Welcome to the October issue of This Month in Commercial Banking. As we count down the waning months of 2020, the commercial business remains largely in a holding pattern. Unprecedented surge deposits remain in place and, when paired with stagnant third-quarter loan growth, continue to present a challenging environment for commercial profitability. This is prompting banks to look for other levers – moving to negative effective deposit rates (though not negative real rates) and gearing up the engagement model as digital interfaces allow for more efficient sales and service contacts. Finally, we turn the spotlight on vault services, where revenues have eroded during the pandemic as banks temporarily and permanently shutter branches.
A New Normal and a New Equilibrium?
Commercial deposit balances have surged an unprecedented 40% across the industry, (See Figure 1) with virtually all banks posting deposit growth rates north of 10%. (See Figure 2.) Many market participants anticipated in the second quarter that a significant portion of surge balances would reverse by the end of the year. So far, however, surge balances have shown no signs of reversing and there is a growing consensus that some balance levels that were previously considered to be “surge deposits” now constitute a “new normal.”
Figure 1: Average Weekly Deposit Growth
(March – October)
Figure 2: Surge Deposit Balance Variance by Bank
Source: Novantas Comparative Deposit Analytics
Novantas believes that significantly elevated commercial balances are here to stay. We also believe that these deposits will reallocate among market segments and individual companies, providing bank deposit portfolios with a new equilibrium. While this will result in only a modest direct impact to balance levels at the largest banks, over-and-underperformance will be more pronounced in banks with higher concentrations in specific sales sizes, geographies, industry verticals and customer segments. We’re seeing evidence of this already. For example, smaller balance deposits, which significantly outperformed larger depositors early in the pandemic, have significantly underperformed since then. (See Figure 3.)
Figure 3: Growth Rates By Account Size
Source: Novantas Comparative Deposit Analytics
Our core thesis for why elevated balances will constitute a new normal is rooted in the mechanics of how the surge was created. Nearly half of the surge is attributable to fiscal stimulus from earlier this year (of which PPP is the largest component). This money was debt-funded and has come mostly in the form of forgivable PPP loans or permanent grants. Short of a reduction in deficit levels, this money may be permanently in the system. The remainder is largely attributable to monetary stimulus and corporate leveraging.
The QE unwind taught us that the Fed’s balance sheet reduction is a slow process. Much of the corporate re-leveraging that took place in the form of credit line draws in late Q1 has since been converted to long-term debt through the capital markets. One often-cited theory is that a resumption in hiring and capital expenditures will reduce surge deposits. Novantas believes these activities will increase the velocity of money (and shift where deposits ultimately reside, likely ultimately bubbling up in institutional funds), but ultimately won’t remove the money from the system. We expect that the liquidity value of these deposits will decline as the reallocation occurs, but the balances will remain.
Accurately forecasting the duration of elevated balance levels within specific bank portfolios is a high-stakes challenge. In a protracted low-rate environment, banks that invest surge deposits in longer-duration assets stand to make sizable excess returns compared with those of shorter duration. Even in this flat yield curve environment, we estimate the spread on three-month returns versus three-year returns equates to $12 million in annual NIM for every $10 billion of surge deposits. If the yield curve steepens, incremental returns could be much greater.
Given the financial stakes of getting this right and the challenges in forecasting this new equilibrium, we recommend that banks take actions to forecast future balance levels. First, they must undertake rigorous customer-level modeling, estimating current surge level, balance movements since the initial surge and the likely end state based on the client’s ability to excel as we emerge from the pandemic. Finally, banks should develop scenario plans for multiple potential outcomes in terms of economic recovery and government stimulus.
Q3 EARNINGS WRAP:
Investors Shrug Off Credit Beats Amid Stagnant Commercial Loan Growth
Third quarter earnings season is complete and one thing that is obvious is that the market isn’t rewarding credit-driven beats.
Investors are increasingly concerned about fourth-quarter and full-year revenue outlooks amid excess liquidity, low rates and credit risks. So far, banks are pointing to modestly lower fourth quarter net interest income (ex-PPP) due to limited commercial loan growth opportunities as bankers also wrestle with excess liquidity deployment into a shrinking pool of short duration, high-quality assets.
