Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

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Thomas Curley 0:13

All right, welcome to this episode of Ahead of the Curve: A Banker’s Podcast. I’m your host Thomas Curley and I’m here with Matt Anderson, Managing Director at Trepp. Matt’s a recognized leader in the banking industry and works closely with financial institutions, regulators, clients, and prospects to identify emerging market needs in order to grow Trepp’s financial institution analytic and forecasting tools.

We also have repeat guest Rob Newberry on today to join Matt. Rob is a Senior Advisor on Abrigo’s Advisory Services team and is a current faculty member at the Graduate School of Banking at the University of Wisconsin-Madison. And over the last ten years he’s been super focused on working with financial institution leaders and regulators to develop a suite of credit administration tools for financial institutions. So, we are excited to have both of them on today to talk about commercial real estate lending. So, thank you both so much for jumping in.

 

Matt Anderson 1:12

Thanks for having me.

 

Rob Newberry 1:13

Yeah, glad to be here Thomas.

 

Thomas Curley 1:15

So, let’s jump right in then, Matt I figure we would start with you. We have lots of financial institutions listening to this podcast and I’m sure top of mind for them is the state of the market. CRE lending I know is a pillar for many bank and credit union portfolios across the country, so I wanted to ask you, you know, how would you maybe describe the current CRE landscape as a whole from a global view but also maybe a little bit domestic as well?

 

Matt Anderson 1:43

Thanks Thomas. So yeah, we’re in a really strong position at the moment. The momentum for the last couple quarters has been quite strong. Interest rates are still low. They have been really low, but they’re on the rise so the concern I think for everybody in the market right now is maybe we’re at a transition point right now from a very low rate but strong growth environment to now a high rate and uncertain growth environment. So, it’s been great so far, but definitely some clouds on the horizon. High inflation and higher interest rates being, you know, among the top concerns and then clouding that outlook of course is the situation in Ukraine with war there and in the disruption in food markets globally and oil markets globally. Oil and food are both key components of inflation, so we’re in a very strange spot right now. It would be an awkward position even without war in Ukraine but that just complicates things even further and, you know, on the rising rate front it’s pretty much guaranteed that the Fed is going to raise rates at their next meeting.

Now the talk is of course around 50 basis points but that would still put the Fed funds rate, you know, .75 which is you know, not really that high in the scheme of things. So, it’s a big jump big single period jump but it’s not a big absolute jump from you know where rates have been in the past. Having said that, the market is already pricing in future increases according to how we unwind, you know, future expectations from the yield curve. Looks like the market is expecting about a 300-basis point increase over the next two years and, you know, the long-term rates have now gone over 3% so that the 10-year rate is right around 3%. That’s going to increase borrowing costs across the board.

 

Thomas Curley 4:15

Anything you’d add to that Rob?

 

Rob Newberry 4:18

Yeah, Matt I had one question. Do you think that the increase in rates and inflation has a positive or negative impact on the credit risk of existing commercial real estate? Right? So, if it costs more to build a new commercial real estate building how will that impact the market as we kind of look forward the next few years.

 

Matt Anderson 4:37

Yeah, that’s a great question. So, for floating rate borrowers, of course, higher interest rates are going to mean higher costs sort of in the near term when those rates readjust, reset they’ll be resetting to higher rates. So, their payments will be going up and as a result, you know, the debt service coverage ratio that’ll go down and that’s a that’s a key metric for you know credit risk. It’s one that we look at in our default and loss modeling. So that’ll for floating rate borrowers, and that’s about roughly half of the commercial real estate market is you know on fixed on floating rate debt you know, so for that segment of the market, the risks will go up pretty immediately. How high they’ll go up is the other you know part of that question. There’s probably a lot of capacity still among those borrowers to handle rate increases. I’m not sure if 300 basis points though would be that easy to you know to handle, you know, that’ll remain to be seen.

There’s another component of the interest rate or rising interest rates and that’s the impact on cap rates. So, when long-term rates go up, real estate underwriting so evaluations tends to be keyed to long-term rates so as those go up your cap rate expectations will go up as well and that’ll have a negative impact on prices. In the short run, there are kind of a couple potential negative impacts on credit risk. So, one just the debt service coverage ratio for floating rate borrowers and then for everybody the negative impact on valuations from higher cap rates. Interestingly though we recently put out a study where we took a look at the long-term impacts of higher inflation and higher interest rates. And perhaps not too surprisingly the longtime folks in the commercial real estate industry, commercial real estate does tend to have a positive correlation with inflation. So higher inflation leads to higher income higher rental income and in the long run that leads to higher valuations. So short term definitely, you know, a lot of risk but longer term for folks that can last the next couple of years and beyond, longer term those negative impacts will smooth out as a result of higher income.

 

Rob Newberry 7:47

Great okay.
Thomas Curley 7:49

And I know you mentioned a study Matt that y’all released and I know I try to do my best to keep up with all the blogs and data releases that Trepp has on a pretty consistent basis. Are there any, you know, reports or data releases recently that stuck out to you as far as certain verticals or sectors that performing better or worse in the commercial real estate area?

 

Matt Anderson 8:11

Um, yeah, excellent question. So, from a share you know performance numbers standpoint, sector wise of course lodging is still you know problematic from, you know, the covid impacts and there’s still some lasting impacts there. Although that’s been you know, tapering off, it’s not gone all the way. So, lodging took a big hit and it’s been coming back but still viewed as high risk. Retail has recovered a lot of ground, retail was also hit with higher delinquency and default rates, higher risk ratings for all the, you know, sort of usual reasons. At the other end of the spectrum, industrial was the darling of the pandemic and still is ah. Volume in the industrial space is probably two or three times what it was pre pandemic in terms of loan volume. It’s still, it’s sort of a not exactly a niche market but it’s a smaller segment dollar wise within the commercial real estate landscape just because, you know, tends to have lower per square foot valuations. So even a large warehouse you know isn’t necessarily going to be as expensive as a you know, mid-sized office building for example. But industrial was, you know, is still reaping the benefits and tailwinds from the pandemic. And then multifamily which, you know, there was a lot of handwringing about multifamily early on in the pandemic but really whatever forbearance that lenders had to extend for the first, you know, several months of the pandemic by the end of 2020 that was really tapering off and now there are only like a few loans here and there that I know of that that our clients have told us that still are getting still under some sort of forbearance. So multifamily is bounced back in a big way and of course rental increases are up strongly and in multifamily so the big question mark right now is the office sector. Office had, excuse me, office had done well through the pandemic partly as a result of long-term leases that are in place that even though office occupancy or physical occupancy had gone way down all the space was still, you know, leased out and the tenants were paying on those leases. But you know, occupancy still hasn’t bounced back in a huge way at least in the in most of the major urban locations. So, I’d say urban office is the big question mark right now. We’ve seen delinquency rates go up a little bit there, so it’s not for the bank loans that we survey the office delinquency rate is about 1.5%, that’s up from pre pandemic level of about 0.5%. So, it’s noticeably up from where it was, having said that you know in the in the great financial crisis those were you know much higher delinquency rates. Commercial real estate overall was at about a 10% peak delinquency or default rate. So, you know, office is nowhere near that at the moment but risk ratings are higher. Lenders, our bank clients in the major markets are keeping a close eye on their office loans. And then from a data point standpoint we did put together some data recently on the office market and we tallied an estimate of about 320 billion of office loans that are coming due in the next couple years. So, this in 2022 and 2023, that’s across the entire landscape. About half of that is bank lending and about half of that is non-bank lending, but still, that’s a big number. There’s currently, there’s plenty of liquidity and there has been plenty of liquidity to handle that but that’s a pretty big number at a time when everybody’s got lots more questions than answers about the future of office.

 

Rob Newberry 13:02

So, Matt would you see the potential for folks to try to change the business use of their space? So maybe moving it from office space to warehouse on the bottom floor to help with the vacancy rate.

 

Matt Anderson 13:22

Ah, yeah, that would that’s an excellent point. We have seen things like that happen in the past where if you go back to previous cycles like in the great financial crisis or even before that back to the early 90s you had cases where, you know, entire markets were really depressed and as a result, the building owners had to get creative and find different uses for those spaces. So, we have seen cases where, for example, office would be converted into residential of some sort or hotels for like multi-story office. You could do that sort of thing. So yeah, it would all depend on the location and physical parameters of the building itself. But I think you’re right, I think owners and lenders if they become owners of real estate, they’ll have to you know, get creative about some of those uses.

 

Thomas Curley 14:32

Shifting gears a bit. You know we’ve been walking through a little bit on the current landscape, but for some listeners I know some more practical tips and tricks when it comes to navigating these volatile times will be super helpful. So, Rob I wanted to start with you and see if maybe from your experience working with institutions if you’ve maybe seen a few common pitfalls amongst those that have you know a lot of CRE in their portfolio and what you would recommend staying clear of or preparing for in that circumstance.

 

Rob Newberry 15:02

Yeah. I think one of the things that people or financial institutions today have, I don’t want to say it’s a common pitfall but there’s a lot of liquidity in the bank market right now. So, they compete pretty heavily against each other for the few commercial real estate loans that are out there and so they might be underpricing the risk that they’re taking on. And so, if you have a commercial real estate I think it’s important to understand your pricing model and make sure that you are pricing in the risk that you’re taking and just not trying to fill your balance sheet full of loans because commercial real estate is the only one you can find out there. Does that make sense Thomas? So that’s one of the common pitfalls. The other one is just understanding, I think as Matt mentioned, there’s a lot of uncertainty in the market so making sure that you’re doing the appropriate stress testing at the transaction level when you’re underwriting the credit initially and then ongoing as we get some of these questions answered on, you know, how the market will perform. And some of these other things that there’s just a lot of unknowns on will people move back to office space, will they still work from home and we talked about do they change the main use of those spaces? So, there’s just a lot of unanswered questions yet that I think you have to be aware of in that you should be building stress test models around your commercial real estate portfolio to make sure that you’re not blindsided in two years if all of a sudden things start to go a little south on you.

 

Thomas Curley 16:39

And I know we’ve done a couple other presentations in the past too, I know another best practice that we’ve talked about, you know, is some of the specialization and getting more in the weeds and I think to the point that Matt was making earlier that I think there are certain sectors or segments that are a little bit more uncertain than others. Is that something that you would recommend for institutions to maybe focus on a certain area or smaller dollar amounts or something around something like that?

 

Rob Newberry 17:08

Yeah I would, you know, it’s like having a good stock portfolio Thomas. I think a good rule of thumb is to have some good diversification. Now there are some vectors that are performing or segments better than others, however, in the big scheme of things if you have a well-balanced portfolio, you’ll be better off. So, you don’t want to load up all on lodging obviously, but if you had a good mix of lodging and warehousing and industrial light manufacturing your overall portfolio will probably perform a little better than putting all your eggs in one basket. So once again, understanding that concentration risk is pretty important and if you have an opportunity to mitigate some of that concentration risk in the next few years as you’re kind of boarding new opportunities or things are refinancing take advantage of that to get a nice balanced CRE portfolio versus you know, sometimes just based on where the financial institution is you get some unintended concentrations and be aware of those as you’re booking your loans and moving forward for sure.

