KBW CEO, Tom Michaud, on The Key Banking Storylines Going into Q4

INTRO: Helping community bankers grow themselves, their team and their profits. This is the Community Bank Podcast.

CALEB: Well, hey everybody, and welcome to the Community Bank Podcast. Thanks for joining the conversation today. I’m Caleb Stevens with SouthState Bank’s Capital Markets and Correspondent Banking division. Today, I sit down with Tom Michaud. He is the CEO of KBW, and if you ever watch CNBC or any of the local business channels, you will probably see Tom at some point throughout the month. He’s a frequent contributor to CNBC, Fox Business, and we are delighted to have him on the show to talk about the biggest storylines going into the backend of the year. Will we have a soft landing? Will we have a hard landing? He’s starting to see an M&A uptick, and we talked about the drivers of that. We also talked about, as a community bank that wants to remain independent long term, what should you be focused on? So, we cover all that in this episode and we are excited to play it for you right now.

CALEB, continued: Well, Tom, it’s great to have you back on the Community Bank Podcast. Back by popular demand. You were on a couple years ago, I think, in the throes of COVID, or we were just now coming out of the pandemic. So, the world has certainly changed since we last spoke. So, catch us up. What’s new in the KBW world?

TOM: Well, Caleb, it’s great to be back with you all. You know, really the last couple of years have been unprecedented. Thank goodness 100-year pandemics only happen every 100 years. Because what happened during the pandemic, in addition, just to the health of folks who were impacted by the pandemic, the policy response, which certainly at the beginning of the pandemic was totally appropriate, created a lot of distortions. And we’ve had a lot of things happen that don’t normally happen in our careers. So, 0 interest rates shouldn’t be viewed as the new normal, and we had 0 interest rates. Free money, essentially. Then we had an unprecedented stimulus. And when you have interest rates go up over 5%, in the fastest and steepest policy increase of our careers, that has implications. We also had some traumatic swings on the political front in terms of regulation. And then we had a bank run last year that really damaged the confidence in the system. So, you add all that up and kind of put it in a snow globe and shake a little, and you got a lot of change.

TOM, continued: So, as you know at KBW—we’re in our 63rd year. We are financial services specialist. I mean I know, Caleb, you know us as the banking industry focused firm and experts, but in actuality, we do the whole financial services sector. Which includes insurance, nonbanks, asset manager, BDCs, so we get a chance to look through our lens at the whole financial services sector and system in the country. And so, last year was still a big reset from what I described earlier for us. And now, with the with the Fed getting ready to change direction on rates, which is looking to happen next week, we’ve had some orderliness. We’ve had the stocks bounce off the bottom. We’ve had some confidence come back into the system. While one of the storylines I think we’re going to talk about is hard landing versus soft landing, but for now, I think the consensus still is soft landing.
TOM, continued: We’re in a world where things are starting to happen. And I couldn’t be more proud of where KBW is today. Our market share is at a 63-year high. We’ve advised on more than 60% of the M&A volume in the industry. We’ve got the number one market share against not only our other regional peers, but all the bulge bracket banks. We’ve been helping insurance companies’ banks raise capital. So, I feel like we’re in a very good position to be helpful, and I feel like we have our finger on the pulse of all the big conversations and decision making in the industry at the moment.

CALEB: Well, we are recording this on September 12th, and so as you mentioned, rate cuts likely coming next week as of this recording. But we’re only one day removed from 9/11, and of course that’s a significant day for all Americans, a somber day for all Americans. But particularly for your firm. For the folks that are not familiar with KBW, would you mind, to the extent that you’re comfortable sharing, the history of the firm as it relates to 9/11 and why that date matters, and any lessons or takeaways 23 years now later.

TOM: Sure, Caleb. Unfortunately, we were in the World Trade Center when the attacks happened 23 years ago, and we lost 67 of our colleagues. We had 224 employees at the time. We had about 180 employees in the New York office. One of our co-CEOs was killed in the attacks, and the other co-CEO’s son was killed in the attack. The folks who were killed in the attack owned over 35% of the equity of our firm. And I was fortunate enough to be coming in late that morning, and I was standing on the sidewalk. But I did watch it all happen. And I can tell you that our hearts remain broken for the families of all those who lost loved ones. And in the aftermath of 9/11, we got ourselves together, and we said we were going to do two things. One is we’re going to work hard to support the families of the 9/11 attacks, which I think we still remain engaged—I know we’re engaged with these families. The KBW Family Fund continues to support many of those families even today, 23 years later.

