Karl Nelson: CEO of KPN Consulting on M&A, Credit Unions, and Banking in a Post-COVID World

[Intro]: Helping community bankers grow themselves, their team and their profits. This is “The Community Bank Podcast”.

Erik Bagwell: Welcome to “The Community Bank Podcast”. I’m Eric Bagwell, thanks for joining us today. We’ve got a really cool interview with Karl Nelson. Karl is Founder and CEO of KPN Consulting, and we’ve known Karl, I guess, for over 20 years and Karl does a lot of speaking at events around the country banking events and does a lot of round tables with different associations around the country. So he talks to a lot of bankers and we’re just going to get his insight on what he’s seeing, what he’s hearing with the industry, where he thinks the industry is going. But Karl’s always a great interview, great speaker; when you hear him, he’s always got some really cool facts that he shares. So I sat down with Karl today and we’re going to play that interview. Caleb Stevens is joining me here as well. Caleb’s producing our show, but also is a Business Development Officer works on our sales team here. And Caleb, you’re going to Kentucky next week to see some banks and you’re going to talk to a few of them about our arc program, which is a loan hedging product, tell everybody about it.

Caleb Stevens: I am. Yes. So a question that I hear often is what do you do when a customer comes to your bank and asks for a long-term fixed rate loan? Because that’s in high demand right now because we’re rates are there near historic low. So people are trying to lock in a lot of buy and hold investor types who are buying something and want to hold it for 10, 15, maybe even 20 years. And so what do you do? Do you try to talk them into a shorter term and risk, maybe losing that business? Do you take that risk and put that loan on your balance sheet for 15, 20 years? But you know, in three, four or five years, what happens when your funding cost goes up? Or do you go to a back-to-back traditional swap program and those can work, but those are full of derivatives and Dodd-Frank reporting and hedge accounting and a lot of things that make your CFO’s head spin, especially for a community bank, and so that often is a little too confusing, complicated, scary. And so what we decided is let’s create a program that really simplifies it, a program that lets a bank lend fixed, receive floating, generate fee income, and without any Dodd- Frank reporting, no hedge accounting, no dirt on your books, all you have is a floating rate note. And so it’s something that I have the pleasure of helping banks up in Kentucky with, own in Florida, up in the Northeast bunch of different states and it’s a great product and I’m excited for folks to check it out. You can learnmore@southstatecorrespondent.com/arcthat’s A-R-C, southstatecorrespondent.com/arc. So there’s our product plug and Eric, I have to say this was, I think your first time doing a solo interview on the podcast. So it was good. It was fun. I just enjoyed hearing you and Carl talk and it was a good discussion.

Erik Bagwell: It was Karl and I have known each other. I think I mentioned on the podcast, we’ve known each other a long time, but we used to play basketball together and so I’ve known Karl , not in a banking role, but he was a point guard and I was just playing everywhere, I guess. But Karl is a great guy and like I said, wealth of knowledge and we’re excited that he came on today too. 

Caleb Stevens: You talked about the Hawks, speaking of basketball at the end of the interview. And I was just sitting there producing it thinking, well man this interview is not coming out for two more weeks, so we’re going to know the fate of the Hawks and the Milwaukee bucks here in a few days. So I hope that things pan out well for the Hawks by the time folks are listening to this, if not typical Atlanta sports teams, right?

Erik Bagwell: That’s right. Hopefully we’re taught, well, it probably wouldn’t be there yet. Maybe it’s a world championship we’re celebrating, who knows, but let’s go to the interview with Karl Nelson now and everybody, thanks for tuning in.
[Intro]

Erik Bagwell: I’m joined now by Karl Nelson, Karl, we’ve known each other a long time and you were our first in studio guests, I think for our podcast, so thanks for joining us. How are you doing today?

Karl Nelson: Doing great pleasure to be here.

