A ‘Pivotal’ Moment: What’s Next for Commercial Banking?

Emerging from a few years of market turmoil, commercial banks are now focusing on liquidity management and credit risk while anticipating new regulations.

The report: The State of Commercial Banking [January 2024]

Source: Q2

Why we picked it: Q2, one of the world’s biggest digital banking and lending solution providers, has strong insight into commercial banking. Its Q2 PrecisionLender data offers valuable information about the state of the market.

Executive Summary

After navigating some rough waters over the past several years, the commercial banking industry is now in a state of calm. However, it is unclear what the future may hold. Banks are shoring up their balance sheets through deposit growth and more judicious capital deployment. Meanwhile, they are concerned about the risk and process burdens of forthcoming regulations and are determining how to best adopt new technologies.

To learn about the state of commercial banking, Q2 gathered PrecisionLender data from more than 160 U.S. banks and credit unions, ranging from small community institutions to top 10 institutions. The report offers a broad overview of the commercial banking industry in terms of pricing, liquidity, demand, technology and other factors.

Key Takeaways

  • Deposit growth remains an industrywide challenge and scarce liquidity is leading to supply-side contractions, while elevated interest rates are slowing loan demand
  • New regulations like the forthcoming Basel III are leading bank treasurers to rethink capital strategy and pricing
  • Interest rate hikes have driven a shift toward floating rate structures and significantly increased the repricing risk on maturing fixed-rate deals
  • Banks are looking to technology to improve back-office efficiency, bridge the talent gap and find new opportunities to drive deposit growth from small businesses.

What we liked: Q2 has a strong pulse on the commercial banking industry and great access to data through PrecisionLender.

What we didn’t: The report contains is difficult to read and takes some time to decipher the analysis.

Liquidity Management

At the start of 2023, all signals pointed to a slowing economy. There were expectations that tightening would wind down and eventually give way to easing. However, by mid-year, economic indicators were more optimal than expected. As rate hikes continued through the spring, the decline in deposit balances accelerated and a wave of bank failures occurred. Expecting that rates would be higher for longer, commercial banks put shoring up deposits near the top of the list.

The drive for deposits: When deposits took a nosedive in 2023, banks aggressively raised rates on deposit-bearing accounts. Deposit betas accelerated and crossed 100% by the end of the first half, ending the year with year-end deposit betas exceeding 2.5%. The increases were greater for commercial customers maintaining large deposit accounts, as banks made great efforts to retain the valuable balances.

Maintaining relationships: In its PrecisionLender data, Q2 found banks more successful in maintaining relationships were agile in adjusting rates, offering an increase at frequent intervals. The least successful group displayed longer periods of static rates followed by large adjustments.

“The commercial banking market is at a pivotal point in its evolution. The industry has so far successfully navigated uncharted waters, demonstrating resilience in the face of challenges and is now preparing for an uncertain future. Regulatory changes are on the horizon, near-term monetary policy is unclear and technology is advancing at lightning speed. The future is unfolding as a dynamic landscape that will demand strategic foresight and adaptability for financial institutions and regulators alike.”

Other priorities: Over the past year, banks have prioritized deposit retention and growth, primarily by proactively managing FTP credit and being agile in adjusting customer rates. Yet discussions with bank executives reveal other tactics. For example, some are using technology to identify where customers may be rate shopping. Others are using old-fashioned bank calling efforts and leveraging systems to identify the accounts customers hold with other financial institutions.

Loan demand and supply: When managing liquidity, bank executives were split between preserving or expanding interest-bearing accounts and being more conservative in extending credit. The decline in C&I loan volume that occurred throughout most of the year may be attributed to the supply side as much as an indicator of declining loan demand. However, senior bankers continue to report a slowdown in loan demand for both C&I and CRE deals, though slightly less negative than earlier in the year.

Read more about business banking trends:

Regulatory Changes Affecting Commercial Banking

The U.S. is on track to adopt its own version of Basel III by 2024, although it has not yet been accepted and still faces significant opposition from industry players. It will target banks with more than $100 billion and trading assets exceeding $5 billion.

