10 Big Ideas for Banking in 2016
Opportunities abound, in affordable housing, capital raising, consumer lending and more. We aim to get you thinking about how new developments on many fronts could affect your business as you plan for the coming year and beyond.
Adults at all income levels are affected — even well-paid millennials with college degrees are spending an increasingly higher percentage of their take-home pay on rent — but those at the lowest end of the income spectrum are struggling the most. For every 100 households with incomes at or below 30% of area median income, there are only 28 affordable units available, down from 33 in 2007 and 37 in 2000, according to the Urban Institute. The situation has gotten so out of whack that there's not a single county in the entire country where the supply of affordable rental properties meets the demand, says Erika Poethig, the institute's director of urban policy initiatives.
"We are not adding more homeowners. We are adding more renters, but we are not adding enough apartments to keep pace," says Poethig. "That's putting more pressure on rents, which are rising most significantly for the lowest-income people."
The situation is likely to get worse over the next few years as contracts on 400,000 units designated as Section 8 expire and could potentially be converted by their owners into market-rate properties, says Poethig.
But with every crisis comes opportunity, and for KeyBank, the opportunity to boost the supply of affordable units — and make money doing it — is just too good to pass up. Armed with years of affordable-housing lending experience within its 12-state footprint, the Cleveland bank last year took the business nationwide in hopes of filling what it sees as a void in the market for funding these types of projects.
Robert Likes, a longtime executive in KeyBank's commercial real estate lending unit, manages the new national platform. He says the bank now has employees all over the country making connections with for-profit and nonprofit developers and identifying opportunities for building affordable multifamily properties or preserving existing ones. Financing for such projects can be complex — it may start with a construction loan, but can also include an equity investment through the federal Low-Income Housing Tax Credit program and a commercial mortgage that might later be sold to Fannie Mae or Freddie Mac — but done right it can generate decent returns at a time when all banks are struggling to grow revenue. KeyBank also benefits from Community Reinvestment Act credit on projects it finances within its branch footprint.
"The demand for affordable housing out there is really unlimited, so we see a real opportunity to take this business national and add substantial revenue," says Likes. "Providing safe, decent, affordable housing for families to help them get ahead is also just the right thing to do."
Recent government efforts to spur interest in affordable housing could make this a good time for other banks to become bigger players in the sector as well. One factor that has made the perpetual shortage worse is banks' reluctance to finance the development or rehab of smaller multifamily properties — roughly five to 50 units — so Fannie Mae and Freddie Mac are trying to make such lending more appealing. Both recently expanded or launched loan programs aimed at growing the secondary market for fixed-rate loans on these projects. The Federal Housing Administration also recently rolled out a risk-sharing program that lets banks and community development financial institutions use their own underwriting guidelines to originate multifamily loans of up to $5 million in high-cost areas (and up to $3 million everywhere else) provided they take 50% of the credit risk. With the FHA backing the other 50%, banks can hold far less capital against the loan than they would with a non-FHA loan.
Benson "Buzz" Roberts, the president and chief executive at the National Association of Affordable Housing Lenders, says these new programs will add liquidity in a market that desperately needs it. "It used to be that Fannie had some interest, Freddie did not and FHA simply did not have a product that was suitable for small loans," he says. "For lenders and borrowers, this competition is really important and really beneficial."
While credit is flowing at the higher end of the apartment market, it's nearly at a halt for older, smaller properties that make up the bulk of the affordable-housing stock. Many smaller banks have lost their appetite for financing the purchase of smaller properties because new Basel III rules would require them to hold too much capital against those loans. There's also not much of a secondary market for these types of loans, says Thomas FitzGibbon, the former president of MB Financial Bank's community development arm and now a board member at the Chicago nonprofit Neighborhood Lending Services.
"There aren't a lot of banks or savings and loans that are in position to do long-term financing without someplace to sell the loan," he says.
Roberts says lenders are particularly enthused about the FHA's program — expected to roll out in early 2016 — because it will allow them to sell the loans to a government entity called the Federal Financing Bank, thus freeing up more capital while relieving them of any interest rate risk. "It's not a secondary market, but it serves the same purpose of providing funding and liquidity," he says.
There are risks to financing such properties, as leases turn over frequently and operating expenses could conceivably rise faster than landlords can raise rents. But most observers say those risks are minimal, given the demand for affordable rentals.
With only about 200,000 new affordable units coming online each year, it would take decades to build the roughly 8.3 million units needed to house just the lowest-income families. Add in moderate-income households spending 40% or 50% of their income on housing and that figure gets significantly larger, says KeyBank's Likes.
