The Future of Community Banking with Karl Nelson from KPN Consulting

 Helping community bankers grow themselves, their team, and their profits. This is the Community Bank podcast. Welcome to the Community Bank Podcast. I’m Eric Bagwell, director of Sales and Marketing for the Correspondent Division of South State Bank with me, Caleb Stevens. Caleb, you’re basically the host of this podcast.

I’m not even gonna introduce you cuz everybody knows, but how are you? I’m good. It’s good to see you back on the show. In the words of the country duo Brooks and Dunn from the nineties. I haven’t seen you in a month of Sundays, so I think the ratings were down since I hadn’t been on, so we had to bring me back.

I’m kidding. Caleb’s done. I know everybody listening. You would agree. He’s done a great job and, and does a great job putting this stuff together. But Caleb, we got, uh, Carl Nelson. Carl’s been on before. He is with KPN Consulting. I think he was on one of our first. Maybe 15 or 20 episodes I would think.

Yeah, Carl’s one of those repeat guests where we’ve, you know, we had ’em on two years ago, three years ago when liquidity was out of our ears and now liquidity’s running out of the system. And you know, Jeremy Lucas was the same way. We’ve had several guests on the show where two years ago we talked to you.

It was a different story than it is today. So good to have Carl back on. Yeah, Carl does a great job. I mentioned this on the podcast of just kind of bringing everything down to a level that’s easy to understand and so, He, uh, he lives close by, came by the office and we recorded this. So, um, great guy and glad that he came on, so I know you’re gonna enjoy that.

But before, before we get to that though, let’s talk about our bank management conference coming up. I know you’ve mentioned it on a couple of podcast episodes now. We did get the ink signed, I think you mentioned this with Kirk Cousins, Minnesota Vikings quarterback. Yeah, he’s a great speaker. He won the Barch Star Award 2023, which is a big.

It’s, uh, kind of, it’s similar to that Walter Peyton Man of the year honor. Mm-hmm. But, um, Kirk Cousins is an, an excellent speaker. He’s been in the Pro Bowl, I think five years now and made it this last year. And so we’re gonna do some really fun things with him. Excited to have him. And then James Olson, I think.

Uh, Some folks may have heard James Olson speak. Ex uh, CIA agent tracked Putin through the 1980s all across Russia. A lot of cool insight, um, into what’s going on with Ukraine, not your typical banking conference. So we’re gonna talk some banking, but we’re also gonna have some fun with Kirk Cousins and James Olsen.

Absolutely, banking will be a part of it, but those two guys are kind of our off. Off topic keynote guys. But Caleb, tell everybody about the link in the show notes. I believe they didn’t go register. All you’ve gotta do is click the link in the show notes of this episode. You can view the entire agenda, uh, for the conference.

It’s July 6th through the ninth, down at the Ritz Carlton and Amelia Island, Florida. Click the link in the show notes to view the agenda and also to register. We’d love to see you and your family there. This. Awesome. All right, let’s get to the, uh, my interview with, uh, Carl Nelson right now.

Carl Nelson, thanks for joining us today. Hope you’re doing well. What’s going on? Doing well. It’s been an interesting couple years in banking and I think we continue to be challenged. Uh, I thought the smart thing to do would be to sort of give a little background of the two years starting with the pandemic.

Point out that this is my 51st year in banking and I have seen four brand new ideas, which I never thought would happen. Uh, number one, of course, the pandemic itself hadn’t seen a pandemic since 1918, so it brought a whole lot of change. No, wait. Did you see that one? I did. I saw that one. You were 20 at the time?

I was 15 at the moment. 15, sorry. Okay. So the pandemic brings some interesting reactions and just to sort of look at the government reaction to the Great Recession, which was essentially to lend money that was repaid. And the other thing it did was it basically had a two year period of protecting all deposits, so it took care of whatever liquidity problems might arise.

