We start the year off by taking a look back at how the commercial pricing story unfolded over the course of 2021: where things started, what happened along the way, and where we stand now as we head into 2022.
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Hi, and welcome to The Purposeful Banker, the 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, Jim Young, senior content strategist at Q2, and I'm joined again today by Dallas Wells, SVP of product at Q2.
Those of you who have been with us for a while, or at least for the past two years, are aware that we regularly publish what we call the Commercial Loan Pricing Market Update, something we started back in March of 2020 at the start of the pandemic. Back then, things were changing so rapidly that we thought we could really do a service to the industry by having our Anna-Fay Lohn go into the commercial pricing database and pull out some key metrics to let people know what was going on right then and there. We could do that because our US database of more than 150 banks of all sizes in all parts of the country really acts as a pretty good proxy for the US commercial banking market.
Anyway, those proved to be tremendously popular right away, and we realized, frankly, that we should have been doing these all along. So even after things settled down, relatively speaking, we kept on publishing Anna-Fay's updates, now on a monthly basis. We'll have links to those updates, and particularly Anna-Fay's 2021 review
, in the show notes.
Long story short, when you look at these updates, they provide a really interesting timeline on how things have evolved in commercial banking. Journalists, we call this kind of story a tick tock, and no it's not the social media platform. But today on this podcast, we're going to take a look back at how the commercial pricing story unfolded over the course of 2021, where things started, what happened along the way, and where we sit now as we head into 2022.
After all of that long preamble, of course I should note that Dallas will be the one doing most of the storytelling. So Dallas, thanks for coming on the show.
Yeah, you bet. Thanks, Jim.
All right, Dallas, let's start. Let's go back to January 2021, if you can remember that far back with everything that's happened in the last 12 months. But what was the mood in commercial banking at that point after what was really obviously a rocky 2020? And what was the outlook for 2021 at that point?
Yeah. Time seems to have gotten all wonky through the whole pandemic thing. But if you do rewind back a full 12 months, in terms of the pandemic, we were in a pretty scary place at that point. The big spike through the winter, we were right in the middle of it. It was unfolding exactly as had been predicted by a whole bunch of folks, where the health outlook was bad, the hospitals were full. That stuff was pretty scary.
The interesting thing about commercial banking is, banks were still trying to react to all of the federal government intervention really. I'm going a little bit by memory here, last winter we would've been in one of the follow-on phases of the PPP program, where basically all the funding would get used up and then Congress would have to go and pass a new batch only, of course, just to make it difficult, with slightly different rules based on the public perception of the round before, which means, all the software had to be redone, all the processes had to be rebuilt, and you had to re-explain to customers, "Are you eligible this time, and you weren't last time? Do you get another slug of funding or not?" That was all-consuming on the commercial side. On the other side of the bank, we had stimulus payments still funneling through as well.
You had financial institutions that at that point we were past the worst of the credit risk scares. There were still plenty of scary stuff for pockets and certain industries, pockets of the portfolio, but it wasn't the March and April of '20 kind of scary like, oh my gosh, are we kicking off a Depression-style economic reaction to this? It was clear that the Central Bank intervention had staved that off. Instead, banks were looking at, well, we're swimming in deposits. We are trying to figure out how to react to all of the government programs and all the technology stuff that we're right in the middle of. Profits at that point were really kind of an afterthought. It was more just reacting to what was in front and survival through those sorts of things. I think that shifted through the year, and I'm sure we'll get into that.
But that's kind of where we stood in January, was just really like almost indigestion from trying to figure out all these things. You had employees trying to do this from home. You had some of your staff dealing with their own health stuff at home and with family members, kids not in school. It was tough. So financial performance, while always important in the banking industry, was lower on the list than it typically falls.