Erik Bagwell: We were just talking about NBA basketball and Karl and I used to play, I think it’s been, you’re actually, let me say this, you’re the oldest, not oldest, that’s not a good word. I’ve known you the longest of anybody in the banking industry. We used to play basketball at the YMCA in a men’s league every Saturday morning, years ago.

Karl Nelson: Well, we ended up over at Mayberry. Remember we had to keep finding gyms.

Erik Bagwell: They kept kicking us out, that’s right.

Karl Nelson: They kept kicking us out, right.

Erik Bagwell: And Karl was the point guard and I just played everywhere; I think. Didn’t have a position so.

Karl Nelson: Well, let’s be clear. Eric was a basketball player and I was just an old man trying to run up and down the court.

Erik Bagwell: Come on now! No, I knew Karl was a banker, I was not in the banking industry then, but was excited to reunite about three years later at a conference. You were working for the home loan bank at the time.

Karl Nelson: Exactly.

Erik Bagwell: Give us a background about your career in banking because you’ve done quite a few jobs.

Karl Nelson: You know, you start out in banking and you try to find the best training you can, and in the early seventies that training was at Chase Manhattan Bank. 
And so my first job out of the service was in fact, in New York City, Chase Manhattan Bank now Born and Bred and Altoona, Pennsylvania. So New York City was a bit of a stretch for my wife and I, but I was there during a training program; learned how to do commercial credit really. And then about 15 months into it, I sat down with my wife one night and I said, well, honey, where do you want to live? Because I don’t think this is the answer for two people from Altoona. And she said, you know three cities that appeal to me are San Francisco, Denver and Atlanta. So, I sent out the requisite letters to Bank of America and I forget who it was in Denver. But the response I kept getting back was if you ever in the area drop in, except in Atlanta, where I got a letter from CNS saying, we’ll pay your way. So we found our way to Atlanta, and worked at First National Bank of Atlanta actually then moved up to Cleveland, worked for Society National Bank , then moved to Miami, Florida National Bank and then came back to Atlanta, really in the early nineties to work The Federal Home Loan Bank, and I was there about 12 years.

Erik Bagwell: Yes.

Karl Nelson: So that was a great experience, particularly to getting to know banks in the Southeast.

Erik Bagwell: Yes. And you travel all over the country. I know you speak at a lot of conventions. You talk to a lot of bankers and that’s what we wanted to have you on today. What are you hearing out there? What are bankers saying? Because the folks listened to our podcasts, they’re all over as well, but they like to hear what happens in other parts of the country too. So let’s talk about the changes you’ve seen as we’ve come through COVID what are you on the backside of it? What are you hearing out there? What are you seeing when you talk to us?

Karl Nelson: Well, I would say number one, human behavior is a constant and the human behavior associated with, I don’t know what’s about to happen, is essentially conservatism and in our world, that means go to cash. And so what happened in March of 2020, the industry plus all the folks we lend to when, to cash and we had a huge influx of borrowing by the very largest companies, and that just went right into the banking system. So in a world; the banking world, where annual deposit growth is three and a half to 5% between the end of 19 and 20, that growth rate was closer to 20%, and we have never had that kind of growth in deposits. So the big issue for most banks today is what are we going to do with all that liquidity? And is it going to go away? So I think right now, we’re trying to figure out those two issues. In amongst all that we’ve got a significant net interest margin depreciation, it’s about 54 basis points in 2020, it’s fallen again in the first quarter. And with all that’s going on in the interest rate environment, you have to wonder if we’re going to lose even more in the second quarter. So that’s kind of where we are right now.

Erik Bagwell: Yes. Talk about a few more of those obstacles that banks are facing now with the economy and going forward. What do you see on the horizon?