TOM, continued: And then we said we were going to rebuild the firm. And we said we were going to rebuild the firm because we weren’t going to let the firm end that way. We weren’t going to let bad actors who flew planes into our building determine what the end of our firm was going to be. And so, we put our shoulder down and we went about rebuilding the firm. Since that time, in addition, and really being focused like I said on doing what we can to support the families, we’ve also joined many 9/11 communities. And I’d say the one that I’m most passionate about, and I’ve joined the board of, is something called 9/11 Day. We convinced Congress to make 9/11 Day a National Day of Service. We weren’t looking for a holiday. We wanted a National Day of Service, and we wanted to honor those who lost their lives—the first responders, our colleagues—by recognizing the goodwill and resilience that existed in our country after 9/11. And I’m proud to say that as far as service projects go, we led a service project yesterday where we packed 9 million meals across 21 cities with 30,000 volunteers and 500 corporate sponsors.

TOM, continued: We believe that 9/11 now is the largest National Day of Service in the country. We ask folks who do a good deed to just log it on our website. We’ve got 30 million acts of good deeds around 9/11, and it could be as simple as going to a neighbor’s house who’s elderly and checking in and saying hello. It doesn’t have to be doing one of our projects. So, the story of 9/11 is still being written, and we want to make sure that 9/11 just doesn’t become two chapters in a history book. And instead, we’re defining what 9/11 is, how it’s going to be talked about. And that’s just one of many organizations that either our families or our colleagues are involved with. But it’s certainly a heavy-hearted day in New York City, which is where I was yesterday.

CALEB: Well, it’s a testament to the culture that you all built at KBW, to not only honor the victims and the families but make that an ongoing part of your DNA and your culture. And I know throughout the whole banking industry, your firm is very well respected and looked up to because you guys add value. You add value to your clients. You add value to your employees. And you guys have a good name in the industry, and we want to spend some time talking about those banks that you’ve been serving now for 63 years. We’re heading into the fourth quarter soon, and I’d love to just sort of give you a free menu to say as you look at going into the back end of the year here. What do you think are the biggest storylines that community banks and regional banks ought to be paying attention to?

TOM: I feel like there are a couple of key pivots that are happening that are really important, as a manager of a financial institution and a community and regional bank, that you need to be paying attention to. I think the first is something very bullish, which is we believe that the net interest income bottom was made in the second quarter. And that the industry’s balance sheets are catching up with the current rate environment. And that we’re going to return to net interest income growth. The last two years with the rate increases and the deposit competition caused there to be a lot of pressure on revenues. And we think that, given the fact that we’ve got a directional change in rates, that some of the pressure is coming off, and that we’re going to start to see a slow grind towards improvement. So, that’s very positive for the operating leverage story of the industry, if we get revenues growing again. Remember, the inverted yield curve that just stopped happening was the longest period of time in my 39-year career that the yield curve was inverted.

TOM, continued: It’s been a difficult operating environment for spread lenders. Banks weren’t built to operate in an inverted yield curve. Just not how the duration analysis works. So, hopefully that headwind pressure ends, which allows for a little bit more top line growth. So, I would say that’s one thing to be getting ready for. The second is this whole dialogue around hard landing versus soft landing. And the economy is slowing, and that’s the goal of the Fed. The Fed’s trying to slow down inflation by slowing the economy. And the economy is slowing, and there is a fear that they go too far, and the economy ends up having a recession or hard landing. And I would say even just this week, there are a couple of companies, Ally Financial, whose stock was down 17% the other day, said that they’re starting to see some degradation of consumer credit quality in their in their auto book. And we are starting to see some cracks in the consumer. And the question is, how far is that going to go? Because some of it is just normalizing because credit was so good. So, if you look at percentage changes on credit, the percentage changes look staggering, but when you look at the aggregate losses and delinquencies, we’re still in an okay shape.

TOM, continued: So, really that is the question. Where is the landing here? Is it hard landing or soft landing? And I think that is an important issue to navigate. So, my view is the fundamentals of the industry are improving, albeit slowly, and we need to be on guard for credit. And then on that question of credit, I should probably talk about commercial credit, because commercial credit has exceeded everybody’s expectations. Our channel checks suggest that there’s really no trend that anyone’s worried about in the commercial lines of their business. It’s really just this consumer angle that’s getting more attention.

CALEB: That’s interesting because I’ve read some, you know, doom and gloom articles about CRE and commercial real estate valuations related to credit risk and the loans that banks are holding related to CRE. Do you think that might be overblown as it pertains to community banks and regional banks from a risk standpoint?

