Dallas Wells interviews Ray Grace, the North Carolina Banking Commissioner, about innovation and regulation in the banking industry. Grace talks about why the word ‘change’ is perceived as more dirty than ‘FinTech,’ and why it’s so important to experiment in this complex economy.
Dallas Wells: Welcome to another episode of The Purposeful Banker, the podcast brought to you by PrecisionLender, where we discuss the big topics on the minds of today’s best bankers. I’m your host, Dallas Wells, and thank you for joining us. Today we’re going to be talking innovation and regulations with Ray Grace, North Carolina’s Commissioner of Banks. Ray, thank you for taking the time to talk to us today.
Ray Grace: Thanks for the opportunity, Dallas.
Dallas Wells: Ray, can you start just by telling us a little bit about yourself and your role as banking commissioner?
Ray Grace: Sure. I joined the Office of the Commissioner of Banks back in 1974, July of 1974, in the middle of a real estate recession. I’d like to be able to say that I had always wanted to be a bank regulator when I was a child, but that’s obviously not true. I stumbled into it at a time when jobs were difficult to come by, but it’s been interesting and challenging ever since.
I started out as a bank examiner trainee and have worked my way through the organization, became Deputy Commissioner back in about 2009, then later Chief Deputy Commissioner, and then was appointed Commissioner of Banks first by Governor Perdue and then by Governor McCrory.
Dallas Wells: Okay, so from 1974 until now you’ve seen a few up and downs in the industry.
Ray Grace: A lot of ups and downs in the industry, it’s fair to say, and a lot of change. A lot of innovation.
Dallas Wells: Yeah, you bet, and that’s actually what instigated this conversation today. It was actually from an article in the American Banker. It was called Regulators Need to Approve New Types of Banks. The article was based on your comments that you made during a North Carolina Bankers Association conference. One of the things that you said at that conference was that the banking industry has the potential to be a laboratory for change. Can you describe what you meant by that phrase?
Ray Grace: Sure. What I was talking about was that newly chartered banks that have models that are outside the sort of traditional commercial bank model offer an opportunity to try out new products, new services, new delivery systems on a limited and very controllable scale. The reason I call these useful laboratories is that obviously these are going to be new banks, they’re relatively small when they start out, and the risk is primarily to the investors although obviously some risk is going to be borne by the chartering agency, us, and certainly some risk to the FDIC fund, although because they’ll be of limited size, I think that that’s a manageable and acceptable risk factor. Systemic risk is not a factor, again, because they are small. I think if the model runs well, we learn from it and we may be able to replicate the success of the model in other banks and, conversely, if the model is a flop then we learn from that as well in a controlled way, at an acceptable cost. It’s like the old saying, nothing ventured, nothing gained.
Dallas Wells: Yeah, but it’s a very controlled way to run that experiment instead of trying to run it live in a traditional bank charter where there’s all the other typical bank things going on.
Ray Grace: Exactly.
Dallas Wells: You mentioned the need for those new types of innovative banks and a couple of examples you used were some North Carolina examples: Square1 Financial and Live Oak. Both of those were largely niche banks; they targeted very specific types of customers, but they did that on a nationwide scale. Were there some other ways that those banks were different besides just who they were targeting?
Ray Grace: Sure. Both those banks exhibited many of the typical risks that are faced by more traditional bank models: Credit risk, interest rate risk, etc, but for these banks, execution risk was particularly acute. Square One was formed to bank newly emerging businesses that had received one or two rounds of venture capital, and this is a very different business model than traditional banks work with and requires special skill sets and really an extensive familiarity with the business practices and needs and risks that are peculiar to those businesses.
Live Oak’s model, similarly, requires highly specialized knowledge of SBA lending. In this particular model, they had a keen focus on very specific and narrowly defined lines of business, what they call verticals. For example, veterinary practices, which was their initial vertical, and sole initial vertical, and now they’re into funeral homes, chicken farms, and a whole host of other verticals.
The other thing that was a little different from traditional banks is that they had a distinctly different culture. I think that culture was largely influenced by the people and the characteristics of the business they serve by the fact that they’re not attempting to appeal to broad sectors of the public like traditional community banks, for example.
