Why Pirates and Dull Knives Matter 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. I'm joined again today by Dallas Wells, our EVP of Strategy.

 

Today, we're going to continue our dive back into the PrecisionLender classics vault with a discussion of two more blog posts that I think it's fair to say are pretty foundational pieces in laying out what we think about or what we think is important for commercial bankers. One is titled 'Loan to Loan Combat with Pirate Bankers' was piece written by George Neal and the second is called, 'Are You Pricing with a Dull Knife' and was written by some guy named Dallas Wheels, Wells, something like that. Anyways, we'll, we'll have links to both of those in our show notes.

 

So Dallas, first let's just take a step back and kind of explain why we spent the last couple of podcasts talking about blog posts that are several years old. I was kind of thinking through this and to play devil's advocate, are we sort of reenacting a version of what happens when I try to play really cool music to my kids and they look at me and say, "You're just wrong." Are these things that we think of as great classics or are... Could you push back and say, yeah, that was from a few years ago. It doesn't really work now.

 

Dallas Wells: Yeah. The good stuff really does hold up over time, Jim so stand up to those bully kids of yours.

 

Jim Young: I'm right.

 

Dallas Wells: Yeah, that's right.

 

So all through COVID, we had a bunch of unusual things to talk about, of just the strange challenges that the industry faced and it's not that those have gone away, it's just that as usual, some of the kind of same core challenges of our industry have bubbled to the surface, which is really how to compete in a evermore commoditized market, in an evermore competitive market, especially one that's a wash in liquidity.

 

So we had all the work from home and being quarantined and all the technology challenges and all the stuff of COVID, all the government programs. We're through the painful, quickly react to that stuff and we've, I think settled into more stability around most of those issues. Doesn't mean the work is done, but it's less reactionary at this point.

 

So it was back to the core of business, which means we're kind of going back to some of these issues that are largely the same. When we wrote them, it wasn't like they were exactly fresh new challenges. They were things that could have been said 10 or 20 or 50 years ago about the business of commercial banking. So we thought it was worth bringing some of these back to talk about some of those core issues again and to kind of revisit them.

Is our advice still the same? Has anything changed or is it still the same advice that we had a couple of years ago when we originally wrote these?

 

Jim Young: Okay. All right. I feel validated. I'm going to continue to get my kids to believe in the grunge was a seminal movement in music, but for now, let's focus on the pieces at hand and first let's start off with talking about, I guess what I'll just affectionately call for short, pirate bankers. That's George's nickname he came up for banks that essentially go around trying to raid clients from other banks by really just undercutting them on price and I guess I would ask how prevalent is this sort of thing still and has it maybe toned down a bit as rates have fallen so much?

 

Dallas Wells: No, it hasn't toned down. This is actually a surprisingly common and surprisingly..., depending on the goal, but surprisingly effective strategy, which is business development is hard. It's hard in any business and that includes when your product is money that you're trying to loan out. The competition is pretty brutal. So finding net new business, it's a well-paying gig at any bank that's out there because it's hard.

 

So what a lot of banks do to sort of shortcut that is if you've got an offer in hand, they'll undercut it and we've called this by a few different names, some variation of this. We've called it ... George called them pirate bankers here. We've called them also bank of last resort, which is ... There are banks that get a reputation in each market, no matter how big, how small, kind of what pond you're swimming in. There's a competitor out there that has that reputation of being a little aggressive on pricing. There's usually a bank that's a little aggressive on credit too. They just don't tend to stick around as long, but there's banks that that's kind of their business development strategy is rather than spend five years building this deep value driven relationship, I'll just undercut you by a quarter point and get my foot in the door that way.

 

As rates have fallen and again, just the liquidity that's everywhere, the strategy actually can make some mathematical sense. Instead of all the rest of the banks, looking at that player in the market saying, "Gosh, how dumb are they? What are they really thinking?" Instead it's, well, what's your opera opportunity costs here? What are you really giving up if you... You can either undercut it by a quarter point or what are you going to do? Sit in cash and kind of earn effectively nothing?

 

I just was talking to a bank executive last week and he was talking about how huge their balance sheet had grown way beyond expectations. It's deposit funds that are just sitting there. They don't feel like they can really invest it in the bond market and get any sort of return out of it and so it sits there as dead weight, or they say, "Oh, why not? Let's get aggressive and try to get some good loan business and build some relationships there."

 

So we call them pirate bankers but I don't know that in this market that derision is really necessary but also there has to be a bottom to that as well and that's what we're still kind of seeking out is these spreads just keep getting tighter and tighter. So your question was, has it toned down? No, not at all. In fact, if anything, the momentum here has just picked up.