TOM: Well, that’s a great topic to talk about, because I think when we get through this cycle, this is going to be a great storybook to read about. I think that commercial real estate is much more than just one broad category. And I think you have to break it down into pieces. I’ll tell you, the piece that that we’re most worried about, are the big commercial real estate credits for the big office buildings in the urban centers, especially on the coast. So, and thankfully some of the big banks like Wells Fargo and Citizens Financial, break those portfolios out for investors. And when they do, because of CECL and the way reserve accounting works, they generally have reserves up around 10 and a half, 11% of those portfolios. Those reserves are geared up for losses that would be worse than the global financial crisis. So, in this regard, this is CECL working.

TOM, continued: You can say those banks have already reserved for what should be the worst-case scenario. And so, it’s no longer an income statement event for them. And then I think when you get away from these big urban cities, the story gets better. And the smaller credit seem to be behaving better, and so, especially if it’s multifamily is better, there still is a housing shortage in the country. So, I’m not suggesting that all is well and there won’t be problems because there certainly will and there’s probably no better segment that’s positioned for a discounted cash flow analysis than commercial real estate. If rents go down and interest rates go up and inflation is here and it’s more expensive to run the building, that income statement doesn’t look better. It looks worse. So, we’re seeing banks getting out there and working with their clients. And I think there’ll be more trouble ahead. The question is, is it manageable or not?

CALEB: Right.

TOM: And you know, look for New York Community, it wasn’t manageable. They had too many big credits in New York City, and too much rent-controlled multifamily. And so those income statements got upside down and what they found was a 50% loan-to-value ratio wasn’t good enough when the value went down 50%. And then the regulators got involved and said, “These are criticized credits.” And once that happens, then the confidence got shaken, and then they had to raise capital and essentially reboot the company. So, you may see an example or two of that, but I don’t think it’s going to be an industry event. And I think it will be manageable. One last thing on this is I don’t think a 25-basis point rate cut is the solution to these pressures. You probably don’t get the heat off of this asset class until rates go down 100-basis points. You need more relief than that. So, we’re just starting what hopefully is better. And then, I did say this is the last point, but now I really do have my last point, Caleb, which is, you know what’s unprecedented is: I can’t remember a cycle where it looks like the rate cutting is going to be this aggressive and credit hasn’t even been a problem yet. Generally. So, the cavalry is here before the real problem has really arrived. So, in terms of the rate changes, especially if we get a one-point cut. That was the end of that question, Caleb.

CALEB: Yeah. That’s helpful. That’s great context and fingers crossed we can keep inflation, you know, as low as possible as we go into hopefully a declining cycle. We have seen an uptick in M&A this year. I know that’s one of the key lines of business for your firm at KBW. What do you think are some of the main drivers? Because M&A was pretty dead coming out of COVID when rates were, you know, on the upswing. AOCI was a huge prohibitor to banks for a while there, but it’s starting to tick up a little bit. What, in your mind, are some of those key drivers that are driving the uptick?

TOM: Sure. I think the first thing is to recognize that the industry is in consolidation mode and has been since the laws were changed in the mid 1980s, right? So, the question is, it’s a consolidating industry, but how fast is it happening? Which I think is the real crux of your question. So, and also, bank M&A slows typically when things are disorderly. The economy is disorderly, the stocks are disorderly, the policy response, the three bank failures is kind of making things disorderly. So, for those reasons, we think that we understand why M&A may have slowed last year, but we’re back. I mean, the opening pitch in my opinion was Capital One’s $35 billion acquisition of Discover. So, and since then, it’s been rather steady. And so, we now are measuring consolidation along the lines of percentage of banks, not number of banks. And it’s about 3% right now, and the range has been around sort of 2 and a half to 4%, let’s say. So, we’re somewhere in the middle in terms of pace of M&A. And I think the drivers are scale has been working.

TOM, continued: If you look at the industry medians, you’ll see that the bigger banks tend to be a little bit more profitable. Now there are drops in profitability when you get to key regulatory levels, like 10 billion or 100 billion. But generally, as you get bigger—and look there are exceptions to every rule. There are really big banks that aren’t that profitable, and there are smaller community banks that are very profitable. So, there are exceptions and I’m speaking to the median. The median is scale is working. And the reason why scale is working is that technology is expensive. Technology is causing more price competition. And, also the cost of regulation is going up. No matter how much Washington says they’re going to tailor regulation, it doesn’t really work that way. And so, the cost of regulation’s going up. And there’s been a lot written by many of the industry executives, including PNC’s Bill Demchak, publicly. For example, he has said, you know, the products at the big bank level are all the same, but some banks have more scale and more ability to spend on marketing and investment than others because of their size. So, he’s been a big author talking about scales of affecting the industry. So, I think it’s around that. And then I guess the last piece on that, is there are two other two other elements.