It cannot be stressed enough that commercial loan growth remains elusive. (See Figure 4.) Deposits will likely continue to have some additional cost reduction opportunities, but this benefit is largely being offset by continued builds in balances, both especially from non-operating balances. Additionally, fee income trends have varied across the spectrum, with higher service charges that can be attributed to PPP and increased card fees.
Figure 4: C&I Loans - All Commercial Banks
Source: Federal Reserve H8 Weekly Report
Expense controls are of top priority. Several banks have announced expense initiatives to offset 2021 revenue pressures. Finally, credit levels may have peaked given the top-down views of the industry. This may give a boost to FY20 earnings, but those benefits aren’t being rewarded at this stage. Commercial lines of business will need to continue pushing revenue levels around fee optimization and growth in order to contribute positively to bank results.
NOTHING TO SEE HERE:
How Commercial Deposits Have Quietly Moved to Negative Effective Rates
The specter of negative policy rates has largely been lifted from the industry. But with ultra-low rates in place for the foreseeable future, banks are struggling to turn a decent profit on deposits. Many are quietly turning to negative effective rates to accomplish this.
We do not see full-on negative interest rates on commercial deposits. But when combining the interest rate or earnings credit rate (ECR) with the deposit insurance assessment fee (DAF), the result is often a negative effective rate.
Banks use two primary means to accomplish negative effective rates. The first is directly, by setting the DAF rate above the interest rate or the ECR. This practice remains rare, but more and more banks are considering this approach. With a growing amount of ECRs set below 20 bp and declining DAF rates in the 10-18 bp range and holding steady, we expect this practice to become more common. (See Figure 5.)
Figure 5: There appears to be a large swath of accounts at negative rates
Distribution of ECR DDA Rates
Source: Novantas Comparative Deposit Analytics – August 2020 – ECR Rates, Novantas NDepth
The second means of achieving a negative effective rate is through a basis differential. ECR and interest are generally credited on collected balances, while DAF is generally charged on ledger balances, which can be substantially higher. Through analysis of individual bank statements in our NDepth data set, we have identified swaths of the industry, particularly larger corporate clients, where negative effective rates are the norm.
Most banks have tiptoed into this domain. Our global experience with negative rates suggests that this caution is well-placed – many European and Asian banks that forced negative rates onto commercial clients underestimated the media backlash, even in commercial.
But when the move to negative effective rates is well-managed, banks can be successful in piercing the artificial floor of ECR equaling DAF. Banks that are successful in eliminating this perceived floor can add a few sorely needed basis points to their margins.
TIME TO UPDATE THE ENGAGEMENT MODEL
For years, Novantas research has shown that many corporations, across all sales sizes, are open to more digital engagement with their bank. These interactions range from the RM providing advice to opening an account and even to completing complex transactions. Our research has often been met with skepticism, especially from bankers targeting middle market or large corporate clients. Many bankers felt like this approach was fine for small business or business banking clients, but isn’t an effective model for larger companies where traditional face-to-face selling is required.
The pandemic is changing that way of thinking. It hasn’t been easy, but the current consensus across the industry is that commercial lines of business must effectively engage with their clients digitally in order to accelerate cross-sell and the deepening of relationships.
It should be noted that new-to-bank acquisition is more difficult through the digital channel. There are obvious reasons for the challenge – changing banks is a much more complex decision and more trust-oriented than other banking actions and therefore tougher to do over video than across a desk. The move to switch is often oriented around the credit decision and bankers really want to “kick the tires” of a business – something that is also very difficult to accomplish over video.
Notwithstanding the NTB challenge, now is the time to take these client engagement learnings of the past seven months and transform the commercial client engagement model to be more digital and multichannel for all client segments. Key components that need consideration include structure (roles and responsibilities, including specialization), deployment (how many coverage folks are needed and where they should be, including gearing), and enablement (sales force and marketing automation).