This time was completely different. This time money was given, and that’s the key. P P P was an $800 billion, uh, handout would be the wrong word, because it was needed. Yeah, there’s no question. Yeah. Between that and the idle program, which was another 200, that that is to be paid back, but we shall see how that turns out.

But it was more than that. It was the unemployment benefit increase. It was checks. Given to folks of certain income levels, but by and large, the impact of that government larges was to put somewhere between three and $4 trillion into the money supply and just to see how that impacted the industry. Look at the deposits of the industry in 2019, which is the last sort of normal year, 20 20, 21, and now 20.

What you’re seeing is a very long trend of deposit growth in the three and a half to 5% range during that period, that trend line is more like 15% a year. So it’s not imaginable that putting that much money in the system would cause future problems, and that’s what’s happened, and those problems are becoming.

Obvious even as we sit here today. The third thing that was kind of interesting was how the Federal Open Market Committee reacted to this moment. Just to give you context, since 1990, we’ve had eight uh, cycles of up and down moves, and what I mean by that, The F omc, starting with Paul Volker in 1980 has always managed the CPI inflation by raising or lowering interest rates.

If the economy looks weak, we drop rates to increase borrowing activity, increase activity. In general, if the economy looks overheated, we raise rates. And so if you examine the cycles of up environments, Those cycles have always been marked by 25 basis point. Slow meeting rises. There are only eight meetings a year, and so by doing 25 basis points, the F O M C was essentially giving the industry and probably more importantly, the US economy.

Time to digest. There have only been. 75 basis point increases in an up environment since 1984 of those occurred last year. So I think what’s happened is the market was first taken aback by the lack of consistency in how they handle an up environment, but also the speed of that has created a very large A O C I problem.

In our industry, and that’s the other issue that I’ve never seen before. When was the last time liquidity was not liquidity. What I mean by that is our securities portfolio is our liquidity hedge. We put it there so that if needed, we sell and we create cash, but nobody can sell because the speed of that rise has created.

No sell problems. So the liquidity hedge that’s usually there is not there this time. I’ve never seen that before. And so it’s created some interesting behaviors in the industry. The chief one being I’ve got a industry loan to deposit ratio of 62%. In any other world, that would mean we have way too much liquidity, not in this world.

And so you see folks who are worried about. Al Flos. Fortunately, I think that was a one off with Silicon Valley Bank and with Signature Bank, but that sort of raised the specter of, well, what if I did need funding? And here comes the, the big one, the difference between the wholesale market, that is to say, broker deposits, federal home loan, bank advances, quick grade advances, and the retail deposit.

I’ve never seen before. It’s so wide a difference that going wholesale really does increase your cost of funds. And we’ve been living through a period of 25 basis points, cost of funds. I have a feeling that if we took that measure at 3 31, the number’s already at 1%. Yeah. And so what we face in the future and the real challenge is a NIM challenge and net interest margin.

And the reason for that is most banks we talk to around the country are worried that their cost of funds is going to increase faster than the yields they can achieve on their assets. And so the challenge for 2023, frankly, is an M challenge, which means it’s a challenge on profitability. Yeah. We’ve had customers tell us over the last few weeks, a year and a half ago, Two years ago, and these are smaller banks.

You know, why, why do you have broker deposits if, if they did? Not every, not all of ’em did. Now it’s, why don’t you have broker deposits? So it’s totally turned around now. So you travel all over the country, see a lot of banks. What are you hearing out there lately? Um, with when you’re talking to folks, what’s the mood?

You know, it depends on the state. Uh, we do peer groups in Illinois, Michigan, Texas. We do peer groups in Georgia. Um, and what we get in states like Texas and Georgia is a, a bit different frankly than, let me say the northern states. I think the southern states have done a very good job with business friendly environments for one, uh, generally speaking low tax rates.