Rising rents benefit property owners, but aren't so great for the broader economy. A recent study from economists Chang-Tai Hsieh at the University of Chicago and Enrico Moretti at the University of California at Berkeley concluded that the dearth of affordable housing in high-cost markets like New York and San Francisco is costing the U.S. economy roughly $1.6 trillion a year. In other words, if housing were more affordable in those markets, money that's now going toward rent would be spent elsewhere, thereby boosting economic output, they contend.
One reason why there's a shortage of affordable units is that many developers would prefer to build market-rate or high-end apartments that generate fatter returns. Another reason developers — and lenders — shy away is because the financing can be a challenge to put together. FitzGibbon recalls a deal he worked on in the mid-2000s while with MB Financial that had six layers of financing from various public and private sources.
"You can make money on [affordable-housing] deals, but it does require a certain level of expertise when it comes to understanding all that goes into them," he says.
Many experts say the solution to increasing the supply of affordable multifamily apartments is renovating or rehabilitating older properties instead of relying on new construction. That's a specialty of Avanath Capital Management, a Los Angeles-based investment firm that over the last two years has invested about $300 million in affordable housing across the country.
Daryl Carter, Avanath's chairman and CEO, is bullish on the sector simply because the demand for affordable rentals is so huge. The occupancy rate at Avanth's 35 multifamily properties is at 98%, Carter says, adding that many of its units have waiting lists. Rents average $1,100 a month.
The key to keeping properties affordable is to not "overimprove" them, Carter says. Refurbish, don't replace, kitchen cabinets. Upgrade the lighting to make the properties more energy-efficient. And resist the urge to rip out those 1970s-era popcorn ceilings, which he says could add $50 or $60 to tenants' monthly rent. "We will have investors tell us to remove the popcorn ceilings, but my response is that every household today can afford a $300 flat-screen television, so they aren't looking at the ceilings," Carter says.
Avanath is actively looking to acquire more properties — and that presents a different sort of opportunity for banks. Banks that invest in Avanath — KeyBank, Wells Fargo and PNC Financial Services Group are all equity investors — not only receive CRA credit but can also share in the returns, thanks to the little-known public welfare exemption of the Volcker Rule.
The Volcker Rule largely prohibits banks from using customers' deposits for their own investments, but it does carve out an exemption for investments that benefit society at large. Affordable housing falls into that category.
Years later, after Northtown got gobbled up a larger institution and the ATM became a fixture of modern life, my granddad always got laughs when he recounted this anecdote. The self-deprecating subtext: Can you believe how wrong I was?
Banks have long been trying to cope with change and, as my granddad's story illustrates, they have not always been ready to adapt. Today the technological challenges facing the industry are far larger than they were in the 1970s, and the need for tech expertise on bank boards is greater. Yet banks of all sizes are lagging.
A recent study by Accenture looked at 109 large banks globally and found that only 6% of their board members overall have professional technology experience. More than 40% of these banks did not have a single board member with a professional technology background.
The situation is even more worrisome at small banks, which may not be grappling with cutting-edge issues like digital currency, but still need to address major challenges like cybersecurity. "I see a very big problem in the community banking space," says Jack Vonder Heide, who consults for small banks on technology issues. "I'm going to call it a dire lack of expertise at the board level concerning all of the pertinent issues related to technology."
Banks of all sizes are being targeted by hackers, and employees are often reluctant to challenge the boss over lax practices. "There's a hierarchy where the boss is exempt from criticism," Vonder Heide says. "There needs to be a real culture change in terms of safeguarding this massive and growing amount of data that's stored in electronic form. And the board needs to set the direction for that awareness within the entire bank."
Many small banks have directors who are in their 70s and are not comfortable using a smartphone, Vonder Heide adds. "How in the world can they make an informed decision on the nuances of bank technology? They can't," he says. "If you have a candid conversation with board members, as I have dozens of times each year, they say, 'You know what? I am so uncomfortable with technology. And I realize that I'm personally liable if I screw up. But what can I do? I just hope that nothing goes wrong.'"
Some banks are taking steps to address the problem. Among them is Bank of Hawaii, which named Victor Nichols, a former chief executive of Experian North America, to its board in 2014.
Bank of Hawaii specifically sought out a director with tech expertise to prepare for the retirement of another board member with a deep understanding of technology. "It was a very conscious search for someone like myself," Nichols says.
The $15 billion-asset Honolulu company also implemented training for other board members who lack a strong tech background. Nichols says having a board that understands technology is particularly useful during presentations by bank employees. "We're able to call out areas where they may need assistance," Nichols says. "I think it makes a big difference."
In its recent report, Accenture recommended that banks provide regular technology coaching to their boards.
The firm also concluded that bank boards should form technology committees that consider questions like what the bank can learn from best practices in other industries. Only 11% of the large international banks that Accenture studied had set up those committees.