 

Jim Young: All right. So you've taken this a slightly different angle and you've sort of, in some ways made the case for pirates are people too here in this kind of thing. So let's actually go down that path for just a little bit then I guess, and... Again, yeah. One man's pirate in another thing is another man, Sir Francis Drake, depending on [inaudible 00:06:47] his-

 

Dallas Wells: That's right. All about perspective. Yeah.

 

Jim Young: Yeah. So in this case, yeah, you're right. This marketplace and particularly what we've talked about in... We had that conversation, I think it was a Chris Nichols piece about the value of putting out loans at low margins right now and we talked about this opportunity cost.

 

So where do you sort of, I guess... I guess to me, how do you avoid the falling into the trap of, hey, we're going to do this thing and then three years from now say yourself, "Wow. Maybe we shouldn't have done this thing." Because you price those loans and it seemed like a good idea at the time, and you said they were going to be loss leaders, but then they didn't turn into that and they don't look so good on your balance sheet.

 

Dallas Wells: Yeah. Well, that's part of it, right? This is a multi-year bet that you're making. So you have this month or this quarters production goals to hit and so it feels good to hit those goals, but six years down the road, these things may still be on your books and painfully so.

The other aspect of that is that there is some setting of precedent here. So I said earlier that there's a bank in the market that has that reputation. Are you jumping into that pool? and now you're the banker with that reputation for playing this game.

 

I think we've mentioned this comparison before, but it was sort of like when JC Penny, the slowly dying retailer decided to... Well, we're just going to do transparent pricing. This 40% off of a marked up sticker price nonsense is just silly and our customers are too smart for that. Let's just put what the price really is on all the stuff and all their customers who are used to going in and finding stuff air quotes on sale walked in and there was no sale signs and they're like, "Oh, we'll come back later." And sales plummeted and they had to put it back in place.

If this becomes your approach, you might want to be prepared that it becomes your long-term approach because it's a hard thing to just shift back to ... Oh, by the way, now we're back being the premium bank that charges premium pricing. So having a both ways is tricky and so, in some ways you kind of have to pick a path. I think the big takeaway there is the pricing maybe isn't as stupid as you're thinking it is. If you're seeing some aggressive pricing out there, maybe it does make some sense and maybe you need to rethink what's a realistic expected spread on a good, solid, deep relationship credit.

 

Just given the reality that there's going to be more players out there doing that, how do you react? Do you always just kind of get into that downward spiral bidding war where you're not even all that glad that you want it, if you do, or do you have some other alternatives? And I think George laid out a couple of good ones in his piece.

 

Jim Young: Yeah. That's where I wanted to go back to on this was, this piece was really written from the perspective of sort of the... I'm just going to call them... Now, you kind of made me feel bad about using pirates in a pejorative way here. I'm just going to call this the non-pirate bank or the bank that sort of has the deal is having the conversation and not the one that's the one that's sort of trying to protect that initial conversation or initial deal.

When someone else comes along and says, "Hey, we can give it..." To that same client, we can give you this deal a quarter point lower, what are some of the ways that you can win those type of battles and also feel good about winning those battles?

 

Dallas Wells: Well, so George's first point, which I think always has to be the starting point is that pricing alone is not just rate and way too many bankers who are smart enough to know better get caught in that trap. There's lots of pieces to the deal terms of a loan. So is it fixed or floating? Is it a five-year versus a 10 year? What's the collateral you're taking? There's lots of pieces to it. So what George is saying is that there's lots of... Carl used to put it this way when he was talking to prospects is there's lots of clubs in the bag, right? You've got lots of ways that you can go after this problem, but that takes some education of your clients also.

 

This isn't buying a car where there's stickers and 300 point font on the windshield. There's some nuance to it, but you have to help them understand that and you have to have some ways to explain that to them.

 

So George's other point, which I think is a really good one and he had some, being our data guy, had some stats to back it up, but you have to preemptively prepare your customers for this. So rather than just say, here's the deal, take it or leave it. Our five-year deals are priced at 2.75, show them some of those trade-offs between those other terms and rates. It's here if it's a five-year. It's there, if it's a 10 year. If you pledged the extra real estate as collateral, here's where your rate is. Show them that there are other ways that you can move this deal around for them so that when somebody comes in and just sort of blindly says, I'll do it a quarter point cheaper, first of all, they'll wonder, okay, what else... What are the other moving parts that may be on missing? And they'll ask more questions or they'll come back to you and say, Hey, they offered me something cheaper. Can we move some of those other things around and see if we can get close to that?

