Banks Weather Economy, Regulations to Stay Strong

“It’s got to be small startups and small businesses that are starting,”
said Kevin Barth, president and COO of Commerce Bank in Kansas City. “You’ve got to always be helping the next business get started here.”

Barth was discussing the long-term strategy for maintaining a healthy banking climate—and vibrant economy—in Kansas City. That strategy is essential in an era when low interest rates and positive cash flow prod national corporations to buy hometown Kansas City companies.

Barth was one of a dozen bankers gathered in the newly remodeled offices of KPMG high above Downtown Kansas City on Nov. 3. They were there for Ingram’s 15th annual Banking Industry Outlook assembly. KPMG sponsored the event, which was ably chaired by Brad Sprong, the managing partner
for the firm’s Kansas City office. 

Assessing the Environment
As an introductory question, the participants were asked what trends they were seeing in the local banking community.

“It seems like credit quality overall has improved in a lot of the banks,” said Mike Maddox, president and CEO of CrossFirst Bank. “As a result, you start to see the market get a little bit more competitive on pricing and structure.” The result, he believes, is a healthier and more stable banking environment.

Kevin Kramer, executive vice president of commercial banking at Bank Midwest, affirmed Maddox’s take on credit quality. He added, “We’ve seen traditional banks in our market do a lot more long-term, fixed-rate financing on the books than we’ve seen in the past.”

Although conceding that there are still weaknesses in the Kansas City banking environment, Paul Holewinski, CEO and president of Dickinson Financial Corp., has seen “more rational kinds of deals getting done.”

From his perspective, Paul Laures, tax managing director at KPMG, has seen an increase in mergers and acquisitions among healthy banks. This, he believes, is a welcome change from the days of FDIC-assisted transactions and a “sign of an improving market.”

Brent Giles, president and CEO of BankLiberty, agreed that the credit quality had improved and that competition had become more rational. Still, he wondered whether the prolonged low-interest-rate environment might be masking some potential risks in the system.

“I think there are some inherent risks,” said Mark Fortino, executive vice-president and CFO of the Bank of Blue Valley.

Although generally positive about improved credit quality, he noted that banks were chasing yield holders and going out a little bit longer on the yield curve. He wondered whether they might be vulnerable when interest rates start to rise.

KPMG’s Stephen Penn agreed that some banks are stretching yield on investment portfolios and “maybe going out a longer duration to achieve that.” If generally pleased with progress in the local environment, he too cautioned about potential issues in the future.

“Things have improved greatly,” asserted David Chinnery, president and CEO of Adams Dairy Bank in Blue Springs. He attributed that in no small part to the fact that borrowers are bet-ter prepared and more calculating than in the recent past.

Jim Rine, president of UMB Bank’s Kansas City region, has seen renewed growth activity among new businesses, which have long been a UMB focus.

Chuck Morris, vice-president at the Federal Reserve Bank of Kansas City, made clear that he was speaking on his own behalf and not as the official spokesman for the Federal Reserve.

He confirmed the observations of the participants in regards to credit quality and the inherent risks of a low interest environment.

As a representative of a regulatory agency, Morris has also heard a good deal from bankers about regulation and very little of that is congratulatory.

Evaluating Technology
In assessing the current environment, KPMG’s Brad Sprong asked his colleagues what role new technology
investments were playing.

Paul Holewinski observed that technology spending had increased significantly at Dickinson Financial. He suspected it has just about everywhere. That spending has not only been on enhanced customer access but also on refinements to the core system. Replacing that core at Dickinson, still in the talk stage, would be “a significant undertaking.”

On the subject of creating a new core, Bank Midwest found itself in a similar position four years ago. Among the advantages, said Kevin Kramer, was the ability to measure client profitability and to respond to regulatory demands.

“Technology may be frustrating,” said David Chinnery, CEO of the smallest bank at the table, “but that’s been the game-changer for us.” He noted that Adams Dairy Bank adds new technology every three months as part of its strategic plan. “That’s been our way to stay competitive.”

For all its virtues, technology adds certain new anxieties as well. In its community banking survey, said Chuck Morris, the Federal Reserve found that the risks surrounding IT were the second-most-serious of risks bankers face. When asked what was the most serious risk, Morris said “regulation,” which provoked more than a little ironic laughter.

Approaching Consolidation
Given the costs of regulation and technology, Brad Sprong wondered whether the trend towards consolidation would continue and, if so, was it a good thing.

“We’re evaluating opportunities every week,” said UMB’s Jim Rine. “Whether it’s a good thing or not remains to be seen.” Although Rine thinks that community banks still have a valuable role, he believes that cost increases are making that role all the more difficult to play.

“Some of those banks are just going to put their hands up and say, ‘I just can’t deal with the regulatory piece any more,’” said Kevin Kramer. Some of them now, he believes, are just holding out for a higher price.
The ability to hire talent, said Mike Maddox, is still another pressure on smaller banks. When added to the cost of technical and cyber-security, he believes many banks will look for suitors. “You’ve got to have scale in order to survive,” Maddox added.

