As our economy reacts to the recent interest rate hikes, businesses aren’t shying away from taking out loans. In fact, the average loan size has grown significantly. In this episode, Alex Habet and Tony Hernandez discuss the latest trend data from Q2|PrecisionLender and highlight some key considerations for relationship managers.
Hi, and welcome to The Purposeful Banker, the podcast brought to you by Q2|Precision Lender, where we always discuss the big topics on the minds of today's best bankers. I'm Alex Habet. Welcome everybody to the show. Thanks for tuning in.
Very excited to introduce today's guest. But before I do, I don't want to get ahead of myself. I want to do a little table setting, a little quick recap from our last episode. In our last episode, I was joined by the legendary Dallas Wells, who's a fan favorite of the show. We focused a lot on the headlines at the time, right? It was right on the heels of a headline-busting rate hike. Bear market news was everywhere. There was also some residual talk of the yield curve inversion that we touched on a little bit, but we recorded that show a little less than a week following, especially, that rate hike, which is certainly by all standards very early to truly gauge the reaction of the commercial banking industry.
However, we were able to see a few early indicators to formulate some of that discussion, which is why when we recorded that episode a couple of weeks ago, we wanted to really start digging in. We focused a lot on the more macro themes in banking, right? How does a fluctuating rate environment, chaos in the equity markets, and that sort of thing, how does it impact the banking industry, especially in the conversations in the boardrooms or in senior manager meetings, right? How will this impact M&A, for example, or how will technology spend or infrastructure spend be affected? Right? Those were a lot of the reactionary conversations that we were hearing from our clients. Now we're a few weeks out and we have the benefit of having those extra few weeks to really start to gauge what does the evidence start to show, right?
To start to see how everything is starting to fall in place, or how it's impacted or how it's positioning for the next wave of moves, which is actually coming up pretty soon again. Now we confirmed some of our hypotheses, but we were also presented with a few interesting new facts along the way. Now we're not just looking at making a quick update to last week's episode. On this episode, we do want to recap some of that information. Also share some of those new things, but we wanted to also train the conversation down to the relationship manager, which is a huge constituent of this channel. In fact, this channel was originally created first and foremost for the relationship manager. But today we have audiences from all over the map who listen into the show. We still have those relationship managers, but we also have a lot of banking executives.
We (also) have a lot of employees here at Q2 or other players in fintech (who listen), but the reason I'm spotlighting this is that we want to go down and back to our original audience, right? This one's for you. And we want to help you make some sense of what's going on. So I'm joined today by Tony Hernandez. Tony spends every day working with our clients here at Q2 to help them get the most out of not only our relationship as a firm with the banks, but also how to make the most out of the technology investments that we help them with.
Now, my personal relationship with Tony goes way beyond Q2. We've worked together for years at our prior employer Bank of America. In fact, we used to share a wall in Midtown Manhattan back in the day. We used to also visit the local watering hole pretty frequently, but we'll leave that for another day, Tony. But in terms of tackling not only major transformational work, a lot of what we used to do back then was work day-to-day doing the typical blocking and tackling, working with relationship managers to help them figure out what's the right structure or how to think about a relationship a little bit more strategically or even how to just, get a transaction properly modeled in our calculators, right?
You'll be hard pressed to find anyone with more time behind the wheel in those kinds of conversations than Tony. So when I say we want to focus on the RM in this episode, well, here's one of the best to do that. So Tony, welcome to the show.
Thanks Alex, and very excited to be here. I guess you'll have to forgive me for this, but (I'm a) longtime listener of the show and a first-time caller. As a way of brief intro, like you mentioned, I have over 10 years of commercial banking experience. With time spent as a credit officer and the latter part of my career as a banker in a strategy role where, like you mentioned, I spent a lot of time working with RMs and their managers on a daily basis. Sometimes playing deal doctor, but also helping the commercial bank, how they were going to enter the digital ...
