WINTER 2024 Why Community Banks Don’t Hedge (and Why They Should) Elections Present New Opportunities and Challenges
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CHARLESTON, WV • MARTINSBURG, WV • MORGANTOWN, WV • PARKERSBURG, WV • SOUTHPOINTE, PA • WINCHESTER, VA Banks, retailers, finance companies, and other businesses offering financial services to consumers face the ever-present threat of expensive and potentially ruinous litigation. Lawsuits, based on federal and state laws prohibiting “predatory lending,” “unfair debt collection,” and “deceptive and unfair” practices, strike at the heart of marketing, sales, privacy, and debt collection practices. At Bowles Rice, our Financial Services Litigation team has experience successfully defending clients, big and small, against lending-related lawsuits and class action litigation brought by consumers and regulators. Our lawyers have experience dealing directly with federal and state regulators on behalf of our banking and lending clients. For more information, contact our firm’s Financial Services Litigation team leader Zack Rosencrance at (304) 347-1161. Financial Services Litigation bowlesrice.com Responsible Attorney: Marc Monteleone 600 Quarrier Street • Charleston, WV 25301
Contents ©2024 The West Virginia Bankers Association | The newsLINK Group LLC. All rights reserved. West Virginia Banker is published four times each year by The newsLINK Group LLC for the West Virginia Bankers Association and is the official publication for this association. The information contained in this publication is intended to provide general information for review, consideration and education. The contents do not constitute legal advice and should not be relied on as such. If you need legal advice or assistance, it is strongly recommended that you contact an attorney as to your circumstances. The statements and opinions expressed in this publication are those of the individual authors and do not necessarily represent the views of the West Virginia Bankers Association, its board of directors or the publisher. Likewise, the appearance of advertisements within this publication does not constitute an endorsement or recommendation of any product or service advertised. West Virginia Banker is a collective work, and as such, some articles are submitted by authors who are independent of the West Virginia Bankers Association. While West Virginia Banker encourages a first-print policy, in cases where this is not possible, every effort has been made to comply with any known reprint guidelines or restrictions. Content may not be reproduced or reprinted without prior written permission. For further information, please contact the publisher at (855) 747-4003. 5 PRESIDENT’S MESSAGE Elections Present New Opportunities and Challenges By Mark Mangano, President & CEO, WVBankers 6 Why Community Banks Don’t Hedge (and Why They Should) By Dennis Falk, SVP and Regional Manager, and Jo Ellen McKinley, SVP and National Business Development Manager, PCBB 8 The Blunt Truths of Banking MRBs By Carol Ann Warren, JD, MBA, Assistant Vice President, Associate General Counsel, Compliance Alliance 11 Workout Your Workouts Make Trimming the Fat Part of Your Bank’s New Year’s Resolution By Michael R. Proctor, Special Counsel, Bowles Rice LLP 14 Top Strategies for Managing Liquidity in a Falling‑Rate Environment By H.D. Barkett, Senior Managing Director, Treasury Desk, IntraFi 16 Scarcity or Prosperity The Efficiency Ratio Under Attack By Dr. Sean Payant, Chief Strategy Officer, Haberfeld 20 Proper Oversight Keeps a Plan Running Smoothly By John Schafer, VP, National Leader, Financial Institutions Channel, Pentegra 22 Credit Risk Management Early and Accurate Risk Ratings By Brad Snider, Director, Laura Knight, Director, and David Bartus, Director, Forvis Mazars 24 Cybersecurity and AI What Community Banks Should Know By Steve Sanders, Chief Risk Officer, Chief Information Security Officer, CSI 26 Is the United States Entering a Prolonged Period of Low Unemployment and Rising Wage Inflation? By Chris Dahlgren, Senior Financial Strategist, The Baker Group 27 2025 Upcoming Events 6 22 4 West Virginia Banker
As a society, we have again successfully chosen elected leaders. As individuals, we will have differing views regarding the election outcomes. Our ability to frequently choose new leaders is cause for celebration. Every election represents a political reset. With that reset, the banking industry will have new opportunities and face new challenges. It is too early to define specific opportunities and challenges. In 2025, the state will have a new governor, treasurer, auditor, secretary of state, senate president, U.S. senator and U.S. representative. New legislators will be joining both the state house and senate. Each of these leaders will bring new priorities and perspectives. Elections create political renewal. That renewal creates opportunities to forge new relationships and reaffirm existing alliances. Against the political backdrop driven by election results, we seek to build our relationships with political leaders based upon understanding their values, educating them on the banking industry’s value to the state and society, and finding common cause on the intersection between their values and preserving a healthy banking industry. The West Virginia Bankers Association is proud and honored to advocate for an industry that serves as the engine driving economic stability and prosperity in our state. However, banking industry advocacy is most effective when supported by broad-based political engagement at the community level. Political leaders do not come to their positions knowing everything about everything. They rely on trusted advisors to inform their approaches to legislative and policy issues. Individual bankers are uniquely positioned to become trusted advisors to political leaders. In 2025, the West Virginia Bankers Association will be working to support meaningful and rewarding political engagement by individual bankers. Kicking off that effort is our annual legislative day scheduled for Tuesday, Feb. 18, at the Embassy Suites in Charleston, West Virginia. We are planning an agenda that should provide interesting