And so what you’re seeing is a lack of activity in many of the northern. Vis-a-vis heavy activity in the southern states, which led I think, to an increase in loans in general in those states with those kinds of characteristics of low taxes. And, uh, weather is key. If you live in the north, nothing you can do about weather and it’s clearly a key.

But the activity really was robust in the fourth quarter lending. And then in the first quarter, what we’re seeing is a, a definite slowdown, and it really raises the question of what is the F O M C trying to accomplish? They’re trying to slow down the economy. How will they do that? They will make it expensive, perhaps in some cases, too expensive to borrow.

And of course, borrowing is how this economy works, leverages how the economy works. What you’re seeing, I think is a reaction to those rising rates. 8% prime now. And I think what’s about to happen is a lot of commercial real estate deals that made sense at a 4% interest rate won’t make sense at an 8% rate.

So I think the challenge we really face is how do we get those deals done? And perhaps for the first time in my career, We’re going to see banks change their pricing dynamic. For instance, I don’t think you’re gonna see Prime plus one deals in the commercial real estate arena because 9% I don’t think the deal will work.

So you’re probably gonna see Prime minus deals. And what they’re probably aiming for is some kind of benchmark against the 10 year treasury. Yeah. And what I think that means is you’re gonna see treasury, 10 year treasury plus two 50 to 300 basis points becomes the standard, which will relate, I think, to sort of a prime minus concept in the, at least in 2023.

Yeah. To Silicon Valley Bank happens in. It’s interesting when something big in banking gets into the mainstream news, it, it’s always opened my eyes as to how much they really don’t know what they’re talking about. Because you kind, you do know banking and you know, but then you see what they’re reporting on.

You’re like, yeah, that’s kind of right. So the big thing was the loss in the investment portfolio. W. Then they raise, then the Fed raises a couple of days later, 25 more base points. It making that loss bigger. What, what signal does that send to folks and, and the, and bankers. What does that send that man you, you’ve told everybody how bad this is, this loss I’ve got and you make it worse two days later.

I would hate to be at the Federal Reserve in these days because at least in my view, this is the first time they had no. For how to do this. And what I mean by that is you can go back to the vocal years and you can see how the roadmap really did control C P I inflation. And if you go back to that period, what you’re gonna see is since 1982, every 10 year period, The average inflation rate c P I for that 10 year period was low, and the range between then and now was somewhere in 1% to 4% range.

So what they were doing with rates was in, in effect, controlling inflation. Along comes a pandemic. There’s no roadmap. And so the first thing I think they did wrong, In hindsight, and, and by the way, I would not wanna have been in their shoes, but maybe we get a, a roadmap for a pandemic out of this. They waited too long.

I think most people, when they saw that roughly 7% inflation in, uh, 21, they said, well, whoop, let’s get started. Well, they didn’t start until March of 22. And then the second thing to remember in future pandemic eras is don’t raise them that quickly. They started at 25, they went to 50, and then they did four, straight 75.

So what happened with Silicon Valley was the damage was already done in the model itself. We were with a $2 billion bank couple weeks ago, and the CEO of that bank said Silicon Valley Bank at 209 billion had the same number of customer. As our $2 billion bank. Yeah. So what’s that tell you about diversification and what’s that tell you about the average deposit of a typical customer?

Yeah. We’ve gotten a lot, I’ve gotten a lot of comments from family members, from folks at church about, you know, you come in on that that next Sunday and it’s like, man, how’s the banking industry? Because they know I’ve been banking and, you know, you say, well, eh, it’s, it’s fine. And, and, you know, just don’t have over 250,000 somewhere.

And, and I know there’s programs that, that, you know, you can explain and diversify, but they for sure it got everybody’s attention. It’s interesting how when you start talking about people’s. Well, it, it, it garners attention quickly. And do you think, let me ask you this, staying with the Fed, are they gonna pause or will they, at what point are they gonna pause and, and nothing happens at, at, at a meeting, do you think that’s, are, are we, are we seeing that soon?

