First the crypto industry. Now the tech industry. Two banks under pressure and likely the most dramatic shut downs / acquisitions we’ve seen since Lehman. Everyone on Twitter is suddenly an expert on ALM. If you don’t know what ALM stands for, this post is not for you.
The stories of Silvergate and Silicon Valley Bank are not warning signs that exposure to cryptocurrencies or startups is dangerous. The roots of the crises both banks faced are more mundane and widespread than those two verticals. The conclusion that doing something new and innovative is what brought about their downfall is not only false, it’s dangerous. And the banking industry is about to have a reckoning. The cause is both staggeringly obvious and preventable it is maddening.
It’s all about the the deposits stupid.
I speak to hundreds, maybe even thousands of bankers per year. The conversations have a limited range of topics from feeling held hostage by their core provider to the increasing competition for quality assets with so much money chasing too few deals. The question I most commonly pose for the last 5 years sparks a disappointing level of passion, call it dispassion even. Bankers would rather rail on about their core than think about their deposit gathering strategy.
The most common responses have been:
We make our money on small business lending
We don’t need more deposits
Let’s unpack these two fallacies.
Show me the money
The majority of banks, especially community banks, describe their strategic focus and differentiation as their relationship with small businesses. “Small business is where we make our money.” Net Interest Margin, a canon of the religion of banking, is in fact where most of a banks income is generated. The ability to generate NIM is predicated on deposits, and specifically the greater the delta between the cost of those deposits and the interest paid on the assets (loans) they fund, the better the margin. Banks may get paid for their loans, but lending is only an attractive business if your cost to fund them are low.
What goes down, must come up
We’ve been operating in the upside down world for 15 years where the federal funds rate is close to zero. That means banks could borrow for next to nothing and had no incentive to pay interest on deposits because no one was. The input to their business lending machine was free. Except now it isn’t. Banks are enjoying a temporary blip where loans where with floating rates have generated more income as the Fed raises rates while only a few, largely online, players have begun to pay more for savings and money markets. That is about to change. The last 15 years of no-interest deposits and increased deposit balances driven by COVID is about to have a serious reversion to the mean.
What we have here is a failure to innovate
John Maxfield is one of the smartest writers on banking the industry has ever known. He and Kiah Haslett should have a designated survivor clause in their travels. There is one thing, however, I think he got fundamentally wrong. He once tweeted “no bank has ever failed because it didn’t innovate.” Many bankers were quick to chime in their support because it supported the narrative they wanted to be true. The reckoning banks are about to face is driven by this sentiment. (He and JP just debated this on a special episode of the Breaking Banks podcast in the wake of all this.)
Michael Porter’s landmark book Competitive Strategy can be summarized as this:
You choose to compete on price or differentiation
Price requires scale and efficiency
Differentiation requires focus and a unique value proposition
The zero interest rate world blunted the importance of scale and efficiency because the inputs were free. Rising rates tilt the scales to largest, most automated players.
For banks below the top 5, maybe top 10, the game is about generating low cost deposits. To do that, the bank has to offer something the customer can’t get elsewhere. And sorry, being in the community and personal relationships are not differentiators.
If you are community banks, now is to the time to run, not walk with your innovation strategy. Uncertainty in the economy and concerns over the loan portfolio leads many banks to cutoff discretionary spending. Innovation, done right, is not discretionary. Innovation is about doing things that others are not. Innovation is about finding ways to attract and retain customers on something other than price.
It’s time to run.