 

Matt Anderson 18:17

Yeah, and I’d add to that. Diversification is of some sort anyhow is definitely your friend because you never know, even the best performing sector right now could be next year’s you know worst performing sector. That happened. So, we’ve definitely seen it with some of our clients that went heavily into, you know, what seemed like really safe sectors and over the long term they really are only to be blindsided by some short-term hiccups in in particular markets or particular product types. So yeah, that can definitely happen. One comment I was going to make about potential pitfall for the kind of flip side of going for diversification, just be a bit careful about out of footprint lending. That tends to be something that the regulators tend to focus on quite a lot for good reason. If you’re lending outside of your geographic footprint, not that you can’t do it, but you just want to make sure that you’re dotting every I and crossing every t when you when you do that.

 

Rob Newberry 19:31

Yeah, and I could talk a minute about we call them participation loans in the community banking space and they probably have a little kind of a dirty word if I mentioned those back in 2009/10/11 because a lot of community financial institutions thought they bought a lot of their problems to mass point through probably trying to diversify but getting things outside their footprint. And there’s some simple common best practices on making sure you’re doing site reviews and doing the same due diligence you would a loan in your own territory. So, make sure you’re not treating it as an investment but actually as a loan and do the same due diligence. But there’s probably also a little extra making sure because it’s outside of your area, potentially outside of your area of expertise and lending in general but also out of your local market. So, you might not even know what’s going on in that geographic area so doing some site visits and doing your checking is critical if you do decide to do participation loans. And Matt I do see that as probably an opportunity because there’s a lot of liquidity and not a lot of loans in certain areas. And so one of the ways to solve that problem is to do participation loans and making sure you understand what you’re getting into will be a key for that.

 

Thomas Curley 20:51

On a slightly different note, but I know one best practice that we’ve talked about in the past is around just management reporting. Matt are there any specific types of dashboards or risk assessments that you would maybe recommend for an institution that has a focus on CRE to make sure they’re understanding their portfolio as well as I need to?

 

Matt Anderson 21:13

Yeah, I think getting a good hand, I mean a lot of it’s pretty straightforward conceptually but then in practice ends up being more challenging. So, believe it or not just being able to summarize your portfolio and have a handle on, you know, where your portfolio is both geographically and property type wise. Maybe by vintage things like that being able to produce metrics on your portfolio at those different levels is meaningful and useful for management and your board to keep an eye on. Anytime you talk to your regulator you want to be able to impress them that you really know what’s going on both in your portfolio and then in your markets. So, once you have a good handle on what’s going on in your portfolio, then being able to expand that and look to your markets and have an idea of how your portfolio and its performance fits within the broader market. I think those are those are all useful things. And we’re getting a lot of questions from folks these days that are essentially trying to do that, so measure just the content of the portfolio, the performance of the portfolio, and then the risks, the forward-looking risks in the portfolio. If you can do that at all those different levels, I think you’re in good shape. Having said that, a lot of the big challenge that we come across these days seems to be around information and information systems. So, lot of banks believe it or not still really don’t have information systems that are up to snuff. There’s a lot of data that’s still in hard copy files somewhere, paper files or if not a paper file then a Pdf file. And really, you need to get it out into an accessible electronic format where you can do something with it.

 

Rob Newberry 23:35

Yeah Thomas, and I would probably add to what Matt’s talking about, you know, unfortunately a lot of community financial institutions still probably have segments a little higher probably at the call code level versus broken down even into the simple commercial segment or vectors that you might want to look at. So, adding some simple things like NAIS code and property address really make a big difference when you’re trying to segment your portfolio not only just for informational purposes and dashboard, but also as you look for CECL and other opportunities.

 

Thomas Curley 24:13

Well one last topic I wanted to hit on because I know it’s always of interest to our listeners is a regulatory perspective. And so I know we’ve already spent some time discussing the markets and best practices, but for financial institutions with high CRE concentrations or a good chunk of their portfolio, you know, what is expected of them right now? Anything different from the usual, Matt?

 

Matt Anderson 24:35

Well really some of what we just alluded to a minute ago about, you know, having a good handle on your portfolio where it is and how it’s performing. That’s certainly part of that, you know, information push that you’re going to get or request you’ll get from your regulator. And then yes as far as stress testing goes, being able to do reasonably rigorous stress testing on your portfolio. That’s going to be a pretty key thing. If you can go down to the loan level and stress at that level then that’s great, otherwise, we’ve seen institutions that will aggregate like loans together and then you know handle their stress testing at that level. That works too. So, you could bundle your you know Houston industrial properties together and take a look at how they’re performing or your, you know, Miami multifamily properties and look at things that way. That works but definitely if you can run your portfolio through the scenarios that the regulators provide for the large banks that tends to be a not exactly a requirement but it’s a bit of an expectation at the regulator level for when they go and do an exam for banks with concentrations.

 

Thomas Curley 26:14

Makes sense. One other topic I know we discussed a little bit before our call today around regulatory expectations, Matt I think you’re the one that brought it up but just saying you were hearing more about climate or environmental risk from the regulatory perspective. You think that ties in a little bit to our CRE conversation today?

 

Matt Anderson 26:32

Yeah, absolutely. So, we’ve started to hear from some of our bank clients that the regulators are asking them pointed questions along the lines of stress testing now instead of just outright expected loss figures under different scenarios. They’re asking more open-ended questions about environmental or climate risk and so they’re asking the banks basically to come back to them and take their portfolio and, you know, define to the regulator where the environmental risks or climate risks in their portfolio are. And then step two of course will be, okay so you know what are you doing to mitigate those risks? It’s good and bad that the regulators are asking at this point pretty open-ended questions. So, the good part of that is that if you can define or craft your own response as long as you’re basically you know covering the content of the question, which is just to say something about your environmental exposure or your exposure to climate risk, then it’s really up to you to figure that out and report it back to the regulator. The downside of that is, of course, then you have to figure it out. But folks out there have started to, you know, make an effort at doing that sort of thing and I’ve seen some creative responses already to, you know, trying to assess the risk in the first place and then say something about what it what it looks like going forward. Just one thing to add on the stress testing front, so there is a sort of intersection between climate risk and stress testing. Some of our clients have been asking for climate risk scenarios for doing the stress testing. So, the idea being, okay there’s a, you know, climate impact of x or y for these different markets, then how does that translate into stress testing type impacts. And so that’s something that we’ve also been exploring recently with some of our clients.

 

Rob Newberry 29:11

Yeah Thomas, and I would add that I love the concept that Matt just talked about on the on the back end on the portfolio. But I also love pulling it forward into the initial risk assessment when you’re underwriting the deal upfront, so understanding upfront how you would classify the environmental risk is one of the major items underlying the total risk along with cash flow, LTV value, and you know understanding that environmental risk will be key I think as we continue to go in the future on commercial real estate and some of the issues we might have with climate issues.

 

Thomas Curley 29:48

Yep, good points and all things to keep an eye out for. Looking at time here I wanted to go ahead and start wrapping up our conversation. Matt I’ll start with you and then Rob feel free to jump in but if our listeners take anything away from our conversation today, maybe, what would be your one or two items you want to leave them with?

 

Matt Anderson 30:11

Yeah, I suppose just reflecting on the last few minutes of what we’ve talked about, you know, we are really at an interesting point or problematic point for the markets overall. So, conditions are really good at the moment or have been good. Loan performance overall is quite good, but I am concerned about the impact of higher interest rates, higher inflation, to really how we’ll you know deal with that will be, that’ll help define the markets over the next, you know, twelve to twenty-four months and even beyond. At the same time, you know, that does kind of plug into our discussion around information systems, dashboards, and stress testing so to the extent that you can model those higher interest rates and the impacts they’re going to have, that’s an important feature of what I think real estate lenders out there right now should be doing on their portfolio. And I liked Rob’s point about making new loans, any new loans that you’re making you want to factor in higher interest rates for sure as a feature of the future landscape and make sure that they can handle those higher rates moving forward.

 

Rob Newberry 31:40

Yeah Thomas, the only thing I was going to add to that was don’t be afraid to do commercial loans right now, commercial real estate loans. So even though there’s uncertainty, here’s still opportunity. You probably make more net interest margin spread on a CRE loan than you would on an investment right now. So don’t be afraid to do it just because there’s uncertainty in the market.

 

Thomas Curley 32:00

For those that are new listeners or maybe haven’t subscribed yet, you can find this podcast in future episodes on abrigo.com or you can find it on your favorite podcast app or platform, just search Ahead of the Curve: A Banker’s Podcast or simply search Abrigo. It’s a little bit shorter. Thanks so much for listening and we’ll be back again with you soon with our next episode and I just want to thank both Matt and Rob so much for their time and insights today. We sure do appreciate it.

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Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

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Thomas Curley 0:11

Welcome to this episode of Ahead of the Curve: A Banker’s Podcast. I’m your host Thomas Curley and I am here with Zach Englert today, who is a consultant with the Abrigo Advisory Services team. He helps provide institutions with real time solutions in the form of credit risk management strategies and regulatory compliance. He is a common speaker on webinars here at Abrigo and with other associations, as well as conferences, covering current events and the impact on financial institutions portfolios. And recently he has been laser focused on stress testing which is why I’m so excited to have him on today. So welcome to the podcast Zach happy to have you on.

 

Zach Englert 0:54

Thanks Thomas, super excited to be here.

 

Thomas Curley 0:57

Awesome! Well, I’m excited and so let’s go ahead and just jump in here. You know financial institutions, banks and credit unions are facing a lot of uncertainty right now and I’m sure we’ll get into some of those specifics there, but just with the overall economic environment currently. I know that you have some thoughts specifically on how stress testing can be a huge help but I thought a good thing to start off with might be really defining stress testing and maybe diving into what is required as far as regulatory perspective and then maybe what are some more prudent things institutions should be doing on the flip side.

 

Zach Englert 1:36

Yeah, thanks Thomas. A few different things to think about when we’re talking about stress testing. The first being is what type of stress testing are we going to be doing because we throw out the word stress testing fairly often. And depending on where you are at a financial institution, depending on what stage of an economic cycle you may be in, it may have different meanings. The idea of stress testing is essentially taking your current economic situation in your current business model and saying what happens if we change some of the variables that you’re facing. Whether to the upside or the downside.

So, some of the types of stress testing we may be looking at would be credit stress testing, where we’re stressing individual loan level cash flows and collateral values to see what happens to that individual credit if we are changing those specific variables. So essentially will the borrower be able to make payments or will the class or be able to cover any remaining debt should something go wrong? We also deal with a lot of capital stress testing, which is essentially is the financial institution still well capitalized in a stress scenario? So, in that scenario we’re going to be stressing the financial statements, we’re going to be stressing the loan level losses, and essentially say if this institution begins to have losses, do they have enough money? Do they have enough capital in that rainy day fund to be able to cover that? And last but not least we also have liquidity stress testing, which is essentially saying, can a financial institution meet its obligations during a stressed environment? Banks and credit unions, they have bills to pay. They have deposits that they need to be able to make sure that they’re able to cover in the event that there is a run on that cash basis. As well as they may also have the capability where loans are currently having a lower and lower yield and they’re not able to adequately make enough money to stay in existence. So, there’s all these different types of stress testing and really what we’re looking for from the advisory side or from the supervisory existence and guidance is we’re saying, can you make payments in these stress scenarios? Can your institution still have enough capital to be able to cover that information or to cover those obligations?