Or what do you think? Well, uh, I’ll give you the impression we get from our peer groups because asking CEOs and CFOs and lenders, what they think is much more relevant than what I think, but basically, There is a view that there are two more, maybe one more 25 basis point increase, which would then set prime at eight and a quarter, eight 50.

And then there is a view that probably in the June or July meeting, there’ll be nothing. There’ll be nothing from that point on in 2023 is the impression we’re getting, and some of it may be connected, unfortunately to a politic. Reality of a presidential election really starting in November of 23. And so there is a feeling that the pause will be probably half of 23.

And then the question for the next round of meetings is, okay, when does the down cycle begin? And so we’ve taken a hard look at how long Upcycles last. Unfortunately, the last four cycles lasted as little. One year and as long as three years. Yeah. So it’s hard to tell. Again, there’s no roadmap, but my guess is you’ve got a actual 19, uh, well, a 2024 election, presidential election.

The Fed does not like to interfere with election, so I think if you see a downward move, it’s likely to occur in the spring of 20. And it’ll be downward. Every upward is followed by downward. That much we know for sure. Yeah, so it’ll be, I think, unfortunately, I think it’ll be politically motivated, but I also think that that will give inflation the time it needs to.

Get somewhere lower than 6%, whether it gets to 2% or not, I, I don’t know. Yeah. Let me ask you this, the building we’re sitting in, um, it’s not a full building. And if you go stand on the other side of this office and look down, there’s a lot of parking places. That have never been full. There’s no oil spots on ’em.

As you look down on the parking deck, we’ve here, we’ve reduced our space just a little bit. We still occupy a decent amount of space. But you think about all the folks not that have not returned to work and are not returning, does this become a credit event at some point? Do you think a serious credit event in the future, or Eric?

I, I think you’re going to have to go industry by industry. I can give you the take of the banking industry. I would say up until spring of 21, the banking industry was still wrestling with remote and, and we always said, don’t call it remote. Call it hybrid. Yeah. But basically what’s happened in the latter half of 22 and now to 23 is the banking industry seems to like its people at the office.

Yeah. And so I think the banking industry is an industry that. Not create that kind of hav because we like our people in the office. Now that may be management by walking around is how we do it, as opposed to managed by objectives. But other industries, um, I don’t know that they’ll have the same view. I do think differently than I did a year ago.

I thought it would be a major problem, but I’m beginning to wonder if the need for. People to be together will outweigh the need for the hybrid workplace. Yeah. So we’ll see. All right. Let’s talk about this cuz we all got diverted to liquidity for a few weeks and still are there, but a lot of changes on the horizon with electronic stuff, real time payments.

I know Fed Now is coming out in July. What are you hearing out as you travel from banks on, on this topic? I think a lot of banks are afraid of. What that will do to fraud. I think the reason is with a delayed system, you have time to react With a real-time payment system, you don’t. So we’ll see. I think the lesson of Zelle, I think one of the lessons of Zelle is that’s a trickier issue in terms of fraud, particularly with the ACH concept.

I think it was a good lesson. I don’t know how this is going to work. I think it’s going to cause more problems with fraud. I think if there’s one thing that’s clear and consistent in all our meetings, it is this concern about fraud and I think real-time payments add to that concern. Yeah. Yeah. It’s a big deal We get.

Caleb and I get emails probably once a week, maybe now, where their fraud has happened at one of our branches and they’re just alerting everybody. And I was in a bank yesterday, um, just making a deposit. I had had something I need to run by the bank and hadn’t been in the banking forever. And I know a lady that works in there, so I said, I’m just walk in this time.

And she had just finished dealing with a fraud issue and was. She was put off by it. She’s like, man, it’s just gotten crazy since Covid. So no doubt that that’s gonna be an issue. Talk about quickly to what are you as you travel? What are some of the banks that are kind of on the cutting edge of getting in front of, uh, anything, whether it’s, you know, anything related to banking.

