2023 State of Commercial Banking Preview

In this episode of The Purposeful Banker, Alex Habet welcomes Gita Thollesson to discuss some of the takeaways from Q2’s State of Commercial Banking 2023 Market Analysis.

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Transcript

Alex Habet

Hi, and welcome to The Purposeful Banker, the leading commercial banking podcast brought to you by Q2 PrecisionLender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Alex Habet, and welcome back everybody.

It's the beginning of 2023, at least at the time of this recording. There's a lot of momentum out there, depending on the kind of work that you're all preparing to do in the new year, how you want to tackle things, how you want to change things, how you want to improve things. A lot of people are looking to hit the ground running. Me, personally, when I'm not busy doing stuff with this podcast, I'm spending a lot of time meeting with a wide variety of banks and partners that we work with here at Q2. And we also spend a lot of time internally in advance of those conversations on how we want to improve our message in this aspect or that aspect or overall.

But one of the things that's abundantly clear is that there is definitely a noticeable buzz this year. It seems more pronounced than normal. A lot of people in our organization love to talk about, what's the state of commercial banking? It's a presentation that we do. Now it's a few years running. It's a once-a-year thing, so it usually will come out at the early part of the year, and in this case, we're going live with it later this week. It's going to be on January 26th. It's become a staple in how we participate effectively in the analysis of all the chaos that's going on out there. And I'm using the word chaos in a joking sense, but one of the things that has become abundantly clear to me in this buzz that we're observing is that I'm marveling at how many of our clients and our prospects have signed up to watch those things, really become a major part of how we give back to the industry, offering incredible and thoughtful and insightful information that impacts countless of people out there.

It's also, I think, a moment of reflection where things stand and, of course, how things can move forward. So look, without further ado, it's great to have Gita Thollesson back on The Purposeful Banker. It's her first time with me, but she's a repeat guest of the show. Gita has led this now for a few years, and she's here on the show today to give us a little bit of a sneak peek around the 2023 State of Commercial Banking. Now, Gita manages Q2's Strategic Advisory Services and is the resident expert on applying Q2 PrecisionLenders' proprietary data to identify market observations and trends. She has an incredible resume with stints everywhere, including S&P, LPC, AFS, I guess all of the acronyms that you could possibly want, right? Here at Q2, in my mind, the buck stops at her analysis of the market. She's the authority on this topic. So Gita, on behalf of everyone here at The Purposeful Banker, welcome to the show, or welcome back to the show, I should say.

Gita Thollesson

Thanks so much, Alex. Good to be with you.

Alex Habet

Thanks. So out of curiosity, what number are we at in terms of State of Commercial Banking? Is this the third one, fourth one, fifth?

Gita Thollesson

This is the fifth. So we started in 2019, yeah, January of '19, and so this is the fifth one. So yep.

Alex Habet

Yeah. It's become officially a thing now, right? There's no denying it.

Gita Thollesson

It has been, yeah. People look forward to it and our readership grows every year. So it's been very encouraging.

Alex Habet

It's been awesome to watch, at least to observe how this thing has also grown. So I guess for those unfamiliar as much within in our audience, what information is used to compile this sort of analysis, broadly speaking?

Gita Thollesson

Well, the information that we have visibility into, it's very different than what most bankers read and hear about. So really the only commercial banking data that's publicly available out there is the stuff that the Fed puts out, which is sort of top-of-the-house information on aggregate loan volume or aggregate deposits, and the FDIC data, which is all based on call reports, and that's also top-of-the-house, quarterly information. It's really not very granular at all.

But the data that we have visibility into, it's actually commercial banking information that we collect directly from the portfolios of banks across the country—banks and credit unions. It's over 150 institutions right now that are sending us data, and it's all of those institutions that are using the PrecisionLender platform. So we actually are on the receiving end of account-level information on commercial loans. These are typically private companies that are borrowing directly from their commercial bank or other financial institution. And so we're getting very granular information on pricing and credit risk, and not just the credit side of the balance sheet, but also deposits and other fee-based business, treasury services, and other business. So it's just a tremendous amount of data that bankers otherwise wouldn't really have visibility into.