So, there’s a lot of different ways that you can approach it and auditors, regulators, what they’re really looking for is, “are the scenarios actually providing a reasonable expectation of potential losses or are you just making up some numbers?” Some of the things that they should be looking for are, are the stress scenarios going to be identifying key financial institution vulnerabilities? Is it going to have a reasonable impact on the stressed events as well as is this going to have a adverse impact on earnings, loan loss reserves, or different areas of capital. And those stress tests should be evaluated pretty consistently so that an institution can maintain appropriate capital that is in line with its overall risk profile. So covered quite a bit there, but that’s kind of a high-level overview of what is stress testing and why are we supposed to be doing it.

 

Thomas Curley 4:40

Great, that makes sense and I know there’s, you know, a fair amount of OCC bulletins and FED statements and I also saw some hypothetical scenarios from the FED, OCC, and FDIC recently. How should institutions take some of those recent statements and incorporate that into their thinking of stress testing?

 

Zach Englert 5:02

So, one of the things that I would highlight is in 2012 there was a plethora of community bank stress testing guidance. A lot of that information came in line with DFAST, which is no longer applicable to institutions under 250 billion in total assets. But the main components of that are still appropriate for institutions who have strong risk management capabilities as well as are participating in a capital planning process. So, what I would highlight is from the 2012 supervisory insights for stress testing at community banks, they highlight that the strategic value of stress testing may be greatest during the expansionary phase of business cycles. During times when losses are minimal and property values are rising, stress testing assessments of riskier assets in concentrated positions can help management anticipate potential risk. Well, I’ll pause there and highlight Thomas that luckily, we’re not seeing anything remotely like that right now. Definitely not seeing an expansionary phase of the business cycle, definitely not seeing rising asset prices, and definitely not seeing concentrated areas where there may be additional risk. So, one of the things that we’re encouraged to do is make sure that we identify that risk and essentially identify, can we cover in the event that we may have some issues there?

 

Thomas Curley 6:21

Yeah well, you’ve alluded to some of the, kind of, economic turmoil that we’ve got going on right now. Let’s maybe talk about a couple of those things and maybe why stress testing specifically is something that institutions could turn to as an opportunity to help their institution out.

 

Zach Englert 6:40

So, in 2019 we started taking a focus on stress testing because a lot of the institutions we work with are in a allowance-related capacity, we are heavily involved in building the CECL models. And during that time period again, in an expansionary phase, we were saying what could go wrong in the future? And we had incredibly low unemployment and there was a lot of liquidity in the markets. We saw a lot of cash free flowing to different areas, whether that was real estate investments, commercial real estate, or equities such as stocks. Then 2020 happened and no one saw a black swan-esque event like the pandemic. And there was a lot of fear in a lot of institutions saying what is going to happen going forward?

Now ultimately, we saw a significant amount of fiscal support come in from the federal government that staved off or a lot of institutions believe, delayed the charge off activity that they would have expected in an event like that. So, we had some institutions say, hey how can we begin stress testing to make sure that we can keep a finger on the pulse on what that may look like? And as the pandemic slowly continued to develop, as people got a better understanding of what was going to happen from an economic situation, I feel like stress testing started to get pushed to the wayside because we saw a reopening, we saw that cash flow startup again, and we saw a lot of borrowers begin to continue to spend to continue to invest. And then we saw a war break out in Eastern Europe and so we have some of these events that were continuing to compound on these unexpected scenarios at a macroeconomic world level that’s having material impacts here in the United States. We’ve seen significant increases in food prices. We’ve seen significant increases in oil prices and that’s going to push discretionary income for a lot of borrowers lower. We’re also seeing some macroeconomic changes in terms of the work situation; we’re seeing huge increases in work from home. That’s going to change how commercial real estate is valued especially as 2023 is going to see the largest rollover rate for renewals of commercial real estate in United States history. So, there’s a lot of these macroeconomic happenings that are fundamentally changing how we manage risk, how we do business, and to have the capability to be able to evaluate that and see what that impact could be I think is going to be super important for these institutions.

 

Thomas Curley 9:09

Gotcha, that makes sense. And you’ve kind of in some of the other answers already alluded to some of the questions that institutions can solve using stress testing. But I guess probably the bigger question is, you know, what is holding institutions back from stress testing? So, you mentioned in 2019 it started to pop up a little bit more and then we kind of put it on the wayside again. Like what are some of those difficulties that folks are running into?

 

Zach Englert 9:35

Some of that is going to be data management in terms of do we have the data to accurately provide stress tests. So, a lot of institutions like to run commercial real estate stress tests leveraging net operating income, leveraging debt-to-service coverage ratios, loan to value ratios and they may not be pulling that information into a single aggregate place. So, if an institution has debt-to-service coverage information, but it’s on their lending platform and they do all of their loan analytics on their loan analytics platform, they’re going to see disjointed data coming from that effort. And it can be very time consuming to pull all of that out into various excel templates or other software and try and build those reports. In alignment with that we also have the supervisory guidance saying you need to be doing stress testing. You need to be stress testing these individual items, but they don’t really offer a lot more depth associated with that. So essentially an institution can run a stress test, they can get results but they don’t really know are those results good? Are those results bad? If you are very well capitalized today at a let’s say a 15% tier 1 capital leverage ratio, which for those of you who are listening and may be unfamiliar kind of with some of those standards or benchmarks or what we may be looking at there; a slap on the risk level I would say is 8%. So, institutions are very well capitalized right now and a lot of those institutions are then stressing and getting 10%, 12% as their severely adverse scenario and, it’s kind of looking, it’s like well we stress tested but we’re still incredibly comfortable. Are we okay? And we haven’t seen regulators come out and give everyone a firm thumbs up on what that may look like. So, we’ve got this idea of, hey we may have mixed data on one side, we may have mixed results on the other side. So how can we get a firm understanding of what is good and what is bad?

And for the data side I think you’re going to have the instance of garbage in garbage out. So, if you can focus on what that process is going to look like and how to get to that good end goal, just make that process repeatable. I would say the same thing on the actual results where you say is this good, is this bad? The first thing is, it repeatable? If it’s repeatable and you can consistently get to really good results, I would say that you’re in a really good spot and that’s highly defendable compared to what you may see previously where, hey one stress tests were really good, one stress test were really bad. But if it’s consistent then you’re going to develop a process that’s going to be very comfortable for your institution to be able to defend. The other thing is if you’re getting really really good results, what we like to do with our clients is build out a break the bank scenario or break the credit union scenario where we’re saying what needs to happen for us to no longer be able to meet capital level requirements. And if you document that out and you showcase, hey we have to drop capital levels by 7 or 8%, then in most cases that’s relatively unrealistic scenario, but from the past three years I hesitate to say unrealistic scenario due to the fact we’ve had a number of those actually occur. But when you’re looking at that information it’s super important to be able to look at that and say what would need to happen and if your scenario happening is we need to see a 50% reduction in commercial real estate values or we need to see a 30% reduction in business cash flows, then you can pretty reasonably say to your regulators that we’re in a very comfortable position from a capital perspective. And to be able to have that document to prove that outputs them in an excellent place because a lot of institutions don’t have that recurring process in place today.

 

Thomas Curley 13:22

Gotcha that’s cool. You wonder how many folks, if they had that in place pre-2019, if they had any of the scenarios hit by chance.

 

Zach Englert 13:31

That’s one of those things that it’s better to have it and not need it than needed and not have it. Like an insurance policy, like contingency planning I’d prefer to know what’s going to happen in the disaster versus have to figure it out as we go along.

 

Thomas Curley 13:46

For sure and before we kind of move on to some other questions we’ve got, you know, does this change a lot by asset size in your experience as far as some of the challenges kind of across the board.

 

Zach Englert 14:00

Very much so. And some of that is going to be data related, some of it is going to be supervisory guidance related. Prior to 2018 institutions over 10 billion in current assets had to comply with DFAST and those were relatively strict reporting requirements associated with stress testing capabilities. So, institutions that were approaching 10 billion or over 10 billion in 2018 are fairly familiar with how to develop a really strong stress test. Whereas the majority of institutions in the United States at the credit union and bank level are sub 10 billion in total assets and they’re being told you need to stress test. But again, back to my earlier statement, they’re not necessarily being told what are good results, what are bad results especially if you’re not even close to the regulatory minimums. So, in those scenarios what I would highlight is you’re generally seeing below about 500 million in total assets, a simple stress loss rate scenario is more than sufficient to meet regulatory expectations. Once you start approaching about a billion in total assets 1 to 2 billion, you’re going to see something where you may want to see multiple scenarios in place and if you have a CRE, land, or construction concentration. The expectation is most likely going to be that they would expect to see some form of loan level stress test as well as that top down or loss rate stress test and over 2 billion in total assets in alignment with a lot of other type of banking activities. Generally, at that asset size you’re going to start seeing those expectations change and get a little bit more stringent. Now I would highlight that that expectation is totally dependent on your regulator, whether that’s a state regulator, whether that’s OCC or FDIC. So, there’s a lot of variables, whether that’s geographic or otherwise but from a general guidance perspective I would say those breakouts that I just highlighted would be a good starting place if you’re looking how can I get started in stress testing today.

 

Thomas Curley 15:58

Gotcha. Yeah, that’s helpful for even me visually to kind of break out kind of the different areas and like you say they’re good starting points. And I think that’s a nice lead into kind of our next set of questions where, you know, we’ve talked a fair amount about the why and why it’s so important and why it can be helpful to conduct stress testing on a more consistent basis. But we’ve probably got folks listening that this is, you know, they don’t do it very often or they’re trying to get in more of a routine or repetition kind of what you were saying as far as making it a very repeatable process. How can an institution really get started? Where are some of the areas where that can be helpful for them?

 

Zach Englert 16:36

For an institution that has a CRE concentration or very material portfolio, they have a material construction or farmland portfolio as well, I think that the easiest place to get started is with that loan level or bottom-up stress test. And that’s something that depending on how they build it they should be able to run on a quarterly basis. And the idea there is, do you need to stress every single commercial real estate loan? Probably not, but just being able to identify your top 10 largest or your top 10 borrower relationships is something that you should be able to stress on a recurring basis. And if you are applying the same methodology and the same input on a quarterly basis, building that out should not be difficult to update because you’re just going to be rolling forward the inputs into the model. You’re going to be rolling for the balances if you’ve got updated financial statements, you’ll be uploading that info. If you want to apply a simplifying assumption such as property values going up or down by 5% from where they were last quarter, 5% over a quarter is probably a little aggressive, but we’ll say maybe 1% quarter over a quarter. But to be able to develop that out, then I think that you’re going to see a really strong risk management culture be built up simply because you’re performing that on a quarterly basis and it’s a starting point. And as your institution grows, as your lending limits change over time it’s very easy to step that up from the top 10 largest relationships to the top 20. Or to take that process and automate it utilizing software and do all of your CRE loans. There’s a lot of different ways that you can build that out.

