Squeezed Interest Margins - Incentive for Innovation

Because of increasing competition, and low interest rates, net interest income is going down. This isn’t what our shareholders and members want. But what can we do about it?

In a previous post, I listed a number of significant challenges and opportunities for community banks. In this, and following posts, I will dig a bit deeper into innovative approaches to addressing each of them. The first was that:

Net interest margins are continuing to narrow. Cost of funds can’t go any lower but competition is squeezing yields on every kind of loan. So although loans and interest income are growing, net income isn’t keeping pace. Interest rate increases would help community banks, but this is outside our control. If we’re to maintain or grow net income, we have to reduce expense (again!) or profitably grow non-interest revenues. Or, preferably, both.

There are several approaches that can be taken. Some feel easier and more comfortable, but they are also limited. Others are outside the comfort zone of most traditional lenders. But the right answer is going to be some combination of both.

Countering squeezed net interest margins

Smaller financial institutions have three basic options:

• Lend more, which increases net interest income despite narrow margins
• Increase the net interest margin by reducing operational expense or improving loan quality
• Increase focus on non-lending products and services that will generate positive non-interest income.

Let’s take a look at each of these in turn, examining how innovative business solutions can help.

Lend More

This is the path most financial institutions are taking today. This shouldn’t be surprising: most bank and CU presidents are lenders by background. There are several ways to increase the loan portfolio. But each of them has its own challenges and opportunities. They are presented in increasing order of innovation (and decreasing comfort!)

Bring in more of the same types of loans

The existing loan portfolio balance can be maintained, but at higher loan volumes. This can be done through increased marketing of existing loan products, and/or expansion of target markets. The great benefit is that this is simply more of what we already know how to do. We may need to ramp up origination and servicing teams, but net income will grow as a result.

However, there are challenges too:

• Increasing loan volumes may require relaxation of underwriting standards. This in turn may reduce the quality of the loan portfolio and increase credit losses. As a result, gains from a larger portfolio may be lost in higher reserves and charge-offs.
• Acquiring more and more low-cost deposits becomes increasingly difficult. Differentiated services and quality of care have their own expense. A higher cost base will eat right back into the margin. Even worse, it may not be noticed unless customer profitability is holistically measured.

Acquire loans through M&A

Loan portfolio growth doesn’t necessarily have to be marketing-driven. Larger banks are increasingly acquiring assets from smaller competitors. This is a valid strategy to increase scale and reduce operating costs. But it is a one-time benefit, even assuming that adequate due diligence has been carried out.

Offer new loan products

New loan products can be offered to existing borrowers. Most likely this would involve competing with other incumbents. Examples would be student loans, supply chain financing, and construction lending.

In all these cases, there are things to learn. There must be new processes and (perhaps) system capabilities, and new servicing implications. Examples include ongoing revaluation of receivables, or project management skills for tracking construction projects. Note that this is not innovative from an industry perspective. There are plenty of financial institutions already doing each of these. It may still be an innovation strategy for a given bank that hasn’t yet offered such products.

Approach new borrower segments

The FinTech lending challengers have been focused on potential borrowers that banks don’t want. This includes borrowers whose repayment potential is difficult to judge with traditional underwriting tools. For example,  sub-prime borrowers, immigrants, students, and new businesses. 

The critical thing for financial institutions is to use new ways of assessing credit risk. The alternative lenders have been exploring several new approaches. Some involve new technologies such as AI-based analysis of social media interactions. They take advantage of extensive additional data available from a variety of public databases. This is the “big data” revolution in lending that has been much hyped recently.

The great opportunity for financial institutions of all sizes is to partner with alternative lenders. Several of them already have a track record of lending to consumers and businesses without much credit history. 

Special case: Marijuana-Related Businesses

I am writing this on election day. I can’t ignore opportunities and risks of marijuana-related businesses (MRB’s). These include growers, distributors and retailers. After this election more than half the states will have legalized medical marijuana. At least seven will also allow recreational use for over 21s. Even so, the risks remain high. Marijuana possession is still a Federal crime. Admittedly, in the Cole Memo, DoJ guidance suggests that law enforcement should focus on dangerous use of marijuana. FinCEN also stressed AML compliance as a priority. But there are opportunities for banks to offer lending, depository and cash management services to MRB’s. Even though compliance will be expensive, these customers yield significantly higher net income.