Karl Nelson: Well, it’s a mystery. What we did in 2020 was we reserved way beyond the norm and as you know, in our world, provisioning for future loan losses is what drives profitability. Just to give you a sense in 2017, 2018, 2019, our annual industry reserve is a little over 
$50 billion, and that creates an allowance for loan and lease losses of about a one and a quarter. In 2020, we poured $134 billion into the reserve; so three and a half times the norm. Why did we do that? It wasn’t because we saw problems, we didn’t know there was no delinquency, there were no additional charge offs. So for the first time in our lives the government steps in, provides liquidity and also provides money, much of it free in order to keep up with your consumer debt or your company debt, you know that as PPP, but there was also a lot of money given to the consumer in the form of direct payments.
So what happens in 2020 is we over reserve profits are off about 25, 30%. We head into 2021 and immediately we begin to see over reserving is at least what is thought went on, and you see this first quarter, 74 billion in profit, a really great quarter, 60 billion; so 2021 is going to be one outstanding year. The mystery, we still do not see delinquency, we still do not see charge offs, but we’re worried that you can’t shut down an economy for pretty much a year.

Erik Bagwell: Yes.

Karl Nelson: And not expect some significant problems. So the mystery is, when are those problems going to surface? Are they going to surface?

Erik Bagwell: Yes, that’s a great point. That it’s kind of still that 800-pound gorilla in the room, you don’t know what are those long-term effects? Well, what are some key lessons that we all should have learned coming out of the pandemic too?

Karl Nelson: Well, certainly in the community bank world, we are an industry that likes our people in the office. And so we weren’t particularly well-prepared for the remote workplace, but we’re an industry that had to be nimble and we’re nimble, and what we did was we created a remote workplace pretty much from scratch. So here we are coming out of it, depends on what part of the country you’re in. If you’re in, let’s say Illinois, if you’re in New York, you’re probably not back to work, if you’re in Georgia, if you’re in Texas, you probably are back to work. So we have this mix concept, both in our industry and business in general. And so what we have to do is, we have to figure out what do we learn about the remote workplace and what are we going to do about it. So far Eric, what we see is community bankers want to come back. The larger banks, most of the larger banks are saying, we’re going to create a hybrid and so what we’re faced with is all right, who works from home? How often do they work from home? And what do we do about excess space? So on the other side of the coin is a banker with a credit perspective, what’s the impact on office space in the future? And do I have anything in my loan portfolio that could go upside down connected to that problem?

Erik Bagwell: Yes, absolutely. So where are we at now, where we come through COVID, we think we’ve come through COVID. What’s the future for the industry in your perspective? Talking to the folks that you talked to all over the country, tell us, well, what’s the attitude out there that you’re hearing?

Karl Nelson: Well, the attitude unfortunately, is still a little bit of what’s coming?

Erik Bagwell: Yes. 

Karl Nelson: The numbers are still very strong. We just actually had a peer group meeting today with some senior lenders in Georgia and we asked the question, are there any cracks? Are you seeing anything, and the answer is no, we’re seeing nothing. So a lot of this stimulus kind of runs its course in the third quarter. That is leading folks to think that if there’s a surprise on the credit side, it’s likely coming as early as the fourth quarter. Problem, there may not be a problem.

Erik Bagwell: Yes.

Karl Nelson: This money may have done what economists say it should have done, government steps in, business and consumer stop spending and government steps in not with loans, which is what happened in the great recession, but they step in with just pure donations, if you will, to the industry, to the consumer. So did this avoid the great economic collapse you would have expected? We’ll see, you’ll see.

Erik Bagwell: No doubt. So what do you see happening as far as industry consolidation? There are folks that think we’re going down to 1500 banks, there’s folks that think that number is crazy. Where do you see it in the next say, five years?

Karl Nelson: Well, the great part about being old is that when I started way back in the seventies, there were 20,000 banks.

Erik Bagwell: Yes.

Karl Nelson: And another, roughly 3000 thrifts. As we look at the landscape today, we’re just under five thousand, forty-nine hundred and eighty, I think at the end of the first quarter, we’ve been on a trend line of 250 mergers a year. The losses, of course, aren’t there anymore.

Erik Bagwell: Yes.