I remember then, we've had a series of these, but we had what we'd call a fireside chat
, where we'd bring in top bankers from around the country to talk about the important issues. We had one, I want to say around in February, and we were talking about essentially, "Hey, how do you feel about where things stand right now? What's your plans going forward?" I remember being struck by how many of them listed loan growth as an important goal for 2021. I remember thinking that sounds like wishful thinking. Now granted again, these are pricing figures, not loans closed. But we definitely saw, starting in March really, an uptick in pricing volume, and really that stayed at that level or maybe a little bit higher the rest of the year, which is at least an indication of activity. But I'm not a banker. So I'll ask you, were you expecting that sort of uptick, and were you expecting it to rise to that level and stay there throughout the year?
I frankly was not expecting that to be the universal top concern. For all the things that I just mentioned, it felt like, okay, we always want loan growth, but that feels like a business-as-usual problem. This was very much not business as usual. I wasn't surprised that that was on the list. It's always on the list, probably always will be. But the fact that across a pretty wide swath of financial institutions, different markets, different sizes, different levels of seniority within those organizations, that was kind of the universal answer.
I think what we had underestimated, because you always get a little trailing data on how widespread this stuff is, but we'd underestimated really how big that wave of deposits and funding really was. It's an imperfect science when the Central Bank takes that kind of action.
On top of that, we had fiscal stuff from Congress as well. You had the floodgates just wide open, the government just flooding liquidity and stimulus into the system. You know that some of that's just going to land on bank balance sheets and sit there, but it's hard to tell how much. Well, the answer was a crap ton of it. Everyone had so much. So I think that's where these bankers, they were coming. They're like, "Look, every day, more deposits show up, and we have to find something to do with this. We have all these costs that we're incurring. We have all this new overhead. We have all this trying to do right by our employees. We don't want to lay people off. We have to make money, and we've got to turn this liquidity glut into something that we can generate some sort of revenue with." When it's that widespread across the industry, I think that's going to be the backdrop for all the other trends that we talk about here.
You mentioned the volume. We index this stuff so that you have a point of reference. Anna-Fay indexed this at 100 for January of '21. That was our baseline. We got up around 150 in the summer, and that's still where we are. So you're talking about a substantial increase in volume from that scary wintertime month. That's about when we had those conversations that you're referencing there. Everybody came and said loan growth was top of mind. Then they went back, and they started cranking out loans. It just has been nonstop since then. Again, still trying to work their way through all of that liquidity, and there's still a big old pile of liquidity yet left. So I think a lot of the trends that we're going to talk about are going to continue into '22 from where we stand today,
You sort of went in my next question, which is, I've said, do you think that story changes in 2022? I remember actually you and I recorded a podcast because at first I was trying to make sense of it. You and I recorded a podcast, I want to say sometime in the summer, and it was based on, I think, an article that Chris Nichols had written. It was basically the case for making low margin loans. It was a little bit of the, hey, I know it's not great, but it beats the alternative sort of thing. I guess I'm wondering if because of that sort of ... with that as context, it sounds like you're saying you expect more of this type of push for volume maybe at the expense of margin in 2022.
Yeah. I think the only element that will change there that banks will need to evaluate as they go is the other wild card that has shown up is inflation. Now, the Federal Reserve's reaction to that, I think, will just be one more variable to consider here.
They've just recently in their statements come out and ... They do this now where they telegraph moves in advance. The Fed tries not to surprise the markets with any of their actions. So you can see the language starting to shift. They're trying to shape expectations. That expectation is that, hey, there's probably slightly higher interest rates ahead in '22.
Part of what Chris was talking about in his analysis ... I'd say we should probably include a link to that article. It was a good one. I think the analysis still stands. But the alternatives were essentially yielding zero and really negative real rates of return there. At the levels that the Fed is implying they're going to change, we're not talking Paul Volcker in the '80s going to the prime rate at 14% or something here. We're talking about going from a quarter point to maybe one point. So you're talking about 75 basis points of increase at the short end. The long-term rates show no movement based on that news. So, in general, even with that, even with those hints from the Fed, the rate market will be pretty darn similar, which is very low, very accommodative. Especially with ongoing new variants, continuation of the pandemic, the Fed will err on the side of caution here, I think. So you'll see banks facing basically very similar headwinds as they did last year. The strategy is still very much the same, find ways to put that liquidity to work somehow that just covers the cost, at least make it break even and keep us afloat.