I can't believe this is the first time I'm hearing the term "deal doctor," but that is a brilliant invention. That's your new nickname from now on. Sorry, I didn't mean to cut you off. Go ahead.
No, it's, trust me, not a nickname I gave myself, but it's kind of apt, right? Because even nowadays where we spend a lot of our time working with our Q2 clients, is helping establish that relationship and doing more with their technology, but it's really about helping our clients, their strategy, come alive. So thank you for the warm intro. And again, overall, very excited to be here.
It's great to have you here. So this is the biggest rate hike in a generation, right? This will naturally throw a ton of balls up in the air, right? Not only for our industry, but for pretty much every industry. Anywhere where there's any sort of money movement involved, right? It's a big deal. So we're doing our best to try to make sense of it. One of the places that I personally look to, at least to try to get an early view, is to look at ... I know we focus a lot on commercial banking here and in the products that we work with, Tony, on a day-to-day basis. But I like to ground myself on the consumer side really early on, just to try to understand, well, the consumer behaviors can often act as a, for lack of a better term, a canary in the coal mine.
If things are going well with consumers, it's probably not going to indicate that there is a systemic problem, let's say on the commercial side. But if it's starting to show as a systemic problem on the consumer side, well, you can bet that it's going to bleed over. So there's a lot of articles floating out there about this. I would encourage everyone in this audience to fire up a browser, Google it. There are a lot of them out there and they're all good and they all present very interesting points of view. But given that today my guest on this show is a fellow B of A alumni, I figured it's probably a good idea to at least say, "Well, what does our old employer say about what's going on?" As an institution, huge market share in the deposit base of the country, major credit card-ish.
So there's a lot of data that they can analyze to determine spending habits and that sort of thing for consumers. So they, B of A, recently published on Bloomberg what's going on. And their main punchline there was that the consumer still is remaining resilient. Borrowing and spending, they remain strong. In fact, Alastair Borthwick—now CFO of the bank and Tony and I used to be in his orbit in our old roles back in the day, very great leader for the company—he used a term that the consumers continue to "spend robustly," which I thought was interesting. It's a little bit of an outlier in terms of adjectives used these days, I guess. The corporate balance sheets are still healthy. The bank balances, loan balances, they're still growing even in this quarter.
So despite inflation, consumers are still paying down their credit cards while maintaining those spend levels. Now they did acknowledge that in terms of savings, loans, mortgages, that sort of thing, they're not accelerating that the way they used to. But they are keeping pace, which is notable. What is also notable is that B of A does not see a recession as a done deal, in terms of what's coming up. They see an alternative path, which is actually a stark contrast to another big player in the industry, Jamie Dimon and his crew at JP Morgan. Just again, it underscores all the different perspectives and all those balls in the air. So now let's pull back a little bit, right? We got a little brief view on the consumer side. What does this mean for commercial?
As you've heard us, and I'm speaking out to the audience, we do analyze the activity on the platform pretty frequently. So it provides a near real-time view as to what's going on in the commercial space. And so, we gave you a little bit of a preview of the latest, what the stats are showing from the rate hike a couple weeks ago, but now we're actually going to talk about, well, what does it look like now that we've closed June out? What has changed or what's new?
For the purposes of this conversation, Tony, I figured, let's just keep it down to the three core metrics that we look at: volume, average deal size, and then finally spreads and coupons and that sort of thing. So, Tony, I know you've got that information handy, mind sharing with the audience, some of the conclusions? In terms of the first half of this year, now that it's closed out, what's happening with volumes?
Yeah, absolutely. So like you mentioned, starting with volume and it's interesting how, despite the recent rate hikes, it appears that the commercial banking sector absorbed the rate hikes without really missing a beat. We have now observed about a four-month run of solid loan pricing activity. The pricing mix has not changed much: SOFR making up about 34% of the mix and fixed-rate instructors just down a touch to 31%. And I want to comment maybe because it's still a relatively not-too-distant memory. I look at the first half of 2022 and immediately want to compare it to the first half of 2020 and how there was a definite flurry of activity in 2020, but it was to to fund existing lines or funding operations through PPP loans. But new loan demand had dried up there for a while with both the industry and borrowers, perhaps, being more tepid given the amount of uncertainty that there was.