From a capital perspective if you’re not doing so today simply starting with a stress loss rate scenario, applying it to the whole institution even if you’re looking at it from a regulatory check the box exercise is a huge step forward from doing nothing. And a lot of institutions are saying hey, because we haven’t started, because we haven’t been told to do anything, we can comfortably continue to not do anything. I think just starting puts you in a really strong spot to edit because the really difficult part is having to create the stress test. But there’s enough material out there to be able to build one and then edit and once you start doing it on a recurring basis it’s a lot easier to make adjustments to be able to say hey instead of doing it once a year, I’m gonna do this twice a year, semiannually, as opposed to just annually. Or if I want to do it more often I can change my stressors to where my severely adverse, which may not have been that bad, I can crank those numbers up and you can really see that impact in a real time scenario as opposed to me asking the question hey Thomas what happens to the hotel on the corner if their vacancy rates drop by 10%? You’re going to look at me, I’m going to look at you and we’re both going to say I don’t know. Well already just saying that out loud, you can see how valuable that information may be if you can go and immediately plug that into the model and see the impact on not only that individual loan, but if that’s a material relationship what’s the impact to your financial institution. And that’s a lot of information that may be not beneficial if it takes you 7 hours to do it. But if it can take you 3 minutes to find out that answer then that’s a lot of powerful information to have at your fingertips.

 

Thomas Curley 19:53

For sure, like you said it’s always good to have the information, be able to pull it if you need it as opposed to having to spend all the time or not even know how to go about it. So that’s a great, that’s a great point. Are there some common mistakes or say lessons learned in your experience you’ve seen where folks start to, kind of, build this out and maybe there’s a chance for us to give them a heads up before they start diving in there?

 

Zach Englert 20:16

Yeah, so a lot of institutions they may have their allowance modeling being done by their accounting or finance team and their stress testing is done by their credit team or vice versa. And then somewhere else in the institution you may have someone performing the strategic planning exercise with their asset liability management model. Well, all three of these models are forward looking. The ALM model is going to be used for budgeting purposes, for capital planning purposes. Generally speaking, in capital planning you’re also going to have stress testing. So, institutions normally are doing all three of these exercises in some capacity even if it’s a simple spreadsheet model for one of them or if it’s a robust third -party software model that they’ve built and worked with the team to be able to utilize. If those 3 models are telling very different stories, then when you’re presenting that information whether to auditors or regulators, you’re going to have some probably nitpicky responses where hey why aren’t these things talking to one another or why are these not in alignment with one another. Your baseline stress test in theory should be what you expect to happen with probably a little bit more stress loss rates. Your allowance model should say this is what we expect to happen and your asset liability management model should be what you expect to happen if you have three different forecasts with three different expectations of what you’re gonna, you expect to happen. Generally speaking, it points to a lot of errors in all three models.

So, the idea there is because we have these forward-looking scenarios, let’s make sure that they line up with one another and again, it’s a lot easier to edit than it is to create. You can pull over some of that allowance modeling and stress testing. You can pull over some of your stress loss rates into your asset liability management modeling when you’re saying what do we expect to happen in the event that interest rates rise. Right now, we’re expecting as much as another two-hundred basis points of interest rate rises this calendar year. And if that were to occur you’d want to know what’s the impact of that on my portfolio and if we coincide that with a stressed loss rate environment, again just more powerful information and a lot of institutions aren’t taking advantage of today because they’re having three separate teams or three separate individuals running their models their own way instead of having those talk to one another and all.

 

Thomas Curley 22:47

Gotcha. Sounds like a classic example of work smarter, not harder if you can get all three of those complicated exercises to use some of the same inputs then you should be in good shape.

 

Zach Englert 22:57

Very much. So.

 

Thomas Curley 22:59

Well, you’ve alluded to and you were just talking a little about asset liability and CECL and we even talked about way back, you know, credit on the credit side. What are some of the use cases for the results? So, let’s say we get everything aligned and they’re kind of telling the same story, you know, what are some of the results that they institutions can look forward to having and kind of helping grow and manage the institution moving forward?

 

Zach Englert 23:25

So, one of the things that came out in 2018 and has been pushed back just a little bit is an article discussing, essentially, what are you supposed to be doing for CECL and stress testing in the future? And the Federal Reserve came out and they said that you should be leveraging your CECL model results or a forward-looking life of loan model for stress testing after you adopt CECL. So instead of saying hey we’re going to have a completely separate model, let’s just use our CECL model and then we’ll ramp up those variable factors. So, if you’re leveraging a probability of default model and you have your probability of default tied out to an economic indicator, let’s use unemployment for an example because a lot of our institutions are leveraging unemployment. And we see unemployment start to hit a worst case scenario such as the severely adverse scenario provided by the Federal Reserve and we say that we think that the next four quarters is going to be 7.1%, 9.0%, 9.4%, and 10% unemployment rate you would expect that to have a higher loss rate in a stress scenario than what you’re experiencing today. We also probably are going to see prepayments slow during that point in time because again, we’re having higher interest rates in the future. So, if we have higher interest rates that means people aren’t going to be refinancing as actively, so we’re going to slow that refi activity, slowing prepayments so loans are on our books longer. We also have a higher probability of default due to the higher unemployment rate, so there’s two different factors there that are increased risk and because of that we would expect to see higher levels of charge off. All I did for that scenario is I took a CECL model which we’ve documented pretty aggressively and then we’ve applied that same logic into our stress testing scenario. And to back that up again I used information that was readily available from the Federal Reserve for my severe adverse scenario and from historical expectations associated with prepayment activity.

So instead of having to create something brand new for stress testing, copy paste edit, just like when you were in college, right? So sorry anyone out there, that’s not true. Sorry prior college professors. But that’s just an example that you can leverage, something that you’ve done really well and be able to leverage that going forward for other processes. You don’t have to recreate the wheel. You can just edit something and there’s enough information out there where you can get a lot of those forecasts and scenarios for free too.

 

Thomas Curley 26:04

As far as, so I think you just walked through a cool example of using up information from a bunch of different systems and places but it’s not that difficult once you can get the data in the same place. As far as some of those reports, you know, giving and showing the information and the results of those you know what departments or roles do you think would benefit greatly from maybe seeing more of this information on a you know quarterly or yearly basis?

 

Zach Englert 26:34

I am a big proponent of dashboard level reporting. So, if you are a credit manager whether that’s in the Chief Credit Officer role, Chief Risk Management role, or even the CEO who’s looking at a touch base, what is our exposure. Then having an updated capital ratio scenario and various stress scenarios is something that is super beneficial. Super easy, especially when you align that over the next nine quarters. So, you can take your ALM forecast and directly underneath that where it has those financials you can say this is our baseline adverse and severely adverse capital expectations should the same type of thing happen going forward. That’s something that all of those individuals can immediately look at and say hey this story checks out, we’re okay with this or hey maybe these numbers don’t look appropriate. What do we need to change to prevent this from occurring? Again, if we may have a insufficient capital or something along those lines.

The second component would be a very similar report but the top 10 relationships by borrower or balance size, in which case you’re looking and saying if something were to go wrong, and again you’d have those expectations such as a decline in collateral value or plausible decreases in cash flows. If that were to happen, what would we expect to see against those top 10 relationships? So, if our top hospitality client, maybe they have 1 to 5 different hotels, if we were to see vacancy rates increase substantially, again plausible decrease in cash flows. If we were to also see an interest rate increase 200 basis points and we were to see a decline in collateral value 30% reduction due to the reduced cash flows. If all of that were to happen, is that relationship still comfortable? Because most institutions, they have a lot of loans but they are going to have a smaller percentage of those loans for their material amount of holdings and if one- or two-multimillion-dollar seven figure loans go bad, I want to know about it. And the people who are actively pursuing strong risk management want to know those what if scenarios. As we’ve seen over the past three years, what if scenarios are starting to look a lot and lot more likely than they may have been in 2018/2019. So having a high-level capital overview and a high-level credit risk or loan level overview is something that is incredibly powerful for Chief Risk Officers, Chief Credit Officers, as well as anyone on the finance team as well.

 

Thomas Curley 29:14

And, you know, once we get, once institutions get those reports dashboards set up, in your experience working with clients over the last you know year or two, what are some of the actions that you’ve seen folks take to related to capital and strategic planning more often? Are there kind of some trends that you’ve seen there?

 

Zach Englert 29:38

Yes. The first thing I would highlight is the kind of end all be all statement of better credit risk management practices. And that’s something where you’re painting with a very broad brush to be able to say that you participate in strong credit risk management and a lot of institutions are super excited that they have strong credit risk management because they don’t have any losses. However, if no one has any losses does that mean that your institution has strong credit risk management culture or are we a part of a twelve yearlong economic expansionary environment and I’m inclined to believe that it’s the latter.

For institutions that have strong credit risk management culture, they’re able to proactively identify loans at risk and be able to observe them separately. Stress testing put you in a position to be able to actively look at those credits and see are they still comfortable in these stress scenarios, if not, what can we do today to prevent that having a material impact on capital or earnings? And being able to proactively identify when something’s going to affect your earnings is a really strong position to be in when you’re talking to board members or in the event, you’re a public entity talking to shareholders or stockholders because you’re able to say we saw this coming we prevented that. You can see when we’re looking at institutions in 2009 to 2012 that there was a significant difference in the institutions that had strong credit risk management. We had 140 institutions fail in 2009 and 157 in 2010. In 2021 and so far in 2022 there have been 0 institutions that have failed. So as such do we think that this is an event of strong credit risk management today or economic cycle? If we assume that it’s the economic cycle and I think, should we go through another recessionary environment the banks who are not only going to not fail but actually perform incredibly well are the ones who actually exemplified strong credit risk management. And they were able to proactively identify contingency planning as well as loans that need to be downgraded probably before we start seeing those signs of distress. Just to name a short summary of how institutions are using that.

 

Thomas Curley 31:56

No but I think that makes sense. I like putting it in a more historical perspective too and kind of looking at it that way. I think it’s to your point stronger credit risk management can mean a lot of different things to different people. All right let’s put you on the hot seat. If somebody jumped on here and maybe skipped to the very end because they just wanted to hear the summary, what would be the 3 big takeaways you have folks take away from our conversation today.

 

Zach Englert 32:24

The very first thing that I would highlight is if you are not stress testing today, and when I say not stress testing, I mean that you do not have a process in place that you are repeating on at a minimum an annual basis, that’s something that you should start. There is a lot of really great resources. The bare minimum I would do would be to go to the OCC.gov website, type in supervisory stress testing, and they have an example that you can copy paste and apply to your institution I think that that is incredibly simplistic, but at least it’ll give you the capability to say that you’re doing some form of stress testing. After you get through step one, so if you are already stress testing today, great, you’ve already checked the box. Way to go. But if you are not doing that, that would be step one.

The second step of that would be if you have multiple forward-looking models, if you are parallel testing for CECL, if you are live on CECL today, make sure that that model is speaking to your stress testing model. If you are budgeting financial statements on the asset liability management side, if you’re leveraging that data for capital planning, make sure that your stress testing model is speaking to that as well. So, we have all of these disjointed forward-looking models, make sure that they’re no longer disjointed. Make sure they’re all speaking to one another and you can carry that forward.

