Tactical allocation of capital is an integral component of success for every financial institution, so capital planning and strategic planning should be closely tied. Just as bank management and the board must regularly review their institution's strategic plan and make adjustments, an effective capital plan should be reviewed and recalibrated at least annually. That assessment has never been more critical, as the financial services industry approaches what could be a tumultuous period. "The full rollout of the capital conservation buffer under Basel III, CECL, and a potentially completely different economic cycle will be hitting at about the same time, so banks need to be considering and planning for that now," said Nick Hahn, director of risk advisory services at RSM US LLP. "It's a bit of a perfect storm." To adequately prepare, bank management and directors should consider the following five key factors as they look back at 2017 and forward to 2018 during the capital planning process: 

1: Strategy
The bank's strategic plan is the most significant influence on the capital plan, since different strategic goals require different capital strategies. According to Jon Bruss, managing principal and CEO of Fortress Partners Capital Management, there are several situations common to our industry that drive the need for capital: growth in assets exceeding the ability of the bank to retain earnings to support the growth, asset quality problems wiping out a large block of capital, or preparation for an acquisition as a buyer are among them. "There is no one solution that works for all banks in all situations," he said. Banks dealing with rapid growth in assets driven primarily by loan growth can fund a capital shortfall with common equity or with debt issued by a bank's holding company. "Any bank that's in the market for an acquisition and doesn't have a quote symbol for its stock is going to need to make that purchase for cash," Bruss explained. There are several options bank leadership should consider for sourcing those funds. "Cash at the holding company level can be sourced with debt raised via an investment banking firm, lent by a correspondent bank or by an offering in the communities served by the bank, each approach carrying a different cost," Bruss advised. Common equity can be used to raise cash to fund that purchase, "by selling shares to members of the community or via an investment banker-assisted community offering," he continued. "That requires thoughtful planning today, because tomorrow you may be an acquirer." 

2: Unexpected Occurrences
In addition to a yearly review, sudden, unplanned-for incidences should trigger a reassessment of the bank's capital plan. "If there's an unexpected loan charge-off that impacts your capital, for example, review your plan again then," said Lee Christensen, partner, financial institutions practice at Wipfli. "That way you know if you're on track or if you need to change the way you operate in order to get back on track." A cybersecurity breach or unanticipated findings during ALM routines and/or liquidity forecasting should also trigger a review. 

3: Competition
Today's financial services industry is highly competitive, and banks need to win against more than just their peers—credit unions, farm credit lenders, and even financial technology companies are all vying for the same customers. That can lead to dangerous choices. "You can sacrifice on term, price, or structure, and for many institutions pricing has reached the bottom, so now they're making decisions to sacrifice on term or credit risk monitoring controls, which ultimately increases credit risk," Hahn explained. "Financial institutions need to be very aware of the role competition in the market has played and how that could impact credit losses going forward and, ultimately, capital." To address this risk, Hahn recommends bank leadership maintain a thorough understanding of how potential losses could impact the balance sheet. "If we see any upticks in losses, you need to understand what's driving it and know if you need to extrapolate or do broader analysis of the portfolio in general to see if it will spread," he advised. 

4: Legislation and Regulation
Looking forward to 2018 and beyond, there are several legislative and/or regulatory factors to consider when doing capital planning. First is tax reform, which Christensen says will be a big event for banks if it comes to fruition because many banks currently hold a large amount of tax-deferred assets on their books. If Congress follows through on the plan to drop the tax rate from 34 percent to 20 percent, those assets will need to be revalued. "That will be a good thing in the long run, but it may have a negative impact in year one because the offset goes into expense, which ultimately flows into capital," Christensen explained.

Another factor to consider is Basel III's phase-in. In mid-October, the Basel Committee on Banking Supervision announced a plan to break the year-long deadlock that has delayed the capital standards' implementation: setting capital floors at 72.5 percent. The measure has yet to be approved by the central bank governors and supervisors on the Basel Committee's oversight body. 

Finally, the regulatory factor looming largest over the industry: CECL. "In the year of adoption, banks will be allowed to look at their allowance as it's calculated under the old and new methods and the difference will be a one-time charge to equity," said Christensen. "We'd recommend banks preserve capital for that hit, rather than maintaining excessive allowance." However, there is still some uncertainty, as banks seem to be waiting for guidance from regulators on how to build their new models, but the regulators seem to be waiting to offer guidance until they see the models. 