 

So you've got a shot to not only keep the deal but have some other moving parts to kind of salvage your profitability and George's stat... Again, it's probably a little dated at this point, but we track in PrecisionLender where multiple scenarios are priced. So as you're putting together a deal. Oh, I offered them a fixed and a floating or a five-year and a 10 year and in those cases where multiple offers were presented, those deals were just way more successful, and especially when there was competition in place.

 

So we've had some of our clients pretty successfully put in place a requirement for multiple scenarios, kind of that multiple equivalent offers. Put a couple of things in front of, in front of customers. There's lots of reasons to do it. George lays out a really good one here. It's a really good negotiating strategy. It will get you another shot and a competitive deal and it will also help you tease out from your customer, which deal terms are really, really important. And if it is all about rate, there are ways to get them a cheaper rate. But what you'll find by doing that is that may not be the only thing that they really care about and then they'll understand when that other bank comes and offers just a cheaper rate. Hey, it's okay. I'm going to stick with this one. That's a little more, because I got more flexibility or easier covenants or whatever the case may be.

 

Jim Young: Right. Okay. And then I guess the final note on that is, and also it allows... at a certain point, if a customer is going to ignore those sort of things and just by God go with that lowest rate period, there are some times where it's okay to let it go.

 

Dallas Wells: Yeah, absolutely.

 

Jim Young: Yeah.

 

Dallas Wells: We had... In one of the banks I was at, we had this customer that we'd been chasing for years and they had a great reputation in town and a very successful business and we got a couple shots to bid on those deals and they were just classic rate shoppers and because of how strong they were in their reputation, they could aggressively shop things and their banking relationship was divided up all over the market. We kind of eventually felt like,

 

"Okay, that's just not really a customer for us. It would make us feel good." It's kind of the tech companies that put the logos on their website. It makes you feel good if Facebook's a client. It would make us feel good if that person was a borrower, but at the returns that that was generating, we were like, "Nah, it's okay. They can bank somewhere else."

 

But you at least want that shot, right? You want that chance and I think that's kind of... How do you deal with these pirates? It takes some preemptive education and relationship building just so that your clients know that you will be flexible. You will try to meet them where it makes sense for both sides and if you have that reputation, then you're not JC Penny. You don't have to pick premium or value. You can be known for being smart and accommodative and flexible, and that's really the reputation that you want, and that can kind of carry you through all the different cycles.

 

Jim Young: All right. So now moving on to the pricing with a dull knife piece. Can you first just share with our listeners your real life instance of how a dull knife can be more dangerous and I promise I will edit out my derisive laughter in the final?

 

Dallas Wells: Yeah. I knew you were going to make me repeat this one.

 

So I was five years old or so, and trying to help cut up some lettuce. So my mom watching out for my safety, I was a bit of an accident prone kid, handed me a butter knife. Like, well, surely the kid can't hurt himself with this. Well, a butter knife doesn't cut very well. So I had to use more and more force and finally pretty aggressively, stabbed it, missed and got it stuck in the palm of my hand, which is just as painful as it sounds like. And was the lesson that now you can see is much easier to get them doing it that way. A chef will gladly tell you that a sharp knife is safer than a dull one and that is exactly why. So thanks for making me relive that. I appreciate this.

 

Jim Young: I tried. I said I wouldn't laugh, but I can't help... Sorry. All right.

So back to the serious point here. But let's tackle this in two parts then. First, why do banks opt for what you would call a dull pricing tool? That's the analogy here. We're talking about actual knives. We're talking about pricing tool that is 'dulled', and then second, how does that end up hurting them?

 

Dallas Wells: Yeah. So what we're talking about really there is... Tools may be the wrong way to describe it, but really just the entire approach to structuring deals and it's really being far too restrictive. Okay. So it's almost... And we still actually see this in a fair number of community banks where commercial loans, even the largest ones that those banks do, they are priced off of a rate sheet or a pricing grid.

 

So all real estate deals, here's your five-year term, fixed rate, there's your rate and anything outside of that, the boss has to approve. So the idea there, and what's interesting about this function of commercial banking is it's where sales and credit and finance all kind of meet. It's the intersection of those things. So we have to evaluate the credit risk and the interest rate risk and properly price it and we want a return on our capital that we're putting out there, but we also just plain have to win some business.

 

So it's an interesting intersection there and there's some natural tension, which is actually really healthy tension. The banks that do this really well, naturally build some adversarial interactions into that so that you have people pushing for higher prices and you have people pushing for lower prices and we debate it and we come to a healthy spot somewhere in the middle.

 

And what these banks are doing is they're trying to say, "Well, we're not going to let you do dumb things so we are going to restrict any flexibility that you might have." So this is a little bit of a follow on to what we were just talking about of, if you don't give your bankers enough flexibility to say, well, I know that was the price for a five-year deal, but what if I just fixed it for four years and then we floated after that? And that gets us just far enough down the yield curve where you can actually meet a rate somewhere or even just our balloon happens in four years instead of five.