Yeah. One of the areas, I'd say the area, where we saw some of these elements really play out in a not-so-fun way were fixed rate spreads and what we saw over the course of the year. Look, again, non-bank guy, it was not hard for me to follow what was happening here, funding costs rising during the course of the year. Coupons stayed pretty much right around 3.5%, did not move. So I can answer the how part of this. I think you got some of this, but maybe if you could clarify the why with what was going on they couldn't price some of this in and protect a little bit of that spread.
Yeah. You had rates drifting higher through the year. Anna-Fay's review has a really good chart on that, looking at the five-year, the belly of the yield curve. Like always, it's not straight up, but it goes higher in the springtime of '21, and it stays pretty steady there through the summer. Then in the fall, it starts climbing again. You're talking about, in the grand scheme of things, 100 basis points of rate increase over that year. To your point, fixed rate coupons not only didn't keep pace there, but actually drifted a little lower again, to over generalize the movement there, but drifted a little lower through the year. So a big squeeze in those spreads.
In essence, what's happening is that exact phenomenon that we were just talking about. Essentially, every bank in the market, too much liquidity, and they put find loan growth as the top of their priority list.
Let's say they're all sitting there with that 3.5% rate that they're charging for good quality fixed rate commercial loans, who wants to blink first? Who wants to go out and say, "All right, this hurts too bad, we're now at 3.75%"? Because of what Chris Nichols talks about, and that we followed up with on our podcast there, the potential opportunity cost, that volume loss there, is not worth that extra quarter point of spread at this point. It's a little bit of a standoff there across the industry of everyone's feeling the pain of the tighter spreads and the decreased margins, but it's not yet worth being the institution to blink and to start building that in and to give up the volume because of it.
You also just have extremely price conscious borrowers who, as the technology gets better, actually have more ability to shop this stuff. So it's coming from all directions. It's tough, but it's still the right strategic move to just eat the tighter spreads.
Yeah. Then combining it with you said more cost conscious, and we already outlined how a lot of them don't need or didn't need as many funds because it got so much of it dirt cheap in 2020. So you've got a whole lot of banks competing for maybe not as much with all the goal of doing more. That's all combined to make the housing market a buyer's market, or I guess a borrower's market in that case.
Spreads on prime floating rate loans was another one. That was, I hesitate to use the phrase bright spot during a pandemic, because they're not. It's all relative shades of not bright. But they went up at the start of the pandemic and were above their pre-pandemic levels. Then second half of 2021, they start going down. Now, they're back down by the end of the year below pre-pandemic levels. Again, the fixed rate story for me is pretty clear one, but the prime floating rate one's a little bit less clear to me, in particular because LIBOR didn't have that sort of path. So any thoughts on primes with the spreads on those and the journey they took in 2021?
Yeah. So if you look at, again, a great chart that's in the article that we're talking about here, you can see the moment in time where the pandemic arrives at our shores. So there's the big spike. What happens there is prime being more of a managed index, unlike the others. The pandemic hits, the Fed immediately drastically cuts the Fed funds rate, therefore prime falls in lockstep. That takes a while to filter through the system, and you have the opposite effect there of, hey, all of a sudden, our funding cost there just got a lot cheaper. Maybe we can hold on to this rate that we've already quoted on a bunch of these deals for just a little while longer. So you get a little higher spread.
The reason I think these diverged so much from the LIBOR market on average, and again there's exceptions to this, but on average, loans based over prime are smaller loans than those based over LIBOR. So really a lot of this volume dried up on a relative basis, on a share basis, during '20 because of all the PPP stuff. The competition was a 1% forgivable loan facilitated by banks on behalf of the federal government. That's pretty tough competition. These deals that were getting done, it wasn't about being price conscious. There was through '20 a lot of credit uncertainty there for the deals that were not PPP, which is what these would be. These were something outside of that PPP lending. So I think FIs were being cautious. They were being selective with this. They were drowning in the government programs. So this was kind of the leftover stuff.