5: Economic Cycle
Banks should review their capital plan more frequently during times of economic turbulence or market instability, and the next period of such agitation is on the horizon. "We're likely closer to the next recession than we are to the last one," Hahn declared. "Many institutions are making the loans that will be their next losses right now." One sector in particular where the coming downturn is apparent is in the highly cyclical agri-business arena; while not yet as severe as some previous dips, ag credits are becoming more stressed. "If and when charge-offs become necessary, the banks need to have the capital available," said Christensen. "We've gone five or six years with very minimal charge-offs. The economy has been on a relatively long upturn during that period, but it doesn't feel like it because we haven't seen the sharp incline that we had in the early 2000s."

Take Action

With these factors in mind, bank management and directors should consider the following action steps (all suggested by one or more of the experts interviewed for this article) to ensure a comprehensive, effective review of their capital plan:

  • Refer back to your original capital plan and your projections. Compare that data with what your current reports tell you.
  • Closely evaluate the 30- and 60-day reports to see if there is potential for those to extend into the 90-day past due report.
  • Adjust your approach to stress testing. Relying on probability of default—looking at what causes borrowers to default—isn't as valuable from a capital planning perspective as using loss-given testing to anticipate the bank's exposure if certain loans go bad. 
  • Understand the capital sources available to your bank in its current state and also in anticipated future states. In other words, verify that your capital plan is realistic. If your institution isn't attractive to capital markets at the time when you need capital the most, know what your alternative source of funding will be. Leveraging your third-party relationships is an important component in maintaining an accurate understanding of today's capital markets.
  • Avoid a siloed approach to reviewing capital. Other risk management exercises and models, including interest rate risk and liquidity, should all impact your capital planning process.
  • Adhere to your loan policies. Amid fierce competition and an economic expansion, it is essential for bank leadership to enforce loyalty to the bank's policies in order to prevent taking on excessive risk.

Capital planning is one of the executive team and board's most important duties, so frequent assessment and adjustment of the plan is not only a good practice from a risk management perspective, but also from a strategic perspective. 

Fortress Partners Capital Management is a WBA Associate Member. 
RSM US LLP is a WBA Gold Associate Member.
Wipfli is a WBA Silver Associate Member. 

By, Amber Seitz

"Coopetition" with fintechs may be the key to thriving in tomorrow's financial services industry

For several years now, the banking industry has been inundated with warnings about how financial technology (fintech) startup companies will disrupt the industry to the point where traditional depository banks—especially smaller community banks—become irrelevant. As it turns out, the rumors of banking's imminent demise were greatly exaggerated, according to Lee Wetherington, director of strategic insight at Jack Henry & Associates. "We're beyond the point where everyone thinks fintechs will destroy banks," he said, explaining that fintechs discovered they couldn't establish user bases large enough and quickly enough to sustain their business models and compete directly with banks. In addition, efforts by some of the nation's largest banks to emulate fintechs (or outright acquire them) helped to neutralize the competitive threat. 

According to an August 2017 World Economic Forum report, banks shouldn't fear fintechs; they should fear other financial institutions who leverage fintechs in the right way.

Rather than direct competition, banks and fintechs find themselves in a competitive, yet co-dependent standoff; each has something the other needs, but since the other is a competitor, partnerships between the two are far from routine. A recent Forbes article described this dynamic as "coopetition," "a term used to describe unconventional collaboration and cooperation within an otherwise competitive field of players." Stacy Grafenauer, vice president/director of deposit operations and electronic solutions at First Bank Financial Centre, Oconomowoc and a member of the 2017-2018 WBA Technology and Operations Committee described the process of banks partnering with fintechs as "building an alliance without compromising sound practices."

Establishing a partnership in order to access technology solutions provided by fintech companies can be a powerful strategy for delivering top-notch products and services to customers. Determining whether partnering is the correct strategy, choosing the most appropriate type of partnership structure, and identifying potential obstacles are three critical steps bank leadership must take when considering fintech solutions. 

Strategic Alignment 

The determination of whether partnering with a fintech is a good tactic for keeping up with the pace of technological growth will be different at every institution. "It depends on the bank's strategy," said Fiserv Chief Operating Officer Mark Ernst. "Having clarity about where technology-enabled delivery fits in the overall strategy of the institution is the earliest question that needs to be answered." The key for bank management is to maintain alignment with the bank's strategic goals, particularly goals related to how the bank wants to differentiate itself from the competition for its specific market and customer base. "Banks choose a fintech because it offers a feature or function that will help them differentiate their bank from the competition," said Wetherington. "The key is figuring out how to leverage fintechs of choice in ways that matter strategically." Of course, size is also a factor that management must consider. A bank's ability to keep up with technology is dependent on its infrastructure, which is driven by asset size, according to Grafenauer. "If you have the infrastructure and the budget to support building those integrations, it is a good strategy because it's a differentiator," she said. Institutions that find ways to blend the community bank feel with a great digital experience will set themselves apart, Grafenauer predicts. "I think this will be the differentiator between community banks," she said. "Fintech companies will play an important role in that." 

