Community Banking Connections

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Bank Strategies in the New Year: Trends and Examples
by Cathy Lemieux, Executive Vice President, Supervision and Regulation, Federal Reserve Bank of Chicago

Millions of Americans ring in the new year by making resolutions. The promise of turning the calendar spurs many of us to give life to ideas and plans that can make the coming 12 months better than the last. Finances, careers, home improvement, and exercise are at the top of most lists, and for good reason: They have the potential to improve our quality of life and our success in the year ahead.

New Year's resolutions also play out at many financial institutions around this time of year, as banks look to strategic planning to take stock of the past year's performance and recast or recharge their business strategies. Like personal resolutions, these efforts can start out with a full commitment only to fade into old habits. In other cases, these new plans thrive and become ingrained in the culture of the organization.

While the current banking environment has come a long way since the depths of the financial crisis, the new year brings with it a reminder that challenges remain for community-focused financial institutions, from low interest rates to scarce pockets of loan demand. This article discusses some telling stylized examples of banks that found ways to get it right — along with a handful of cautionary examples of strategies missing some key ingredients.

Challenges for Traditional Banks

The very low interest rates of the past five years have been a valuable source of support for the business and consumer borrowers that make up the broader U.S. economy. But low rates continue to be a stiff headwind for traditional banking organizations. With few exceptions, net interest margins have declined every quarter since 2011, most recently to 3.26 percent,¹ well below the 10-year average, which is above 4.0 percent. Although a steady drop in funding costs has helped support margins, a steeper simultaneous decline in interest income has challenged community banks' earnings.

The "low for long" rate environment has not translated into robust loan demand nationwide. While there are some bright spots of growth, many banks have struggled to maintain or grow loan portfolios despite holding high levels of deposits.

Competition for "good credits" has led to banks of all sizes competing fiercely to be the lender of choice. In some cases, institutions have responded to weak loan demand by entering specialty or niche markets — such as energy, health care, and equipment financing — in which they previously had little or no presence.

These markets point to commercial and industrial (C&I) lending, which has become a business line of emphasis at many institutions; in some cases, supervisors have seen rising concentrations of C&I loans. Just over a year ago, my colleague Cynthia Course from the Federal Reserve Bank of San Francisco contributed a prescient article to this publication, in which she reminded C&I lenders of the importance of sound risk controls and concentration limits.² I encourage bankers who are interested in C&I portfolio growth to read her article.

Another sector showing signs of fierce competition is commercial real estate (CRE), where loan balances are also once again trending upward at some smaller banking organizations following a years-long decline in the wake of the financial crisis. Although construction and land development credits were essentially flat over the past year, as of the third quarter of 2013, loan balances for CRE and multifamily properties rose by 10.7 percent.³ Federal Reserve data point to growing competition for this business from large financial institutions and other investors,⁴ which may tempt some community banks to loosen their underwriting standards.

Knowing Your Strategy — Desk-Side Stories

There are books, consulting firms, and university programs devoted to the finer points of strategic planning. In most cases, these are great resources for community bank managers. However, bankers have a long tradition of learning from one another, and, as they do, they build the institutional wisdom and memory that so often help banks get through tougher times. The following composite stories are telling examples of banks that found ways to get it right through three key themes of good strategic planning:

• Casting a vision with the right people and careful execution
• Attracting and developing expertise at the board level
• Sticking to a well-thought-out plan, evaluating and revising as needed

I hope you find these stories interesting and helpful as you evaluate your own strategy.⁵

The Right People, Thorough Execution. The following examples highlight the importance of laying the risk management groundwork in staffing and capital when casting a new strategic direction.

Consider the example of a community bank grappling with slow economic growth in its local market — in this case a combination of outlying suburban and rural communities. While the large urban center 70 miles down the interstate has put some distance on the financial crisis, its construction activity and tech-focused jobs have yet to provide much help to this bank's local markets. The loan demand among nearby small businesses and farmers by and large results in low-return credits that yield no more than a percentage point or two above mortgage bonds backed by the federal government.

To buttress earnings until the local economy improves, this community bank decided to invest more funds in structured investment products as well as larger loans syndicated by other banks. While the higher yields on these investments were attractive, the bank's board of directors was also aware that these types of loans and investments had been a source of deep losses for other institutions during the most recent financial crisis. The board also paid close attention to a recent report by the U.S. federal banking agencies showing that criticized assets among Shared National Credits (SNCs) held by banks remained elevated at 10 percent of the $3 trillion U.S. SNC portfolio.⁶ The agencies' report also called attention to leveraged loans and weakening underwriting practices among SNC participants.

To round out the new strategy, the board authorized the bank's senior management to set prudent controls for underlying credit risk, growth rates, and balance sheet concentrations. At the same time, the board budgeted funds for the bank to hire two senior staff members — one with experience evaluating and selecting large shared credits, and another with knowledge of structured and complex investment products. The board also adopted a recommendation from the chief financial officer to set concentration thresholds on the amount of investment products relative to capital in which the firm was willing to invest. (For additional discussion of tying strategies to sound capital planning, see Jennifer Burns's insightful article in the Third Quarter 2013 issue of Community Banking Connections.⁷)

A similar story has played out at some rural community banks focused on agricultural credit and customers. Yet, as the next example shows, banks that shift strategies without sound planning can serve as cautionary cases.