In contrast to now, borrowers are still pursuing projects. And in some cases, perhaps even looking to borrow sooner than they normally would as they look to get set pricing or lock pricing before it potentially rises again. Matter of fact, one of the clients we recently spoke with, they shared a story of how a deal came to their desk whereby the borrower effectively said, "Hey, I don't care how much you charge me in fees, but I want to get this pricing locked in now." So the volume, again, that we've seen over the past four months continues.
I was going to quickly mention on volume and size since they go hand in hand is that the biggest deals also appear to be getting bigger by a margin of about 40% when you compare lending now to the start of the year. So the elevated levels that we saw a few months ago are still holding. Now, there could be a lot of factors that may drive that, but having to recently deal with some home projects myself, I can tell you everything was costing a lot more, from door handles to raw materials. So these factors along with many others may be contributing to that broader "why." On why not only we see larger deal activity, but also why we have also seen some of this sustained increased volume.
Yeah, that's interesting. When I was looking at some of the raw data that was coming around, especially around sizes, which is a very simple thing to just analyze over time. And if you just look back to only in January, which is where we indexed, or we set the index at 100 at January and we compare it, the last two or three months, we've been 40% higher than that, which is enormous. Especially when there is a sustained level, maintaining that increase. Now, it'll be interesting to see how that shakes out in the next few months, but that was my biggest probably eyebrow raise. Is just how large of an increase that was.
Right. And I think it's interesting, too, when you think about it in a vacuum, perhaps, maybe not that shattering, but I always like to bring it down to my level. And if you think about it, even with $100, that means that you're needing $140 to fund your projects, right? So it's a tremendous amount of volume in terms of how much that borrower need has grown by.
Yeah. And you touched a little bit on spreads already, but the other thing that was just really interesting and caught my attention certainly is just how efficiently the market has, or at least the banking space has adapted to the new rate environment. Not only did they do a wonderful job so far adopting SOFR as a replacement to LIBOR. There was, I think, a lot of fear and anxiety around that before the cutover. But, I think we're at least now as a company here, Q2, where we work with a lot of other banks, we're looking at it and we're actually pleasantly surprised by the progress in there.
Fixed rates have been a little bit not as rosy of a story the past few months, but that's also appearing to change as well toward the better, a little bit. Sorry, Tony, you were about to mention something.
Yeah, no, definitely. And let me jump in and expand on some of those points. So SOFR has seen healthy growth over the first half of 2022. Earlier I mentioned how it now represents 34% of all pricing activity in our data. And I actually echo your sentiments where I am both relieved and surprised by the adoption. Given just the amount of uncertainty that there appeared to be on what alternative rate was going to lead, if any at all, really. Given that there were so many options that appeared and now seeing SOFR at 34%, I hope that for all the bankers who led that charge, that it's been a smooth and steady transition. So going to fixed rate a little bit, where that represented 31% of the volume that we saw while coupons had been a little pressed there, they have now started to also, or appear to start to, keep pace with the overall market rates.
We recently saw fixed-rate coupons in excess of 5% for the first time since January 2020. So to me, that starts to signal that perhaps what we saw earlier was just a little bit of lag in where those deals were initially discussed, brought to the table closed, and now we're starting to see those fixed rates react. Go back to that anecdote I shared earlier of where we have, one of our clients mentioned, "I need to lock this now so what fee is it going to take for me to be able to lock this today?" So probably a little bit of that.
