Everything Old Is New Again
At some level, the more things change, the more they stay the same. Whether your financial/lending institution is large or small, the risks each one faces generally fall into four categories. These are credit risk, market risk, liquidity risk, and operational risk.
Each year, management is faced with the same challenges of acquiring new customers, preserving the current ones, and dealing with changes in the overall economic environment. Most economic literature projects 2023 to be a particularly difficult and challenging year. Rising interest rates and weak economic growth combined with high inflation has increased concerns over deposit levels and liquidity constraints. While these concerns may be true for financial institutions of all sizes, community banks and credit unions are likely to be affected more acutely. In this month’s blog, we will attempt to look at five key challenges facing community-based financial institutions. Everything Old Is New Again.
Credit Quality and Underwriting Standards
Absolutely nothing new here; just the environment is more challenging. Maintaining strong credit underwriting standards, a sound risk rating system/matrix, and an active portfolio monitoring discipline to quickly identify deteriorating credits will be essential. Implement a standard practice of regular interim financial reporting, covenant compliance reporting, borrowing base reports, etc. This will establish a sound baseline for early warning signals. Next, “Inspect what you expect! When conducting annual and interim reviews, lending professionals need to be proactive in adjusting risk ratings to watch status. Or worse, if necessary, to reflect negative performance trends. Watch rated credits are likely to be higher than a year ago. One should expect that trend to continue over the next year given the current economic environment.
Something that may be a bit of a change for 2023 is dwindling cash reserves. Customers are using up any surplus funds acquired through stimulus programs. This will mean increased competition for deposits and shrinking net interest margin.
While economic volatility is common for both large and small institutions, community bank portfolios are likely to have greater challenges. First, not every community is impacted the same way by economic volatility. With a smaller geographic footprint, the community bank will be more susceptible to local market conditions. This includes unemployment rates and diversity (or lack thereof) of industries. Managers, lenders, and credit staff are typically an integral part of the community in which they do business. Therefore, they are more inclined to be aware of changes in the local economy.
Community banks, like all banks, operate in a highly regulated environment. However, the cost for compliance represents a greater percentage of operating expenses than in larger institutions. Staying up to date with evolving regulatory requirements is both critical and costly, whether that is in the implementation of new regulations or the consequences of non-compliance. It is also important to avoid “self-inflicted wounds,” such as distractions of various social justice causes including DEI (Diversity, Equity, and Inclusion) or ESG (Environmental, Social and Governance). Management should stay focused on their key responsibilities, including having the best people in the right jobs servicing the businesses in their community while also obtaining the best returns for the owners/shareholders. (Sidebar: Don’t be surprised when you find that these two things are related.)
The risk of having concentrated exposure to a particular industry or borrower segment is closely related to concerns with economic volatility mentioned above. Achieving diversification across various industries may be more difficult for community banks because they typically have a smaller geographic footprint. That said, monitoring the commercial portfolio for potential concentration issues should be conducted regularly, and establishing concentration limits by industry segment can be effective in managing concentration risk.
One of the many consequences of the COVID pandemic was an increased emphasis for adopting digital banking solutions to accommodate more online banking applications. Not only does this put additional pressure on the need to develop more robust technology infrastructure but also on the need for cybersecurity measures. To develop a fast and “frictionless” experience for the client is extremely costly. It can also be incredibly frustrating as technology changes so rapidly that a bank or credit union’s “new and improved” technology could be obsolete by the time it can be developed, deployed, and implemented.
In conclusion, everything old is new again. The community banking environment continues to be very challenging. Many of the risks are the same ones that community banking institutions have faced in the past (credit quality focus on both underwriting and monitoring) and some are increasing in importance (embracing and implementing new technologies).
The team at Enlighten Financial can help with navigating some of these issues. Things such as credit underwriting, loan review, portfolio concentrations and monitoring so you can focus on your key strengths. Which is building customer relationships. It is the focus on relationship banking which allows me to be optimistic about the future of community banks. While having fewer resources to deal with the challenges of technology and regulatory changes, having a team of dedicated community banking professionals is very difficult for the “big guys” to compete against.
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.
Image by Megan Rexazin from Pixabay.