Impacts on banks: Global Systemically Important Banks (G-SIBs) will see significant impacts as new regulations challenge established methodologies and significantly alter how credit capital is calculated. For example, targeted banks would no longer be able to use Advanced Internal Ratings Based (AIRB) models to assign risk weights. They would instead have to use a standardized approach, forcing institutions to rework their internal tools and navigate the uncertain terrain of new calculations. While regional banks will face more tempered challenges, they must also address new concepts like operational and market risk capital.

Other concerns: Industry leaders are also concerned about the substantial increase in capital load. Anticipating up to a 25% rise in capital requirements, these banks argue against the need for additional buffers, saying they are already well capitalized.

Three options: As financial institutions prepare for these changes, they have three strategic options. The first is to take a hands-off approach and treat the regulations as a portfolio-level reporting exercise. A second option is to adopt the regulations as proposed and push them down to the bankers at the point of pricing. Another option is to view the changes as an opportunity to explore new, bespoke methodologies that more accurately reflect the nuances of commercial banking while ultimately summing to levels that would comply with new requirements.

Pricing and Credit Risk

Considering credit risk and regulatory uncertainty, it’s no surprise that bankers are thinking carefully about extending credit and ensuring an adequate return on capital.

Negative yield curve: While 2023 started with an inverted yield curve, the curve steepened considerably over the course of the year, from -23 bps to -140 bps. The problem is these extreme curve points don’t accurately reflect the cost of liquidity on the balance sheet.

Combined with uncertainty about future interest rates, it has diminished the appeal of fixed rate structure as bankers are reluctant to take on the interest rate risk and prepayment risk associated with these deals.

C&I and CRE delinquencies: While C&I delinquencies have remained steady, charge-offs recently increased as banks incurred more losses. On the other hand, the CRE market has faced challenges and rising delinquencies. All executives anticipate stress in the office space sector and charge-offs are growing and now exceed pandemic-era highs.

NIM and profitability: NIM has historically moved in lockstep with interest rates. Deposits betas have usually stayed far south of 100%, meaning banks would achieve a funding cost advantage in a high-rate environment. That dynamic has now changed in the rise in deposit rates and NIM is no longer benefiting from the Fed’s rate actions.

Since the start of 2023, NIM has been flat or declining. The plateau in NIM comes from sharp interest expense increases, which offset the benefits banks would otherwise have from rate increases. Quarter over quarter, interest expense has been on par with interest income, give or take a few points.

Payoffs and repricing: Over the past 18 months, rate hikes have caused considerable payoff repricing risk for banks and borrowers. Nearly a quarter of interest-bearing balances stem from fixed-rate loans, with 11% set to mature in 2024 and another 11% set to mature in 2025. As many of these credits originated during periods of lower rates, maintaining a comparable spread would entail a significant increase in nominal rates.

Efficiency, Payments and Talent

Efficiency: Mid-sized and large businesses are increasingly looking to increase back-office operations efficiency through greater automation and integration between banking and ERP/accounting systems. Growing demand by mid-sized banks signals a growing awareness of the transformative impact on accounting departments. Financial institutions that move quickly on ERP integration will have an edge over those that don’t.

Instant payments adoption lags: Given the demand, financial institutions have been relatively slow to adopt instant payments. Another survey by AFPT in the summer of 2023 found that 41% of organizations are receiving real-time payments for B2B transactions and 29% expect they will have adopted real-time payments for B2B transactions by 2025. Q2 notes the current economic environment encourages banks to focus on other things over instant payments. There are also issues with regulatory compliance and risk management.

Employee enablement: Banks are increasingly turning to technology to bridge the gap between commercial banking experience and technological prowess. While they have traditionally sought experience when hiring for roles like treasury officers and relationship managers, they are now seeking candidates with technology experience and teaching them the nuances of the industry with tools like AI-enabled copilots.

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