Let's all take a step back and look at these observations. Look, I'm a child of the Great Recession. That's when I entered the workforce. And I started at Merrill Lynch during the beginning of the Great Recession, which was almost at the epicenter of what was going on, but it ingrained this culture of doom and gloom, I guess, when there's just a lot of economic headwinds, at least in my mind. But the story here is just, it's remarkably different. And it's, I don't know, I have a little bit of a whiplash effect. This is, again, just me personally, having been in a similar yet dire situation by contrast. But the story is there are some positives here, right? The banks are managing the flux really well.
In fact, they're positioning themselves for potentially a boost and profitability. At least if the early indications are true. Funding costs are being managed well. This might be a little bit more unfortunate for the commercial customer; they are bearing the cost. They are getting passed the cost of the increase in funding costs pretty efficiently by the banks.
All of this is just interesting. There are a lot of parallels to that consumer side of the story. The banks are keeping up. They're doing a good job through this so far, and it opens up a lot of opportunities and unique ways for them to compete in this environment that we're in now.
Which is really where I want to spend the rest of this episode and really home in on your expertise, Tony. Let's jump into the mind now of the everyday relationship manager out there. What would be, and I'll just let you spitball this, what would be some advice that you would give them just off the top of your head?
Yeah, absolutely. And if you allow me to recap what we just covered, is that combined with the volume and the size of the deals that we're seeing when you have a new loan or shoot, even the replacement loan, that we're seeing for the same client, it's bigger than the previous. And what we see with the rates with the coupons edging higher, spreads holding in some cases, even increasing. So there's been no squeeze on rate there. It's the perfect mix for potential profitability right there. And what we then see that is when the banker finds a great credit, they're leaning right into it. No problem.
So when it comes to what advice I would give to the relationship managers or bankers, play a little bit of deal doctor, if you allow me to go back to that, is that one of the things that I took away from that role is that the best bankers always brought a lot of options to their clients.
For example, your client might have asked for fixed-rate debt, but given the increasing rates and that the borrower may have a larger borrowing need, they may take pause on where the coupon may be when you first present those initial rates. So by providing a smorgasboard of options on how they can finance their project, it makes you a really valuable partner for them. So the structure, let's say we have a $5 million financing need where percent terms are doing the full financing fully in a fixed-rate structure, exactly what they asked, but also bring a SOFR or a variable rate option. Then as a third is where we present terms for $3 million in fixed, maybe $2 million in SOFR. And that third one might be perhaps a little controversial, but then what you're trying to do here is give you a borrower options.
If they are looking to reduce interest rate cost, that blended option might be a perfect way to do that so long as they understand the interest rate they might be taking when doing something like that. And as the banker, we should also look into presenting various options. As the data has shown us, the spread on SOFR deals has been trending higher compared to some of the fixed-rate structures. So this is a situation where it could benefit both parties. You're able to reduce the overall interest expense of the borrower while also providing the banker and the institution with a slightly more profitable deal.
So I'm going to ask you a slightly unscientific question and just the first thing that just comes to mind, given your experience, working with so many bankers. Totally get what you're saying here, come with options. Traditionally, do bankers tend to focus only on one option and they really just build their whole story around that, or is it a common practice and you're just reinforcing it?
Probably a little bit of both, but I think that as technology improves and the accessibility to information changes, I think that more often than not to be successful—and bankers are trying to be that trusted partner for their clients, for the borrowers—that they do start to bring more options, not only in terms of pricing and structure, but perhaps even different tenure options as a way to find, again, a solution that is beneficial to both the borrower and the bank.
Yeah. At least it's been my personal observation. Again, it's kind of mixed, but it feels like a no brainer you want to pick from a series of options that just fits, especially when you're starting to talk about chunkier, larger deals. And so you'll hear us encouraging bankers that we interact with to really be thoughtful about that. And we spend, as a company, as a software provider helping these bankers, we spend a lot of time building tools to help them do that really efficiently. Any other points of advice maybe perhaps on coupons or anything else you want to speak to the structural stuff you already brought up?