"The challenge is to bring about more fundamental change in boardroom culture by ensuring that the opportunities and risks posed by technology take a much higher priority on the boardroom agenda," the Accenture report says.
Banks that don't have tech-savvy boards risk running afoul of policymakers. On Dec. 17, Republican Sen. Susan Collins and Democratic Sen. Jack Reed introduced new legislation that would require all publicly traded companies to disclose in securities filings whether their boards have cybersecurity expertise.
Jean-Louis Bravard spent 18 years at JPMorgan Chase, including stints in high-level technology roles, and he recently wrote an article for Harvard Business Review titled "All Boards Need a Technology Expert."
"I find very few people in my age group who really understand the importance of data," says Bravard, who is an adviser to several tech ventures. "I meet with senior bankers and people on boards, and they are still living in 1995."
Banks have spent the years since the financial crisis whittling down their consumer loan offerings, exiting categories from student loans to small-dollar personal loans, and even in some cases ceasing to offer new mortgages. Nearly every bank drastically tightened its underwriting, cutting off consumers deemed to be credit risks.
The retreat can be attributed to weak demand, credit concerns and regulatory pressures, but it also reflected a broad economic trend: U.S. households, under pressure from unemployment and stagnant wages, were deleveraging, trying to pay down the excessive borrowing of the pre-crisis years.
Even as households struggled, the post-crisis era was a boom time for U.S. businesses, which enjoyed record corporate profits and surging stock prices. Banks responded by shifting their focus to commercial credit and fighting hard for prime commercial-and-industrial and commercial real estate loans.
But some say the pendulum is swinging back, and it may be time to retire the notion, driven home from painful experience during the crisis, that consumer lending is best avoided. With the U.S. consumer borrowing again, loan categories banks have fled are poised to grow.
"The pivot toward consumer lending is happening," says Jason Ware, the chief investment officer at Albion Financial Group, an asset-management firm that invests in banks. "Banks are starting to look at it as more ripe for opportunity than in the few years after the financial crisis."
This changing attitude toward consumer loans is more apparent following a bad year for the corporate world. Profits in the third quarter, which nobody expected to be great, were even worse than forecast, forcing analysts to lower their projections.
Weak commercial revenue hasn't led to heavy loan losses so far, but regulators have begun ringing alarms about possible bubbles in C&I and commercial real estate, two categories that have been the cornerstones of banks' post-crisis strategies. The delinquency rate for C&I loans is still extraordinarily good by historical standards, but recently started moving in the wrong direction. After hitting a historical low at the end of 2014, it rose for two straight quarters, to 0.81%, according to the most recent data available.
That's by no means dire for C&I loans, but the market is slower, if still firm, says Ware. "We see a pretty firm commercial loan market, but with pockets of weakness, like oil and gas."
Meanwhile, U.S. consumers have enjoyed better-than-expected job and wage growth this year, and consumer confidence and unemployment have improved to levels not seen in a decade. There are also signs that the long deleveraging of American consumers appears to have finally run its course, with credit cards and other revolving loans starting to tick up after about five years of stagnation.
And consumer credit is better than ever before, even as Americans households have started levering up. The charge-off rate for consumer loans held by banks improved to 1.96% in the second quarter, the lowest level since the Federal Reserve began tracking it in 1987.
The question for banks looking to re-commit to consumer lending is how. Mortgage demand is still weak, and there are regulatory barriers to making small-dollar personal loans. It's a particular conundrum for small banks, which can't easily compete with the likes of JPMorgan Chase and Citigroup in basic offerings like credit card loans.
"Consumer is a hard niche, and you've got to find the right distribution channel if you're not a legacy provider," says Marty Mosby, an analyst at Vining Sparks.
One strategy is simply to expand the credit range downward to get higher-yielding consumer loans on the books.
Santander Consumer in Dallas and SunTrust in Atlanta are among those embracing this strategy. Santander recently began keeping more subprime auto loans on its books, and SunTrust is ramping up consumer lending through its LightStream unit, which is willing to finance just about any type of purchase, including new cars, hot tubs and jewelry.
The online-lending unit bases its underwriting decisions on automatically generated credit bureau data. This helps alleviate a thorny issue: the time and expense of underwriting small consumer loans.
"The loan file is presented very efficiently," says Randy Ellspermann, LightStream's chief financial officer. "They can make very fast decisions on the information they're provided."
Another tactic is to find niches that other banks shun or ignore. That's the strategy of Citizens Financial in Providence, R.I., which is looking to boost profitability after splitting from its former parent company, Royal Bank of Scotland. In the past year Citizens has started refinancing student loans, a niche in which it competes with just a few nonbank lenders.