and informative experiences for both bankers familiar with political engagement and those who are new to the process. Legislative day will include education sessions devoted to current political issues and the political process. Bankers will have guided opportunities to interact with political leaders and hopefully their local representatives, support industry recognition by attending house or senate sessions, and engage in informal conversations with political leaders at an evening reception. Elections bring exciting changes. We hope you will join with the West Virginia Bankers Association staff and volunteer leadership in embracing those changes. You have a role to play in preserving our industry’s ability to serve our customers, communities and the state of West Virginia. We look forward to supporting you. PRESIDENT’S MESSAGE MARK MANGANO President & CEO WVBankers Elections Present New Opportunities and Challenges 5 West Virginia Banker
Why Community Banks Don’t Hedge (and Why They Should) 6 West Virginia Banker
By Dennis Falk, SVP and Regional Manager, and Jo Ellen McKinley, SVP and National Business Development Manager, PCBB For community banks, the decision to hedge isn’t just a matter of strategy; it’s a pivotal choice that can safeguard their balance sheets in an era of fluctuating interest rates. While not every institution chooses to embrace this protective barrier, those that do can navigate the complexities of financial risks with greater confidence. Interest rate risk was a major concern for respondents in Bank Director’s 2024 Risk Survey. It’s no wonder. Persistently high interest rates have squeezed bank margins and earnings, given the increasingly expensive funding landscape and the number of fixed-rate assets many community banks carry. Yet 80% of total survey respondents — 91% of those at institutions with between $250 million and $500 million in assets, and 89% of those at institutions with between $500 million and $1 billion in assets — say that they don’t hedge, even though hedging instruments can help manage interest rate risk. Why Community Banks Don’t Hedge Community banks have a variety of reasons for not hedging. They may be concerned that hedge accounting is complex, collateral and capital requirements tie up liquidity, and/or believe that interest rates are about to decline, so there’s less of a need to hedge against the possibility that interest rates will climb. Here are a few of the major reasons why community banks wouldn’t venture into a traditional loan hedge using a rate back-to-back swap: 1. Managing Derivatives. Derivatives may carry a historically negative impression for a lot of financial institutions. Traditional back-to-back swaps require the lender to carry derivatives on their balance sheet, making for complicated accounting. 2. Collateral Requirements. Many financial institutions are fielding liquidity concerns and have been for a bit now. Entering into a loan hedge that requires them to post unknown amounts of collateral over an uncertain period of time merely to oblige to the agreement can seem unappealing and risky. 3. Upcoming Rate Changes. As interest rates fall, financial institutions might anticipate hedged loan swaps to become less beneficial. The Risks of Not Hedging The most obvious risk of not hedging, of course, is the risk that a bank’s primary strategy will lose value as economic conditions change. Without a hedge, the bank will have no corresponding gain to offset the loss. Regulatory risk is another possibility. Bank examiners may have looked askance at traditional back-to-back swaps in the past, but there are different methods of loan hedging that indicate a positive sign that financial institutions are managing interest-rate risk. In fact, survey respondents whose businesses have had a regulatory exam since March 2023 said that the examiner paid particular attention to their interestrate sensitivity. The Case for Hedging — Especially Interest Rate Swaps The long period during which interest rates stayed at all‑time lows ended a couple of years ago. Future interest rate directions and timing are impossible to know, so hedging against rate changes is a smart strategy. Community bank business models naturally carry interest rate risk. Financial institutions use short-term deposits to fund fixed-rate commercial loans with 5- to 10-year durations. Deposits can reprice faster than loans, and mobile and internet banking mean that community banking clients find it simpler to move deposits to institutions that offer better rates. Digital banking technology, money market funds and other bank account alternatives, and customer sophistication have all created a world in which balance sheet risk changes much faster than it did 20 years ago. Community banks need to be quick to address that risk, and it’s faster and typically less expensive to employ an interest rate swap than to change an organization’s loan or deposit pricing or restructure a balance sheet to address drivers of interest rate risk. While a 2017 change in accounting rules for hedges makes it less complex to account for hedges that cover cash flow from an asset pool, it’s simpler still to arrange a loan-level interest rate swap through a correspondent bank, which offers hedging without complicated accounting or extensive documentation. Regulators often approve of strategies to mitigate interest rate risk. Despite the reputation traditional hedging carries, certain other methods of loan hedging, like interest rate swaps, are much more favorable and advantageous in a world of uncertain future rates. To continue this discussion, or for more information, please contact Dennis Falk at dfalk@pcbb.com or Jo Ellen McKinley at jmckinley@pcbb.com, or visit the PCBB website at www.pcbb.com. Dedicated to serving the needs of community banks, PCBB’s comprehensive and robust set of solutions includes cash management services such as settlement and liquidity for the FedNow Service, international services, lending solutions and risk management advisory services. 7 West Virginia Banker