Types of Partnership Structures

Banks of all sizes have several options for partnership structures when it comes to fintechs, so each institution should determine the most appropriate strategy for its size and capabilities as well as its current and future needs. One option is a one-to-one partnership with—or outright acquisition of—a fintech, though for most institutions, forming a one-to-one partnership is "practically difficult," Wetherington explained. "Most mid-tier and smaller banks don't have the capacity or resources to negotiate one-to-one partnerships with major fintechs," he said. The majority of fintechs need to scale as quickly as possible (before they exhaust their venture capital) so they are looking for the largest financial institution partner they can find. However, there are some fintechs seeking to capitalize on the power of local partnerships. "There are some local fintechs who look to partner with local financial institutions, but that can also be challenging because smaller fintechs may not have an appreciation for the regulatory compliance concerns of banks and the difficulty of connecting with all the other areas the bank needs them to," said Ernst. 

Another type of partnership is the one-to-many relationship, that is, bank access via a platform or industry consortium. "The rise of platforms [such as Akouba, Avoka, and LendKey] could be the technological way in which smaller institutions connect to fintechs of choice," said Wetherington. According to Ernst, most banks' current technology providers will seek out new technology as it becomes available and tailor it to local financial institutions. "Another way this happens is through large industry consortiums," he explained. 

Similarly, shared services companies offer smaller banks the benefits of a platform or consortium partnership with the added advantage of more control. "It's a viable way for smaller banks to get enough scale to be able to partner with a particular fintech of choice at a better price," said Wetherington, pointing out that a shared services company could also potentially acquire a fintech. "Those are the kinds of options you have when you pool resources," he said. However, this smaller-scale many-to-one partnership structure requires the participating banks to overcome their own technological challenges, particularly relating to sharing data. "You'd have a lot of hurdles to get around," said Grafenauer. "If you had other banks on the same core and your processes were generally the same, it could work," she continued. "But I'd look to your core for a viable solution first." 

Perhaps the most efficient and effective way for smaller institutions to access fintech products is via their legacy vendors/core providers. "Most core providers are aware of what the fintechs are doing and are buying what they have to offer and selling it to banks," Grafenauer explained. This arrangement smooths out many of the wrinkles banks experience when establishing partnerships individually or on a smaller scale. "The reason it's more effective is we've done the pre-integration of all the fintech's capabilities," Ernst explained. "By the time we're bringing it to market, the fintech has proven to some degree to be viable for market." For example, Fiserv developed the INV Accelerator in early 2016 as a way to connect high-potential startups to the real world in which financial institutions operate, assist with compliance concerns, and integrate with core processing technology. "From our perspective, that's the way you can take an interesting idea and make it available to a number of smaller institutions in a way that integrates with what they're already doing," said Ernst. For those institutions who would like more control over their fintech solutions, Wetherington recommends engaging with legacy providers in order to amplify your voice, for example by sitting on an advisory board. "Be the squeakiest wheel," he said. "Develop relationships with decision-makers inside your existing vendors." 

Potential Obstacles 

The two primary components to a bank's integration with a fintech are regulatory compliance and technology. Thorough understanding of the risks inherent in each is critical in order for bank management to mitigate that risk. 

With compliance, one of the biggest risk factors is simple ignorance on the part of the fintech. "As a banker, you have regulatory compliance top-of-mind," said Grafenauer. "The fintech is trying to help you meet the customer where they want to be, but they typically have no idea what the regulations are that bankers are faced with when they're creating solutions." One example is data security. Fintechs tend to be smaller and younger companies, so regulators are likely to focus on how sensitive information is transferred and stored in terms of security and compliance. "You have to do really diligent vetting up front of how the fintech vendor stores and secures its data," said Wetherington. Another regulatory concern is the fintech company's sustainability. "Regulators are very concerned about the stability of anyone's technology provider," said Ernst. "Before you introduce your customers to someone else's capabilities, you want to know that entity will be around and viable. While there's a lot of talk about fintech startups, the reality is that very few of them ever make it." 

On the technology side, the largest hurdle is the sheer complexity of integrating the data necessary to deliver the fintech's product or service to the bank's customers. "Most banks think about the compliance side first, but the technical side is far more complicated than most people realize, both with scale and with how the data flows," Ernst explained. 