And last but not least make sure that you have an effective contingency plan. A contingency plan is not “that will never happen to me.” A lot of institutions approach any form of stress testing with that’s not reasonable, that’ll never happen. And in the same way that people say, “hey I’m never going to lose my job,” “I’m never going to default on a mortgage,” “never going to have x amount of credit card debt,” there’s a lot of coulda shoulda woulda. If you have a contingency plan in place, it’s just like an insurance policy that’s capable of being there even if you don’t need it. And is that going to take time? Is that going to take effort to build out? Yes, but in the event that it is needed it is going to pay off tenfold. So, let’s go ahead and make sure that we build out that contingency planning, should you have loans go bad, should you not hit earnings in the same way that you would expect. Again, just start building out strong credit risk management procedures and let’s make sure that we take it a step ahead of being able to say that and actually being able to show the efforts and results of what you’ve built previously. So those are my three things to take away if you just joined or if you made it all the way through.

 

Thomas Curley 34:54

And that folks is the truth about stress testing so no need to be stressed out at all when we’ve got Zach on the line with us. For those that are new listeners or haven’t subscribed yet, you can find this podcast and future episodes on https://www.abrigo.com/. You can also find it on your favorite podcast app or platform just search Ahead of the Curve: A Banker’s Podcast or simply Abrigo because it’s shorter. Thanks so much for listening and we hope to be back again with you soon and we just want to say a special thank you to Zach for joining us afternoon to get excited about stress testing.

 

Zach Englert 35:30

Thanks Thomas and thanks everyone who joined. Talk to you later.

 

~music interlude~

Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

~music interlude~

 

Thomas Curley 0:11

Welcome to our latest episode of Ahead of the Curve: A Banker’s Podcast. I’m your host Thomas Curley and I’m here with Terri Luttrell, Compliance and Engagement Director at Abrigo, and Kevin Gulledge, Senior Risk Management Consultant at Abrigo. Terri is CAMS audit certified and has 20 years in the banking industry. She’s worked in both medium and large institutions in the areas of compliance, fraud, commercial lending, and deposit operations. As an AML consultant, Terri has helped develop BSA and OFAC programs to ensure regulatory requirements are met and successfully managed at institutions across the country. Kevin brings over a decade of retail banking experience having worked with mid-size and large international institutions in a variety of roles including retail operations, compliance, and BSA/AML. Recently, Kevin has been working with institutions on best practices related to BSA/AML as well as calibrating and analyzing risk-based systems and working with BSA officers and regulators on both internal and external projects.

So welcome to the podcast y’all.

 

Kevin Gulledge 1:21

Thank you Thomas.

 

Terri Luttrell 1:22

Thank you Thomas, glad to be here.

 

Thomas Curley 1:24

Awesome. Well, it’s great to have you both on with, one, a fun topic but two a super important one as well. So I think we’ll hit both end of the spectrum there. I’m looking forward to the conversation. I did some research on cannabis related businesses and banking leading up to our call today. And one of the questions I initially had was, you know, what are the risk involved for financial institutions? But then I also started thinking about some of the potential growth opportunities it could present. So definitely both sides of the spectrum there. And I know we’ll get to both of those here in a second. But, before we dove in I thought it might be good to set the stage with some definitions that can maybe be commonly confused or might just need some clarification for our conversation moving forward today and kind of hemp verse marijuana. So Kevin I figured we’d start with you and maybe jump in and define those for us.

 

Kevin Gulledge 2:17

Sure. Yeah, so when we talk about hemp and marijuana, you know, there’s a legal definition that splits these two definitions. But let’s be clear whenever we talk about hemp and marijuana there’s really no difference when we talk about cannabis. Cannabis is the name of the plant, hemp and marijuana are just different flavors of the plant. So in the 2018 Farm Bill there was language in that bill that once passed, essentially legalized the production of hemp. And to legalize the production of hemp they needed to define what hemp was. And so if we look at a cannabis plant, let’s just start with a cannabis plant. If we look at a cannabis plant, there’s a lot of compounds and cannabinoids within the plant. And one of those compounds that you might have heard of is THC, tetra hydra cannabinol, I’m only going to say that once because it’s mouthful.

 

Terri Luttrell 3:16

Very good Kevin!

 

Kevin Gulledge 3:17

But THC, when we talk about hemp versus marijuana, hemp would be defined as the cannabis plant that has less than 0.3% THC in the plant. If it has more than 0.3% TCH it is considered marijuana, so just straight up seems a little arbitrary but that is how it is defined in in this current day and age. We’ll talk a little bit later about some of the nuances with this in terms of hemp and marijuana. We’ll talk about delta eight versus delta nine THC. I don’t want to throw too many terms at you right now, let’s just remember that for this definition cannabis is the name of the plant and hemp and marijuana are just different flavors. If it’s less than 0.3% THC it’s hemp, if it’s more than 0.3% THC it would be considered marijuana. Now you know Terri yeah, you know you can talk about some of the things that are happening at the state level. That’s one of the major things that we’ve seen at the federal level is that 2018 Farm Bill.

 

Terri Luttrell 4:23

Yeah, and thanks Kevin, I will talk about the state-specific things that you need to know. But being in the AML profession has led me to know a whole lot more about cannabis than I probably did even though I was a teenager in the 70s, so that is where our expertise comes from not from actual personal experience. I’ll lay that out there for you, but I’m going to address the state specific differently for the marijuana and the hemp. I’m going to start with the marijuana because that’s the trickiest one and the one with more risk. So as you know, at least half of the states now have some sort of legalization of marijuana. Many of them were just medicinal still but many of them and it’s coming on board more and more are the recreational. So we know that’s a factor. So can you provide lending services for marijuana related businesses? Well as Kevin said at the federal level marijuana is still illegal. It is substance one, just like heroin. It’s just there’s a risk there. For hemp, the Farm Bill did generally legalize that. So if you want to do some agricultural lending to the hemp business. your risk is much lower for that. The main thing you need to know whether you’re doing services for either of them is know your state laws. For hemp there has to be some state laws and licenses in place even though it’s federally legal so make sure that you know for hemp what’s going on, understand that your customers are in compliance with all of those regulations. For the states specific for marijuana you also need to know that very differently. You need to know your state’s laws, you need to know all of your state’s laws that are in your footprint. So all of your neighboring, they may be doing cross-border transactions. So it’s it’s a lot. The good news here is you can rely on the licensing boards for the states. Make sure their license are up to date, but they are regulated highly. So a lot of that, if you get documentation from the states, have your customers provide that enhanced due diligence documentation and then your risk is going to be lower. You don’t have to manage all of the knowledge of the state regulations.

 

Kevin Gulledge 6:38

Yeah, the 2018 Farm Bill I think, you know, is something that’s recognized nationally and it’s important to recognize that. But also at the same time drill into what’s going on with state laws. You know several years back now, a few years back, we had the beneficial ownership rules that have come down. These are still in play so in terms of capturing this information, you know, you’re still going to want to capture this information on these businesses and there’s always going to be risks involved with that and we’ll talk a little bit about the risks involved there. But with the 2018 Farm Bill legalizing hemp production, marijuana is still not, you know, even though we have all these state laws in place. So, critical to understanding state versus Farm Bill, Farm Bill versus state, vice versa, and making sure that we’ve got all those bases covered. And one last thing that I’ll leave there is to say if you’re currently using terms in your policies and procedures that say marijuana or hemp, it’s fine, I mean as long as you can define it and you’ve got different you know processes and policies for both. But it may just make more sense to move to the cannabis related business term and more of an umbrella term there. So, that’s one more thing I’d put in there about understanding the laws and just understanding your own internal, you know, policies, procedures, and program.

 

Terri Luttrell 7:53

Yeah, totally agree Kevin. And this seems to be the way we’re describing it, a little bit overwhelming, but it really isn’t. There are so many ways that you can learn besides what we’re just talking about today. I came from an AML background but didn’t really know much about cannabis until it started becoming a banking topic. So researching it, there’s so many free webinars out there today. That’s maybe one of the only good things about the pandemic, but sign up for those, learn them, learn the basics. Go to your state websites and find out what your state can do. Follow FINCEN’s guidance on marijuana, there’s lots of them. So the resources are there. Don’t think it’s over your head or too risky for you to take this endeavor. Later we will talk about the benefits of it and I am actually a proponent of cannabis banking. I think it can be done and mitigating the risk and I think it can be extremely profitable for the bank. So, I’m coming into this with an open mind and as you gain your knowledge I hope you can too.

 

Thomas Curley 8:54

Yeah, and Terry to your point you said, you know, you’re kind of a fan and you think that it can be used as a growth engine I think that’s a nice segue into kind of what we wanted to talk about kind of for this next section. You know what kinds of FIs are using cannabis right now as a growth opportunity?

 

Terri Luttrell 9:10

Interestingly, you’re saying growth opportunity. But and that’s the truth. It is a growth opportunity in more than one way, but surprisingly the smaller banks and credit unions have been the one to take the first step. And credit unions, you know, they’re member driven. They’re not in it for the profit. So they say, so we say, but they have been willing to take the risk and some of them have done it very very successfully. With the hemp legalization, it’s been a while now but it’s still taking a little bit longer just because of the risk and the risk of the unknown. So, when we’re talking about lending, probably hemp is going to be the first place you are going to be starting. You probably won’t start with the marijuana dispensary to make a loan. We will talk about the individual loans later, but the agricultural part is a great place to just tip your toes in this and see what you can do with your policies, procedures, get your examiners on board et cetera. But as we get more familiar with this and really if the federal government legalized marijuana there’s going to be so much interest in this. People are going to get on board, so from a competitive advantage it makes sense to research it now, get ready. Start with something littler, we’ll talk about the different risks in a straight dispensary versus some of the indirect. I think Kevin’s going to discuss that in a moment but it’s just not that that difficult. I think to try to get on the bandwagon, one thing I would keep in mind that we do have legislation. It’s called the Safe Banking Act relatively gives banking institutions a safe harbor if marijuana remains illegal. So, that’s very helpful for you to be able to say, okay, nobody’s going to come after me for money laundering because technically as long as marijuana is illegal you are money laundering. If you have proceeds from marijuana running through your federally insured bank, which is all of us. So, with that Safe Banking Act, if it ever does pass the senate and the congress approves it and it’s signed into law, that gives you that safe harbor. It has been stalled because a lot of people want just the flat legalization. They don’t think the safe harbor is enough, but come on Congress let’s do one step if you’re going to take forever to legalize marijuana and give the banks a chance.