The Blunt Truths of Banking MRBs By Carol Ann Warren, JD, MBA, Assistant Vice President, Associate General Counsel, Compliance Alliance For the typical office worker, marijuana is not typically the most “HR-approved” subject of discussion. But in banking, marijuana and marijuana-related businesses (MRBs) are hot topics. There are conversations, debates and questions related to the definition of marijuana, what exactly an MRB is and, most importantly, whether banks can serve these types of businesses and what types of policies will need to be drafted to serve them. 8 West Virginia Banker
First, there is a question of whether banking MRBs is even legal. Under federal law, the sale of marijuana is illegal. Marijuana or cannabis is defined as “all parts of the plant Cannabis sativa L., whether growing or not; the seeds thereof; the resin extracted from any part of such plant; and every compound, manufacture, salt, derivative, mixture or preparation of such plant, its seeds or resin.” Marijuana is classified as a Schedule I drug under the Controlled Substances Act, enforced by the Department of Justice (DOJ). The main concern and issue related to marijuana is the delta9‑tetrahydrocannabinol (THC) content. This ingredient is believed to give marijuana its psychoactive effects. THC content is the hinge of legality on the federal level. If THC content is .03% or higher, then the substance is illegal at the federal level. However, due to the shift in public perception and the increasing number of states legalizing marijuana, the Department of Justice has chosen not to prosecute marijuana‑related crimes. As mentioned, many states have chosen to legalize marijuana, thus creating the tension between some states’ laws and federal law. While there have been efforts to reconcile the discrepancies, there is no reprieve in place as of the publication of this article. Contrary to the legality of marijuana, hemp products are legal in all 50 states. Hemp is defined as “the plant Cannabis sativa L. and any part of that plant, including the seeds thereof and all derivatives, extracts, cannabinoids, isomers, acids, salts and salts of isomers, whether growing or not, with a delta-9 tetrahydrocannabinol concentration of not more than 0.3% on a dry weight basis.” With the confusion surrounding the legality of marijuana, banks are stuck between a rock and a hard place. Most states have legal MRBs that need banking services, but marijuana is still illegal at the federal level. The Cole Memo was introduced in 2014 with the intent to bridge the gap between federal and state law. It established guidance to keep marijuana-related facilities off federal land, protect children from the sale of marijuana‑related products and curb drug-related crimes. The Memo afforded banks some protections and guidance, but it was rescinded in 2018 due to its inability to effectively reconcile state and federal law differences. Despite the Memo being rescinded, it remains the only guidance that banks really have to establish guidelines and principles related to banking MRBs. The Financial Crimes Enforcement Network (FinCEN) believes the principles laid out in the Memo are valid and still expects banks to follow them as much as possible. To read the full Memo, scan the QR code. https://dfi.wa.gov/documents/banks/ dept-of-justice-memo.pdf Even in states where banking MRBs is not prohibited under state law, many banks choose not to bank MRBs due to the difficulty and due diligence required to do so. Conversely, other banks are willing to take on the risk of banking these customers. Banks willing to undertake these types of customers must consider several issues. First, banks must identify the risk level of an MRB. Risk levels defined in guidance range from Tier 1 to Tier 3, with Tier 1 being the riskiest. Tier 1 MRBs are those that are directly related to manufacturing, growing, dispensing or distributing marijuana‑related products. These are typically dispensaries, farms or producers and generally require specific state licensures outside of the standard state licensure for a business. This is usually done through the State Department of Agriculture, but licensing requirements can vary from state to state. Tier 2 MRBs have a decreased risk because these are businesses that do not directly touch marijuana. Examples of Tier 2 businesses are marijuana paraphernalia sellers, industry associates and sellers of farm equipment for MRBs. Lastly, Tier 3 MRBs are the least risky businesses. They have loose ties to MRBs. These include consultants, commercial real estate owners who rent to MRBs and technology providers. Next, the bank will need to be aware of its Suspicious Activity Reporting (SAR) obligations. There are three different SARs that come into play: (1) Marijuana Priority, (2) Marijuana Limited and (3) Marijuana Termination. Each SAR has different requirements based on the type of activity noted. Further, the bank will need to develop robust policies to bank MRBs. The policies should include detailed lists of signs that bank staff may notice as “red flags” of MRB activity, a discussion of the information needed for enhanced customer due diligence on MRB customers and a comprehensive MRB risk assessment. Lastly, banks should consult with bank counsel having robust knowledge of the marijuana-related laws in the state because knowledge of state law is critical for the bank to determine the level to which it can facilitate MRBs. Until there is more clear guidance from the federal government, the internal and external bank debates may continue. For each bank, determining their state’s stance on the legality of marijuana, deciding whether the bank is going to serve MRBs and defining the bank’s applicable policies and practices will tremendously help to organize the chaotic conversations that surround marijuana and marijuana banking. With the confusion surrounding the legality of marijuana, banks are stuck between a rock and a hard place. 9 West Virginia Banker