Citizens is also pushing into unsecured consumer lending, and recently inked a partnership with Apple to finance iPhone upgrades.
Another promising field is online consumer lending, which has already drawn attention from Wall Street heavyweights Goldman Sachs and the Blackstone Group.
Both are preparing to start making personal loans online. For smaller banks, teaming up with marketplace lenders like Lending Club has become a popular alternative, allowing them to offer customers another product while letting the platform handle pricing and underwriting.
Banks can approach it many different ways, but the shift from commercial to consumer is gaining momentum. After years of shunning small-dollar consumer loans while piling into corporate credits, banks could find the growth potential is greater in financing washer-dryers sets rather than oil rigs.
But you recognize that most of it is coming from people with a vested interest in seeing blockchain technology become the big thing that they think it will be — Blythe Masters, for one.
The JPMorgan Chase veteran is the chief executive of the blockchain technology company Digital Asset Holdings. So you have to expect her to talk up the blockchain as she has, tout its potential to change the way the financial world operates, emphasize how it can reduce risk, improve efficiency and ultimately provide better customer service.
Among traditional bankers, some might agree there's great potential in technology that facilitates an immutable record of transactional data.
Yet many remain skeptical about anything associated with bitcoin. Eyes glaze over at the details of how it works. Applications for the average bank seem to be distant still.
If this is how you think about the blockchain — that is, when you think about it at all — expect to be paying far closer attention soon. "The biggest idea in banking right now is blockchain technology," says Brad Leimer, the head of innovation for Santander Bank.
Leimer is quick to say he's not a bitcoin, blockchain or distributed ledger technology expert. But he considers the blockchain "big news" that banks of all sizes should care about. "It has fundamental properties capable of changing just about every financial transaction that people do today," he says.
A recent post on Simon Taylor's Innovation Blog — talking about the stages of blockchain understanding — is one Leimer relates to personally. Leimer says Taylor is right when he says people go from being dismissive of bitcoin as a currency, to curious about the underlying technology, to incredibly excited about the use cases.
"I've seen not only myself but my company go through that in the last 12 months," Leimer says.
When he started in his current role just over a year ago, he asked what Santander was considering doing with the blockchain. The answer was not all that much, "because it's connected to bitcoin, it's sensitive politically, and it's sensitive in regulatory circles." Now it's working with fintech startups on a variety of ways to use the technology, with trade finance being one of the areas Leimer is most excited about.
"2015 was the year that bitcoin was pulled out of the blockchain discussion and it became a technology," he says. "In 2020, we need to be actively leveraging this technology in day-to-day use."
The value of the technology has to with how it enables new forms of money movement and data storage that is cryptographically secure, he says. "Data and money have always been associated, but they've never been able to be encapsulated together. That really starts to make you think, 'What can that actually do?'"
One idea is a smart contract between two corporations that allows the release of a portion of funds whenever certain parameters are met in the shipment of goods.
As more data is stored via blockchain over the next decade or so, other possibilities open up, Leimer says.
"We're talking about mortgages that can be originated and closed within days, and potentially hours, if all of the data that was required for a mortgage was on the blockchain — searching for the title, checking that there are no liens against the property, all of the things that make mortgages take time," he says. "If all of the data was on the blockchain, it could simply be tapped into."
Leimer says even CEOs at community and regional banks should be learning about the blockchain and talking to their technology providers about it. "The question they should be asking themselves is, 'Are we missing out by letting the biggest banks develop this new paradigm?'"
Lenders have long relied on formal contracts with agents, known as marketing services agreements, to get referral business. These agreements spell out how the parties will advertise together or provide other services to consumers.
But in 2015, the Consumer Financial Protection Bureau, while not outlawing the practice, put the industry on notice that it considers certain forms of MSAs to violate of the Real Estate Settlement Procedures Act ban on payments for a referral.
In response, several major lenders, including Wells Fargo, PHH Mortgage and Prospect Mortgage, announced they would terminate their MSAs. With these arrangements on their way out, traditional word-of-mouth referrals become more critical for driving new business.
Some are suggesting that an end to MSAs will help ensure that the best loan officers and mortgage companies get referral business. Essentially, rather than relying on an MSA, loan officers will have to prove that they can provide the best mortgage experience for relators and consumers.
"Referrals are earned by doing actions beyond the sale," says Hunt Gersin, president and chief executive of Your Neighborhood Sales Consultants, a consulting firm focused on the mortgage business. "Give, don't expect to get anything. Follow the philosophy of 'give to give,' not 'give to get.'"
It's a tough time for such a shift, since mortgage originators are also adapting to other regulatory changes, including the CFPB's new disclosure form.