Dallas Wells: We’ve seen, obviously, the pace of new charters come to a complete halt for a while through the crisis, and there have been just a handful of those that have even started the process, a couple that have been approved over the last couple years. Do you expect that groups that are applying for new charters will continue to follow that niche pattern that we’ve seen work pretty well for folks like Square1 and Live Oak, or do you still expect to see some of those classic community banks, those all things to all people general approaches that you mentioned?
Ray Grace: I think, clearly, this is the model that most people are familiar with and the one that most bankers understand, and it’s generally bankers who start banks. It’s also the model preferred by regulators, especially the federal regulators, so I think that makes it the path of least resistance and that makes it the one that we will be most likely to see more often. I think the traditional community bank model is still viable in most markets where consolidation has eliminated or, in some cases, reduced the availability to community banks, particularly where there were very successful community banks that have been taken out of play. That does leave pockets of demand for return to the type of service that those banks provided, but I have to say ours is a really highly complex and diverse economy with a lot of new, evolving businesses and changing banking needs and preferences. Because of that, I think it’s more important than ever that regulators, state and federal, be willing to consider new, innovative, specialized banks.
No community bank that I’m aware of can or would adequately serve the needs of those companies that were banked by Square1 or Silicon Valley Bank, and the same is true for Live Oak Bank. Fundamentally, I think all industries need to be refreshed, reinvented from time to time if they’re to remain relevant, and banking is no exception.
Dallas Wells: I think in North Carolina, particularly, like a couple other pockets around the country, a lot of the economic expansion has been in technology and, as you say, new industries that the banking world has to get used to serving, and the regulators have to figure out how to regulate them as they do that. It will be interesting to watch that over the next few years.
Ray Grace: It will, indeed.
Dallas Wells: In North Carolina, much like the rest of the country, you mentioned in the same talk that you’ve seen a number of charters shrink and go away due to M&A activity. Does that consolidation make regulation easier just because there’s fewer doors to go knock on and hoods to check under, or does the growing size of those institutions level all that out?
Ray Grace: Right before the run-up to the Great Recession back in 2006 or 2007, we had 116 state-chartered banks domiciled in North Carolina. We’re now down to 53. That number actually would be down as low as 51 but for a couple of conversions of national banks to state charters in the last few months. In answer to your question, I would say generally no. Consolidation does give you a smaller number of banks, but the ones that remain, as you say, are larger and they become, by virtue of that, more complex. Also, there’s a sort of logistical problem as our agency is funded by assessments on the assets to the banks we supervise, and the assessments are tiered to reduce the percent of the incremental increase in the size of each bank, the cost to them, so consolidation also brings budgetary constraints.
There’s the possibility that if we continue down the road to consolidation at the rate we’re going, I think we could see a banking system much like Canada’s with just a very few, very large banks. There are those, I think, who would argue that a system like that would be easier to regulate, but I disagree. As evidence, I would cite the difficulties and all the head-scratching now going around the too-big-to-fail issue, problems associated with regulating the few SIFIs (systemically important financial institutions) in the current system. More importantly, maybe, I don’t think the Canadian system would serve our nation as well as the system that’s evolved here. After all, we’re very different countries.
By the way, I don’t believe that regulation needs to be easier. I think regulation needs to be smarter and more adaptive.
Dallas Wells: Good point. As you point out there, I don’t think anybody would look at the larges banks in Canada or especially the Bank of America, JP Morgan Chase, those size of banks, and say that there’s anything simple about regulating them just because there are fewer of them, so that’s a point well-taken. Along those same lines, outside of a few acquisitive banks that are in the state under your supervision there, supervised assets have largely been flat. Any thoughts on why that is? Why, outside of acquisitions, things have just been churning in a very flat way over the last few years?
Ray Grace: Yeah, I think it’s fairly clear. What you’re talking about is what we call organic growth, very slow, organic growth, and bank asset growth is funded primarily by deposit growth augmented as necessary by borrowing. The near-zero interest rate environment we’ve been in for years now, largely because of monetary policy, has sucked a lot of the money out of banks that would otherwise be deposited with them. Depositors have diverted their funds to more lucrative investments in search of better yields. The stock market, for example. With the tepid economic recovery and a tendency by consumers to de-leverage as a result of lessons we hope they learned during the downturn, loan demand has been soft, competition for good loans is keen, and so the opportunity for growth the old-fashioned way has just been limited.