Workout Your Workouts Make Trimming the Fat Part of Your Bank’s New Year’s Resolution By Michael R. Proctor, Special Counsel, Bowles Rice LLP With the new year upon us, now is the time to choose our favorite resolutions for a positive start to 2025. For banks, this process might include a comprehensive special asset plan. An increase in interest rates over the last few years has caused variable rate loans to adjust upward. Higher rates have also made it more difficult for borrowers to refinance. At the same time, inflation and supply chain issues have led to disruptions in some businesses. The combination of these factors seems to have caused an increase in defaults and special asset referrals over the last year or two. Banks should be prepared for the possibility that defaults will continue to increase in 2025. A special asset increase has been predicted for the last five years, ever since the COVID-19 pandemic. Some feared there would be a repeat of the 2008 mortgage crisis. The flood never happened. In large part, the Paycheck Protection Program, Emergency Rental Assistance Program, student loan grace periods and internal flexibility of banks provided enough breathing space for business and consumer borrowers to prevent a large-scale downturn. Separately, some lenders made the decision to “extend and pretend” to maintain the status quo. This is not to say that all borrowers were saved, but thankfully, history did not repeat itself. With the end of these programs, the increase in interest rates and questions facing the economy generally, there is potential that the next special asset and restructuring chapter may be starting. In the bankruptcy world, the Small Business Reorganization Act (SBRA) has become an extremely popular option for small businesses entering Chapter 11. This option became available in 2020 and quickly gained popularity because it offered a streamlined and less expensive process than a traditional Chapter 11 reorganization. Since SBRA’s passage, the debt limit temporarily increased from $2.7 million to $7.5 million, allowing a greater number of businesses to qualify for this process. However, the higher debt limit included a sunset provision, which ended in June 2024, again preventing larger businesses from using SBRA. There is significant support for restoring the higher debt level, and it is possible that this will happen in 2025. Restoring the cap may assist some small- to mid-sized distressed businesses in restructuring and addressing loan obligations. Bankruptcies offer certainty and can be effective ways for borrowers to shed certain obligations while refocusing on their operational financing. But, in most circumstances a bank has little ability to force a bankruptcy. Without a bankruptcy filing where a borrower falls delinquent in payments, a collection plan is straight forward. But the situation where a borrower is 11 West Virginia Banker
While it is impossible to forecast exactly what 2025 and beyond will mean for workouts, the ingredients are there for an increase. satisfying its payments and falling short of other loan obligations may present a different challenge. A favorable climate for borrowers over the last decade led to some heavily negotiated loan terms and borrower‑friendly provisions in loan agreements, including favorable grace periods, financial covenants and cure provisions. Some banks find themselves saddled with these provisions in the hands of uncooperative borrowers. This has led some banks to re-evaluate their relationship with these borrowers. But preparation in this situation can also mean patience. Just like a borrower did not fall into distress in a day, the relationship cannot be fixed in a day. If a borrower is continually falling short on debt service coverage reporting, and generally being difficult, it may be time to try to convince the borrower to refinance. Banks may also be tempted to invoke non-monetary defaults in these situations. While this may be possible, a lender would be wise to follow the loan agreement closely and carefully document the defaults. The case of Bailey Tool & Manufacturing Company1 should be a warning to ensure that non-payment defaults are carefully enforced. In that case, the lender declared a default after deeming itself insecure among other defaults. Eventually, the lender took control of the borrower’s accounts and receivables, blocked the borrower from making payroll, and tried to replace the borrower’s management and otherwise “micromanaged” the company. Ultimately the borrower filed bankruptcy and sued the lender, obtaining a significant judgment including punitive damages. In another case of interest to non‑payment defaults, Beaumont Lamar Apartments LLC v. Wallis Bank,2 the lender grew frustrated with the borrower’s delays in construction (which were not the fault of the borrower) and ultimately refused to continue to fund the project and accelerated the loan. The borrower initiated a variety of claims against the bank and its individual directors for negligence, fraud and breach of fiduciary duty. The bank sought summary judgment on these claims, which was denied, forcing further litigation and ultimately settlement. Non-payment defaults take a variety of forms, and any attempt to initiate a lawsuit against a borrower based on a non-payment default should be viewed objectively and coordinated with legal counsel from the beginning. Each distressed borrower presents its own challenges for a workout, whether the default is a payment or non‑payment default. While it is impossible to forecast exactly what 2025 and beyond will mean for workouts, the ingredients are there for an increase. So, as you prepare for the next year, don’t forget special asset planning as part of your bank’s resolutions for a productive and profitable new year! Michael R. Proctor serves as Special Counsel in the Canonsburg, Pennsylvania, office of Bowles Rice LLP. Admitted to practice in Pennsylvania, West Virginia and Ohio, Proctor focuses his practice in the areas of bankruptcy and commercial law. Contact Mike at (724) 514-8934 or mproctor@bowlesrice.com. 1. 2021 WL 6101847 (Bankr. N.D. Tex. Dec. 23, 2021). 2. 2024 WL 455343 (N.D. Tex. Feb. 6, 2024). 12 West Virginia Banker