“With rising technology costs, compliance costs, and regulatory issues,” said Paul Holewinski, “it doesn’t look really bright for smaller organizations.” As he noted too, some 90 percent of American banks are under $1 billion in assets, and 30 percent under $100 million. “It’s impossible to think that consolidation won’t occur and at a much more rapid rate.”

Mark Fortino expects to see a different character in the consolidations of the next several years—fewer acquisitions of troubled banks and more “mergers of equals.”

As the CEO of a small bank, David Chinnery speaks often to his industry peers about the pressure to consolidate. “Everyone keeps saying they’re going to merge,” said Chinnery, “but nobody is doing anything.”
“The gap between the asking and selling price is huge,” explained Chuck Morris, “and it doesn’t seem like there’s been a convergence.”

“Consolidation tends to spike during difficult times,” said Kevin Barth. “We’re getting more and more calls from banks that are wanting to sell, not in Kansas City, but in markets where they know we’re looking at acquisitions.” As Barth noted, the longer interest rates stay near zero, those banks that have been relying on income from their bond portfolios will continue to see earnings decline.

One of the factors driving consolidation has been excessive regulation. The Federal Reserve’s Chuck Morris was asked whether regulators, who generally oppose “bigness,” consider whether the regulations they promulgate feed that very phenomenon.

“It’s something that regulators are very cognizant of,” said Morris. According to Morris, Esther George, the president and CEO of the Federal Reserve Bank of Kansas City, has spoken quite a bit about the regulatory burden and how it has affected community banks.

Morris noted too that there had been many calls for having a dual regulatory system, an idea the Federal Reserve does not think highly of. “The issue,” said Morris, “is to make sure that we design the regulations that appropriately affect banks in terms of their business model and that makes sense for those institutions.”
“We try to have a good solid relationship with the community and with the entities that we regulate,” said Morris. “We understand their business and we have a good dialogue going back and forth with them.”

Maintaining Security
Brad Sprong asked his colleagues whether advances in technology, particularly the use of cloud computing, compromised security.

Bank Midwest has been using the cloud for four or five years, said Kevin Kramer. They have been very pleased with the results. “It helps us grow without adding another server as we continue to grow.” The cloud also helps the bank curtail fraud by alerting customers quickly to unusual purchases on their credit cards.
The biggest losses that banks are taking, said Kevin Barth, have less to do with high tech thievery than with “social engineering,” a term for non-technical intrusion that often involves tricking other people to break normal security procedures. “We spend a lot of time educating our commercial customers and our bankers on how to fight social engineering,” Barth added. “It’s a big, big issue.”

There was no consensus as to who was organizing this kind of fraud. Mark Fortino noted that much of the weakness is internal. The Bank of Blue Valley, like some other banks, hires outside firms to test the bank’s staff for points of vulnerability. “The first time was fairly alarming as to how far they got” in attempts to access bank data, said Fortino. The bank has done considerable training since.

Commerce Bank, Barth attested, also spends a lot of time educating clients as well as its own bankers on how to avoid being compromised. “There are a lot of security features that banks are doing now,” said Barth. “It’s going to be a little less convenient for the customers, but it’s ultimat-ely going to make for a safer transaction.”

Non-Bank Competition
Brad Sprong wondered whether non-banking institutions, such as retailers, were creating competitive disadvantages for traditional banks.

Wal-Mart, for example, is a major competitor for Adams Dairy Bank, said David Chinnery. The irony here is that the bank was located across the street from a Wal-Mart to take advantage of store traffic. Chinnery believes that bad press has driven a certain class of people away from banks, despite the fact that 80 percent of the people doing banking business at Wal-Mart could save money using a traditional bank.

“A lot of the services people receive at Wal-Mart,” affirmed Brent Giles, “they could do at other places for less.” Giles is of the opinion that some people avoid banks for fear of closer scrutiny of their accounts, especially if they are at risk of having their wages garnished.

“The perception is that all of us bankers don’t want them,” said Chinnery, “but they are the ones opting out of banks.

It’s not like we’re opting out for them.”

Dickinson Financial, on the other hand, has chosen to co-locate in quite a few Wal-Marts across the country as part of its convenience-based banking retail strategy. “It’s worked out very, very well for us,” said Paul Holewinski.

Stephen Penn questioned whether non-traditional sources of funding, private equity firms for instance, were competing with local banks on the lending side.

“I haven’t seen any competition,” said Brent Giles. The only potential competition he has noticed has come from private individuals looking for yield on their money.

Jim Rine has not seen private equity taking opportunities away from UMB on the lending side, even though there has been a good deal of private equity activity in the Midwest over the past several years. That remains a concern, he said, “because generally when that happens, the local business (with that bank) goes away.”
On the commercial real estate side, Mike Maddox has noticed insurance companies and the like coming back with very aggressive, long-term fixed rate, non-recourse money.