Dallas Wells: That’s one of the conversations we have a lot of times with banks is caution around that urge for growth, and of course they all have it, wanting to grow their businesses, but with the industry itself growing very slowly, if you’re going to grow faster than that, you’re either cutting some returns and taking business from someone else or you’re adding some risk. That’s just the fundamental law of it. I think that’s the issues we ran into before the crisis, where people were seeking growth for growth’s sake and it’s amazing how short the memories are sometimes.
Ray Grace: Sure, and chasing yields for yields’ sake. We’re reaching out the risk curve to enhance yields.
Dallas Wells: Shifting gears just slightly. We’ve talked about new charters and some of the opportunities for innovation there, what about existing banks? How can some of them participate in that innovation? Does it require a wholesale business plan change, or can they make some smaller pivots within what they’re doing?
Ray Grace: I think smaller pivots can work and they’re certainly much easier than wholesale business plan modifications. I think it’s important that bank management and directors build their awareness and familiarity with the need for innovative change. They need to stay abreast of trends and developments in the industry. They need to be tracking customer habits and preference changes. That has to be, as I said, at both the board and executive levels.
Innovation requires an open mind, I think, and a willingness to accept risk, both on the industry part and on the part of regulators. There’s a tendency in recent years, sort of a natural tendency really, a cyclical thing coming on the heels of the recession we just experienced, for regulators to try to wring the risk out of the system, but without risk in banking, there is no return. I think legislative attitudes need some adjustment, and I think that partnering with FinTech companies to offer retail banking products to millennials, reaching the customer where the customers are, physically and by virtue of their preferences, remains big issues, but they also have to maintain profitability while adapting technology. It’s getting to be kind of a convoluted answer, I know, but it’s a complex equation. Paying for new technology can be problematic right now because earnings are hard to come by and the cost of regulatory compliance is so high, so it makes funding significant technological innovation difficult. That, in turn, argues in favor of smaller pivots, I think.
Dallas Wells: You mentioned Fintech there, basically the friend or foe question, and FinTech I think has become a bit of a dirty word to a lot of bankers because they see it just as a foe, but we really see some banks that are doing some interesting things around letting the FinTech companies take some of those risks, as far as getting the technology, the concepts built out, prove the concepts, and then the banks can partner with them. Some of them are buying FinTech companies. The question is, will the recent troubles of some of those FinTech companies, specifically some of those marketplace lenders, is that going to lead to a regulatory backlash against some of that? The Lending Club news that came out a couple weeks ago and things like that that are big deals within the industry because it’s almost, in some banks, like a see I told you so. They’re not playing by the same rules. I think that could also bring some harm about, as you say, the banks that want to make some small pivots, take some chances, and work with some of these FinTech companies. How can regulators help with that process?
Ray Grace: First of all, let me take what I think was the second question first, about recent troubles contributing to a more level playing field for marketplace lenders. You mentioned LendingClub, which has been interesting to follow. I think that’s inevitable. As these companies begin to get traction and grow market share, that’s going to, of course, focus more regulatory attention on them, and with the CFPB on the field now looking for areas to target, I think that’s an inevitability.
As to the comment about FinTech being a dirty word to many bankers. Reading the American Banker and Financial Times, and Wall Street Journal, as I do regularly, that’s a commonly used term I think, but let’s be candid: Really the dirty word here is change.
Change is a dirty word to bankers, to bakers, to candlestick makers, pretty much everyone. It’s a human condition, I’m afraid. FinTech has been called a disrupter and a whole lot of other words not used in pleasant company, but I think banks ignore FinTech, as with any significant change, at their peril. I think much of the animus toward FinTech stems from the fact that it comes out of an environment that thus far has been largely unregulated, and it’s young and it’s impatient and pushy and it tends to work without constraints, but it’s equally true, I think, that it’s highly creative, that it’s innovative, it’s imaginative, it’s bold, and it manages to find ways to do the things banks do through their traditional platforms cheaper, faster, and in the eyes of a lot of consumers, particularly millennials and other future generations of bank customers, better.