 

Kevin Gulledge 11:35

And there are banks in this space. Banks are having success in this space as Terri’s mentioned. If you keep up with the SARS stats that the treasury and FINCEN put out, around 700 institutions are in this space and have been in this space really since the get-go. There was a little bit of an increase after the 2018 Farm Bill where we saw a little more institutions diving into this and being able to do it. But I’ve seen everything from the small one branch community operation up to the large multi-state, you know, hundreds of branches operations and everything in between have success with this. And it really depends on how far you’re willing to go and like Terri said maybe you dip a toe into some of this and with lending that’s generally the first place you’re going to do that. But you know some of the fee income from this can be astronomical. You know, a lot of these customers, these cannabis related businesses, they want to be in the banking system. So they’re willing to do whatever it takes to be in the banking system and if that means you pay a four figure a month fee, they’ll pay the four figure a month fee. It’s all about bringing this out of the shadows and into the light and the more we can do that the better off everyone will be. So, you know, institutions are in this space having success right now so why can’t you? And I think Terri, you know, raised those points very validly and, you know, just ask yourself why can’t we have success in this space? You know, there’s risks involved with everything, you know, are we willing to do what it takes to mitigate those risks? Sometimes you can point to this fee income and say, look you know if I can bank a few of these customers, make this fee income, well now I can afford to hire somebody else. So, it helps with staffing decisions and risk decisions down the road. So if you can get a leg up on your competitors I’m sure you would take any advantage you could get to get a leg up on your competitors and this is one of those areas that I think is rife for that. And cross-selling opportunities are going to be there, you know, with lending, with checking accounts, with savings accounts, with other things. You’ll have other opportunities. And perhaps even some really inventive products and services come out of this. I’ve seen banks get and credit unions get really creative with some of these things. So there’s opportunity there. There’s still a lot of green fields, green oceans out there so I would I would not discourage, you know, from thinking about this if it’s something where you think it’s in your risk appetite. Let’s explore those options.

 

Terri Luttrell 14:14

Yeah I totally agree Kevin and from the lending side just like any other loan, you should probably try to get your operating account, especially with a higher risk business so you can have your BSA team be watching the transactions, monitoring for that making sure there’s no illicit cash on top of the legitimate cash. So you can have the loan and origination fee if you normally would, but put it up because of the risk you have what Kevin was talking about the flat fee for your operating account plus account analysis. So there is so much opportunity for income in this space. I think Kevin really hit it on the head here.

 

Thomas Curley 14:54

And, you know, obviously Kevin alluded to, you know, whether you’re willing to take the risk or not. And that was kind of what we want to talk about next. Terri, what are some of those things that, you know, folks that get into the space or maybe that are thinking about starting a program around CRBs, what would you say to watch out for?

 

Terri Luttrell 15:16

Definitely cash. So cash is king here. This is very much a cash business until it’s federally legal, Most credit card companies are not jumping on board with the marijuana industry yet. But what to watch out for is the cartel money and these are real scenarios. The cartels especially in the western part of the United States, they’re finding legitimate marijuana dispensaries and other growing opportunities and they are forcing and coercing these legitimate business people to accept their dirty cash and run it through their businesses. So that is what’s so important about having your BSA team with your lending team. Y’all talk with each other and collaborate, but put the burden on BSA paid for by the fee income. They are going to have to balance that cash against two things, what they said was expected and what the state allows, you can’t just sell an unlimited amount of marijuana. So in each state will be different, so that you have to be able to know what’s expected based on state law and then if there’s an influx of cash you’re going to notice something’s wrong and your red flags are going to go up. That’s the biggest thing I think you need to watch out for because if your legitimate business gets caught, they have been money laundering whether they were coerced or not.

 

Kevin Gulledge 16:35

Totally agree with Terri. Totally agree, I think that when it gets into maybe not necessarily the agricultural aspect of this but when we start getting into the storefronts, the retail stores, and you know you could probably nowadays go down to Whole Foods and they’ve got CBD related products on the shelves. Well for your clients, where are those products coming from where are they being sourced from? Nowadays, there’s like I said there’s a lot of research going into the plants. You’re seeing a lot more compounds that are now being popularized, so you’re seeing things when we talked earlier about the definition of marijuana versus hemp we talked about the THC content of the cannabis plant. That’s technically delta nine THC. There is another compound within the plant called delta eight THC. Now this can be extracted from legal hemp plants, but how do you know that? Are you doing the site visits? Are you checking on these products? Again with state licenses, are you keeping up to date on that? You know there are there’s ways to extract CBD from a hemp plant or from a marijuana plant. So again, where are they being sourced from and it’s and it’s critical to understanding that. And again, you’re going to need to take, you know, them at their word right. I imagine you’d probably get a bunch of hands that would go up if you asked who wants to do a site visit and go try out these CBD products. I’m sure you’d get a lot of hands going up. But at the same time, it’s important to understand where those things are originating from. Are they originating from legal hemp plants depending upon maybe like the state of Texas doesn’t have you know the medical marijuana or the recreational marijuana like other states. So again, are we up to date on our state laws? Are we up to date on what products are truly legal and where are they sourced from? You know all of these are the risks involved with that and in turn you know we’ll talk about direct versus indirect care in just a moment, but I think that, you know, understanding the products and this goes for you know all your risky businesses right? You’re not just going to do this for hemp or marijuana, you’re going to want to do this for your liquor stores. You’re gonna want to do this for, you know, doctor offices, car dealerships things like that. Understanding source of funds. All that you’re going to be doing that for these businesses as well. So just critical to understanding, you know, where are these products coming from? Where are they making their money right?

 

Terri Luttrell 19:02

Yeah, one other thing I’ll add in here since we’re talking about the lending side of it is if you are in the grow lending, agricultural lending, maybe not, maybe marijuana if you’re that brave. Your loan collateral could literally go up in smoke if you are tested and you’re above that THC level that Kevin was talking about if you’re growing hemp. And that’s happening, so you really have to be in tune, get the lab reports from the customer that the state makes them do. It’s extremely important.

 

Thomas Curley 19:37

Terri how much does, I know we talked a little bit about it and you mentioned the western part of the United States, how much does an institution specific risk and where they are located affect maybe the opportunity this might present.

 

Terri Luttrell 19:51

Well, it’s just a matter of time. I mentioned western because Mexico is their border town and I’m I’m here in Texas, I see it as well, although we don’t have the legalization here yet. But in the northeast you have the cartels but you also have major crime organizations. Uou still have the Italians, you still have the Russians, you still have all kinds of different ethnic mobs that are into drug trafficking that are doing the same thing. So even though I said western as relating to that, that’s been in the news but assure yourself that it’s happening everywhere.

 

Thomas Curley 20:27

Well let’s go ahead and switch things up here for a minute. Kevin and Terri, I know we’ve alluded to kind of direct and indirect during our conversation already. Maybe we should, you know, level set and define that and maybe some of the different risk associated there. Kevin, do you want to jump in on the indirect side?

 

Kevin Gulledge 20:44

Yeah, direct versus indirect and, you know, we can look at this in different ways. So if we look at direct versus indirect, we’ll use some examples. So whenever we talk about direct versus indirect you know FINCEN and the Treasury, they’re helping to define this. You know, are you putting your hands on it?. Are you getting directly involved with the plant? Are you making the majority of your money from the plant? You know, that would be a direct relationship. An indirect relationship would be, just as an example, let’s say that you’re lending money to somebody who or an entity that owns a strip mall. Within the strip mall there’s a dispensary or within the strip mall there’s a CBD store, right? The CBD store is not paying the bank directly for rent or lease, they’re paying the landlord who then pays you. So that’s an indirect relationship and we’ll talk about some of the ways that you might want to look at these customers and risk-tiering. But, let’s just make that very simple. Direct or indirect. Director you’re in the plant, indirect it’s sort of indirect relationship with somebody who’s dealing with the plant. Terri did I miss anything on that?

 

Terri Luttrell 21:53

No I think that sounds good. Well the main reason of the distinction is the risk obviously. So you’ll need to decide as an institution, do you want to go with the direct? Do you want to do the plants, the growers, the dispensary, anyone who touches that funnel? Or maybe you want to start slower with some of the indirect. Maybe you just want that real estate strip center with the dispensary there or you can go as far as employees who work at dispensaries. They get their income from their jobs and they live in an apartment complex that you happen to be doing a loan for. Well that income is paying rent that goes to your loan. So yeah, the risk there is a little bit but what I suggest is doing a complete risk analysis on all of the direct versus indirect that you could possibly be providing services for and loans too. And then you can decide what your risk appetite is and drill down exactly what is the risk, what you’re going to do to mitigate that. Whether it’s staffing up, enhance due diligence, or working with your BSA team on the site visits to help you with all of that. That is what I would suggest is make sure that whatever you decide your board of directors is going to have to approve. It’s going to have to be in your policy, so they are the fiduciaries. They need to understand the risks as much as your research will lead you to understand.

 

Kevin Gulledge 23:23

I think all great points. You know, to further expand on the direct versus indirect, let’s think about it for just a second. Okay, so if somebody is a dispensary, they put their hands directly on the plant. If somebody is a grower or a distributor they put their hands directly on the plant. I’ve worked with Steve Kemmerling, he is a consultant, he doesn’t work for FINCEN or the Treasury. He has his own consulting firm, CRB Monitor and they’ve put together this risk tiering system. So this goes a little bit further beyond direct versus indirect. So direct again would still be somebody, they are a tier one sort of an entity. They put their hands on the plant, they’re making all of their money from the plant. This would be somebody that’s directly involved. They would be a tier one. Tier two and tier three is when we start to get into the indirect customers. So then it just becomes a question of are they working with a tier 1 cannabis business? Do they make the majority of their funds from a tier one cannabis business? So let me give an example. A marketing entity that creates marketing materials for cannabis businesses. Seventy-five percent of their business comes from cannabis, twenty-five from other entities. Well they’re making the majority of their funds from dispensaries, people that put their hands on the plant. They are an indirect business, although the majority of their funds are coming from a tier one. They’re still indirect because they’re not putting their hands on the plant but they could probably be considered the mid-level risk. And then we come down to a tier three which would again to use the same example, let’s say we have a marketing firm and twenty-five percent of their income comes from dispensaries the other seventy-five comes from other entities in other lines of business. So yes, making money from a tier one not making as much money as somebody who’s a tier two would be making from a tier one. But again, this just brings up questions of, how far do we risk matrix these customers? I could make the argument that the gas and the electric companies, you know, they’re giving you know electricity. They’re giving power. They’re giving, you know, heat to these customers that are growing cannabis. Is that the same? Is that, should I be considering my local utilities as an indirect tier three? Probably not, no I don’t think we need to go that far but it shows you how far we can go with some of these questions. So it’s critical that, yes, you make some risk decisions based off of this but at the same time we don’t want to get to the point where, you know, like does the does the utility company in this town provide electricity to these customers? How much of it? There’s questions that you’ll never be able to answer so it it becomes a question of how far do we go? How maximum do we start risk rating these customers? But the tier one, tier two, tier three, direct versus indirect that gives you some ideas there in terms of building out your policies and procedures. And again what terms are we using cannabis versus hemp versus marijuana. Let’s make sure we’re using the right terms. Get all of those documents updated, you know, with that risk tearing information. Now we’ve got a new process potentially for risk rating so that that can help with that risk rating process at account opening and through the ongoing process.

