it actually went into my wheelhouse here, which is the marketing aspect of it and the brand, because just thinking through it and what's one of the biggest advantages your community has over the de novo is you have a built in brand recognition. People know who you are, and in some ways would be disposed to want to bank with you over the big monolith, the local guy. And so how do you get to a point where you can compete better without totally damaging your brand equity in the process? Because like you said, you make those hard decisions and you're going to ruffle feathers, local feathers in that situation. So how do you do that?

 

And it's interesting, because I was about to ask about Jill, because Jill Castilla's bank in Edmond, Oklahoma has some of the best brand equity out there, so it's sort of a two-prong thing. You've got to work on that and you've got to make sure that what you're doing in the community, they understand you're plugged in and then they hopefully understand why you're having to do some of the things you're having to do, which are not fun, to be competitive.

 

Dallas Wells: Right.

 

Jim Young: So, all right. Don't think we actually solved all of banking's problems in this episode.

 

Dallas Wells: No easy answer to these, yeah.

 

Jim Young: Yeah. We'll save that one for the next episode. Dallas, thanks again for coming on.

 

Dallas Wells: You bet. Thanks, Jim.

 

Jim Young: All right. And thanks so much for listening. And now for a few friendly reminders. If you want to listen to more podcasts, check out more of our content, visit our resource page at precisionlender.com, or head over to our homepage to learn more about the company behind the content. If you like what you've been hearing, please make sure to subscribe to the feed in Apple Podcasts, Google Play, or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young and Dallas Wells. You've been listening to the Purposeful Banker.