"You may have been driving for 30 years, but all of sudden every car switched and now the gas pedal is the brake and the brake is now the gas pedal," says Jeffrey Jaye, a mortgage broker in San Ramon, Calif. "It's like your whole life has changed in the way you've done something."
Jaye says his first two closings using the new disclosure form went so badly that he doesn't expect the clients (both first-time homebuyers) or the real estate brokers to refer other business to him. The complications stemmed from the new process, but the brokers had an easy scapegoat and blamed him for the closing delays.
Jaye says lenders will get better at the new process. But he is working to save the relationships he has rather than pursuing new ones right now. "I'm in survival/retention mode," he says.
Mortgage sales trainer Karen Deis, a former mortgage company owner and originator, compares referrals to restaurant reviews. "You either rave about the restaurant, it's OK or it stinks. I look at it as, you, as the loan officer, are the restaurant. If you provide good service, good information and continue to market on a regular basis" you will get a good review and earn more business, she says.
Deis created the Mortgage Girlfriends networking group for loan officers in 2007. Some of its members arrange regular, invitation-only Realtor Roundtables. The loan officer rarely speaks at these events, and instead brings in experts to offer insight on topics of interest. The speakers might be from real estate-related businesses or even people like self-defense instructors or chiropractors (agents spend a lot of time in their cars, Deis notes).
Mortgages are seldom discussed. "After almost every session, these gals swear they get between three to five referrals from the real estate agents afterwards," Deis says. "They're sitting around talking. They've now made friends with them."
Mortgage Girlfriends members also coach real estate agents on writing a business plan and do annual property valuation reviews for consumers — which are cobranded with agents.
Even when a real estate agent goes out of business (which happens to about a third of them every year, according to the National Association of Realtors), those annual reviews can pay off for lenders, Deis says.
"This gives you the opportunity to do the comparative market analysis every year and then introduce a new agent by saying, 'The agent you did business with is no longer in business. I would like to introduce you to Bob Smith, who will now be doing your comparative market analysis. If you know of anybody who is buying or selling a home, please call Bob Smith and here's his information,'" she says.
But a few investment firms have developed structured products that offer community banks a chance to band together to raise needed Tier 1 capital at relatively low cost.
These products - called collateralized debt obligations - also avoid some of the issues that caused regulators to frown on such financing in the past.
StoneCastle Financial Corp. in New York completed one such deal in October, raising about $205 million for a group of 35 community and regional banks in 24 states. EJF Capital in Arlington, Va., did a similar deal around the same time on behalf of 23 banks, mostly in California and Texas.
Michel Iannaccone, a managing director at Finpro, says he expects to see more.
"From the bank side, there are very few sources of capital available," Iannaccone says. "And from the investor side, there is clearly interest — though how long it'll last will depend on how the economy and the market does."
Josh Siegel, StoneCastle's chairman and chief executive, also predicts more to come. His company is eager to do another deal just as soon as it can line up enough banks.
StoneCastle is targeting tiny, privately held banks that otherwise would not have access to the capital markets.
Its pioneering deal was used to fund 10-year subordinate loans to the banks. Though the loans count as Tier 2 capital, if a bank holding company uses the proceeds to purchase stock in its underlying depositary institution, the depository can treat the new capital as Tier 1 common equity, Siegel says.
Four large institutional investors snapped up the deal. "The hardest part is rounding up the banks to do an issue," Seigel says. "Selling it was the easy part."
The investors did not include any banks, which StoneCastle barred from participating as buyers to avoid any concern from regulators.
Otherwise, Seigel says, regulators might see too much of a resemblance to a common pre-crisis source of funding that wreaked havoc.
Back then, community banks were able to issue trust preferred securities, a longer-term, debt-equity hybrid that counted as Tier 1 capital, and there was a ready market to buy the bonds backed by this debt. But many TruPs CDOs ended up being bought by banks themselves, which only compounded their problems during the financial crisis. TruPs no longer count as Tier 1 capital and, under the Dodd-Frank Act, can no longer be securitized, so that market has evaporated.
Though issuing common or preferred stock is an option for community banks, it's not so easy or attractive these days, Seigel says.
"This issue we just did ends up costing the banks about 4.5% after costs and, if you compare that to other options, it's 'Wow!' Remember, the average community bank has a return on equity of 9%, so to finance your capital at half that rate is really attractive," he says.
Sluggish loan demand, depressed revenue, higher compliance costs — the pressures prompting larger banks to act are the same ones that already have spurred smaller banks to do mergers and acquisitions in greater numbers.
Other factors include restrictions on dividends and share repurchases, excess capital and increased confidence in asset quality.
While the largest U.S. commercial banks — Bank of America, Citigroup, JPMorgan Chase and Wells Fargo — are out of the merger business, "the time is ripe for other large banks, including Canadian and Japanese, to get back in," says Fred Cannon, director of research for Keefe, Bruyette and Woods.