Yeah. Right. So earlier we encouraged folks to lean into that. It looks like the data points to that the banks have been able to successfully pass on those rate increases. While coupon is important in both structures, I think it's just as important to be mindful of spread. Particularly if you get into a competitive environment, and I cannot stress that enough. I think many of us fall victim to muscle memory or the behavior we see from our competitors and when looking to reprice existing loans. So again, getting into a competitive environment if our default is to go and either change the spread or the rate that we're offering by increments or reductions of 25 basis points. Now that can be observed in our data and I wager that if we were to poll some of our listeners, they may even also state that typically when they change pricing is by increments of 25 basis points.
So it's always important to pay attention to spread since that gives you a more direct feel for what your profitability will be. But right now, again, our data shows that the market is responding to higher rates and bankers should really lean into asking for that higher spread or coupon, especially on fixed-rate debt. And I know that it's not always easy to present terms in that manner. Shoot, for a lot of our bankers, that might be the first time where they're working through a raising rate environment of this magnitude.
So I'll share a quick story of something that happened to me when I was back in my lending days. We had gotten to the final round of negotiations with one of our clients. Now, I happened to have a pretty solid relationship with the CFO and he came up to me and was just overall excellent. "Tony, I cannot take a price increase on this loan, despite everything that's going on. The board will just not have it. Is there a way where we can talk about what the fees might look like so I can get my spread of X basis points and you're able to get whatever profitability you need so that we show partnership?"
And then when that happened, luckily for me, that happened really earlier in my career. But it opened my eyes of, not only should we be mindful of spread, but if we're going to have to give some concessions on where spread or coupon might be, too, then try to bolster what those fees might look like. So, again, going back to how we're bringing options to the table, it's not only the mix of fixed variable, etc., but perhaps a mix of how much we're charging from an interest perspective versus fees.
And then again, when it gets competitive and we're looking at a strong credit, etc., maybe challenge ourselves a little bit and ask if the 25 basis point discount is warranted or if a need or if 12 basis points will still get us the deal? Be nimble on our feet. So that when we're in that competitive environment, we're able to respond to what our client is telling us. Whether it's we have some pause on where the interest rate environment might be, but they might be more comfortable with giving you a one-time upfront fee.
That's a wonderfully simple example of at least articulating when we say, "Hey, let's find the right solution for the client and the bank." That's a perfect example of that, because you know you're listening to the needs of the client and they say, "Well look, it's going to be a more difficult pill for us to swallow with this kind of structure. Can we manage our interest expense a little bit?" He can get by with higher upfront fee, that's less of a pressing issue from that perspective. And so here we are working with that client, meeting their needs while not necessarily sacrificing what the bank has to do, at least for their shareholders, as well. So thanks for sharing that story. That's a great story.
So, Alex, I think to summarize some of the trek that we just went on, I'd encourage our bankers to not be intimidated by asking the borrower for a higher spread or coupon. Again, the data shows that market is not losing out on spread in this rate environment, and lean into the value. Lots of factors show that the average deal size has gotten larger. Where we're applicable, think of bringing options to your client and assess how you can meet their needs while, again, overall improving the bank's position.
Tony, thank you so much. I want to really express just how grateful that we are, myself and this audience to have you join our show. That'll do it for this week, but I'm sure this is also ... at least something tells me that this won't be the last time you're going to be on this show and this audience gets to hear from you. So once again, thank you. And I hope you had a good time doing the show, as well.
Absolutely. Alex, thanks for having me.
And thank you to all our listeners for tuning in today. If you want to listen to more shows, you can always go to the podcast page at explore.precisionlender.com, or you can head over to q2.com to learn more about the company behind the content. And if you like what you've been hearing, make sure to subscribe to the feed on Apple podcast or Stitcher, and you'll now find us in a few new places like Spotify and iHeartRadio. If you have a moment, let us know how you've been enjoying the show by leaving us a rating wherever you listen to your podcast. Until next time, this is Alex and you've been listening to The Purposeful Banker.