 

We take a little bit less interest rate risk, a little bit less credit risk, and we've quantified what that's worth and we can make that trade. Well, if you have people pricing off a grid, they're literally like, "Look, I have a three-year spot and I have a five-year spot. I can't do a four year deal. It's not on my grid." Okay, well, you've taken away their ability to be flexible. So what they're going to ask for instead is they're going to look at their five-year rate and they're going to say, can I do an exception? So can I get it a quarter point or half point cheaper than that?

They're going to go with the only lever that you've left them, which is stay in the box and ask for a lower rate, because it's the only way you can win the deal.

 

That's how it ends up being more dangerous and that's an extreme version that it's on a grid, but banks are... There are a lot of banks that just culturally are really restrictive with what they allow their bankers to do or to not do in putting together a deal and that means that you just become... Rate is the only lever that they have and that's the one that they will use over and over again and it will show in your margins.

 

So what we're advocating for there is one, of course, give them the tools to actually be able to do those things. At this point, it's just table stakes. But second, and this is the part that even some banks that have bought the very best tools still don't execute as well as they should is set some out of bounds lines. There are some things that just should be off limits, but within the boundaries that you set, give your bankers a lot of freedom. If they want to book a 63 month loan, have at it. You can do the math on it. If they want to do a loan at 82% loan to value, if the credit group approves it, we know how to price that. We can do the math on it. We can measure what a guarantee is worth from a minority partner in the company. All those things should be on the table as extra levers to be able to negotiate a deal so that it doesn't have to just be about rate.

 

And again, all these deals are kind of bespoke anyway, above a certain size, let your bankers be well-trained, well-paid professionals who are good at doing this sort of thing. Which means you got to invest in the process and the tools and then give them some authority to do that. And our banks that have clear out of bounds lines and then lots of freedom in between, those are easily our top performers.

 

Jim Young: All right. I think you kind of preemptively answered my question, which was sort of the, okay. I get why a dull knife is dangerous, but I can still cut off a finger with a sharp knife sort of thing.

 

Dallas Wells: Yeah.

 

Jim Young: Sounds like what you're sort of saying with that freedom within limit sort of thing is maybe kind of the answer to that of if I'm a banker and I go... I get what you're saying, but I also worry about what's on the other end.

 

Dallas Wells: Yeah. So there are some things that will cut off your finger so make those things off limits and those do require special approval and just make that really clear. But again, in my maybe overdone example, you have a spot for a three-year loan and a five-year loan and they want to do a four, is that cutting off a finger? No. That's just you being overly restrictive and trying to over simplify the rules there. That's where I think you've got to have a little bit of trust in the people that you're putting on the front lines to go try to win business.

So don't let them do things that will completely sink the balance sheet, but those should be kind of two outer limits, too high or too low of whatever thing and in between just do the math. We know what it's worth, put it out there at that price and come to an agreement with your client of where that needs to be.

 

Jim Young: Yeah. And final torturing of this analogy. I guess, if you can set it up well in the first place, then it becomes like asking someone like me who is a moron in the kitchen to use a chef's knife to cut up cucumber. I can handle that. We're not asking me to start working at a Japanese steakhouse.  That sort of thing. Because if be do that sort of thing, you can make it so that... Yeah. You can use the tools you need and get the job done. Yeah, let's not kill that-

 

Dallas Wells: Yeah. That's exactly right.

 

Jim Young: Let's not kill that analogy anymore, but Dallas, thanks for, again, taking another trip with me back down into the vaults and I suspect we'll probably do it a few more times in the coming months, because as you said, we've had... These have been unusual times for everyone and banking is no exception, but there are still a lot of truisms for the business that it does some good to go back and refresh our memories on.

 

Dallas Wells: Yeah. It's surprising how many times we back and it's exactly the same as it ever was with just a little bit of a new twist on it. So here we are. We're back to the business of negotiating these complex financial instruments with your customers and there's some just core things there you got to get right and this is part of it.

 

Jim Young: Yeah. And music from the '70s, '80s and '90s still rocks. I'll stick with that.

 

Dallas Wells: It does.

 

Jim Young: All right, well that will do it for this week's show. Dallas, again, thanks for coming on.

 

Dallas Wells: You bet. Thanks.

 

Jim Young: And thanks again so much for listening. Now for a few friendly reminders.

If you want to listen to more podcasts, check out more of our content, you can visit the resource page 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 [inaudible 00:24:30] 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 Purposeful Banker.