Bernstein analysts also anticipate an increase in merger activity, mostly for banks with less than $50 billion of assets.
They pointed out in a research note that October was the busiest month for bank mergers since June 2011 in terms of total deal value.
A handful of major deals also made for a busy year overall. The long-delayed M&T Bank Corp. deal for Hudson City finally won regulatory approval — which many interpreted as a favorable sign. Announcements came from KeyCorp that it would buy First Niagara Financial Group and from New York Community Bancorp that it would buy Astoria Financial. Closings went through for BB&T's acquisition of Susquehanna Bancshares, Royal Bank of Canada's acquisition of City National and CIT Group's acquisition of OneWest.
These kinds of large transactions had been relatively rare since the financial crisis.
But now mergers are a viable option for growth among the larger regionals once again, says Cannon. Size remains a limiting factor, but is no longer a reason for a freeze on M&A.
Several years ago, both Capital One and PNC Financial Services Group did relatively large deals that grew their assets to almost $300 billion, he says. "I think the rest of the banks can make acquisitions depending on: 1. How clean the buyer and seller are (buyer is more important); 2. How big the resulting bank is."
It's still unclear what size deal would cause the Federal Reserve to balk, Cannon says. "Would the Fed approve an acquisition where the combined entity would be greater than $300 billion? $400 billion? $500 billion? Probably not above $500 billion."
But under that $500 billion bar, Cannon expects to see a lot of M&A activity going on in the coming year.
If you guessed 2015, that's certainly reasonable, but also off by a millennial lifetime. Those words come from a 1988 book called "Breaking Up the Bank," in which Lowell L. Bryan, then a McKinsey consultant, argued that the industry should "unbundle, or break apart, the bank into its component functions," with each line of business legally separated from and unsubsidized by the others. (The technology he deemed threatening was securitization, then in its infancy.)
Today, banks are again said to be under siege and threatened by new lending technology (this time from online platforms). Many bankers are worried they'll be "unbundled" in a different way than Bryan envisioned — by startups picking off the most profitable, customer-facing parts of their business.
But history suggests that unbundling is a periodic, temporary phenomenon and that the disadvantages of a monoline business ultimately will lead to rebundling, whether it's banks acquiring nonbanks or nonbanks converting to banks. Just as biologists believe that diverse groups of crustaceans independently evolved into crablike form (a process known as carcinisation), it may be that nature wants to evolve a bank.
There are at least two arguments for rebundling as an eternal recurrence. The first is that during rough times, it's difficult for a lending business to survive without the stable funding sources available to banks, such as retail deposits guaranteed by the Federal Deposit Insurance Corp. and backstops like the Federal Reserve's discount window. The second is that surviving lenders have their own incentives to diversify and become more banklike.
"At the beginning of any credit or economic cycle, funding is available, losses are low, and you see the formation of new companies designed to hive off some part of banks' lending business," says Todd Baker, the managing principal at Broadmoor Consulting and a former banking executive and lawyer.
Since 1981, he's watched monoline credit card issuers, subprime auto lenders, mortgage bankers and storefront installment lenders come and go.
The nonbank model worked fine until "credit caught up with you significantly," Baker says. Then, "all of a sudden you had large losses," and liquidity would dry up. But, "ideally you sold out well before that."
A rare exception to the typical scenario is Capital One, a former monoline card lender spun off from Signet Bank 20 years ago. After the 1997 Asian and 1998 Russian debt crises, Capital One realized funding could be a major weakness and remade itself into a retail bank. The transformative 2005 purchase of Hibernia angered Capital One shareholders at the time, since nonbank lending during good times is a higher-return business, says Baker. But the move would prove prescient several years later.
"Not one of the major finance companies made it through the 2007 and 2008 crisis," Baker says. MBNA and Household were sold to banks beforehand. Countrywide had to be rescued by Bank of America during the downturn. CIT Group, American Express, GE Capital and Ally Financial (which is the former GMAC), submitted to bank holding company regulation to gain access to bank liquidity. Countless mortgage shops simply failed.
Baker anticipates a similar fate for marketplace lenders and other online platforms that have garnered so much buzz and investment capital in the last two years. The institutional sources of money they rely on to finance their loans will flee when loan performance worsens or regulators crack down, he predicts. Even those companies that don't hold loans on the balance sheet will be unable to originate and sell loans at gains fat enough to cover their fixed costs, he contends. The lucky ones will be acquired by banks, which will benefit from their innovative, millennial-standard technology.
One thing might be different this time: the more unusual a marketplace lender's niche, the harder it will be to find a bank buyer and to get risk-averse regulators to approve a deal. "Finance companies were bought by banks because regulators were willing to let them do that," Baker says. "They were willing to let HSBC own Household. Would they do that today? My concern is this will not be an easy task."
