Where is the Economy Going?

Our industry has learned to live with economic uncertainty over the centuries we’ve been in existence. It continues to seek ways to improve its ability to predict the next economic cycle and its impact on banks.

The topic of “the next recession” has been prominent at our forums this spring. While there hasn’t been a clear consensus about the timing, severity and impact of the next recession, many of our conversations shed some light on the outlook of most of our members regarding the economy. Our groups have discussed our anticipated Fed Funds rate by yearend. Most members in several recent meetings predict the rate to reach 2.5-3% by yearend. Other predictions anticipate even higher rates; no one anticipated lower rates by yearend. As to the timing of the upcoming recession, the groups’ consensus crystallized around 2Q23, and most anticipate a shallow recession. Few members anticipate no recession at all, given the strength and breadth of our economy.

Personally, I see we are facing an unprecedented number of factors which can meaningfully impact the accuracy of this prediction, ranging from the war in Ukraine to the possibility of another government stimulus to support Americans as they struggle with rising energy costs and a major inflation surge. Consequently, no predictions from me.

The real question is, since we cannot see the future, what should we do today to handle a wider range of economic scenarios without sacrificing important growth and profitability prospects?

Below are several thoughts from me, based upon the many conversations our Forums have had in recent months.

• The eternal lesion: Concentrations Kill. We all know this lesson, and yet it bears reminding.
  
• Refine your segment definitions with respect to concentrations. For example, not all office CRE were created the same. Downtown office space in many cities has suffered greater vacancy rates than suburban offices. In fact, some suburbs are experiencing a resurgence of office space and small malls, in stark contract to numerous major cities.
  
  Another example is hotels; some, which cater primarily to large groups and business clients, have web hurt much more than others who are carpeting to domestic personal travel and who pivoted to become more attractive to that segment. Not all hotels are created equal, and the credit risk they represents varies widely.
  
  Refining your concentration limits to reflect such differences and many others will hopefully not impede loan growth prospects without exposing the bank to undue credit risk.
  
  
• Address concentration cross-dependencies. For example, oil and gas is an obvious concentration category. But much depends on the operators of the business and their role in the industry. Beyond that, other sectors are being impacted directly and indirectly by this vertical, such as trucking, heating, delivery services and more. Understanding these cross-dependencies and setting concentration limits that recognize them are important toward effectively managing your credit risk.
  
  
• There is some debate around the role of pricing models in ensuring appropriate pricing at any point in the cycle, and even more so as we head into the wind. I view pricing models, such as Precision Lender, as a critical communication tool to your bankers regarding your lending “sweet spots” and ways to achieve target customer profitability by utilizing a broader range of bank products beyond the loan itself. Pricing models can be used in the sales process to show customers and prospects the many ways the deal can be done and priced as desired by the customer, in exchange for deeper relationship across a broader product line (such as TM, other payment services, etc.). All too often customer profitability models are used to reduce loan hurdle rates. Instead, they can be used to find more creative ways to meet customer needs, meet the competition head-on and deepen your relationship. This is particularly relevant as pricing pressure intensifies with too few borrowers being chased by too many lenders…
  
  
• The COVID cycle shows us how much depends on the effectiveness and nimbleness of our borrowers’ management team. Some restaurants were forced to close, while others thrived by building a mobile presence and retaining delivery services. The quality and creativity of Management are difficult to assess, but they are more important than ever during economic downturns.
  
  
• Most of us are heavy collateral lenders. Now is the time to reemphasize cash-flow and borrowing capacity, as the value of the collateral might plummet as it did in many cases in 2009-10. We are already seeing softening in the residential real estate market, and more to follow on the office and commercial front. Now is the time for belt-and-suspenders, and to reduced reliance (but not elimination) on collateral underwriting.
  

In times of uncertainty we tend to pull in our horns. Today, we are generally awash with liquidity, and loan-to-deposit ratios are low. Loan growth is essential to our profitability. Finding ways to anticipate the risk and mitigate it in advance can help facilitate your loan growth without compromising your credit quality, particularly without compromising terms and covenants. Now is the time for creative lending: finding new, narrowly-defined verticals; converting some margin income to fee income through an effective combination of a mix of loans and other products; and recognizing the greater vulnerability of certain borrowers to a downturn than others.