04 Sep Forget Loan Categories: The New Way to Look at Post-Pandemic Community Banking
By Kamal Mustafa, Invictus Group Chairman
The pandemic has upended the very nature of community banking. This change requires a new way of strategic thinking, which we explain in this article. Banks that fail to adopt to the new environment will end up at a competitive disadvantage for years to come.
To understand this shift, let’s first consider some generalizations about pre-pandemic community banking. Community banks have always been a creature of their footprints. Their loan and deposit portfolios, structures and composition are defined by their footprint needs.
Loans are generally tied to the income/cash flow of borrowers, while collateral for these loans has been primarily skewed toward the real estate owned by borrowers. The importance of collateral in helping preserve bank capital under loss conditions has created a credit and loan structuring focus on specific loan categories.
By structuring relatively standard loan agreements against specific loan categories, community banks have optimized the lending and credit and accounting segregation process. Loan categories span a wide swath of industry codes that are defined by the North American Industry Classification System (NAICS), which in 1997 replaced the Standard Industrial Classification (SIC) system.
Traditional management techniques and internal organization are geared toward optimizing the community bank’s approach to these different loan categories and their unique characteristics. Bank financial statements tend to focus on loan categories, and market analysts concentrate on the growth, profitability, and risk profile of the specific loan categories.
For many decades, the focus on loan categories has served banks well. Issues dealing with strategic growth, acquisitions, the 2008 recession, changes in Federal Reserve monetary policies, and regulatory oversight have all been addressed more than adequately by this loan category focus. Financial statements have not changed, either, with balance sheets focused on loan category assets and income statements on income by loan category.
This was all fine, until the onset of COVID-19 and its subsequent economic fallout.
The Ongoing Impact of The Pandemic on Community Banking
The sudden appearance of the pandemic, its meandering progress through the global and U.S. communities, combined with the federal medical, political, and economic policy responses, have created a nearly opaque crystal ball for community banks. The shape, intensity and magnitude of the first pandemic wave has yet to be determined, with a high certainty of similar confusion regarding the coming second wave. The potential changes in consumer and corporate behavior created by this pandemic have yet to be truly defined.
Community banks have their hands full. They are dealing with the existing changes in their marketplace, the low interest rate Fed policy, a relative explosion of deposits, and potential defaults in different market segments. And these defaults are delayed and obscured by federally encouraged moratoriums on interest and principal payments.
In the chaos of the pandemic storm, one key critical new pattern has evolved. This pattern has and will continue to have a significant impact on community bank strategic planning, profitability, mergers and acquisitions, and eventually financial reporting.
This pattern is the unusual and unique impact of the pandemic on different NAICS codes across the U.S. market. The pandemic has been discriminatory about different NAICS codes, affecting their operations and finances in distinct ways that will continue to evolve and change.
Some NAICS codes suffered a loss of available labor due to workplace environments that were conducive to the spread the pandemic (beef processing plants, for instance). Other NAICS codes were affected by CDC-directed safety measures (restaurants, hotels, gyms, etc.). Changing consumer behavior and health concerns affected certain NAICS codes (transportation, etc.). Some NAICS codes have already ceased to exist with their activities being replaced by other NAICS codes (brick-and-mortar retailers versus online retailers). Other NAICS codes that depend or service the directly affected NAICS codes continue to be whipsawed.
This shift in focus toward NAICS codes and their unique reaction to the pandemic has and will have a greater impact on community bank analytics than any event during the last several decades, including the Great recession of 2008.
When the pandemic fallout ends, at some uncertain time in the future, every community bank will be looking at an altered footprint because:
- Certain NAICS codes will have massive turnover in ownership, as well as their operating and financial structures.
- Certain NAICS codes will succumb to alternate NAICS codes.
- Changes in consumer behavior will continue to be felt for some time across other NAICS codes.
- During this period, credit characteristics of affected NAICS codes will change considerably, directly and indirectly affecting the collateral value of their long-term assets.
From both a credit, capital and asset growth perspective, community banks will have to look at their activities within these NAICS codes to measure the true impact. Analysis solely focusing on loan categories will only serve to obscure the critical impact of these changes.
- Loan duration, structure and collateralization will have to be readjusted for the changes in affected NAICS codes.
- Credit policies and procedures will have to be adjusted, not by loan type but by the changed characteristics of affected NAICS codes.
- Banks whose footprints have a high percentage of negatively affected NAICS codes will have reduced opportunities for growth. Banks will have to look outside their footprint to ensure growth and profitability or alternatively consider shrinking their assets.
- Acquisitions must be evaluated, not on historical loan performance, but rather on the changing nature of their footprint and its impact on existing assets and future growth.
This change in focus toward NAICS codes is not an overnight process. Banks that react slowly will be left in the dust. While it is extremely difficult to predict the movement of the pandemic waves and their final impact on different industry segments and consumer behavior, it is clear that banks have to begin focusing on the NAICS codes within their footprint.
- They need to identify and evaluate their existing and evolving exposure to these NAICS codes.
- They need to change their lending strategy, loan documentation, and credit procedures to anticipate and cope with these changes.
- They need to evaluate their surrounding footprint for its exposure to these affected NAICS codes.
- They need to investigate territories outside their footprint that could reduce their exposure to these NAICS codes.
- They need to reevaluate capital adequacy, incorporating the impact of the pandemic on both a short and long-term basis.
The bottom line is depressingly simple. Community banks are creatures of their footprint. The pandemic is changing their footprint by directly affecting specific NAICS codes within it. In the next three years, these changes will storm through their marketplace before entering a new steady state. The only way for banks to manage, strategize and maximize shareholder value is to reevaluate their marketplace through the lens of NAICS codes.
The Importance of Loan-Level Analysis
As is immediately obvious, evaluating the growth potential, credit and capital risks associated with stressed NAICS codes will not only require a focus on these codes, but is only possible using loan-level analysis.
- Stress tests based on historical loan category performance make no sense and are backed with no acceptable logic.
- Acquisitions, including those presently under consideration, that do not do a detailed loan-level dive into the stressed NAICS segments are a disservice to the acquiring bank’s shareholders. These deals could, on the other hand, be of considerable value to sellers whose financial statements do not yet reflect the impact of the pandemic on their footprint.
- Strategic plans that do not concentrate on the distribution of existing loan categories within stressed NAICS codes will be misleading at best and dangerous in most cases.
Loan-level analysis from the NAICS code angle is critical, and it must be paired with footprint analysis. Many community banks are ultimately real-estate lenders. However, real estate itself is a NAICS code and masks the true construct of the footprint’s economic profile. For example, those community banks that specialize in residential real estate or multifamily must look deeper. The homeowners and renters are likely to be employed in other NAICS codes, and therefore the cash flow profile of these loans is more of a function of the footprint’s NAICS code distribution. The real estate NAICS code, which will represent at least a plurality in the NAICS code distribution of many community bank loan portfolios, is essentially useless information without that full analysis.
To summarize, the community bank footprint NAICS composition is shifting. These changes cannot even be approximated through a loan category analysis. Only a loan-level analysis can provide management and shareholders the ability to quantify earnings and capital issues through the pandemic and post-pandemic period.