Top Strategies for Managing Liquidity in a Falling‑Rate Environment With the Fed cutting rates by 75 basis points since September, bankers are rethinking their strategies for funding and liquidity management. Declining interest rates may tighten the spread between earning assets and liabilities, requiring bankers to adjust to the changing environment. Here are three strategies bankers can leverage now to walk this tightrope: 1. Examine and Reprice Short-Term Liabilities: Falling rates will impact profitability. To counterbalance, banks will need to reprice a portion of their liabilities, reducing interest paid to some depositors. While some customer runoff will be inevitable, bankers should prudently consider their approach, as cutting rates too swiftly (or for too many customers) could lead to unexpectedly large losses in funding. Thoughtfully considering which classes of customer will see the first-rate cuts (preserving higher rates for higher‑value depositors), in conjunction with using short‑term funding solutions, can help banks maintain desired funding and optimal liquidity levels. As an example, IntraFi’s ICS® service can provide floating‑rate, short-term funding that reprices quickly, enabling banks to take full advantage of falling rates and replace high‑cost deposits that may leave because of rate changes. This can be done using ICS’ One-Way Buy® feature, through which banks can access floating-rate funding at select terms (from overnight to multiyear) without collateralization requirements. 2. Assess Whether to Repay Long-Term, Fixed‑Rate Liabilities: Banks will also need to check their longer‑term liabilities and decide if they are worth holding or paying off early and replacing them with shorter-term, lower-cost deposits. Fortunately, the math behind this decision is easy — bankers will just need to compare the prepayment penalty against the cost of continuing to pay above market rates. For banks that make the decision to replace their longer‑term liabilities with shorter-term funding, ICS One‑Way Buy is a simple way to acquire floating-rate funding tied to an index of the bank’s choice. Institutions that are looking to reduce the burden of longer-term liabilities but still desire fixed-rate funding may benefit from leveraging CDARS® One-Way Buy, which allows banks to acquire large blocks of fixed-rate, wholesale funding and mitigate margin compression — while paying a single, all-in rate with no transaction fees apart from the cost of funds. 3. Pay Attention to Your Bank’s Securities Portfolio: The changing shape of the yield curve over the past two years has forced some institutions to take considerable losses, By H.D. Barkett, Senior Managing Director, Treasury Desk, IntraFi 14 West Virginia Banker
TAKE YOUR MEETING TO NEW HEIGHTS AT AMERICA’S RESORT. Prepare to have your minds come alive in an environment that is both inspiring and captivating. From elegant ballrooms to intimate boardrooms, The Greenbrier features a variety of spaces that can accommodate meetings of any size. Experience the difference at America’s Resort and elevate your next meeting. 101 Main Street, West White Sulphur Springs, West Virginia 24986 304.536.7882 • Greenbrier.com and, in 2023, even contributed to several notable bank failures. Most institutions have fortunately weathered the storm, though they may be holding on to unrealized losses. This latter group may be in luck — as rates decline, those once-underwater securities now have a chance to come up for air. Banks should monitor the yields of formerly upside-down bonds against the cost of funding. These potentially recovered securities can be helpful to counterbalance any losses incurred in paying off long-term liabilities, offsetting at least some of the prepayment penalty. These are far from the only considerations facing banks during a fundamental shift in rates, but by prioritizing these items, banks can act quickly to boost profitability during this period of change, setting themselves up for even greater success once rates settle. Solutions, such as IntraFi’s ICS or CDARS services, can provide both short- and long-term wholesale funding alternatives, as well as deposit-gathering and liquidity management tools that banks can use in any rate environment. IntraFi is not an FDIC-insured bank, and deposit insurance covers the failure of an insured bank. A list identifying IntraFi network banks appears at www.intrafi.com/network-banks. Certain conditions must be satisfied for “pass-through” FDIC deposit insurance coverage to apply. To meet the conditions for pass-through FDIC deposit insurance, deposit accounts at FDIC-insured banks in IntraFi’s network that hold deposits placed using an IntraFi service are titled, and deposit account records are maintained, in accordance with FDIC regulations for pass-through coverage. Deposit placement through an IntraFi service is subject to the terms, conditions, and disclosures in applicable agreements. Deposits that are placed through an IntraFi service at FDIC-insured banks in IntraFi’s network are eligible for FDIC deposit insurance coverage at the network banks. The depositor may exclude banks from eligibility to receive its funds. Although deposits are placed in increments that do not exceed the FDIC standard maximum deposit insurance amount (SMDIA) at any one bank, a depositor’s balances at the institution that places deposits may exceed the SMDIA before settlement for deposits or after settlement for withdrawals or be uninsured (if the placing institution is not an insured bank). The depositor must make any necessary arrangements to protect such balances consistent with applicable law and must determine whether placement through an IntraFi service satisfies any restrictions on its deposits. ICS, CDARS and One-Way Buy are registered service marks of IntraFi LLC. H.D. Barkett is senior managing director, Treasury Desk at IntraFi. Mr. Barkett has been involved in banking and financial services for more than 30 years, working with financial institutions on issues involving asset/liability management, liquidity management, risk assessment and management, and portfolio hedging. Formerly, he served five years as vice president of sales and marketing and director of new initiatives with the Federal Home Loan Bank of Des Moines. Prior to that, Mr. Barkett was vice president of Institutional Fixed Income Sales with both Shay Financial Services and Paine Webber. For 12 years, Mr. Barkett held various management positions at Federal Home Loan Bank of Dallas in its Investments Group, Financial Strategies Group, and Sales and Marketing Department. Mr. Barkett joined IntraFi in 2002. 15 West Virginia Banker
