Make no mistake: We are entering economic times that will challenge us all. But community bankers must realize – not just for financial and strategic reasons, but for psychological ones, as well – that they are better positioned to survive this crisis than they think. Here are five factors that will help community banks thrive during the months ahead:
- Capital levels are higher than they were heading into the 2008 Financial Crisis. The regulators coerced the banks into holding higher levels of capital as a result of the 2008 Financial Crisis. The median Tier 1 Leverage Ratio has increased from 9.3% in 2009 to 10.9% by the end of 2019. As a result, there is a higher margin for error and a naturally larger buffer to absorb unexpected losses. Let me be clear though: Not all this capital is defensive capital. Invictus’ custom stress testing work with clients across the U.S. consistently demonstrates that most community banks have both a sufficient level of capital to absorb stress AND excess capital to deploy into new and/or restructured credits (which is what the regulators want the banks to do right now). Even if the COVID-19 crisis results in a longer severe recession, most community banks should have more than enough capital to absorb stress and keep lending. Unless we have a recession that is materially worse than 2008, far fewer banks will have to pursue defensive strategies such as de-leveraging and cost cutting (especially into muscle) to maintain sufficient capital levels.
- Banks can be the heroes, not the villains this time. In 2008, a few bad apples spoiled it in for the whole bunch. That crisis was blamed on the banking industry because of subprime mortgages, excessive balance sheet leverage, predatory lending, encouraging speculative construction, and bailouts (TARP, etc.). While outrage at first focused on the largest banks (especially after the failures of Bear Stearns and Washington Mutual), community banks caught much of the shrapnel. Not only did that result in increased and perhaps excessive regulation, but it also damaged the industry’s reputation. The deployment of both monetary and fiscal assistance to help banks in 2008 led to populist movements on both sides of the aisle.
However, the 2020 COVID-19 crisis is different; it was started by a virus and the social distancing policies implemented to contain it have immediately affected selected industries such as hospitality, retail, oil & gas, restaurants, and manufacturing. Post-2008 policies are being tested for the first time, and regulators are desperate for banks to lend. Regulators have announced massive stimulus programs, relaxed reserve ratio requirements, and are even exploring eliminating liquidity coverage ratio testing for large banks and delaying CECL. They have already introduced measures to incentivize banks to pursue forbearance strategies with affected borrowers. Regulators have argued that their policies do not discourage banks from lending in the face of a recession. Today’s crisis is an opportunity for banks to not only create additional goodwill with the public, but to also partner with their regulators and further build (or rebuild) that relationship. Bank regulators are going to come under enormous pressure if their policies do not prove to be effective. In 2008, the regulators needed to bail out the banks. The banks may now need to bail out the regulators.
- Risk management infrastructures are stronger. After 2008, enhanced risk management was driven by both regulators and banks themselves. Many banks created the new position of a Chief Risk Officer. Stress testing has also become a prevalent tool, even if most community banks use it as a check-the-box exercise. Still, that is better than nothing since it can be useful for monitoring and underwriting individual credits. Most banks have a capital plan, even though the ones I’ve seen are typically calibrated incorrectly. And most importantly, underwriting standards got tighter. Today’s credits are better underwritten than credits originated between 2005-08 from a risk perspective. The real problem with current loans on the books is their lack of yield, and most banks have competed more aggressively on that side of the equation as opposed to the risk side. The bottom line is that banks are not only better capitalized for a potential protracted downturn, but they also better prepared because of their risk management initiatives post-2008. That being said, they need to continue to step up their game and start preparing for the worst-case scenario sooner rather than later.
- This is when the value of the “relationship model” rises to the surface. In good times, many customers often lose appreciation for the value of a community bank relationship. They tend to focus on the terms and conditions of the transaction, often seeking to shop around for the best rate and least restrictive underwriting. Larger banks that are more interested in using the loan as a trojan horse to sell the customer other higher margin services are more than happy to play that game. But when customers endure stress and can get an actual human being on the phone at a community bank instead of getting stuck in a phone tree at a larger bank, they will remember that forever. When their community bank is willing to be flexible and help them quickly restructure their loan so they can get through this crisis, that will matter. When times are good again, they will never leave, and it will no longer be about trying to squeeze an extra 25 basis points out of the interest rate. Larger banks are built to provide this support to their corporate clients and uber high net worth customers, not to small- and medium-sized businesses.
- The “Deposit Dilemma” will be put on hold. For the last three years, deposit growth and the rising cost of funds have been the biggest single immediate challenge for many community banks. That issue evaporates, now that the Fed has returned to zero interest rate policy (ZIRP) and QE, and perhaps unfortunately, “the flight to safety” out of the stock market. This buys community banks time to pursue longer-term investments aimed at retaining and growing deposit relationships. I’m not suggesting that community banks would rather have the stark challenges posed by the continuing COVID-19 crisis. Hopefully, the COVID-19 challenges will dissipate when the virus gets under control. The Deposit Dilemma, though, is more of a structural challenge. Eventually the Fed will try to unwind ZIRP and QE, the stock market will recover, and as a result, some of those ‘surge’ deposits that are on their way will disappear. Those community banks that can manage to find a way to improve their deposit gathering capabilities during this process will be in a far better position to have a sufficient pipeline of ‘raw materials’ to convert into loans (finished goods) on a longer-term basis, and be in a stronger position to justify their independence. One note of caution on the deposit front: Be on the lookout for deposit drains from customers who are enduring extreme stress right now. This is especially true for those customers that you also have a lending relationship with (and especially if they have undrawn amounts on credit lines with your bank). There have also been some reports of large deposit withdrawals at banks across the country, perhaps driven out of general fear. Nevertheless, the conditions are ripe for the eventual return of surge deposits despite short-term issues.
Stress testing is one of the most effective tools community banks can use to quantify the strength of their position as well as get out in front of problem loans as much as possible. However, banks need to use a stress test that is more tailored to the current challenge. Invictus is ready to help community banks run expedited COVID-19 stress scenarios.