Over the past few years, at one rural bank, the low-interest-rate environment reduced interest income on variable-rate agriculture loans. To diversify business lines and improve profits, the bank's senior management decided to take advantage of opportunities in surrounding counties to fund higher-yielding loans for big-ticket construction equipment and vehicle purchases by businesses. To conserve resources, the chief executive officer (CEO) decided to use existing staff — who did not have a thorough understanding of these types of credits — for these new lending efforts. Before the loans were two years old, asset quality issues arose within the portfolios, and the resulting losses put a strain on the bank's capital. Board meetings now include deliberations for disposing of repossessed vehicles and machinery, the values of which do not cover their associated loan balances.

Beefing Up the Board. The next few examples highlight the importance of an active and engaged board of directors.

In a story familiar to many institutions, a community bank serving an urban area with a mix of businesses and residential neighborhoods spent considerable time triaging the effects of the most recent financial crisis — in this case, asset quality issues among small business loans. After five years of hard work, the bank began exiting what its board of directors had come to call "crisis mode." Capital had been restored, a small portfolio of new loans was performing well, and the neighborhoods the bank serves were showing signs of improving economic conditions. The bank then shifted its attention to loan growth within its CRE portfolio.

To help the bank adopt a forward-looking approach, the six members of the board unanimously decided to recruit two new directors with ties to local business sectors. After a search, the board added the owner of a small but established manufacturing company, as well as a business attorney. To maximize the new directors' contributions, the board also spent some funds to send each one to an educational conference for experienced professionals joining their first bank board of directors.

Two months later, after careful deliberations with the new directors, the board and senior management identified three specific types of local borrowers the bank would target for new loans and related business services. The resulting three-year plan included allocating capital relative to distinct borrower risk profiles to ensure the bank's overall capital was managed prudently and to cushion against unexpected losses, as well as dedicating funds to hire a banking professional with experience in choosing and refining underwriting systems. Specific risk controls were established to limit the bank's concentration by loan type and industry. A patient approach to reaching the bank's goals for growth recognized that improved earnings may take more than a few quarters to achieve, allowing management sufficient time to roll out the new strategy. The board also decided to avoid equipment leasing and financing activities after watching a local competitor struggle with asset quality and end-of-lease inventory management issues.

Educating and engaging board members can be valuable in the strategic planning process. Conversely, jumping into a new product or business line without effective challenge from board members can result in future headaches.  (For additional discussion of introducing new products or services, see Teresa Curran's helpful article in the First Quarter 2013 issue of Community Banking Connections.⁸)

For instance, over the past 18 months, the CEO of a large urban community bank noticed an uptick in inquiries from institutions and brokers looking to sell blocks of mortgage servicing rights (MSRs). Although the mortgage servicing industry was previously dominated by very large financial institutions, including Wall Street banks, the financial crisis led to significant shifts within the sector, prompting many organizations to exit the business altogether. Sale prices for MSRs had fallen even as their characteristics made them appear more attractive in the current environment. At the next board meeting, the CEO proposed a purchase of MSRs to help offset weak income from loan interest and fees. The board approved the purchase at that same meeting.

Less than a year later, the MSR business that seemed so promising began to show signs of stress, with implications for the broader institution. The trouble started when more loans defaulted than the bank had forecast, hurting servicing income. A few months later, two borrowers filed lawsuits claiming the bank's newly assembled servicing staff had violated amended consumer protection rules regarding force-placed home insurance and the processing of foreclosure and repossession documents. The bank's general counsel strongly recommended setting aside litigation expenses equal to many months of servicing revenues. Some weeks later, three large local business customers read about the lawsuits in the local media and moved their deposit business to a local competitor.

To be clear, the type of activity the bank engaged in — in this case purchasing MSRs — was not the root cause of the strategy's failure. Rather, the institution's problems were due to the lack of effective review at the board level in questioning potential issues arising from management's proposed strategy, as well as from a failure to lay the appropriate risk management groundwork.

Evaluating and Revising. Finally, it is worth noting the importance of evaluating and at times revising any strategy a bank sets. In today's environment, many community banks that have very traditional commercial banking activities have found themselves reevaluating their strategies, even if these "strategies" are informal and not committed to paper. In the case of the bank discussed in the previous section that grew its CRE portfolio as it exited "crisis mode," the board committed to reviewing its progress and execution every six months. Likewise, at the bank that faced troubles with mortgage servicing, the board of directors recently agreed to carefully review its performance every quarter.

In a final example, a suburban banking institution that serves a cross-section of neighborhoods is long on institutional memory. Although the organization has for years focused on lending to CRE borrowers, it maintained relatively strict underwriting standards during the most recent financial crisis. It is no coincidence that three of the bank's senior managers began their careers during the savings-and-loan and commercial property crisis that hurt a lot of institutions in the early 1990s.

As less careful competitors retrenched in recent years, opportunities to quickly increase local CRE lending began to present themselves. However, in most of the higher-return opportunities, borrowers were asking for down payments below the bank's historic thresholds. In other cases, would-be borrowers were seeking credit to purchase properties they did not intend to occupy themselves — another loan feature that fell outside the bank's existing underwriting systems. After presenting these new opportunities to the board, the directors decided to turn down 90 percent of the new opportunities. The board made exceptions for three relatively small loans to long-time customers but set aside separate capital to isolate the risk to the rest of the institution. New risk management controls allow senior management to propose additional nonconforming loans, but they must be approved by the full board, not just the bank's loan committee.

Conclusion

Given today's difficult operating environment, many banks are understandably reevaluating their strategies to remain competitive and profitable. The new year is the perfect time to review performance and set resolutions for the year ahead. While challenges to our nation's community banks are stiff, these examples demonstrate that success is possible if banks have involved boards of directors and well-planned strategies supported by the right staff, capital, and controls. They represent the kinds of decisions that can make for a promising year ahead.