The 2020 Pandemic marks the end of the post-2008 recovery business cycle for the banking industry and the economy as a whole. As we enter the post-pandemic economy, community banks across the country are struggling with how to project and plan for loan growth. Extrapolating historical trends from the pre-pandemic economy makes absolutely no sense. That economy looked entirely different from every angle, including interest rate policies, inflation expectations, GDP, and unemployment. So how should banks think about loan growth moving forward?
Let’s start with how banks thought about loan growth in the past. The conversation always began with loan categories, but that won’t work anymore. Banks need to forget about loan categories and instead first break down their loan portfolio by NAICS code. I strongly suggest you read this article about how and why this is such a critical adjustment banks need to make.
In a nutshell, it’s the NAICS code or industry composition of a given footprint that defines a bank’s growth prospects. Businesses that are in industries that are growing need additional capital including bank loans to support this growth. And the number of businesses in those industries also is growing, which expands the universe of prospective borrowers as well. Businesses that are in industries that are not growing are often primarily focused on reducing costs, which includes borrowing costs, as well as consolidating, which shrinks the universe of prospective borrowers. While this is simple and essentially Banking 101, it’s surprising how many community banks have forgotten these fundamentals.
What community banks need to do is identify those industries that they believe are best positioned for growth in the post-pandemic economy. While there is some data that is available, it’s mostly historical data from the pre-pandemic world, rendering it virtually useless since the post-pandemic economy is going to look vastly different. Community bankers need to identify these industries using a combination of loan-level data and domain knowledge. Strategic plans should be designed around increasing loans to these industries to optimize growth and earnings.
Industries that are growing also means that the pie of loans allotted to that industry is also growing. This is the ideal situation because it will be easier to find borrowers and there will be less competition. This should also equate to relatively reasonable interest rates and underwriting structures. Loan growth is a natural function of the industry’s growth.
Industries that are not growing means that the pie of loans allocated to that industry is also NOT growing. If your bank wants to grow loans to borrowers in these industries, you will have to take market share from other banks. This is not the ideal situation, since it quickly turns into a race to the bottom; first on rates, and then eventually on underwriting standards. This is a totally different ball game, and although winnable, often requires a scorched earth strategy that only a handful of banks are best positioned to win.
Community banks deserve a tool that can help them plan for loan growth by NAICS code and then translate those results to loan categories as an output. This will help them allocate resources (loan officers, marketing, etc.) to the right segments of their footprint, as well as help them figure out whether a pie-growth or market share-growth strategy is required. This will drive the rest of the P&L down to the bottom line. This information is also critical to identify industry concentrations and determine concentration limits effectively, so capital is optimally allocated.
Loan growth targets plucked out of thin air or even by loan category are putting management at risk. Management teams running community banks across the country are under increasing pressure from their boards to drive loan growth.
Boards need to know what management is up against. They must understand the trade-offs and risks associated with starting a market share war if pie growth opportunities are limited within the bank’s footprint. Or the bank needs to think beyond its footprint to search for pie growth, but that’s a discussion for another day.