The solution to these challenges is to treat a partnership with a fintech company with the same care and due diligence as any other third-party provider. "Fintechs are just another third-party vendor, so all of those checkboxes still apply," said Wetherington. As with so many other external relationships, selecting the most appropriate partner is essential for success. "Picking the right partner is the most important step in this process," said Grafenauer. "Invest time in doing a really thorough job of reviewing your contracts and agreements."

Ultimately, the biggest obstacle getting in the way of lucrative partnerships between banks and fintechs may be the lingering perception of fintech companies as threats. However, the reality is that banks have firmly maintained secure relationships with their customers. "You'll always be able to find someone to talk about how fintech is putting banking at risk, but what we see is fintechs trying to tap into the trust that exists between banks and their customers," said Ernst. That trust is the secret ingredient to traditional banking's persistence in the face of disruptors. "Our customers aren't going to trust whoever developed the latest and greatest app with their financial security; they look to us," said Grafenauer. "Fintechs are not competitors. They're solution-providers." 

Fiserv is a WBA Associate Member.
Jack Henry & Associates is a WBA Associate Member.

By, Amber Seitz

The November 2017 edition of the WBA Compliance Journal has been published.

This month's Special Focus provides a summary of key legislation of interest to WBA. Compliance Notes features information on the Wisconsin Bureau of Child Support's update to the Child Support Lien Docket Website.

Click here to download a PDF of the issue. 

By, Ally Bates

Resurgence of rare charter may reshape the banking industry

The FDIC has two decisions to make that will have a tremendous impact on the financial services industry. On June 6, online personal finance company Social Finance, Inc.* (better known as "SoFi") applied for an industrial loan charter (ILC) for the purposes of offering FDIC-insured NOW deposit accounts and credit card products—this in addition to the student loan refinancing, mortgages, and personal loans the company already offers its customers. The de novo would be chartered in Utah under the name SoFi Bank. On September 7, payments giant Square filed its application** for a Utah-based ILC for the purposes of expanding its lending arm—in addition to payments, Square also offers small business and consumer loans. While (at the time of this writing) the FDIC has yet to take action, approval or denial of these applications will set the stage for the next phase of bank-fintech relations. 

Historical Context 

Now state-chartered companies operating with federal deposit insurance, the ILC business model has been in existence since the early 1900s. Since their inception, non-bank retail companies have used these entities primarily to make consumer finance loans in order to sell their products, explained Attorney James Sheriff, partner at Reinhart Boerner Van Deuren, s.c. For example, BMW, General Motors, and Target all had industrial bank subsidiaries (and some still do). "The charter allows commercial companies to own financial institutions that can take federally insured deposits," explained Attorney Patrick Neuman, partner at Boardman and Clark, LLP. This bucks the long-standing policy in the U.S. to separate commerce and banking, a policy created in 1933 by the Glass-Steagall Act and reinforced by the Bank Holding Company Act of 1956 (BHCA).

Only seven states currently have provisions allowing for ILCs: California, Colorado, Minnesota, Indiana, Hawaii, Nevada, and Utah (where the vast majority of industrial banks are headquartered). Due to their exemption from the BHCA, ILCs are regulated only by their chartering state regulator (the Utah Department of Financial Institutions oversees ILCs with over $143 billion in combined assets) and the FDIC. The Federal Reserve has no authority to regulate the activities of the parent company, which—unlike traditional charters—is not limited to activities that are substantially related to banking.

However attractive this charter may seem, it has not been a popular option in recent years. No ILC applications were filed between 2009 and SoFi's application in June 2017—a timeframe which includes a three-year moratorium imposed by the Dodd-Frank Act (lifted in 2013). The last company to garner attention for its ILC application was Walmart in the mid-2000s. Fearing the retail juggernaut's entry into retail banking, the banking industry successfully lobbied for laws in several states (including Wisconsin) prohibiting ILCs from having a banking facility within 1.5 miles of a retail location owned by the same parent company. At the time, it was considered a great success. However, today's applicants aren't interested in physical retail locations. "Before, the goal was to bring consumers into the store in order to win their banking business," Sheriff explained. "Today, the brick-and-mortar isn't important, but rather wanting to expand financial products and services. It's a different threat."