Then what you can see starts to happen in '21 is those programs wind down. Now banks are, again, that's where we're talking about sitting there with this glut of cash that showed up through '20. All of a sudden, you got to put it to work, and rates have stabilized. They've been on the short end of the market. They've been at zero, or effectively zero, for a good long while. That's another outlet now to put that money to use. So then you see the spreads just get tighter and tighter and tighter until they're now below where they were pre-pandemic, well below that. I don't think that's a trend that's going to change direction any time soon. Even as that prime rate eventually starts to tick up just a little bit, I think you're still going to see banks pricing those pretty aggressively.
Yeah. Also given, this is one of the things that Anna-Fay pointed out in there, the NIM on those loans is still far and above what you're getting somewhere else.
Yeah. Those are solid spreads compared to everything else.
Right. So I don't think they're really going to sweat dropping those spreads a little bit more in there, that the margins again are worth it for them.
Well, I've tried to avoid it to this point, but it's time. You mentioned LIBOR, and there's really no sense to put it off any longer.
Your nemesis is back.
Yeah. I was going to say. But on the other hand, after years, literally years, of talking about it, the great LIBOR, the SOFR transition finally began in 2021. Looking at the PrecisionLender pricing database, we finally began to see enough data to start tracking it in August. So two questions here, taking whichever order you want. One is your initial impressions about what you've seen with SOFR pricing. And two, any thoughts about the fact that we had to wait until August to get to the point where there was even a trickle of this type of data?
Yeah. I'll start with the second part of that first, which is I think there was a whole lot of banks out there that were hoping this would be delayed. They were looking around like, "They're not really going to make this happen after everything we've dealt with over the last year and a half. Surely this gets delayed." It was such a broad international change to pull off that I think, effectively, the regulators were like, "Sorry, this train has left the station." Like, "This is happening, whether it's convenient or not. The change is happening you anyway."
I think that reality dawned on a whole lot of management teams. We felt it around the summertime, where it went from a, "Ah, we'll get to it eventually," to, "Oh my gosh, this is our most pressing issue. We got to deal with this." That's why we started to all of a sudden see it show up later in the summer. Most of that, frankly, was test transactions, meaning like, hey, let's price a few deals and let them flow through the systems and make sure we didn't miss anything before we really have to start doing this across the board as the calendar turns. So volume's pretty light, but all of a sudden in October, November, it really started to pick up as we get close to that deadline.
As for the impression of where spreads have landed and what that market looks like, this is part of what we tried to tell banks that were getting really wrapped around some of the details of this. "Look, you're calculating interest accruals. I get that the arithmetic matters." It's very critically important for a lot of systems. But we saw a lot of banks trying to figure out, "Well, how are we going to price SOFR?" They got really tangled up in those same details. Well, this index, is it arrears, not arrears? How are we going to calculate it? That's like seven basis points different. There's credit risk, no credit risk. They're trying to get a feel for how all that's going to settle out.
Our take on it was like, "Look that stuff's not going to matter. Not right out of the gate." You'll get to that point where every little basis point, you start squeezing on it. But I think you see from the first couple months of data, those spreads are all over the place. Again, we're showing the averages. The actual variance on those things was fairly wild for the calm and steady world of commercial loan pricing. They're all over the place, and it's because everybody has to feel this out. Again, it's light volume. The market will establish itself. In the meantime, the fact that your calculations made the number come off by a basis point and a half difference, 14 months out on the curve, not that big of a deal. We'll get there once we figure out all the mechanics through all the systems.
So I wouldn't place any judgment yet on how these are priced relative to LIBOR. You can see some of the standard truisms holding there of differences between industries and differences between size of the credit facility. Those things are holding true, but the actual levels, we'll see. I think we'll see once we get into '22 and the LIBOR volume actually does really, really shrink down to nothing and everything happens in SOFR or one of the other alternatives, I think that market will take just a little bit to settle out, but we'll get there. Then we can talk about where those levels are.