Um, what, what are they doing now? A bank that’s gonna be independent and a survivor through whatever comes. What are they, what are they looking at right now? Talk about that for a second. Well, you know, as well as I do that since the end of oh six. 8,600 banks has become 4,700 banks. So yeah, the consolidation of the industry is real.

It’s, it’s 220 to 230 a year. They’re not disappearing over failure. They’re disappearing over merger. So I think the first question is why, and the best answer I can come up with truly is a lack of succession planning. There is not enough good succession planning going on in the industry right now and. I used to say that about the ceo, uh, the person who was in that chair for whatever the reason, not preparing for the replacement.

Now you’re starting to see succession planning at the board level, and the latest one, frankly, is succession of owners who’s the next owner of this. And you’ve both have heard lots of stories about how. The daughters inherited the bank from the patriarch who created it. Yeah. The daughters have kids. The daughters are now 65 to 70.

They don’t even live in the community anymore. And the kids are in California, right? Oh, yeah. So there is a, a real concern about, well, what will happen to those shareholders? Will they demand a liquidity event? And at a certain size, liquidity events are a c. And so I sort of get back to this point, whether you like it or not, size does make a difference in our industry.

So the one thing that I see consistently in our peer groups is the a hundred million dollar bank trying to figure out how to be two 50, the 2 5500, the 500 a billion, the billion, 10 billion. And I don’t know that it’s a love of growth so much as it’s a love of how do I cover the costs in my industry that don’t create profit?

And obviously we’re talking about some of the regulations dealing with consumer issues, but the biggest complaint you’re gonna get from a bank is how much money I spend on non-income producing activities. So how do I cover that size? That’s how you. Yeah. Makes sense. All right, final question. Go into your crystal ball.

We talked to a lot of banks over the last couple weeks at the Silicon Valley thing. It, it scared ’em, it, it kind of was like, man, they kind of sobered a lot of folks that, man, I wasn’t thinking about this. What does, what does the banking industry look like 10 years from now? You know, this happened quick.

What does it look like five to 10 years from now? What would you guess? What’s it gonna look like? It’s a timely question. I spent about a half an hour. This morning with a, a bank in Alabama CEO is as sharpest attack and has been around a long time, did all the right things right. But he even, he is wondering, well, is this the time to get out?

And his concern, I think is more, what does this industry look like? You’ve got FinTech, you’ve got credit unions, you’ve got the biggest banks just getting bigger and bigger. They’re now 40% of the assets in the industry, so lots of competitors. So what happens going forward? The only instant of de Novos being formed, frankly, is very limited.

What I see more of is a group buying an existing. And then moving frankly to where they want to be. We saw it in a South Georgia bank that was purchased. Yeah. Moved to South Carolina. Not moved in the sense of, but that’s where the team is in South Carolina. And so I think what you’re going to see is consolidation continues.

We’re now at 4,700 in change in 10 years. I think that’s three. Maybe 3,300, and I don’t see a big de novo period in our future. It’s just too expensive and it’s all so fraught with risk. What will the industry look like in 10 years? So much smaller. You’re gonna see bigger banks. Right now, the sixth, fifth largest bank, US bank is 650 billion.

The South, the SunTrust bb, and. Deal created another 600 billion, and I think PNC is moving in. So you have a concentration that should be worrisome for some. And the some would be small communities. Those big banks do not seem to have a big interest in branching into small communities. So what’s at risk here really is communities in America, big cities.

Not to worry you’re gonna do just. Small communities, that’s an issue and I think we’re gonna have to figure that one out, or we’re going to have a lot of haves and a lot of havenots from a community economic. Standpoint. Yeah, that’s a good point. So, well, Carl, it has been a pleasure. You do a great job bringing it down to a level.

Everything you talk about to something that I think everybody can relate to and understand, you’re a good friend. We appreciate you coming on today. Yeah, it’s a always a pleasure. Thanks to work with South State.