Alex Habet

So, and to just latch onto that, beyond loan data, one of the things I read internally, and you can probably correct me in real time here, but this year we're also including a lot of additional payment data and data from other of our Q2 products in our family that collect. Could you share briefly the breadth of that additional new scope of data that we're bringing into this analysis now?

Gita Thollesson

Yeah. That's really exciting to look at the other side of the balance sheet. And so there are really two major new areas that we're covering in this report. One is the digital evolution of the market, which goes just so far beyond what we all used to think of as digital transformation. So it used to just be a conversation about the online banking platform, and it's sort of morphed into so much more than that. Customers are looking for end-to-end solutions. They want an integrated banking experience that ties into their ERP, all their back- office processes. So we're doing a lot of analysis on that.

And then in terms of innovation, we've also tapped into some fantastic data. We've used some of the Q2 Centrix data to look at fraud, which has been one of the key drivers for the decline in checks and B2B payments and the corresponding increase in ACH. But we're also looking at the new payment rails that are coming out this year with FedNow and real-time payments. And it's so much more than just looking at the immediacy of the payments. It really has to do with just the entirely new payment rails that includes remittance information getting passed along throughout the process. So a lot of new stuff in this year's report.

Alex Habet

Yeah, that's great. So just given your background, having worked in this industry now for a very long time, I'm curious—what's your pulse on what you have available to you today versus what was available to you, let's say, just a few years ago or 10 years ago, in terms of data and analysis that you have at your fingertips now? Are we in this new era of next-generation-level view of what's going on?

Gita Thollesson

We are.

Alex Habet

Yeah.

Gita Thollesson

Yeah. We absolutely are. So really, there are a few things that are different about the data that we have available today than say what I had 10 years ago. One is just the depth and breadth of that data, the number of financial institutions that are reporting in data on their entire commercial book, and not just on the loan side, but other business as well. But the other thing that's really different about this data is that we also now have visibility into what RMs are thinking about even if those deals haven't yet closed. And so just by virtue of PrecisionLender being in the cloud, we can actually see deals that bankers are working on while they're still in that very early phase.

So somebody actually just asked me this morning, when do you think pricing is going to turn? And I can answer that pretty definitively because we can see that. We can see what's the pricing that people are putting in today for deals that'll close in two or three months. And so it's much more current information on the pulse of bankers out there than what we used to have.

Alex Habet

That's really cool. So we're moving along as the years go by and we're just kind of upping the ante. And so I hope it's exciting stuff and it just makes these kinds of reports and these insights that you and the team are delivering just that much more important year over year and really just sets apart what we do from the rest of the market as well. So, will you be doing those cool little polls that you do typically where you ask people questions and then show the reactions back in real time? Are you planning on doing that again this year?

Gita Thollesson

We are, and there's only so much that you can measure in the data. And so there's a lot of value in just getting a read from folks, putting people on the spot and seeing what they're hearing, what they're thinking. And so we've done a couple of pre-webinar surveys, so we'll share those results. We've asked things like, what are your key strategic objectives for the coming year? What are the biggest changes that your customers have experienced? Beyond just the obvious interest rates and inflation. And so getting some sense as to that, we'll come into the webinar with that information, but then we'll also do some live polls during the webinar and ask things like, what are you experiencing in terms of credit risk? Any early warning indicators? That sort of thing. And we'll share those results live.

Alex Habet

Yeah. So that's another great reason, for those of you out there, if you have a chance to join live, you can participate in those polls and you get to be part of and experience that real-time reaction to some of these thought-provoking questions that Gita will also be posing out there. So again, January 26th, I think it's 3 p.m. Eastern time.

Gita Thollesson

That's right.

Alex Habet

Tune in. It's going to be a great show. I don't want to ask you to do a lot of spoiler alerts, but I do want to level set around how the State of Commercial Banking has evolved at least over the last year. And so as we mentioned, we talked about it a few times already on the show, this is an annual event. And so one of the things that I thought would be interesting was to look at the key takeaways from last year's event. I suspect some of the key takeaways still apply today and some might have changed. So I'm going to put up the five key takeaways that you published and I'm just going to ask you to give yourself an assessment. How has each of these held up?