Leading banks are:
- Challenging the current roles and responsibilities structure through this new multi-channel/digital lens: The review should ensure the right mix between general relationship-oriented resources and specialized resources (industry, product or capability). Given the new model is less location-dependent, the ability to mix and match resources against a client’s needs is enhanced. A significant opportunity exists to formally develop an inside sales capability that is enabled by technology and analytics. These resources can manage their own clients, but also effectively augment the “feet on the street.”
- Significantly increasing gearing ratios: There is no doubt that a more digital/multi-channel approach can increase productivity while also improving the effectiveness of the sales force. (See Figure 6.) For example, RMs who travel less have the capacity to expand the current number of relationships they manage. The traditional middle market client-to-RM ratio of 30 can increase to 50. For the business banking segment, where client-to-RM ratios of 75-100 are common, optimized sales models can increase that ratio to 250-400!
Figure 6: Big Potential for Engagement Models
per RM (Clients/Revenue)
|Future State: Digitally-Enabled||Improvement in Revenue / RM|
|Business Banking RM||70/$1.4M||160/$3.2M||$1.8M|
|Middle Market RM||30/$4M||45/$6.0M||$2.0M|
Notes: Novantas Case Study; Clients per BBRM in a digitally enabled model is an average between BBRM and Inside Sales; assumes no improvement in revenue/client (BB@$20k; MM@$133k), though the deployment of marketing analytics and digital tools should improve customer penetration.
Figure 6: Big Potential for Engagement Models
Notes: Novantas Case Study; Clients per BBRM in a digitally enabled model is an average between BBRM and Inside Sales; assumes no improvement in revenue/client (BB@$20k; MM@$133k) though the deployment of marketing analytics and digital tools should improve customer penetration.
- Expanding the investment in digital tools, especially marketing automation. Many banks have been updating their CRMs and increasing utilization of these platforms. Very few, however, have taken advantage of marketing automation to increase client communication and engagement, while also significantly increasing lead generation and conversion through digital marketing strategies.
The commercial line of business is facing a significant profitability challenge due to continued modest economic growth and low interest rates. Embracing the digital channel for client engagement is one way to mitigate profitability challenges by improving banker efficiency and effectiveness.
PANDEMIC TRIGGERS LOWER FEES FOR VAULT, OTHER SERVICES
The reduction in bank branches – whether the result of industry consolidation or pandemic-related disruption – is having widespread reverberations across the industry. One of the less-noticed implications is a decline in bank revenue for vaults and other services that are now shifting to non-bank providers.
Banks should be aware of these trends and determine strategies to defend themselves against this surge in the “shadow banking” industry.
For example, commercial vault activity is down a dramatic 34% among a representative corporate cohort so far this year, according to NDepth data from Novantas. (See Figure 7.) As a growing number of banks are shutting down vaults due to increased regulations and COVID-19 concerns trigger a rush by companies to safeguard assets, private security providers (such as Diebold, Garda, Loomis and Fort Knox) are seeing profits rise. A similar flight to private security was triggered after the 2008 economic recession.
Figure 7: Vault Services Bank Fees - 2020 YTD
Source: Novantas NDepth representative corporate cohort
Furthermore, the payment vehicle mix is changing with an increased demand for cash on hand, including bank notes and coin. At the same time, a reduction in staffing at the U.S. Mint has triggered a national coin shortage. These developments have led customers to turn to alternative providers such as currency exchanges to meet this demand. (See Figure 8.)
Figure 8: Currency and Coin Service Fees - 2020 YTD
Source: Novantas NDepth representative corporate cohort
Some banks are starting to take notice of these trends, looking to partner with third-party vaults and other related services to outsource this function while focusing on core commercial deposits. These agreements can achieve economies of scale because these providers typically have specialized resources and more industry experience to manage this emergent currency need.
Alternatively, banks can expand their prepaid card outreach efforts to assist the sector of customers that is negatively impacted by branch closures. Solutions to assist utility bill payments similarly will be an innovative way to address the attrition due to COVID-19 and the related loss of branch business.