TOM, continued: One is we’ve seen some banks get upside down in their interest rate operations in the sense that they’re held-to-maturity losses are quite extreme, or the bank is sort of frozen because of the spread at their bank, and they have some tough positions on the asset side. And a way to unlock that as an M&A deal. I’ve seen deals happen where I think that has been an element. And then the other piece is succession. Sometimes there’s not a clear leader to take over when the leader is retiring or leaving, and that can lead to an opportunity where a board of directors thinks that combining with another bank makes the most sense. That’s another factor that we see.

CALEB: And we see that quite often, as well, with the banks that we that we work with. Tom, I’ll let you run in just a minute because I know you have to bounce to another appointment. But any final advice to the community banks out there who are listening that they’re not looking to sell right now. They want to remain independent. They’re committed to their communities, to their clients, and they think the future ahead for their bank is bright. What should they be focused on over the next 5-10 years?

TOM: Well, first of all, I would really pick up on something I said earlier. Size alone doesn’t determine who is going to succeed and who is not. When I joined KBW, we had 75 employees. We were a privately-held company, and then I’ve been here now 39 years and we’ve been really able to grow our franchise, our relationships in our business. And I still think that opportunity exists. So, I don’t think size alone is a foregone conclusion. But I do think active management is really important. And I think you just don’t want to let the market happen to you. I think you really need to have a plan on how your bank is going to add value and going to remain on the forward half of change in the industry.

TOM, continued: Smaller banks don’t have to be the cutting edge. The trillion-dollar banks are going to do that. But the question is, if the trillion-dollar banks have a good idea or a good product, with the servicers that are out there today, you can typically be a fast follower. You know, I think of things like Zelle. I think of things like real time payments when I say that. And also, we work really closely with the processors. They’re clients of ours, as well. And I can tell you, and I know Jack Henry, for example, has got a big position in the community banks. They’re working very hard to be able to move faster with newer technology to help smaller banks remain competitive. And so, I think that is what I would be thinking about. First of all, know that size alone doesn’t determine the outcome. But just make sure that you’ve got a really proactive knowledge of how your bank makes a difference. And what niche is your bank going to fill. And just don’t let the market happen to you. That’s what I would say would be the key elements.

TOM, continued: And I am also a very big advocate for Deposit Insurance Reform. You know, I don’t think in times of stress, America should pick their bank based on its size. You know, one thing I would point out, in about a week’s time, you had Credit Suisse fail and you had Silicon Valley Bank fail. When Silicon Valley Bank failed, the first thing the FDIC said was, “If you’re over 250,000 in deposits, you get a certificate, and we’ll get back to you someday in the future to tell you how much of your money you’re going to get back above that number.” That was pretty scary and made everybody say, “Well, where’s the rest of my money?” When Credit Suisse failed, which is essentially what they did—and remember they’re a global SIFI, so, one of the 30 or so banks in the world that the world’s regulators thinks they’re globally systemic. When they were in trouble, the regulator, over a weekend, forced them to sell to 100-year competitor across the street and no depositor was threatened of losing any money.

TOM, continued: That’s what happens when you’re too big to fail versus Silicon Valley. Think it was like 9 days difference. Those two things happening. So, we need to make sure that we keep deposits settled, and that America doesn’t pick its bank based on bank size when they’re stressed. And so that that’s something I continue to talk about.

CALEB: Reminds me of a saying that we say around here that we borrowed from Chick-fil-A, which is we want to get better, not necessarily bigger. But if we get better, customers will demand that we get bigger. So, focus on getting better, not just getting bigger.

TOM: And, you know, just to add value. Look: the most profitable growth anybody can have is organic growth. And then you keep an eye on inorganic and acquisitions. But having forward momentum on organic growth will make you better if you wish to be a buyer.

CALEB: Yeah, absolutely. Well, Tom, thank you for your time. This has been very helpful, and we’ll have to have you on in a couple more years and see what the world does.

TOM: Well, don’t let it go a couple of years. Come on, these topics are too much fun to talk about!

CALEB: Yeah, well, we can make that happen.

TOM: We’ll do it. We’ll do it sooner than that, Caleb. Thank you for having me.