Comparison of commercial and industrial bank charters

Renewed Appeal

The current financial services landscape is ripe for renewed interest in ILCs. Technological advances have made brick-and-mortar branches unnecessary and nation-wide reach attainable. However, banking's regulatory structure has not kept pace with the change. "Right now, in order to be a financer these companies need to get licensed in all states they do business in," Sheriff explained. One of the biggest attractions of an ILC is the federal pre-emption it offers. "Instead of 50 state regulators examining your consumer finance company, there's one state and the FDIC," he said. 

Another major draw of an ILC is that it allows the parent company to retain the flexibility to experiment that fintech startups are known for. "SoFi is a tech company and doesn't want to be hamstrung by the Bank Holding Company Act," said Neuman. "ILCs are not subject to consolidated supervision at the holding company level. That's a big advantage." 

Operationally, fintech companies like SoFi and Square would receive another important benefit from obtaining an ILC: a stable funding source. "Both companies make loans, and if they get an industrial loan charter they get access to federally insured deposits. Deposits are a significantly less expensive source of funding than investment capital or bonds," Neuman explained. The availability of government-backed deposits as a funding source would alleviate concerns over whether institutional funding is stable enough to weather an economic downturn or significant market fluctuation. 

What Happens If…

FDIC's approval of either pending ILC application would have profound implications for the future of the financial services industry. "If the FDIC decides to approve one of those applications, it could be a game-changer," said Neuman. "If either application is approved, there will be a flood of new applications." If SoFi or Square does receive an ILC, the banking industry will need to prepare for several long-term effects. 

First is a new, aggressive source of competition. "The most often-cited concern with ILCs is that they could lead to a concentration of economic power in banking," said Neuman. With ILC charters, giant technology retail companies like Apple, Amazon, and Google could offer the same products to consumers as banks. "They'd be behemoths to deal with in a consumer or small business banking sector," said Sheriff. In addition, those companies' data collection activities would not be restricted by the BHCA, enabling them to obtain and analyze consumer data that is not available to most banks. "That could seriously undermine a bank's ability to compete," said Neuman. One area where the competition could be especially fierce is in small business lending. "If the ILC option becomes more popular, and if small fintech lenders like Prosper get these charters, it would create a lot more competition for community banks in small business lending," said Sheriff. "It has some real potential detriments for community banks."

Another concern directly relates to SoFi's business model, which is driven by a focus on HENRY customers (High Earner Not Rich Yet). "Much of their business is student loan financing for professionals such as doctors and lawyers. There's concern in the industry that fintech lenders won't adequately serve the working class household or be able to meet CRA requirements," Neuman explained. "This type of business model could lead to a disproportionate allocation of credit." Banks can only speculate how the state regulators and FDIC will address CRA concerns with ILCs. 

Increased popularity of ILCs may also dampen partnerships between banks and fintech companies—partnerships that currently expand product and service offerings for many bank customers. "If FDIC starts approving these charters, there will be fewer partnerships between fintechs and banks," said Sheriff. "The fintech companies will no longer need to partner in order to get data and deposits." This is not conjecture. Former SoFi CEO Michael Cagney told TechCrunch the company plans to offer checking, deposit, and credit card services through a regional banking partner if the ILC application is not approved. 

Finally, ILC opponents see increased risk to the industry as a whole if these charters have a resurgence among technology companies. "What happens if one of these goes through and becomes huge, but then the parent company makes some wild bet and goes under? That could be a huge hit to the FDIC and the banking industry in general," Sheriff said. "Bank regulators aren't familiar with how to evaluate some of those widespread risks. We've separated banking and commerce for 85 years for a reason." The same concern applies to the potential for further increasing the market power of the "Big Five" (Amazon, Apple, Facebook, Google, and Microsoft) by adding banking services to their already diverse lines of business.

What if the FDIC denies the pending applications? Will community banks be able to breathe a sigh of relief and go back to business-as-usual? Probably not. "If these fintech companies don't get approval for an ILC, I believe they'll pursue other avenues, such as an OCC fintech charter," said Neuman. "Banks are going to see fintech as a real competitor in the lending space, and sooner rather than later." Influencer companies in the technology sector have set their sights on banking products, and they won't be easily deterred. "The bottom line is that there is activity in this area right now," said Sheriff. "This isn't hypothetical."


Boardman and Clark, LLP is a WBA Gold Associate Member. 
Reinhart Boerner Van Deuren, s.c. is a WBA Associate Member. 

*View a copy of SoFi's application here. On October 13, SoFi withdrew its application for an ILC charter as it undergoes a leadership transistion, but says "a bank charter remains an attractive option."
**Square's ILC will be named Square Financial Services, Inc., according to a Wall Street Journal report.

By, Amber Seitz