Reduce lending costs

This may be a good time to reassess full life-cycle lending processes. Can cost be driven out of any of the stages of life for a loan? This may run in parallel with efforts to increase loan volumes without increasing staffing. It is worth asking if you are completely tied to your existing lending platform, most likely acquired from your core banking vendor. Consideration can be given to every stage:

• borrower acquisition
• underwriting and due diligence
• collateral and guarantee management
• origination, borrower onboarding (e.g. KYC) and documentation
• servicing, collection, amendments and payoffs
• bankruptcy and foreclosure procedures

Approaches that can be taken to reduce cost in any of these areas include:

• Upgrading the entire loan platform to one with better automation. This may be a newer offering from your core banking vendor. But it could also be a specialist platform from a different vendor. This may be cheaper even with the added cost of core integration.
• Purchasing add-on components that will enhance a particular lending activity
• Outsourcing utility functions such as loan documentation
• Seeking FinTech companies that have specialized in any of these areas driving cost of lending

Improve credit quality

Some financial institutions will stick to their traditional lending channels, products and borrower profiles. But there is still potential to improve portfolio quality. The goal would be to reduce loss reserves and charge-backs. This could also potentially reduce risk-based capital requirements. A promising side benefit of alternative lenders is the plethora of new credit risk assessment approaches. “Big data” can be leveraged far better than would have been true even five years ago. All of a borrower’s financial, demographic and social history can be discovered from a variety of sources. The more difficult question is “what on earth do we do with it all?” That is where some of the alternative lenders have been quite creative, and there is no reason not to leverage their discoveries.

Community banks and credit unions should be aware of new approaches in the marketplace. Several FinTech companies use advanced analytics and machine learning to get more accurate predictions of repayment behavior. Other FinTechs focus on verifying information a borrower provides on assets and income. Yet others provide sophisticated, and sometimes surprising, input on credit quality. This is especially valuable for borrowers who are deemed “sub-prime”. (Sub-prime is generally defined as borrowers with a below 700 FICO score. This includes more than 50% of the US adult population). It may be the only hope for borrowers (such as new small businesses) with insufficient credit history for credit bureaus to score.

Increase Non-Interest Income

Non-Interest Income as a percentage of total revenue averages barely 15% for smaller banks, while the largest are closer to 37%. Many smaller banks receive less than 10% of their income from fees. This makes community banks vulnerable to the current unfavorable interest rate environment. 

Non-Interest Income as a percentage of total revenue averages barely 15% for smaller banks, while the largest are closer to 37%. Many smaller banks receive less than 10% of their income from fees. This makes community banks very vulnerable to the current unfavorable interest rate environment.

Non-interest income is often also referred to as fee income. It represents fees levied for specific non-lending services – deposits, payments, etc. Many community banks and credit unions were founded in order to make loans. They are also often run by life-long lenders. Almost all offer some fee-based services, but mostly in order to attract deposits. The idea of growing non-interest income as a strategic imperative is alien and uncomfortable for many bankers. But interest rates are likely to stay low for some years to come. Competition for loans traditionally offered by banks is increasing. Is there really a choice?

Fortunately, some non-interest income earning capabilities are becoming easier for smaller financial institutions. Technology is addressing some of the previous operational and risk management issues. And specialist technology and operations partners are growing in number and capability.

There are two major approaches that community banks take to increase non-interest income:

1. Provide business products (e.g. cash management) equivalent to those offered by large banks. This will generate fee income on its own. It also reduces the loss of customers caused by the need to refer them to other banks. (A common example of this would be for cross-border payments). Detailed discussion is beyond the scope of this article, though I may cover some in future posts. Some examples are:
   1. Working capital management tools. This includes investment sweeps, concentration accounts, and short-term asset-based loans (e.g. receivables or inventory financing)
   2. Payables management tools. Examples are check and ACH fraud avoidance (positive pay), invoice capture and payment workflow, and direct interfaces with ERP or accounting systems
   3. Receivables management tools. Examples: lockbox, receivables matching, accelerated credit, and direct feeds to ERP or accounting systems.
   4. Risk management tools, including forward contracts, swaps (FX and interest rate), and other hedges
2. Offer wealth management products for businesses and their owners.

• Advisory services for M&A and capital raising activities
• Escrow and trust services
• Investment management, including 401(K) administration, SEP-IRA, etc

Conclusion

Stagnating net interest income is a major headache for every small financial institution. There are many options for them to pursue in order to address it. The right options will depend upon a mix of market conditions, company history and expertise. Also critical will be the ability to partner with third party technology, operations or financial entities.

Regardless of the right options, though, all involve a degree of innovation, and a few basic principles should be kept in mind:

1. Innovation should be driven by the business strategy, and never the other way around.
2. There are many kinds of innovation. Some involve technology. Some of those involve new partners. Very few will involve brand new cutting-edge technology (you can leave that to the big banks!)
3. When exploring FinTech options, don’t get overwhelmed or bogged down. Use third-party consulting and advisory services that specialize in discovering and integrating the best FinTech solutions.
4. When new partners are engaged, third-party risk management must be rigorously applied.
5. When engaging FinTech partners, ensure the solution will work before committing (do a proof of concept, and also a high-level assessment of non-technology implications. These include operational risk, regulatory risk, operations, customer service, and of course product- and customer-level profitability.
6. Keep the focus on implementing the innovation. Don’t get spread too thin by pursuing too many initiatives at once.

All common sense, and yet these are all principles I have seen forgotten or ignored.

Even the smallest banks and credit unions can innovate strategically. The question isn’t whether to be innovative, but how.