I think banks need to recognize the opportunities that fintech presents both to keep its existing customers and attract new ones. They need to embrace the good ideas and capitalize on them. Rather than allowing fintech to disrupt or swamp the industry, candidly, I think bankers need to subsume it. They need to recognize it for all its apparent advantages. Fintech is lacking where banks have the greatest advantages: Capital, market share, credibility, operational infrastructure, and experience.
I’d also like to say, and I think this is an important thing to note: Now that the worst of the Great Recession has passed, I think there are a lot of bankers out there who survived the bloodbath and now they think that they can go back to doing business the way they always did and everything will be fine again. That we’ll all live happily ever after. I think that just ain’t so.
Dallas Wells: Yeah, I think there were fundamental changes from a risk management standpoint, the technology standpoint; it’s a different business now.
Ray Grace: Exactly.
Dallas Wells: As banks are thinking about how they handle the FinTech issue, and especially as they think about partnering or learning from some of those concepts, how can they mitigate some of the risks that are inherent in that? Things like compliance as there’s new approaches, new channels, for customer interaction, and also maybe just the risk that they simply become a backend utility with all the plumbing while the FinTech partner really owns the customer relationship. How can banks navigate and weigh those two things?
Ray Grace: Well, I think branding and marketing are important tools to use there, as well as the traditional relationship banking model. From what I’ve seen and read, millennials do not pretend to understand but they seem to consistently say that they want simplicity in their lives. If banks can continue to offer relationship services that is part of their traditional model, even though their delivered through a FinTech interface, I think they can continue to compete.
In terms of risk mitigation, clearly banks need to have controls in place to make sure that their FinTech partner isn’t running away with bank data, or allowing others to run away with it, maybe more importantly. That means that banks need someone at a high level of management who understands the technology and can relate to these partners, sort of a liaison function; somebody who can recognize what FinTech is exactly and what works and what it cannot handle. That needs to be somebody who’s also got some enthusiasm as well as the technical knowledge, even if that means that they need to train the person like that in the more traditional aspects of banking.
Dallas Wells: Yeah, and essentially try to bridge that gap and balance the competing things there.
Ray Grace: Right. Somebody who speaks the language.
Dallas Wells: A translator.
Ray Grace: Somebody who really does understand the technology and the control implications can bridge that gap between banks that are used to prudential regulation and a highly controlled financial environment and the young people in the FinTech industry who are not only not knowledgeable about those things but not terribly patient with them, in my experience.
Dallas Wells: Yeah. Agreed. Well, Ray, that’s good stuff and I think that’ll wrap it up for us for this episode. Thanks again, so much, for making the time for this.
Ray Grace: Happy to do it. I would like, if I might, offer one last comment.
Dallas Wells: Sure, absolutely.
Ray Grace: In many ways bankers seem to be a little pessimistic. Given what they’ve been through for the last seven or eight years and what they’re currently going through in the regulatory environment and in markets, I think a certain amount of pessimism is understandable. Taking the long view, I’ve been at this for over 40 years now and I’m still optimistic about the industry. I think the challenges presented by technological changes over the years, economic downturns, periodic regulatory upheavals like the repeal of Reg Q, for example, or more recently, of course, Dodd-Frank. The banking industry has always been resilient. I think and hope they’re going to figure this FinTech thing out, as well. I hope that my fellow regulators will help facilitate the process rather than complicate or obstruct it.
Dallas Wells: Very good. I think that’s, again, another good point. We’ve been down this road before in this business and history may not repeat itself but it certainly arrives and banks just need to go back to those days when we’ve tackled this before and do the same thing again.
Ray Grace: I think that’s right. It’s a good industry.
Dallas Wells: Yeah, absolutely. Well, Ray, thank you. Also a big thanks to everyone for listening. We’ll provide links to some resources and to Ray’s contact information in the show notes for this episode. You can always find those at PrecisionLender.com/podcast. If you like what you’ve been hearing, make sure to subscribe to the feed in iTunes, SoundCloud, or Stitcher, and we’d love to get ratings and feedback on any of those platforms. Thanks for tuning in. Until next time, this has been Dallas Wells, and you’ve been listening to The Purposeful Banker.