Scarcity or Prosperity The Efficiency Ratio Under Attack By Dr. Sean Payant, Chief Strategy Officer, Haberfeld 16 West Virginia Banker
Many financial institution executives spend considerable time thinking about strategies to improve efficiency in order to improve overall profitability. The efficiency ratio is the ratio of noninterest expenses (less amortization of intangible assets) to net interest income and noninterest income, so it is effectively a measure of what you spend compared to what you make. The very name — “efficiency ratio” — makes us think about how efficient we are with those precious income dollars. If a financial institution has a high-efficiency ratio, they are simply spending too much of what they make … right? That is exactly what the name implies (emphasis on the spending side of the equation). But this is just a ratio of two numbers, and as we all know, there are two ways to bring the ratio down — reduce costs or increase revenues. The focus across industry press and conference best practices is generally aimed at strategies to cut expenses — using technology, looking at staffing levels, increasing productivity, etc. Although this advice is sound, what happens when a financial institution has already cut what can be cut AND it is still struggling with efficiency? It is sometimes difficult to save your way to prosperity. For many financial institutions, the focus should also be on the bottom portion of the equation — increasing revenues. Let’s look at an institution that has $500 million in assets, a good return at 1% ROA and a reasonable efficiency ratio of 60%. Let’s assume the FI can improve its efficiency ratio by 5% through revenue increase or expense reduction. Financial Metric Before 5% Efficiency Ratio Improvement by Revenue Increase 5% Efficiency Ratio Improvement by Expense Increase Assets $500,000,000 $500,000,000 $500,000,000 Efficiency Ratio 60% 55% 55% Net-Interest and Non-Interest Income $12,500,000 $13,636,364 $12,500,000 Non-Interest Expense $7,500,000 $7,500,000 $6,875,000 Net Income $5,000,000 $6,136,364 $5,625,000 ROA 1.00% 1.23% 1.13% Change in Net Income $1,136,364 $625,000 $500,000 less if the better efficiency ratio is achieved by reducing expenses! It shouldn’t be surprising that increasing revenues provides better performance, even though this sometimes seems like a counterintuitive approach. Because many financial institutions need to increase investments for growth in order to significantly grow their revenues, thereby increasing the expense side of the equation, and because of their excess capacity, this will actually make them more efficient over time. Many financial institutions have cut expenses almost to the bone and can’t materially improve their efficiency ratio by further reducing costs. They 17 West Virginia Banker
need to take a step back and realize some fundamental business dynamics that are often ignored in our industry. Most community financial institutions still have tremendous excess capacity, meaning they could serve significantly more customers without significantly increasing expenses. The answer to improving the efficiency ratio is to fill excess capacity with brand NEW profitable customers. How do other businesses look at the issue of excess capacity — for example, a manufacturing company? • The facility is running at 50% of the capacity it was built to produce; • The factory has done everything it can to be as efficient as possible — evaluate staffing levels, implement technology solutions, etc.; and • Management’s major goals and objectives are still focused on improving profitability by further evaluating already efficient processes and selling more to current customers. Given the excess capacity at the manufacturing company, wouldn’t it also make sense to evaluate if more widgets can be run through the facility? Would the market support providing more products to more people in order to increase net income without substantially increasing expenses? The manufacturing company analogy is very similar to the situation being faced by community financial institutions. Their branches currently attract 30% to 50% of the new customers they were built to serve each year, and the situation is getting worse as transaction volume continues to decline in branches. Most financial institutions have used technology and staff reductions to become more efficient; however, they still spend much of their time, effort and energy focusing on cost reductions and additional efficiency enhancement. When a community financial institution starts welcoming significantly more new customers per year, fixed costs do not substantially change — no new branches have been built, no additional employees have been hired. Actual data from hundreds of community financial institutions illustrates the impact on actual expenses is just the marginal costs — generally an additional $30-$50 per account per year (even if we must mail a paper statement). Conversely, the same database shows that the average annual contribution of each new account per year is between $250 and $350. When comparing clients that have embraced this strategy to the overall industry over a three-year period of time (2014 to 2017), their improvement in efficiency ratio was 63% better. This has been accomplished by significantly increasing the number of new customers coming in the front doors of existing branches. There is only so much blood in a turnip. Controlling costs, embracing technology to reduce process costs and evaluating staffing are all things financial institutions should be doing; however, if they have already become very efficient in these areas, the focus must shift to driving revenue. Most financial institutions have tremendous excess capacity in their existing branches today. The solution is to start filling them up. Sean C. Payant, Ph.D., is the chief strategy officer at Haberfeld, a data-driven consulting firm specializing in core relationships and profitability growth for community-based financial institutions. Sean can be reached at (402) 323-3614 or sean@haberfeld.com. Most financial institutions have tremendous excess capacity in their existing branches today. The solution is to start filling them up. 18 West Virginia Banker
