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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