Marketplace lenders beg to differ on their long-term prospects, of course. Mike Cagney, chief executive of Social Finance, argues that its platforms provide real-time feedback on loan buyer demand, allowing them to adjust rates rather than get caught holding underwater loans like the finance companies of the past. Yet even Cagney foresees companies like his becoming more banklike, albeit under happier circumstances.
SoFi, which offers student, mortgage and personal loans for affluent millennials, is looking at adding a deposit product, which could be FDIC-insured or may have private insurance. The goal is not to provide a source of funding for SoFi's loans, which would continue to be financed on its market platform, but rather to meet its customers' every financial need.
"I do think you're going to see folks like us and others go after that side of the balance sheet, some for funding, but others to offer a comprehensive solution set so you never have to think about going to Wells Fargo," Cagney says.
A startup can offer the same products and services as a bank, but is not hamstrung by disparate legacy systems that don't talk to each other, leading to absurd situations like depositors having to reenter all their information when they apply for a mortgage from the same bank, he says.
Similarly, Jared Hecht, CEO of the online small-business loan platform Fundera, who gave a talk on unbundling last year at (where else?) the South by Southwest technology conference, nevertheless sees a business imperative for rebundling.
Lending products are "inherently not sticky," Hecht says. "It's difficult to instill a sense of loyalty in the customer." Hence startups are "beginning to think more holistically" about how to serve customers. "You don't just want to be a loan, a blip of a transaction over the course of someone's life."
David Brear, who holds the enviable title of chief thinker at Think Different Group, a consulting firm in London, wonders if marketplace lenders, known for their fast turnaround, can maintain the same quality of service as they branch out into other areas.
"Banks didn't start in the way they are today, incredibly complex with 500 different products," Brear says. "They started by doing something well, then moved on to the next thing. I like to joke that the grass was well cut, but then when they were looking at other things, it got overgrown."
In 10 to 15 years, hot U.K. startups like the short-term lender Wonga, the online investment management service Nutmeg and the mobile-first Starling Bank might face the same challenges banks do today, Brear says. "Would I start a bank from scratch like HSBC today? It's unlikely," he says. "But I can see why they evolved the way they have."
So can Bryan, who retired from McKinsey in 2012. He says the cycle of unbundling and rebundling is driven by regulation at least as much as by market forces. Nonbanks prosper in areas where banks cannot compete, often because regulations prevent the banks from doing so.
"Regulation is one of those facts you have to deal with, just like in nature you have to deal with the fact that there's a mountain range there or a desert," says Bryan, who now runs his own advisory firm and serves on corporate boards. And when regulations change, businesses must adapt to the new environment to survive.
Given the "overregulated" state of banking today, "I'd expect we're going to see an awful lot of innovation and new business models created outside the big banks, until they get big enough to create problems and regulation changes. Then they'll be acquired by the big banks."
So a word of caution to would-be disruptors: Banks as we know them today may not be pretty, but then neither are crabs.
It's an idea that could make sense for others.
Like many banks, the $11.9 billion-asset Old National sold branches during the financial crisis to boost capital. Long-term leases ensured that the company could continue to occupy the locations.
Such transactions — often called sale-leasebacks — have been a popular option for banks in recent years. One advantage is that it allows them to realize sales gains. And they can invest that cash in new technology, for example.
But with the industry on the rebound and interest rates persistently low, real estate investments have started to look appealing of late, says Christopher Wolking, Old National's chief financial officer.
"We don't have as much opportunity to deploy cash" — and Old National has a lot of it — Wolking says.
Besides reallocating excess capital, the move is helping Old National get ahead of a new accounting standard recently passed by the Financial Accounting Standards Board that will require companies to record the value of operating leases on their balance sheet. Most property leases are currently considered off-balance-sheet activities, industry experts say.
The change, which won't go into effect until 2019, will undermine a key selling point of sale-leasebacks — taking liabilities off the balance sheet, says Gerry Levin, senior managing director at Mesirow Financial, which specializes in real estate investing.
That doesn't mean buying is the way to go in every case.
Some banks continue to pursue sale-leasebacks, particularly in markets where real estate valuations are quickly rising.
Flushing Financial in New York, for instance, recently completed a sale-leaseback, cashing in on the fast-rising value of branches in trendy Brooklyn neighborhoods. Others have used the deals to lower costs and boost capital for making more loans.
Wolking, however, made it clear that he thinks other banks should look into buying back their leased locations. His Evansville, Ind., company, which now owns about 40% of its 164 branches, paid two real estate firms $66 million for the 14 properties on which it had previously done sale-leasebacks.
