The pandemic has upended the very nature of community banking. This change requires a new way of strategic thinking, which we explain in this article. Banks that fail to adopt to the new environment will end up at a competitive disadvantage for years to come.
To understand this shift, let’s first consider some generalizations about pre-pandemic community banking. Community banks have always been a creature of their footprints. Their loan and deposit portfolios, structures and composition are defined by their footprint needs.
Loans are generally tied to the income/cash flow of borrowers, while collateral for these loans has been primarily skewed toward the real estate owned by borrowers. The importance of collateral in helping preserve bank capital under loss conditions has created a credit and loan structuring focus on specific loan categories.
By structuring relatively standard loan agreements against specific loan categories, community banks have optimized the lending and credit and accounting segregation process. Loan categories span a wide swath of industry codes that are defined by the North American Industry Classification (NAICS) system, which in 1997 replaced the Standard Industrial Classification (SIC) system.
Traditional management techniques and internal organization are geared toward optimizing the community bank’s approach to these different loan categories and their unique characteristics. Bank financial statements tend to focus on loan categories, and market analysts concentrate on the growth, profitability, and risk profile of the specific loan categories.
For many decades, the focus on loan categories has served banks well. Issues dealing with strategic growth, acquisitions, the 2008 recession, changes in Federal Reserve monetary policies, and regulatory oversight have all been addressed more than adequately by this loan category focus. Financial statements have not changed, either, with balance sheets focused on loan category assets and income statements on income by loan category.
This was all fine, until the onset of COVID-19 and its subsequent economic fallout.
The sudden appearance of the pandemic, its meandering progress through the global and U.S. communities, combined with the federal medical, political, and economic policy responses, have created a nearly opaque crystal ball for community banks. The shape, intensity and magnitude of the first pandemic wave has yet to be determined, with a high certainty of similar confusion regarding the coming second wave. The potential changes in consumer and corporate behavior created by this pandemic have yet to be truly defined.
Community banks have their hands full. They are dealing with the existing changes in their marketplace, the low interest rate Fed policy, a relative explosion of deposits, and potential defaults in different market segments. And these defaults are delayed and obscured by federally encouraged moratoriums on interest and principal payments.
In the chaos of the pandemic storm, one key critical new pattern has evolved. This pattern has and will continue to have a significant impact on community bank strategic planning, profitability, mergers and acquisitions, and eventually financial reporting.
This pattern is the unusual and unique impact of the pandemic on different NAICS codes across the U.S. market. The pandemic has been discriminatory about different NAICS codes, affecting their operations and finances in distinct ways that will continue to evolve and change.
Some NAICS codes suffered a loss of available labor due to workplace environments that were conducive to the spread the pandemic (beef processing plants, for instance). Other NAICS codes were affected by CDC-directed safety measures (restaurants, hotels, gyms, etc.). Changing consumer behavior and health concerns affected certain NAICS codes (transportation, etc.). Some NAICS codes have already ceased to exist with their activities being replaced by other NAICS codes (brick-and-mortar retailers versus online retailers). Other NAICS codes that depend or service the directly affected NAICS codes continue to be whipsawed.
This shift in focus toward NAICS codes and their unique reaction to the pandemic has and will have a greater impact on community bank analytics than any event during the last several decades, including the Great recession of 2008.
When the pandemic fallout ends, at some uncertain time in the future, every community bank will be looking at an altered footprint because:
From both a credit, capital and asset growth perspective, community banks will have to look at their activities within these NAICS codes to measure the true impact. Analysis solely focusing on loan categories will only serve to obscure the critical impact of these changes.
This change in focus toward NAICS codes is not an overnight process. Banks that react slowly will be left in the dust. While it is extremely difficult to predict the movement of the pandemic waves and their final impact on different industry segments and consumer behavior, it is clear that banks have to begin focusing on the NAICS codes within their footprint.
The bottom line is depressingly simple. Community banks are creatures of their footprint. The pandemic is changing their footprint by directly affecting specific NAICS codes within it. In the next three years, these changes will storm through their marketplace before entering a new steady state. The only way for banks to manage, strategize and maximize shareholder value is to reevaluate their marketplace through the lens of NAICS codes.
As is immediately obvious, evaluating the growth potential, credit and capital risks associated with stressed NAICS codes will not only require a focus on these codes, but is only possible using loan-level analysis.
The community bank footprint NAICS composition is shifting. These changes cannot even be approximated through a loan category analysis. Only a loan-level analysis can provide management and shareholders the ability to quantify earnings and capital issues through the pandemic and post-pandemic period.
By Kamal Mustafa, Invictus Group Chairman