Proper Oversight Keeps a Plan Running Smoothly By John Schafer, VP, National Leader, Financial Institutions Channel, Pentegra Watch an Olympic gymnast compete in floor exercise, and it seems as if the routines are almost effortless. But years of practice and endless hours of perfecting moves creates this demonstration of strength and grace. Now compare a toddler’s tumbling maneuvers on the living room floor. While we may congratulate them with Olympic‑sized enthusiasm, we know that there may soon be a crash with the end table. In some ways, plan sponsors who insist on administering every aspect of their retirement plan may be like our inexperienced toddlers: They may be good at running their business — but they may not be fully aware of the technical details and fiduciary risk involved when it comes to administering a retirement plan. By partnering with a fiduciary expert, plan sponsors can stay ahead of potential plan problems and ensure compliance with retirement plan rules and regulations. Plan Fiduciary Basics Because this is such a pivotal part of maintaining a retirement plan, we often revisit the importance of knowing — and fulfilling — plan sponsors’ fiduciary duties. Black’s Law Dictionary defines “fiduciary” as “one who must exercise a high standard of care in managing another’s money or property.” This may seem straightforward. But over the years, legal decisions and guidance from the IRS (and other federal agencies) have given us more detail about what this means in the context of retirement plans. In a nutshell, here are some of the fundamental tenets that plan fiduciaries need to know. • Plan sponsors (employers) are always considered fiduciaries. • Fiduciaries have a duty to administer a plan for the exclusive benefit of plan participants and their beneficiaries. • Fiduciaries who violate their duties can be held personally liable for a breach. • Fiduciaries may delegate certain duties (for example, day-to-day administration) to third parties. • In the event certain responsibilities are delegated to third parties, plan sponsors still have the responsibility to prudently choose those service providers — and to regularly monitor their performance. 20 West Virginia Banker
The fiduciary duty that a plan sponsor owes to plan participants is the highest duty in the law. It requires that plan participants’ interests are elevated above the interests of the employer. To ignore or minimize this requirement is to invite dissatisfied participants and possible sanctions from the Department of Labor and the IRS. Reduce Fiduciary Liability by Delegating Responsibility The potential liability for failing to meet fiduciary obligations can be substantial. But we don’t point this out to create undue concern. Instead, we believe that the surest way to help you avoid problems is to inform you about what you must do as a plan sponsor — and then to equip you with the tools to satisfy your responsibilities. There are a range of actions you can take. On one end of the spectrum, you or your colleagues could become retirement plan experts. This usually entails considerable time and resources. Sometimes larger companies hire workers who are dedicated to this function, perhaps in full-time human resources roles. But smaller businesses tend not to have highly skilled retirement plan experts on staff. Another approach involves outsourcing all retirement plan administration. Third-party administrators (TPAs) can be hired to provide nearly all the services that are needed to effectively run a plan. This strategy can relieve plan sponsors from nearly all the daily administrative tasks that a plan requires. Still, plan sponsors cannot avoid their overall fiduciary duty to choose proper service providers — and to regularly monitor their work to ensure that they are adhering to the terms of their service agreements. And this brings up an important point: such agreements are critically important. They should be written in plain language and should clearly spell out precisely which services will be provided. Plan sponsors should consider walking away from any contract that they don’t understand or that the provider is unable to explain satisfactorily. A third approach takes the middle ground between outsourcing everything and doing it all yourself. For example, some smaller employers might be quite good at onboarding new employees and may not need help with that. Or their payroll provider may offer some assistance by providing the employer with the information needed to properly enroll employees as participants when they become eligible for the plan. And some investment providers may supply recordkeeping services as part of their package. Each situation is different, depending on the needs of the employer. Plan sponsors may decide to seek outside help for only a portion of their required administrative duties. Pentegra is uniquely positioned to help plan sponsors meet their fiduciary and administrative duties. If you would like to continue the conversation, please contact John Schafer, VP, National Leader, Financial Institutions Channel, at john.schafer@pentegra.com or (317) 506-6875. CONTACT US TODAY TO PLACE YOUR ANNOUNCEMENT AD. SHOW-OFF. THERE'S NOTHING WRONG WITH BEING A Call (801) 676-9722 or scan the QR code to get started. Place QR Code Here ▷ Show off your employees. ▷ Show off your accomplishments. ▷ Show off a job well done. Employees are motivated when they are recognized and feel valued. This magazine is a great platform to celebrate your team’s accomplishments! 21 West Virginia Banker