Karl Nelson: All of the failed banks occurred really in that 8, 9, 10, 11, 12 period, so that’s pretty much past. So let’s say the trend of 250 continues even though in 2020, it dropped to about 210, we think it comes back. So I think you can almost count on 250 deals a year. Question, De Novo activity as you probably know, Craft Bank started here in Atlanta and we’ve had some De Novo activity, but having started a De Novo myself back in 2008, you don’t really want to start one with the fed funds rate, earning you a whopping eight basis points.

Erik Bagwell: Yes.

Karl Nelson: And so the interest rate environment will slow the De Novo activity down, the merger activity won’t stop. So 250 a year in four years, you’re lost another thousand. You’re down to 4,000, let’s say by 2025, Yes.

Erik Bagwell: Yes. I think that’s probably a good number. It’s funny, we’ve talked to a bank last week, that will remain anonymous, they’ve got a group together, ex-banker excuse me, that starting another bank and it was good just to talk to somebody that’s starting a bank, it was neat to hear, but you’re right. 
I think that’s going to be kind of tempered for a while in this interest rate environment. So let’s talk about credit unions just for a second. What’s your read on the industry, the credit union industry and what are you hearing out there from folks when they talk about credit unions?

Karl Nelson: Well, It’s an interesting question particularly today, because I think our listeners know that the purchase of small banks by the credit union industry is pretty much now about three years old, and we’ve done about 20 deals, but they’ve all been the same small bank, rural community. We have had announced in the last month, a deal that’s very, very different. And this is the VyStar Credit Union out of Jacksonville, Florida purchasing Heritage Southeast Corp. The interesting thing about this is Heritage was just created with a merger of three banks about 18 months ago, and I’ve not seen three banks merged, so that was kind of an exciting, unique situation. Those three banks came together and had an okay 2020, but the first quarter results for that Heritage Group is incredibly strong. So what’s about to happen is we’re going to have a credit union, 10 billion in size purchase a billion-three bank. That’s a different ball game, and I suspect what’s going to happen. That industry has consolidated exactly like ours, there are about 5,000 credit unions.

Erik Bagwell: Yes.

Karl Nelson: There used to be 20,000. The big difference is in that industry, we don’t fail, the NCUA takes over, finds a buyer and merges. So I think that continues. And I think credit unions are doing the same thing; they’re trying to get larger. It’s all about covering costs, and so that continues pretty much in the same way that we continue. So again, probably 4,000 credit unions by the end of the next four years.

Erik Bagwell: Yes.

Karl Nelson: Here’s the rub, everybody in the audience knows credit unions don’t pay taxes. Well, one of the things that bankers, particularly in the bank association world hope for is that Congress will do something about that. Here’s what you have to understand the entire credit union asset structure. The whole shooting match is smaller than any one of the four largest banks. Another way to say that the entire credit union industry has assets of about a trillion- seven, trillion-eight.

Erik Bagwell: Yes.

Karl Nelson: We have four banks that have assets in excess of 2 trillion. So it’s hard to get in my view, it’s hard to get Congress interested in solving something that they probably do not view as a problem.

Erik Bagwell: Yes. Great point. I know credit unions are a hot topic, especially with that last deal that I remember the first bank I was working with got bought by a credit union. This is probably been nine years ago, and it was a tiny credit union that bought them and this one is an eye opener.

Karl Nelson: Yes. 

Erik Bagwell: It’s kind of a different look. Just wrapping up with Karl, let’s talk about the future. What are the biggest challenges for banks going forward?

Karl Nelson: Well, what the pandemic did is it speeded up several important issues for us, I’ve mentioned the first one; the remote workplace. What does that look like in the future? And this is a particularly relevant issue because we were already having difficulty attracting and retaining talent. A lot of the talent coming out of the university system today would love an opportunity for some remote work; it just fits that lifestyle better.

Erik Bagwell: Yes.