"I cannot imagine that people who had done those aren't considering [buying them back] today," Wolking says.
Suppose the management of a large bank promises to achieve a goal — say, hit a market share target, slash expenses by a certain amount, or upgrade core processing systems without going over budget.
How can the bank's investors, the board or even others in the C-suite know if the projections are realistic? Middle managers or rank-and-file employees may have a sense of whether the claims are plausible, but they don't necessarily have an incentive to say anything that contradicts the boss.
Enter prediction markets. Promoted since the early 1990s by the economist Robin Hanson, these are a way to induce people with expertise on a topic to show what they really think in the form of a bet. If there is no threat of retribution, and a financial reward for accurately forecasting outcomes, informed people will bet on their beliefs rather than adhere to a party line, the thinking goes.
A prediction market is like "a socially ignorant nerd who blathers the truth all the time, whether people want to hear it or not," says Hanson, an associate professor of economics at George Mason University and a research associate at Oxford University's Future of Humanity Institute.
He doesn't claim that the predictions are infallible, just that they're more reliable, than, say, an "independent" consultant incentivized to tell the people who hired him what they want to hear. It's a way to "get more accurate estimates than through other channels," Hanson says. Think the opposite of a "yes man."
Perhaps the most famous prediction market was Intrade, where speculators made bets on election results, weather and the outcome of wars. Some corporations (Microsoft, Google, Hewlett-Packard, and Starwood among them) have experimented with internal prediction markets as a way of eliciting candid advice from those in the know. Consensus Point, which employs Hanson as its chief scientist, makes software for running internal markets.
Maybe large banks, among the most siloed, opaque and politicized organizations around, could use this mechanism to get at the truth about everything from the prospects for a large technology project to whether a chief executive should stay.
In the latter scenario, Hanson describes an imaginary corporation that amends its charter to make the CEO's tenure depend on prices in "dump" or "keep" markets. Some people would agree to buy or sell the company's stock if the CEO is dumped by the end of a certain quarter. Others would make similar agreements to trade the stock only if the CEO is kept. The value of these agreements would vary depending on the market's view of the CEO's abilities. For example, an unpoplular CEO would make the "dump" agreements more valuable and the "keep" agreements less valuable. If, during the last week of the quarter, the "dump price" exceeds the "keep price," the market is recommending that the board cut the CEO.
You might think that a company's stock price itself is a referendum on the CEO, but Hanson points out that many other factors can influence equity markets. "Markets are saying thousands of things that are hard to disentangle," he says. A prediction market is a "more direct" message.
Bets don't have to involve stock. Neither do they need to focus on major issues. Prediction markets can help provide clarity on more granular outcomes within a corporation. Employees could be given the opportunity to (anonymously) buy a contract that pays out $1 if a certain outcome happens, such as a deadline being met for bringing a product to market. If the contract is trading for pennies, it's a signal to management that confidence is low. Options might be to delay the marketing for the product, change who's in charge of it or kill it.
Prediction markets are strictly advisory, and management is under no mandate to act on the feedback. But if more such markets were created, the track records of companies that followed their advice could be compared to those that didn't. If those that heeded their internal markets generated higher returns, it would shame the others, Hanson says. At the very least, a company or its managers would no longer have the excuse that a problem "came out of left field and nobody could see it coming."
One objection to prediction markets is that, like other markets, they can be rigged, but to Hanson, attempts to manipulate them can only help by adding liquidity. In his view, traders in financial markets fall into two categories, wolves and sheep. Wolves are those who trade because they have good information. Sheep are those who trade for any other reason — "if you trade against them, you're likely to win," Hanson says. A manipulator, then, makes a "nice tasty sheep," and the more people try to manipulate prices, the more wolves will come in to bet against them, resulting in more accurate prices.
But Hanson admits that there are some big impediments to widespread adoption, not least of all legal issues. Prediction markets can run afoul of insider trading and gambling laws. Intrade suspended operations in 2012 after the Commodity Futures Trading Commission sued.
But Hanson says the biggest barrier to corporate adoption is the very thing that makes prediction markets valuable: they speak the truth. "An honest, accurate forecast might not be welcome," he says. Often, when a market predicts that a project will fail, it "embarrasses the person in charge."
Even if corporate America remains lukewarm to prediction markets, they might sprout up anyway. Hivemind is a software project to create decentralized prediction markets using the technology underlying (what else?) Bitcoin. "No one wants to open Pandora's Box of truth," says Hivemind founder Paul Sztorc. "My project aims to open the box and keep it jammed open!"
Opportunities abound, in affordable housing, capital raising, consumer lending and more. We aim to get you thinking about how new developments on many fronts could affect your business as you plan for the coming year and beyond.
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