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Do Your Job

Posted on April 13, 2023 Published by

When my parents caught me paying attention to things that did not pertain to the task at hand (generally involving something I was bored with), the refrain was, “Stick to your knitting”. This was rather strange, as I don’t know how to knit. However, now I see the wisdom of being focused on what my job (read: responsibility) is. Given the current state of the banking industry, this would seem particularly relevant.

Today’s U.S. Economy

By way of abbreviated history, the U.S. economy experienced strong economic growth a few years ago. With low interest rates, low unemployment and negligible inflation from 2017 to 2019, things were good. A severe shock hit in 2020 with the COVID 19 pandemic. This led to a rash of government stimulus and a reduction in Fed Funds rate to essentially zero in March 2020. If the rising tide of economic success and growth wasn’t bad enough, throw in billions in free money and zero interest rates. Everyone tends to lose focus. The new reality is that, in response to excessive spending, we have 40-year high inflation. The Fed’s response is, predictably, to raise interest rates which have increased 4.75% since March 2020. Recession is looming.

Now throw in a wild card – Silicon Valley Bank (SVB). SVB had a unique customer base from both an asset and deposit perspective. Over 50% of its deposit base consisted of tech companies, many of which were backed by venture capital investors. As interest rates rose rapidly, venture capital monies slowed. With less money flowing into SVB’s corporate customer base, companies began spending down their deposits. Instead of paying attention to the warning signals of increasing rates and the impact on the bond portfolio, they appear to have been content to invest monies in “trendy” and risky industries. Things such as various social justice causes, and generous sponsorships and bonuses. As deposits shrank and the bank needed additional liquidity, they learned the lesson that while a treasury bond may be very safe as it relates to default risk, it is still subject to market (price) risk.

Potential Government Response

In the traditional government response that “we must do something,” the Fed said it would “bail out” depositors at SVB. It would be done by providing full insurance of deposit accounts in excess of the $250,00 limit. However, not for lenders or shareholders. This announcement was quickly followed by testimony that they are “not going to run around bailing everybody out”. This message was quickly interpreted to mean that deposits at the largest institutions that may be deemed “systemically important” would be covered. Not so with smaller banks, though. The net effect is to encourage depositors to move balances to larger banks creating a “bank run” type situation.

This has created a truly unique situation. It will require the full attention of banking professionals in the community bank segment of the industry. Historically, bank failures have been the result of a failure on the asset side of the balance sheet through loan charge-offs. There is no doubt that the increase in interest rates and the impact of inflation on the cash flow available to service debt at both the commercial and consumer level is being seriously compromised.

As discussed in previous blogs, the increase in interest rates can also impact your secondary source of repayment by depressing the value of your collateral. The negative impacts to debt service coverage and collateral value will put negative pressure on risk ratings. To stay current with the trends and impacts on your portfolio borrowers, prompt credit quality monitoring will be imperative. The professionals at Enlighten Financial can assist in reviewing your portfolio and assist in identifying hidden risks.

Dreaded Double Whammy

But we now have the “double whammy” in terms of asset/liability management. Rising interest rates are going to put additional pressure on net interest margin as lending institutions compete for deposits. Concern over the safety of those deposits and insurance coverage by the FDIC is likely to cause existing deposits to move to other institutions for perceived “safety.” As deposits move away, it may be necessary to liquidate portions of the bond portfolio (at a loss) with the associated impact on capital and resultant regulatory issues.

All in all, this is a time when each institution must have its best players on the field. Not only do these players have to possess the correct skills, but they need to be focused on the job at hand. They can’t be distracted by extraordinary considerations (ESG and DEI come to mind). If we do the right things right (that is, “Stick to your knitting”), you give your organization the best chance to not only survive but potentially to thrive.

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.

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— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection