Since COVID-19, profitability planning for community banks has mainly hinged on how the government was coping with the pandemic and the key role financial institutions played in keeping the economy afloat.
of economists say inflation will be more significant than expected over the next 12 to 18 months
Source: Bankrate Second-Quarter 2022 Economic Indicator
In 2022, things changed with whiplash speed, as the Fed hiked interest rates to quell inflation, the mortgage refinance market dried up and the effects of macro changes, from the Russian invasion of Ukraine to a talent shortage, began to be felt keenly.
Before 2022, says Thomas Grottke, managing director at Crowe LLP, “a lot of factors were going right. Liquidity was through the roof, we had [large one-time] earnings gains from PPP and from mortgage banking, and the cost of funds was low. Then, bam! The last six months has been a completely different environment.”
Andrew Pyles, president and CEO of $350 million-asset Eclipse Bank in Louisville, Ky., agrees. “There are headwinds we’re facing,” he says. “Banks are searching and asking: ‘Where are we going to make up that income from PPP and mortgage refinancing?’”
It’s certainly an interesting time to be a community bank, but there are still plenty of ways to make efficiencies with an eye on profitability.
1. Strategize for a rising interest rate environment
On June 15, the Federal Reserve raised interest rates by 75 basis points—the highest increase since 1994—and that move came on the heels of a half percentage hike in May. Regulators made no bones about the fact that a number of additional rate hikes are likely to happen this year.
Even the Fed’s rate hikes might not be enough to halt rising inflation, though. In fact, 41% of economists in Bankrate’s Second-Quarter Economic Indicator poll for 2022 say inflation will be even more significant than expected over the next 12 to 18 months.
“I counsel my community banks to be careful about extreme growth in rising rate environments,” says Jim Adkins, managing partner at Artisan Advisors in Barrington, Ill. “Quickly, your fantastic rate today might not be a fantastic rate tomorrow.” He advises bankers to manage their balance sheets carefully, keeping in mind that in this type of environment, it’s difficult to forecast how high interest rates might climb.
Jeff Reynolds, managing director at Darling Consulting Group in Newburyport, Mass., says that when inflation gives rise to talk of recession, it’s time to anticipate additional earnings pressures on banks because of credit concerns. He suggests that shifting at least some cash into the bond market “sooner rather than later” might make sense.
2. Rightsize mortgage departments
During the pandemic, the Fed bought up massive numbers of mortgage-backed securities, with banks enjoying unprecedented sales levels and gain on sales margins. “For most banks in the past 18 months, if there was a mortgage that wasn’t nailed down to the floor, they probably sold it,” says Reynolds.
Banks are now facing twin challenges: replacing lost income from mortgage refis and making sure their mortgage loan departments aren’t overstaffed.
“When the music stops, how are banks going to replace that mortgage fee income?” Reynolds asks. “The cost of employing mortgage lenders can be relatively high, and if you look at your 12-to-24-month forecast, banks are going to have to consider what they can do to rightsize expenses.”
3. Consider your branch strategy
Assessing the value of bank branches is an exercise that began long before the pandemic, but vaccine and mask mandates added new considerations to the debate. “Why should you, as a community banker, carry [a branch with little business] with all of these headwinds?” asks Grottke. “If you’re sketchy on profitability and there’s no growth, you have to think about selling.”
Reynolds agrees: “During the pandemic, a number of larger banks took the opportunity to cull their real estate footprints, and we didn’t see as much de novo branching by smaller banks.” He continues: “Can we shrink the size of the branch into something that’s more conducive to today’s wants and needs versus those of 1980, and maybe lease out some of that space?”
Reducing a bank’s branch footprint does not necessarily mean sacrificing growth. To the contrary, says Reynolds: Many savvy community bankers are eyeing smart branches, where tellers can be accessed through videoconferencing at a kiosk.
An added impetus for rethinking branches is the staffing shortage and the high price of labor, says Reynolds. He knows of one community banker who found a terrific candidate for a teller position, only for the young woman to accept a job offer at the local Jack in the Box. Even when banks don’t “lose out to burger joints,” he says, they’re reporting increases in branch staffing costs of between 5% and 10%.
Rethinking branches isn’t a one-size-fits-all exercise. Pyles notes that while Louisville, Ky.-based Eclipse Bank went from a single branch before the pandemic to two branches today, with plans to open two more within a year, he, too, is looking at branches very differently than he did even a few years ago.
“We believe in branches,” says Pyles, “but we believe the purpose they serve is more consultative, and we’re using them as a meeting space or for troubleshooting.
“The days of people coming in to cash their Social Security checks—those are pretty much gone. But with a handful of branches in a market, you can accomplish quite a bit.”
4. Strengthen controls
“The best way for community banks to keep their profitability high is for their control systems to be working properly,” maintains Cathy Ghiglieri, president of Ghiglieri & Company in Pinehurst, N.C. As a former Texas banking commissioner, she emphasizes the importance of internal loan reviews and audits and urges bankers to train tellers with care. Poorly trained tellers, she says, could bring about losses by issuing cashier’s checks inappropriately or even overlooking attempts at money laundering.
Banks that lack proper controls are liable, contends Ghiglieri, to internal and external fraud losses—as well as litigation expenses and regulatory penalties. These large hits to profitability are difficult to make up in other areas.
5. Play the long game
Adkins is convinced that some of the most significant levers to profitability require an initial investment and do not pay off immediately.
“The regulators keep hammering banks, saying, ‘Remember this, and don’t do that,’” he says. “But one of the biggest problems in community banking today is a fear of risk. We’re in the risk business. If there were no risk, there would be no banks.”
He argues that the pandemic helped community banks by prodding them to be more creative. “With COVID, bankers had to say, ‘How am I going to serve a customer who can’t come into a branch?’” he says. Often, these bankers rose to the occasion by employing tech solutions or other innovative approaches. Community banks should embrace this future-forward approach proactively, not reactively.
6. Use technology to drive down costs
In an environment where there are pressures to raise deposit rates, improving efficiencies becomes more critical than ever, says Mark Few, senior vice president at $330 million-asset First State Bank of Burnet. His Texas-based community bank is therefore considering implementing robotic process automation (RPA) to complete repetitive tasks more easily and quickly.
As an example of a banking task suited to RPA, Few cites checking an appropriate box on a computer system when a customer signs up for electronic banking statements. By automating processes like this one, he says, “you could look at reducing one or two full-time employees—or even a whole department—depending on what it is you’re trying to automate.”
Adkins agrees that using technology to streamline backroom processes is a golden opportunity that’s not always seized. “I can visit my clients,” he says, “and I still see paper forms all over the place when things could be done digitally. Community banks need to take advantage of the digitalization of banking operations.”
7. Invest in tomorrow’s talent
“You don’t go to school to learn how to become head of deposit operations. That’s a position you learn on the job, over years,” says Martin F. Connors, Jr., president and CEO of $850 million-asset Rollstone Bank & Trust in Fitchburg, Mass. His point, one echoed by several community bankers and financial service consultants, is that talent is something banks need to cultivate today so they are prepared for future challenges.
Recruiting is easier in some regions than others. Connors notes that in Fitchburg, 40 miles west of Boston, he’s competing against Fidelity Investments and MFS on the financial services side, as well as a thriving high-tech corridor. “We’re all competing for the same people, and a lot of the younger people want to live in Boston, so attracting young talent is a challenge,” he says.
Crowe’s Grottke points that the “graying of community bankers” exacerbates the talent shortage—and can make it difficult to increase profitability by taking advantage of growth areas like commercial lending. He advises bankers to hire and actively develop junior lenders, even ones who don’t seem “ready,” to replace the cadre of older lenders on the verge of retirement.
Adkins agrees, suggesting bankers experiment when it comes to harnessing young, tech-savvy talent. He would, for example, love to see a community bank budget for an ad hoc think tank consisting of two or three smart college students with finance or tech majors by giving a mandate to dream big.
“The graying of the industry is a big problem for community banks,” says Adkins. “My advice is to bring in young people and give them a wide berth.”
8. Forge partnerships, especially with fintechs
“All the interesting, customer-facing innovation that we see—all the fun stuff in banking—is coming from technology,” observes Adkins. He worries that too many community banks are watching from the sidelines, rather than forging the types of partnerships that can help them operate in unexpected and innovative ways.
Reynolds concurs and urges community bankers to begin thinking differently by retiring stale ideas about budgeting.
“You can look at spending on technology on the expense line,” concludes Reynolds, “but the way many community bankers are looking at it is as an investment that’s going to take off.” For community banks that are thinking that, it’s an investment more than worth making.
Pandemic fallout: No end in sight
When designing an operating budget, one obstacle is the unpredictability of the COVID-19 virus.
“Managing people through COVID has been a real challenge,” says Martin F. Connors, Jr., president and CEO of Rollstone Bank & Trust in Fitchburg, Mass. “I’ve lost track of how many cases we’ve had. If you average five people to a retail branch and one person has COVID, then the other four need to quarantine.”
Thomas Grottke, managing director at Crowe LLP, makes a similar point. With recovery from the pandemic so erratic, he says community bankers are finding it tricky to determine the fate of branches—or even decide how many new employees to bring on board—because there are still so many unknowns.
For instance, he says, commercial lenders are contending with the aftershocks of the pandemic, especially in urban markets where a high percentage of office space remains unoccupied. At the same time, lenders are seeing changes in demographics, he says, as rural areas like Berkshire County, Mass., are experiencing growth for the first time in many years.
Finally, Grottke maintains that “the fluid environment” is yet another reason for increasing hiring budgets for 2022 and 2023. “There’s always a risk of sickness, and any bank could be down people,” he says. “This isn’t the time to operate under pressure on head counts.”
Staying profitable and secure by warding off IT risk
Russia’s war on Ukraine is creating several ripple effects, many of which are only now starting to become evident. One of these is a rise in fraud and ransomware, both of which tend to flourish in times of turmoil.
“Cybersecurity issues and risks, those can really trip you up,” acknowledges Andrew Pyles, CEO of Eclipse Bank in Louisville, Ky.
Thomas Grottke, managing director at Crowe LLP, agrees, noting that IT risk has escalated significantly in recent months and years. The issue has even forced ratings agencies like Standard & Poor’s and Fitch to take note, with Fitch praising coordination by banking regulators to address cyber risk as “a credit positive” in a December 2021 report.
To actively manage mushrooming IT risks, Grottke urges community bankers to budget for penetration testing and maintain strict controls over all banking practices. Given the environment, he concludes, it makes sense to pay for whatever compliance software and staff are necessary to keep catastrophe at bay.