Karl Nelson: So we’re going to be flat up against, can we find a hybrid in our industry? Are we going to hold to? You got to come in, are we going to lose talent because of that? So we’ve got to figure that out pretty quickly, along with that, we’ve got to figure out the office-based problem. Number two, we have been slow as an industry to adapt to a customer base that seeks convenience over everything else, whether it be opening a deposit, making a loan. What the pandemic did is it forced us into some efficiencies, like e-signature things that we weren’t doing before, but suddenly we saw we had to do, question do we keep it up? We had a visit today with a banker and we said, what did you figure out during this? And the answer was, well we had already started down the path of a automated consumer loan, unsecured methodology so that we never touch it, it spits out a yes or no, it does the documents, and it’s a very cost-efficient method. Well, we all know that a bank that tries to make $10,000 consumer loans is going to spend more money making the loan than they can earn on it, so this is what happened. The really interesting angle though, was what happened when PPP came on board was, we took that same system and turned it into a PPP system that allow this $200 million bank to grow to 300 million in 15 months, a lot of it PPP. So while so many banks were struggling with getting on the portal, struggling with how do we do it, this bank, because it had already started down the path of automated loan systems was able to jump in and do very well.
Question: What are you going to do with it? What are you going to do as a community bank in particular about online account opening and some kind of online loan platform? And I think we better figure that out. If we don’t the FinTech sector, which is already figuring it out and already figuring out the next demographic isn’t excited about coming in and spending a half an hour with us to open an account, is going to go in that direction. And that’s what we have to worry about. It’s not the existing customer, it’s the future customer, that’s an issue.

Erik Bagwell: When you’re talking to folks, do you get the sense that people are aware of that? It sounds like that bank was that now, I think about this, we’ve talked about this before, if you’re in a small town, now Amazon they can bring anything to your door the next day. So do I need to drive an hour to the city to go get something, probably not. Banking’s turned into that. The community banks out there, then the rural areas. Do they realize that? Are you hearing that from them that, hey, yes technology something, if I’m not, we joke about the technology talk at all the conferences over the years. That’s where everybody gets on their phone, looking to see who won the basketball game last night. Is there a sense of urgency out there that you’re hearing that, hey, Yes, I got to get on the game a little bit with it? 

Karl Nelson: It’s really a mixed bag. The banks that will survive in the future will have to be more efficient and those banks, I think, understand it’s a problem. They’re trying to gauge their future customer base because they know their existing customer base very well and they know what that base loves; they love the relationship model. So the question is, what’s the next customer base one? Do they want to come in and have a cup of coffee with us and talk, or do they want to fill that application out at 10 at night before they go out dancing and get it done efficiently that way? You better figure it out, because if you can’t and you run out of that old customer, and I’m an old customer, then you’re going to have a problem. And I don’t think it’s as well understood as it needs to be.

Erik Bagwell: Yes.

Karl Nelson: However, that’s why we lose 250 a year.

Erik Bagwell: No, you’re right. It’s funny. I was with my 16-year-old son the other day, and we had to run by the bank to, I had somebody to give me some cash. I just didn’t want to say, Yes, let me go take it and deposit the bank. He said, daddy, isn’t there a way to do this without going to the bank? And so you’re right, that mindset is why are you going there? You know, when everything else is, let’s, don’t go somewhere because they’ll bring it to you. That’s something banks have to figure out you’re right. So Karl, it has been a pleasure to catch back up with you and to talk with you and we appreciate you coming on and sitting down with us today. And we didn’t know who won the game last night, and there was a big game in Atlanta, tonight,

Karl Nelson: Big game.

Erik Bagwell: I know it’s in Milwaukee,

Karl Nelson: In Milwaukee, unfortunately.

Erik Bagwell: So hopefully the Hawks will come through.

Karl Nelson: I hope so, they’ve been a nice surprise for us.

Erik Bagwell: Awesome. Thanks for joining us today.

Karl Nelson: Thank you, Eric. My pleasure.