“And they’re going down-market a little more than they used to,” added Kevin Kramer. “Used to be they wouldn’t touch anything under $20 million.”

“They’re doing it for the same reason the banks are,” said Kevin Barth. Namely, they can’t get the desired yield in the bond portfolio so they are adding larger commercial real estate portfolios.

Preserving Bricks and Mortar
Brad Sprong noted that not too long ago, all the talk was that no one would ever build a bank branch building again because everything would be online.

He questioned whether those projections had been borne out in reality.

“We are looking for additional locations, actually,” said the Bank of Blue Valley’s Mark Fortino. That much said, Fortino does not foresee as many new bank locations as there were several years ago. “But I still think,” he said, “that your presence in the community, as a community banker, is going to be still vital to your success.”

According to industry publications, Jim Rine observed, banks want their new branches to build in a “cool factor” and be more like an Apple store than a traditional bank branch. “In the meantime,” said Rine, “I don’t know that that necessarily makes sense, depending on the market in which you serve.” Much depends on the demographics of the region and the customer base. Rine believes that banks are going to manage their distribution channels accordingly.

Consumers still want to go to the branch for two things, said Kevin Barth: either to open an account, or for problem resolution. Banks’ ability to manage those issues through a computer or a tablet will determine whether branches will be less necessary. “Branch transactions are dropping,” said Barth. “There will be fewer branches 10 years from now—a lot fewer.”

Because CrossFirst is relatively new, it does not have a legacy branch network, and it doesn’t intend to buy any. “We rely on technology and people,” said Mike Maddox. “Our model is not going to have more than one branch.”

Brent Giles had a different perspective. He noted that the most common reason customers open new accounts at BankLiberty branches is because of the location. He noted too that about a third of the bank’s customers visit a location each quarter.

“It used to be, 10 years ago, you just looked at the rooftops and stuck a bank in there,” said Kevin Kramer. That still happens, but for a different reason, namely to get the bank’s name out in a non-traditional way. “Sometimes you look more at intersections, and what the traffic patterns are vs. just rooftops.”

Fortino argued too that having branches drives the franchise value. “Your deposit base is where a lot of that value comes from,” he said. On the retail side, commercial customers may be everywhere, but the deposit base demands some type of presence. As Brent Giles noted, small business customers use branches as well.

Championing the Midwest
The question was raised as to how well Kansas City banks have fared over the past five years in comparison to their peers on either coast.

“Some parts of the Midwest have done better than others,” said Mike Maddox, which is one reason why CrossFirst is getting involved in the energy business.

“If you’d told me we’d ever be making commercial real estate loans in Fargo,” said Commerce’s Kevin Barth, “I’d have told you you were crazy, but there are some very successful companies we’ve been helping expand up there.”

“You’ve got to have the talented people that know the business,” said Kevin Kramer. “You just can’t take a commercial banker and say you’re now our energy banker. You can’t just halfway go into that energy space. It takes a lot of specialization.”

The only reason Commerce Bank has focused on energy, said Barth, is because it bought banks in Oklahoma. There, much of the manufacturing and distribution is tied to energy. He agreed that “if you’re going to be down there, you have to understand energy.”

“Same for us,” said Jim Rine. UMB went into Texas two years ago. With a presence in Oklahoma and Colorado, it sees some huge energy opportunities there as well, but here in Kansas City, energy business is somewhat “peripheral.”

“There’s a lot of energy business in Kansas,” said Mike Maddox, “but it’s more south, south-central, southwest.”

In KC, Commerce remains focused on the life sciences, both on the animal side and on the human side. “You look at what’s going on with Cerner,” said Barth. “Clearly they’re a huge driver of growth. Look at what’s coming out of Stowers Institute. They’re getting closer and closer to commercialization of some their research.”

The Royal Factor
The Royals’ surprising run through the playoffs and into a seventh game in the World Series left the whole region giddy for a month. Participants were asked whether the team’s success would have any lasting effect on the community.

“You can’t buy the marketing Kansas City enjoyed for the whole thing,” said Mike Maddox. “You don’t know what impact that may have. There may be some CEO somewhere who said, ‘Hey maybe I should think about Kansas City as a place to put my company.’” Maddox believes the Royals’ success had a big impact on young people throughout the region, as well.

“The press was so consistently favorable too,” said Kevin Barth. “It just put Kansas City in a very positive light all around the U.S., and the world for that matter.”

“The psychological effect was amazing,” said David Chinnery, “especially when you’re watching the TV and the media’s talking about how great Kansas City is.” For the younger people at his bank, it was a learning experience.

“The younger crowd is back engaged,” said Kevin Kramer. He noted that the frequent shots of the Power & Light District reinforced all the work that had been done Downtown. “Hopefully, we will start to lure more and more young people to Kansas City,” he added.

“I thought it was very good for the city,” said Jim Rine, “but internally, there were a lot of tired people. I think we did lose productivity.” On both ends of that observation, everyone agreed.