Credit Risk Management Early and Accurate Risk Ratings By Brad Snider, Director, Laura Knight, Director, and David Bartus, Director, Forvis Mazars The FDIC 2024 Risk Review noted that “risk ratings may see a deterioration as a result of the refinancing of commercial real estate (CRE) loans.”1 The rising trend in delinquencies and lower occupancy in certain sectors, coupled with softening collateral values, could weaken CRE loan portfolios, particularly from loans coming due during this period of higher interest rates. Borrowers could face difficulties refinancing properties due to higher borrowing costs, which may affect repayment capacity and lower collateral values — two essential components considered by lenders.2 With an estimated $1.6 trillion in CRE loans maturing between 2024 and 2026, accurate risk ratings are instrumental in managing current portfolio risks while helping develop strategies for loan growth in asset classes preferred by your institution. In fact, the Office of the Comptroller of the Currency (OCC) Semiannual Spring Risk Perspective from the National Risk Committee reported that “it is crucial that banks establish an appropriate risk culture that identifies potential risk, particularly before times of stress. The ability to proactively understand and respond to potential increased credit risk during times of stress remains a prudent resilience-planning component. Recognizing concentrations early and developing effective strategies for managing concentration risk enhance financial resilience.”3 The OCC indicated that commercial credit risk remains moderate although it shows signs of increasing. Early detection and timely monitoring and analysis of credits is critical to accurately risk rating loans and borrowers. This includes collecting and reviewing required financial information in accordance with loan agreements and developing a plan of action based on anticipated events, updated forecasts and actual performance. Brad Laura David 22 West Virginia Banker
1. “Analysis: 2024 Risk Review,” fdic.gov, May 22, 2024. 2. “Analysis: 2024 Risk Review, Section 4 – Credit Risks,” fdic.gov, May 22, 2024. 3. “Semiannual Risk Perspective, Spring 2024,” occ.treas.gov, June 18, 2024. Brad Brad joined Forvis Mazars as part of the ProBank Austin acquisition. Brad had previously joined ProBank Austin in 2011. Brad has an expansive history working in commercial banks and has expertise in business development, loan structure, credit analysis/underwriting, and workout and collection resolution. Through his hands-on banking experience, he has worked with a diverse client base of financial institutions ranging from small community banks and credit unions to multibank holding companies. With a focus on credit risk, he works with clients to develop and implement credit teams, loan process and procedure improvements, and risk mitigation solutions. Brad works with clients on several credit-related projects, including loan review, stress testing, concentration analysis, ACL and other projects as needed. Brad is a member of the Tennessee Bankers Association (TBA), TBA Credit Conference Committee, Kentucky Bankers Association and Risk Management Associates. He is a graduate of Georgetown College, Kentucky, and the Graduate School of Banking at Louisiana State University, Baton Rouge. You can contact Brad by calling (505) 321-2542 or emailing brad.snider@us.forvismazars.com. Laura As a professional on the Loan Review team at Forvis Mazars, Laura reviews loans to assess the creditworthiness of borrowers and assists in reviewing the effectiveness of credit administration practices. She manages loan review engagements and due diligence reviews. In addition, she oversees continuing education training for the loan review team and is an instructor for the firm’s Consultants Foundation Training. Prior to joining Forvis Mazars, she worked in the credit department of a large midwestern bank in Wisconsin, Indianapolis and St. Louis for more than six years. Laura is a 2006 graduate of Carroll University, Waukesha, Wisconsin, with a B.A. in business administration, majoring in finance and management. She is also a 2023 graduate of the Graduate School of Banking at the University of Wisconsin-Madison and received the Executive Leadership Certificate from the University of Wisconsin-Madison. You can contact Laura by calling (317) 383-4000 or emailing laura.knight@us.forvismazars.com. David David has experience serving the banking industry since 1986. He manages loan review and loan consulting engagements for Forvis Mazars’ Loan Review service line in Dallas and Indianapolis, with a focus on sales and marketing in the broader Texas market. In addition to credit risk assessments, he provides consulting services for credit administration, cash flow analysis, loan underwriting, and collateral and loan documentation. Before joining Forvis Mazars, he served as a commercial lender, credit manager, financial analyst and special assets manager. He has originated and managed sizable commercial and investment real estate loan portfolios for multiple financial institutions. His experience in commercial credit administration and special assets includes oversight of the credit adjudication process, underwriter and financial analyst training, and risk assessment and management of high-risk credits, including loan restructuring, collection and litigation. David serves on the board of Vision Communities Inc., a nonprofit developer and manager of affordable multifamily properties. He is a 1985 graduate of The University of Texas at Austin, with a B.A. in international business, and a graduate of National Commercial Lending School at The University of Oklahoma, Norman. You can contact David by calling (317) 383-4110 or emailing david.bartus@us.forvismazars.com. A best practice to consider is to align the intended source of repayment with the actual source of repayment and document any changes with timely file updates. If the intended source of repayment is no longer viable or does not meet bank policies, analyze and re‑grade accordingly. If you are “shifting” grade justifications, there is a clearly defined weakness. Recent conversations with loan review clients have indicated additional scrutiny from bank regulators on accurate risk rating and increasing downgrades from regulators. In closing, identifying weaknesses and properly risk rating credits is a focus of regulatory exams and a proactive, transparent approach may be a key factor in a successful exam. For more information, visit our website at www.forvismazars.com. Early detection and timely monitoring and analysis of credits is critical to accurately risk rating loans and borrowers. 23 West Virginia Banker
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