So here are the key takeaways from last year, right? The first one was the banking market is poised for a rebound. So that's an interesting one to opine on right now. We've got the second one is the outlook for credit is favorable. The third one is the pressure on NIM continues, and I think you're going to probably have an interesting point or two on that, especially when we talk about things like deposits and other costs that banks are experiencing. The fourth one, the transformation in banking is accelerating, OK? I think that one's probably going to be consistent today. And the fifth one is primacy has taken a hold.
So I'm going to bring you back here on camera here and just, we don't have to sit and go one by one through all of those, but those were the key points. The market is poised for rebound, the banking market poised for rebound, outlook for credit is favorable, pressure on NIM continues, transformation of banks accelerating, and primacy has taken hold. So out of those five-

Gita Thollesson

Well, we weren't that far off.

Alex Habet

Yeah, I think so.

Gita Thollesson

We actually, we did OK on some of those. So really the biggest thing that changed in '22 versus where we thought things were going to land was really the Russia/Ukraine crisis, so that conflict. This time last year, I think that was just before all of that went down. And so at that point, think about it, we were just coming off of two years of COVID, right? We were finally starting to see the light at the end of the tunnel, things were looking up, the GDP numbers were good. I think at the end of '21, we were forecasting something like 4% GDP for '22. And so things actually were looking good.

And the turn in the economy that happened in '22 with the recessionary signals, the sort of two consecutive quarters of negative GDP growth, that took everybody by surprise. That was unanticipated. So we went from a very favorable economic outlook at the beginning of last year to then lots of talk of a recession. And with the constant increases in rates as a tactic for combating inflation, that was in effect threatening to spur a recession. So that was really the one biggest change from where we thought things were going to be at the beginning of last year.

But aside from that, I think we were actually pretty accurate. So if you think about it, we talked about the credit outlook being favorable. That's still the case. I mean when you look at the metrics in terms of things like delinquencies and charge-offs and even things like rating downgrades. So we talked earlier about the proprietary data that we have visibility into. So we can see, by the time a loan goes into a delinquency state, it's almost too late, I mean those problems have been brewing for a while. But we have visibility into the ratings that banks are assigning to their credits on performing loans, and we know what the probability of default is associated with those ratings. So we could see even when loans are getting downgraded.
And as of now through the end of last year, we actually are not really seeing a lot of downgrades. So the credit picture is still very, very strong for the industry as a whole. So I think we were pretty accurate on that. Now we'll see if that starts to change as we enter the coming year, and that is one of the poll questions that we'll ask during Thursday's webinar, so we'll see. But as of now, I think we were pretty accurate.

Alex Habet

Specific on the credit side, have provisions gone up with the banks? I know you do that kind of ancillary analysis as well. Has that trended higher?

Gita Thollesson

Yeah, it absolutely has, and that's actually one of the things that's sort of interesting. You sort of hear and see differences between what people are doing in terms of provisions as well as what people are saying when you look at the Fed survey versus what's actually happening in the market. So, yeah, provisions have been going up quarter over quarter for the last several quarters, and that's showing that banks are concerned about credit. And when you look at the Fed survey, the responses are very much along the lines of, "This is a recession that's coming, we're going to tighten, we're expecting loan demand to fall, and we're expecting credit risk to go up." So you hear that and then you look at the data and it tells a very different story. So it's a very, very interesting contrast there between the actuals versus the anticipation.

Alex Habet

All right, Gita, so what about the pressures on NIM that were observed last year? How is that story playing out in this year's analysis?

Gita Thollesson

Well, that story has completely changed, and that's not unexpected. So the end of last year was when we started to see, or the end of actually '21 was when we started to see the big rise in inflation. We wrote about that in last year's paper. And so it was expected that the Fed would start to raise interest rates, and that obviously happened throughout '22 and may continue as well. We'll see how this year plays out. But the beginning of last year, so really the pressure on NIM was because of the fact that rates were so, so low and spreads weren't compensating. Typically, I mean just there's a direct correlation between lending rates and cost of funds.

And so as the Fed starts to lower rates and the gap between wholesale funds and deposit funding narrows; NIM suffers. And unless you are raising spreads, which banks were not doing during the pandemic, you're going to suffer some losses in terms of NIM. So it was fully expected that as rates started to recover, NIM would improve. And we've absolutely seen that in the market.