 

Terri Luttrell 26:47

Yeah, since we’re talking to a lending audience here most of the talk has been about business lending. Let’s talk about individual loans for a minute. You’ve got your car loans, you got your boats, and you got your mortgages. What about the people who do derive their income from the cannabis business? Will you be willing to take that risk to provide those personal loans as consumer loans? That is something for you to decide. It’s definitely not as risky as having a dispensary loan and having to monitor everything. But you do need to address that you will be providing individual loans possibly to people who derive their income from cannabis. That needs to be a risk your board of directors has approved in the policy because if you have made the decision, well we’re not going to lend to the cannabis industry but then this person that wants a car loan slips through the cracks your policy has a hole in it. So just be a little flexible in there and maybe the car loan person lies about where their income is, they don’t want to tell you where they work. Maybe you live in Texas and it’s not legal here and he works over in Oklahoma. Whatever so just know that you can say in your policy, we don’t knowingly provide lending services to cannabis related. And that way if they slip through the cracks and they haven’t told you the full truth about their source of income you’re okay. You catch it later, you address it at that time.

 

Kevin Gulledge 28:12

That’s a keyword there, knowingly. Knowingly. If you have that in there that helps. It’s a little catchall term, so just remember that one.

 

Thomas Curley 28:22

And before we jump to kind of our next you know topic you know Terri, Kevin do you feel like institutions are having or asking the right questions and are having the right conversations now as they think about this or do we think we’re we maybe in the pre-learning phase still.

 

Kevin Gulledge 28:39

That’s a great question. I think some folks are well ahead of the curve. I think some folks have been out in this space for years now. And how many years have we gone to ACAMS and this is, you know, the top topic at the at these meetings still to this day. So I think that if you can arm yourself with as much knowledge as possible like Terri said. Sign up for those webinars. You know we’ll host webinars, I’m going to be hosting a session on this at ThinkBIG, our conference, in a couple of months. So there are opportunities to learn more and I would just say soak it all in. Take in as much as you can. Talk to industry experts but there is definitely a learning curve here, there is no doubt about that. There is a learning curve here and some folks are, they are ahead of the curve. So it’s just matter of getting out there and learning really.

 

Thomas Curley 29:32

For sure. And I appreciate the podcast title plug early on Kevin, Ahead of the Curve or that’s what we’re attempting to do here right?

 

Kevin Gulledge 29:39

Ah, didn’t even notice I did that.

 

Thomas Curley 29:41

Well I know we’re running up on time here. You know ,Terri was there anything on enhanced due diligence that you thought was super important that we should bring up before we kind of closed it out here.?

 

Terri Luttrell 29:51

We have touched on most of it. But I’m going to stress again, site visits are a must. Kevin says everybody’s going to raise their hand and run out and want to go try the product. Whatever, that may be true, but just like if you have adult bars, bars and restaurants maybe with some adult entertainment, I’ve had banks provide services for these establishments but nobody’s willing to go to do a site visit with them. If you’re not willing to go into a dispensary yourself and you’re providing services. maybe that’s not the industry you should be in. You have to go yourself or send somebody who you trust to go see what that business is all about. Make sure it’s real. Make sure you don’t have armed guards that look like cartel people with AK rifles right there. It’s just something you have to do. Also know that you are gonna have to make those enhanced due diligence measures that are going to be costly. Probably additional staff, they have to be knowledgeable and that’s going to cost something. But you have your cost analysis because of your fee income, so you can definitely justify that.

 

Kevin Gulledge 31:01

State licensing. State laws. Understand what’s going on, especially if you’re multi-state and you know you’ve got a multi-state footprint. Make sure you understand those laws and licensing. So for those site visits make sure that we’re checking the right boxes and we’re getting the right documents from these folks. It’s going to be different sometimes from county to county, jurisdiction to jurisdiction. They might have different rules. I’m here in Colorado. The state of Colorado allows for recreational marijuana, there are some counties that just flat out don’t do it. So it’s important that you understand that if that’s happening locally. Just understand what’s going on with your local laws and, you know, again keeping in mind that of course there’s national laws that hopefully with the Safe Banking Act, you know, get passed. But just keep an eye on those and stay tuned on those. I wouldn’t hold my breath, but just stay tuned.

 

Thomas Curley 31:55

That awesome. Well let’s go ahead and maybe wrap it up. Terri, I know we’ve talked about this budding industry, but if folks were gonna take anything away from this conversation beyond just some of our fun jokes and stories today, what would maybe be your two takeaways.

 

Terri Luttrell 32:10

Well just to roll it up, Thomas. I’ll roll it up tightly for you. Just the risk analysis, look at your direct and indirect do your risk analysis to ensure it’s a good fit for your institution. Document everything that you do. The analysis didn’t happen if you document it and know it’s there and it needs to be especially important in this industry. As Kevin said, any higher risk industry. This is very cash intensive, it always will be so keep that in mind. Open the lines of your communication with your BSA team. This has to be a collaboration. Don’t make cannabis loans without them knowing. They have to be on board and be able to help you with the due diligence. And your regulators as well, tell them what you’re doing up front and get their buy-in. They’re not opposed to cannabis banking if it’s done right and they may even have some really good suggestions for you to sure everything up. And lastly, I will say take the money and run this is an opportunity for your institution.

 

Thomas Curley 33:12

Yeah, well said well. Thank you all so much for your time today. I really appreciate having you both on.

 

Kevin Gulledge 33:17

Thank you Thomas.

 

Terri Luttrell 33:18

Thank you Thomas, appreciate it.

 

 

Thomas Curley 33:20

For those of you that are new listeners, you can find this and future episodes of the podcast on abrigo.com or on your favorite podcast app or platform. Just search Ahead of the
Curve:  A Banker’s Podcast or simply search Abrigo and you’ll find it quickly and you can hit subscribe. Thanks so much for listening and we will be back with our next episode as soon as we can. Thank you so much.

 

~music interlude~

Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

 

~music interlude~

 

Thomas Curley 0:16

All right -This is Ahead of the Curve: A Banker’s Podcast. Welcome to our next episode, I’m your host Thomas Curley and I am here with Rob Newberry who is a Senior Advisor with a Abrigo’s Advisory Services Team. He is also a faculty member of the Graduate School of Banking at the University of Wisconsin Madison. For the past ten years he’s been working with financial institution leaders and regulators to develop a suite of credit administration tools for community banks and credit unions. Prior to Abrigo, Rob spent 15 years at Wells Fargo holding very strategic and leadership roles in areas such as business intelligence and delivery innovation. And he is a proud graduate with his MBA from the University of Iowa.

 

Rob Newberry 1:00

Ya, Go Hawks!

 

Thomas Curley 1:02

So Rob welcome to the podcast.

 

Rob Newberry 1:05

Rob Newberry

Yeah, no problem. Thanks for having me, excited to get to talk today about what’s going on in the market.

 

Thomas Curley 1:10

Awesome! Yeah, well speaking of the market I know there’s been a lot of what do you want to say, uncertainty around some of the things that were going to happen at the beginning of 2022. And one of those big things were kind of a potential rising rate environment with some of the fed meetings coming up. You may want to walk us through maybe talk about some of that and what’s going on there with some of the expectations and things that might be up on the horizon.

 

Rob Newberry 1:34

Yeah, absolutely.  You know you’re right; we live in an interesting time right now with covid and stimulus money that’s out there and so one of the things that’s happening is we had some inflation. And anytime you have inflation the fed has a target number that they want to hit, which is around that 2% and we’re kind of trending it about that seven and a half percent and what’s a little different now than has been in the past is I think there’s a couple reasons inflation’s happening.

One is, I don’t want to overuse this term but we might have been a little overstimulated so we flooded the market with money, right? So now people have a lot of demand for products. At the same time covid created a lot of shortages either through computer chip shortages, there’s been disruptions in the distribution channel of how products get to consumers. Also, we had a shortage of supply which has caused inflation right? So, prices are all going up and so typically what the fed does is they’ll raise the interest rate to try to kind of subdue the demand. I think what the problem will be is because we have so much extra money in the market, it might take a little more rate increases than has been in the past because of that double edge sword that we’re working with right? A shortage in the supply chain and extra cash kind of sitting in the sidelines that could be put in the market. Those 2 combinations mean that we expect in 2022 several rate hikes probably by the fed to try to lower the inflation rate. So, like said interesting times, we really haven’t had a place I think in recent history where we’ve had both a shortage of supply and an excess demand. So. It’ll be interesting to see how many rate hikes it actually takes to kind of get inflation under control heading into 2022 as we kind of ease out of the pandemic and covid issues that are going across the country here.

 

Thomas Curley 3:40

Yeah, sure seems that things have been a little bit backwards recently from kind of conventional thinking. Two words you kind of mentioned them are kind of alluded to both of them but around you know margin compression and inflation, but do you want to maybe talk about those a bit more specifically and kind of what’s going on?

 

Rob Newberry 3:56

Yeah, and so when we talk about financial institutions there’s a couple things that we need to be concerned about. One is the cost of funds right and how institutions get money is you know we can borrow it from the fed, we can get it from customers right and then we use their funds and lend it to other folks. And so, what’s happening in today’s environment, if you had an account today and we’re only paying you let’s say 10 basis points, but all of a sudden, the fed raises rates twice what do you think is going to happen to the expectations of that customer right? They’re going to expect more return because they know the interest rates are going up in the in the industry. At the same time, we also have already lent money out at a certain rate and so what typically happens in a cycle like this is you do get compression or margin constraint where we’ve already lent money out at 4% but now our cost of funds are steadily creeping up and depending, and we’ll talk about ceilings and floors here in a minute Thomas, but it does create some compression on our net interest margin spread. And we’ve seen that if you look at financial institutions returns since covid started, we’ve seen a little compression in net interest margin and what I would say their overall profitability over the last couple of years for sure.

 

Thomas Curley 5:20

And gotcha that makes sense. What I find interesting just, you know, I’m relatively newer to kind of the banking industry, but typically a rising rate environment is something that’s a little bit, you know, cheered upon when it comes to institutions. But I know when we were talking before this prepping, you know there’s definitely some challenges that a rising rate environment presents that, you know, maybe those haven’t been through before maybe don’t remember, or maybe have just chosen to forget.

 

Rob Newberry 5:43

Yeah, you know one of the things is bankers always kind of think that in a raising rate environment they’ll be able to charge more for interest rate, higher loan rates and they’ll make more money. But at the end of the day, really, we kind of make money by managing that margin or that net interest margin spread. So, if the cost of funds that you have to pay your customers or borrower from the government is 2% and you’re offering 4% loans you still have that, you know ,2% margin. Well, if your cost of funds goes up to 4%, if you offer 6%, you’re still only making 2%, right? And so, I think a lot of bankers get tripped up on thinking well I’ll be able to charge more interest and I won’t pay as much for my cost of funds and the problem we’ll have is when financial institutions aren’t as liquid because they’ve lent all their money out. In order to get more funds, they have to pay more up just like inflation for a consumer. It’s kind of like inflation for a bank, right? Now we have to pay more for the money we need to lend out and so even though banks a lot of times think they’ll make more money in a raising rate environment; it really gets into how well they’re managing that net interest margin spread. Whether they’re on the loan side or on the cost of funds of what they’re paying their depositors.