Final question here, and actually I'll throw in this caveat here with a little bit of behind the scenes. I feel like I'm in a time machine. We're recording this in 2021. You're listening to it in 2022. But with that caveat of we're recording this right now as Omicron numbers are spiking up. If you got into this point in the podcast and you're like, "Boy, none of this bears any resemblance to what's going on right now," January 3rd or later, apologies for that. But hopefully, that does not shift things.
But finally, Dallas, just more of a general thing here. We've gone through 2021, and we sit at the same position we were in time-wise last year. Any thoughts about what you think is lying ahead in 2022 and how things shook out in 2021?
Yeah. We talked about a lot of the pricing trends. I think the other thing that came out of '21, and it was a follow-on of what happened in '20, everything had to shift online for some period. Now there are still pockets where that is required in some way, but much of the market is back to some version of business as usual, or at least interactions as usual. The thing we wanted to pay attention to as that happened is, okay, we know that application volume and loan closings and stuff had to start happening virtually. How much of that would stick as we got back to normalcy? It was waiting with bated breath for a lot of financial institutions that are making some big investments in that exact infrastructure.
So far, I think what we're seeing is that there's no going back. That genie's out of the bottle. The borrowers who realized like, "Hey, you actually can service me, where I don't have to come in and spend six hours in the branch to get this thing closed and funded and wet signatures on everything, it was possible to do this. So I'm no longer going to tolerate those sorts of inconveniences."
This is especially true in the small business, business banking corner of the commercial world. We're seeing it now trickle into all the treasury, cash management kind of stuff too, where business customers are like, "Look, I don't have to do this stuff on the consumer side anymore for my personal accounts. You didn't make me do it through the worst of the pandemic. I'm not coming in there to do this stuff. You figure out a way to service these things."
So more and more of a push there, and a lot of the technology is new. It's new to the vendors. It's new to the banks and to the credit unions and to the teams trying to install it. So I think that's what a lot of 2022 is really going to be, is just a continuation of, we got a whole bunch of digital transformation, a whole lot of years worth compressed into a very short timeframe, and now there's catch-up. There was all sorts of stuff squished together, and you saw banks actually being really agile and doing some minimum viable products. Well, the inevitable thing about a minimum viable product is you got to come back and take out the scaffolding that you put up and actually build some real infrastructure around it. That's the process that's happening now.
I think that the good news is, is the feedback is, this is a good investment. We're going to do okay with this stuff. There's plenty of demand. We have to go this way. The FinTech pressure has only picked up. So we're money good here, but now we got to lean into it, and we got to have the staff and the resources and the time to do it. So lots of technology rollouts, lots of prioritization discussions, lots of struggles with budget to get all those things done, but that's '22. It's making good, solid, permanent structures around what we had to slap together over the last year and a half.
Yeah. Guess it's sort of digital 2.0, in some ways, I guess, in terms of the release. Well, 2.1, 2.2, and all that sort of thing too, just to get ...
There you go. Yeah.
Also, I will say 2022, I look forward to not talking about LIBOR. So hopefully, we've moved past that.
Yeah. May it never again be a topic for you, Jim. I hope that's a resolution you can make and keep.
All right, well that will do it for this week's show. Dallas, thanks again for coming on.
Yeah. Appreciate it, Jim.
Thanks again so much for listening, and now for a few friendly reminders. You want to listen to more podcasts or check out more of our content, you can visit the resource page, precisionlender.com or head over to the homepage to learn more about the company behind the content. If you like what you've been hearing, make sure to subscribe to the feed in Apple Podcasts, Google Play, or Stitcher. We'd love to get ratings and feedback on any of those platforms.
Until next time, this is Jim Young, Dallas Wells, and who you've been listening to The Purposeful Banker.
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