I mean it's just NIM has just taken off over the course of the year, but that's really no thanks to pricing. We're not seeing banks start to raise spreads just yet, which is interesting because normally as you enter a recessionary period, that's the first thing the banks do. They start to raise pricing, they start to increase the margin over the market indices, primes over what have you, cost of funds. That's not really happening just yet. And despite that, NIM actually is improving entirely because of the rate increases. So if we do enter another downturn and then the Fed starts cutting rates, we're likely to see that pressure continue, especially if banks don't start improving pricing.

Alex Habet

Oh, that's a major shift, as you pointed out. And just thinking of that one, is that the biggest shift you would say out of that list?

Gita Thollesson

Yeah. I mean that's probably, that and then the fact that we thought we were headed for a rebound in terms of the economy and we're now talking about a recession. But even that, as we'll talk about during the webinar and in the white paper, it's certainly not the typical recession. We're not seeing the same signals that we normally see. Look at the jobs market, how strong that's been. I mean it's definitely very atypical compared to what you normally see when you're entering a downturn.

Alex Habet

So just out of curiosity, someone who focuses a lot of time and attention on this stuff, what are you going to be looking for month to month as new fresh batches of data hit your desk? What's the first thing you're going to start to look at? Just give us a sneak peek on how Gita's brain works.

Gita Thollesson

Yeah. So what I'm most excited about, we have a monthly blog that Anna-Fay (Lohn) puts out, and she typically taps into opportunity data. So she looks at the latest information on what bankers are thinking about, what they're considering in terms of pricing. She's doing some analysis now on term liquidity premiums that's really fascinating. A lot of that kind of stems from the fact that we could potentially face another liquidity crisis just given what's happened with deposit balances, which is another trend that's run counter to where things were this time last year. But she's starting to see those TLPs rise and is going to be writing about that as well as looking at the latest trends in terms of pricing and deposit volume and so on. So, that's what I'm most excited about, just to see in advance of this actually going down what the early data is indicating.

Alex Habet

Yeah, so it's interesting you bring up deposits because I was perusing the news, as one might, right? I'm sure you do a lot of that as well yourself. And I ran into a very interesting article, just like you meeting with banks all the time, deposits traditionally have not been a major topic of discussion the last few years, and now all of a sudden it's kind of like front page story for... It was certainly the case for some institutions and now it's even trickling up all the way to the top institutions. I want to show you this article that I ran into at the American Banker a couple days ago essentially acknowledging that even the largest banks at this point are finally maybe over that hump of being too flush with deposits and therefore not feeling like they had to compensate for it. It seems like that pressure is now even arriving at their doorstep.

So in this case, we have B of A, the second largest bank in the United States, saying, hey, now we actually have to start paying for deposits because they're now concerned about the rate of deposits going out the door. Which is a really interesting dynamic because when you have, especially the larger players holding such a huge market share of deposits, if they're not raising what they're paying, it's going to have a muted effect on the economy overall. But now that picture is changing. So I'm wondering what's your reaction now that you're actually also seeing the big banks start to be concerned about deposits?

Gita Thollesson

Yeah. I mean that's been one of the biggest sea changes in the market over the past year. So a year ago, banks were flush with deposits. They had more deposits than they knew what to do with and they had so much liquidity and just not enough loan demand. So a year ago when we asked banks, what's your top priority for the next year? The common response was loan growth and everyone was trying to figure out how are we going to grow the book to put some of these deposits to work? And if anything, as rates have risen, the value of deposits is that much more because it's really a great way to keep your funding costs down as opposed to going into the wholesale market to fund your loans.

So what's happened over the course of the year, probably about the middle of the year, we started to see deposit balances level off after having climbed so much. And banks were just not anxious to grow deposits. They had more than they knew what to do with. It was a lot of excess capital. So they kept the deposit rates very low. Deposit betas were really very, very low. And probably through the middle of last year, despite the fact that the Fed Funds rate was increasing, obviously banks responded by raising the Prime rate immediately whenever the Fed would raise the Fed Funds rate. They really kind of dragged their heels on raising deposit rates. And that started to change toward the end of the year that we started to see deposit betas climb. And it's just this realization that, hey, these deposits are really valuable, especially in the current rate environment, and we've got to hold onto them.