 

Thomas Curley 7:03

And I know a big, I guess, advantage or a way that folks can kind of manage that spread is through, you know, loan pricing models and some software. What are your thoughts on, kind of, utilizing a tool like that to maybe help with something like that?

 

Rob Newberry 7:17

Yeah, you know we talk about it. There’s a few concepts when we talk about managing loan pricing from a, once again at the end of the day it all kind of comes down to managing that spread and so one of the bigger factors is understanding that input cost right? What do you have to pay for those cost of funds? Loan pricing models are great in a couple ways. One is if you have the right assumptions in your model, you can actually understand and protect that net interest margin and make sure that you’re charging enough for your loan rates to protect that margin.

Now usually in a beginning of an interest rate cycle where rates start to go up, you have laggers right? Where someone’s been living under a rock and they don’t understand that rates are going up so they still are offering 4% and my institution wants to offer four and a half percent. Where do you think, the customers are going to flock right? To the person that maybe has had their head in the sand for six months and doesn’t know what’s going on and so they can impact the market in a couple ways. One is you get that that interest margin compression and with the loan pricing model what it helps institutions do is understand is that a good deal for me to chase at instead of getting the loan? Or should I pass on that deal in wait and get a better opportunity with the customer that meets my expectations for my net interest margin requirements, so that I can protect the financial institution’s net interest margin and eventually ROA and ROE for that financial institution. So yeah, so there’s a couple ways that helps. One is once again, understanding what the lag is in the market and what you’re going to increase your rates based on how the fed increases the rates and two, when you look at competitive pressures through a loan pricing model, so if a competitor down the street is pricing at 4 and you think you should price at 5 you could actually see how much money you would be sacrificing to match that rate and understand is that something that you want to do or not. Without a pricing model a lot of times Thomas what customers end up doing or financial institutions is they just match that competitor and they don’t realize how much money they they’re losing by doing that match comparison.

 

Thomas Curley 9:30

Yeah, no I think that definitely, obviously, you’ve hit a lot on profitability there and trying to protect what you what you have right now and obviously just matching a competitor without really thinking about some of the other you know items that go into that. You know, are there any other examples or best practice you would say on how to maybe go about protecting kind of the current profitability that some of these financial institutions have right now?

 

Rob Newberry 9:52

Yeah, there’s a couple things you can look at. One of the things would be, one of the normal practices in a flat rate environment is a lot of financial institutions put in floors which would be what I would say is they’re going to say I’m going to give you prime plus 2% but the minimum that the rate will go down to is I have to at least charge you 4%. Well, the problem you have is in a raising rate environment one side of the equations going up while the other stays steady at that 4%, so your cost of funds will steadily rise and create profitability or margin compression on the financial institution side on that front. And so, from a profitability perspective in a raising rate environment, you want to be careful of your floors for a couple reasons. One is depending on how fast rates go up, will it trigger if you’re using a variable loan product enough where you can reset your rates to capture what the increased cost of doing that loan is so that you can protect that net interest margin. So, if you have a bunch of floors in, you’ll probably want to reassess maybe some of your loan pricing policies to say hey is that floor high enough? Or do I want to remove the floor and have a better a bigger spread on what the prime rate is to almost get to the floor so that when prime goes up it follows it a little closer to protect your net interest margin. So that would be something as we look into going into a raising rate environment. You’re going to want to consider.

On the other side of the equation right, that’s kind of the loan side, on the deposit side of the equation you have to understand how much of the interest rate you’re going to and how fast you’re going to pass it through to your customers. So just like on loans, there’s a lag when fed raises the rates a quarter and you’re only paying your customer ten basis points are you going to pay them 35 basis points now that the fed raised at 25 basis points? Or are you only going to pay them 25 and how long is it going to take you to raise what you’re paying your customer on their deposit account. So that’s the other thing when we talk about policies and a raising rate environments very important to understand those strategies on how to maintain your customers. You don’t want them to leave because, Thomas, your financial institution’s paying the full 35 basis points and I only want to pay 20, the savvy customers are going to go to your bank and say hey I can make a lot more money if I leave my money at Thomas’s bank then I can at Robs. And so, you really have to be careful not to lose a bunch of your liquidity or have we call it surge balance, right? Where sophisticated individuals might move their funds where they can make the most money versus people that maybe are a little asleep at the wheel and they don’t understand that they can make 25 basis points down the street so they just leave their funds at your institution.

 

Thomas Curley 12:48

Gotcha that makes sense and I guess that brings up I know one of the questions we talked about before was, you know, should you charge more for customers given this time that there’s kind of different factors happening on both ends of the spectrum.

 

Rob Newberry 13:01

Yeah, you know, it gets interesting and, you know, I don’t want to kind of breach the fair lending rules. We’ll talk a little about commercial first and so you know depending on the risk of that deal right, you should you want to match the risk with the reward as a financial institution. So, if you know that the customer is a little more risky and there’s a little more probability that he might not pay you back, you’re going to want to charge a little more money to make sure that you can break even on that deal, right? If you have a really solid customer, you probably don’t raise the rates as much as if you have someone that’s average or a little shaky coming out of covid. So, Thomas you would adjust your rates a little on the commercial side based on that. Same on the consumer side, right? A lot of folks are familiar with FICO scores and payment history and some of those things. A lot of times you’ll see whether it’s an auto loan, a home mortgage depending on the FICO score you might get a little better rate. It all gets into that credit risk component when we talk about profitability and loan pricing right? Is hey, because there’s more risk, I have to charge you a little more money for the folks that don’t make don’t pay me back to cover those losses. And so, you will see a little of that as we go into a raising rate environment and so it’s just like deposits, even if rates go up a whole quarter, if I’m a really good customer I probably don’t pay a whole quarter more. I probably only have to pay 15 or 20 basis points more because otherwise I’ll go down the street and get a better rate from another financial institution.

 

 

Thomas Curley 14:39

So yeah, competition is definitely not going anywhere so you got to be careful there on both ends. So, I think we’ve hit on a bunch of you know topics on hey here are some things that I have been doing that’s been keeping me profitable and we’ve also kind of touched on some of the challenges of a rising rate environment. But maybe what are some best practices or ways that you see the institutions can really take advantage of this rising rate, like is there something that they can tweak a little bit that really propels them kind of into this new environment.

 

Rob Newberry 15:08

Yeah, you know there’s a couple things you can do. One is product innovation, a little of it. You know much like banks and credit unions are worried about raising rates of environments as far as what it’ll do to their financial position. As a customer, I also know rates are going up so I probably want a product that maybe you don’t want to offer me right? And so, as a customer I want a fix term product right now because if rates continue to go up, I want to pay a lower interest rate and a lot of times bank are the exact opposite. In a raising rate environment what does a financial institution want to give you? They want to give you a variable product, right? Because they want that protection if rates continue to go up that they can charge you more money and so it’s coming up with some of these new maybe fixed product features that give a little protection to the customer but still give the financial institution a little upside. And you can get a bunch of market share, right? So most people are afraid of raising rates that they might lose market share, but it’s a great actually time to gain market share if you do the right things as far as if I want to grow my deposit base for a certain target market, do I pay actually a little more on basis points up front now and lock them into a longer term CD or something where maybe I can get some money now and pay a little up at the beginning but save money on the back end if rates go up. And so, there’s a bunch of different strategies both on the funding side of the balance sheet as well as the lending side of the balance sheet that you can do in a raising rate environment like that Thomas. But a lot of it gets into those product features and I would challenge financial institutions is take a walk a mile in the shoe of your customer and understand what they want because you know if they don’t want it it’s gonna be harder to get that net interest margin spread that you’re looking for because they, you know, says the old supply and demand curve right? They have a demand for a fixed product and you’re supplying them the variable product. They don’t want that so you can’t sell as much as of that if that makes sense.

 

Thomas Curley 17:12

And also, always brings to mind your favorite illustration of the various salts. So, from if anyone has joined any of your webinars in the past with us…

 

Rob Newberry 17:22

Yeah, absolutely yeah. When you get down to it, it’s all supply and demand Thomas and that’s what’s interesting too about the inflation and why I think we’re going to have to have multiple rate increases here in the near future is just because it’s hitting both sides of that equation. On pent up demand because I have money and you know, my son’s a great example. He wanted a new, I don’t know we’ll call it an Xbox and there’s only limited amount so he’s willing to get on a list and pay more money upfront to make sure he gets one because he’s worried that there might not be any for another eighteen months. But he wants to make sure he has one, right? And that’s kind of like the thing that’s going on in the market now is if you really want a new car, you’re willing to pay up. Well, what happens is there are people that wanted to buy a new car can’t afford it now are gonna buy a used car, now all the use car prices also go up. And so, you kind of see how that inflation’s impacting the market in general on that front.

 

Thomas Curley 18:19

So, you’re right I was actually going to say that the car market has been crazy. I’ve just seen some articles about used cars and I can’t remember that percentage, you know, increase in the overall prices but compared to, you know, two years ago that same car might actually be instead of depreciating asset it might actually be making people money all of a sudden which is definitely a strange thought.

 

Rob Newberry 18:38

Ah, yeah, it is but you know what happens is they still have to pay more for the next car. So, it’s kind of like the housing market, right? Housing market’s up, but if you make an extra 10% selling your house, you actually had to pay another 10% for the house you just bought. So, for them it is kind of a wash. But yeah, is that mindset that you have to struggle sometimes on. Yep.

 

Thomas Curley 18:58

I know for sure. Well I know we’re coming close on time here and so what I wanted to do was just kind of if folks maybe weren’t able to listen to the entire podcast or maybe they zoned out for a hot second, you know, what would be maybe your two or three big takeaways Rob for kind of knowing the rising rates are coming, knowing that profitability will always be something that financial institutions are striving for. What would be maybe your two cents’ there.

 

Rob Newberry 19:24

Yeah, I would say, kind of, leverage some of the software you might already have. Loan pricing models are a great way to protect your net interest margin. Remember, you’re not making money on what the cost of funds are coming from the government. You’re making it on that net interest margin spread. An in order to protect that spread you might have to have some new product features to provide enhancements or features in your products that your customers actually are willing to pay up for to protect that margin. And once again, take a mile walk in the shoes of your customer so you understand what they really want. And you know it’s not necessarily a bad time, it’s opportunity really for financial institutions to actually increase market share if they approach it the right way and still maintain their profitability or their margin that they have right now.

 

Thomas Curley 20:19

Well said and I think that those are some great tips for our listeners here. Well, we’re right at twenty minutes here so I just want to thank you so much for joining Rob. I think always good just to talk a little bit on loan pricing and also given when this episode will probably pop out here, we might actually get some clarity on some of the rising rates for sure as well.

 

Rob Newberry 20:39

Yeah, well thanks Thomas for having me. I’m always glad to come and pop on here and have some interesting conversations with you.

 

Thomas Curley 20:44

All right – we definitely appreciate it. For those that are new listeners or maybe haven’t subscribed yet. you can find this podcast and future episodes on Abrigo.com or you can find it on your favorite podcast app or platform, just search Ahead of the Curve: A Banker’s Podcast. And you can hit subscribe or whatever they choose to call that button on the podcast platform that you use. Thanks so much for listening and we will be back again with you soon.

 

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