If anything, after the flattening out, they've actually started to decline. And we see that in Anna-Fay's data as well. She's looking at commercial deposits based on the PrecisionLender client base and seeing those numbers level off as well. So we're starting to see banks really pay up, especially on the commercial side, to try to hold onto those deposits.

Alex Habet

So the widening of NIM, or other profit indicators I guess, over the last year might be short-lived?

Gita Thollesson

Yeah, it very well might be. I mean at a recent conference that we were at, one banker said, "We look like geniuses when rates are rising," because our NIM is going through the roof, and that may not be anything that we're doing, it's just that rates are rising so NIM is great. But then as rates come down, unless you've really either improved your pricing discipline or tapped into other sorts of fee-based business to improve overall relations or profitability, you are going to see a deterioration.

And that's part of why I think one of the points we talked about last year was how important primacy is in terms of getting the full relationship. That's still equally important now, and banks may not need that with rates being as high as they are, but when we do enter the next downturn and rates start to get cut, that other fee-based business is going to be that much more important. And I think that's where some of this new content that we're going to cover around digital and payments innovation is going to be so important because those all tie into this source of fee revenue for banks.

Alex Habet

Yeah, no, that's great. This is kind of a cyclical thing, by and large, I guess for the most part. And so only focusing on where you are in the cycle, it's one thing, but it's another thing when you can start to look at other options and, like you just mentioned, the tables will turn again. And so what are some actions that some in our audience could take today, or just at least be prepared for mentally could go a really long way?

Gita Thollesson

Absolutely.

Alex Habet

So last question I'll ask you before I let you go, and again, I really appreciate your time. Views on uncertainty: So you mentioned the biggest variable in last year's economy was the conflict in Europe. I mean I would assume that remains by and large the biggest factor in the uncertainty going forward. Is there anything else you would spotlight in addition to that contributes to that? Would it be things like other geopolitical risks?

Gita Thollesson

Well, there's a ripple effect, right? So the geopolitical uncertainty and unrest has also exacerbated the supply chain disruptions, and the supply chain disruptions have driven inflation. And so there's been a domino effect of some of those issues. If you think about where we were two years ago, we had supply chain issues because of COVID. Now COVID is kind of in the rear-view mirror, and yet we still have those issues because of all of the unrest. And that's part of why we have such an odd economy right now that we've got inflation, but it's not so much because of an overheated economy as much as because of some of these supply chain issues.

And so that's probably the other big one. But then there've also been a lot of other changes in the overall market. So look at climate change and that's impacting ESG. That's also actually an opportunity for banks to provide solutions—ESG financing and even supply chain financing is an opportunity for banks. So things are absolutely changing. Disintermediation, there's so much that's going on right now. And then that's not even to mention some of the other topics that we'll be covering, like the payments innovation, FedNow coming out this year, real-time payments, those new payment rails. There's just a lot changing in banking. So it's an exciting time.

Alex Habet

Yeah. Well, it also underscores why, for those of you who can join on Thursday, it's Thursday, right? January 26th?

Gita Thollesson

That's right. Thursday at 3 p.m. Eastern.

Alex Habet

3 p.m. Eastern, you're going to get a whole in-depth analysis on all the things that Gita was talking about, and then some. It's really thought-provoking content that applies to all of us. And so it's kind of never been more important to pay attention to this stuff, frankly.

So look, Gita, I want to thank you again. I'm hoping you'll come back to the show sometime soon after this event, kind of giving us a little bit of a retrospective on this year's analysis. But thank you again, and I personally look forward to reading the full report and attending on Thursday. So thank you.

Gita Thollesson

Absolutely. Good to be here.

Alex Habet

All right. And that's it for this week's episode of The Purposeful Banker. If you want to catch more episodes, please subscribe to the show wherever you like to listen to podcasts, including Apple, Spotify, Stitcher, and iHeartRadio. And if you have a minute to spare, let us know what you think in the comments. You can also head over to q2.com to learn more about the company behind the content. Until next time, this is Alex Habet, and you've been listening to The Purposeful Banker.

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