Download the full Canadian issue

VOL. 7 NO. 3 | 2016

CANADA

Net Stable Funding Ratio:Preparing for a Game-Changer

Addressing the Looming Crisis inPromotional Deposit Pricing

Efficiency vs. Transformation:Striking the Balance in a Shifting Terrain

Savvy Analytics or Shaky Guidance System?Metadata Governance for Big Data

DIGITAL DISRUPTION:Are Canadian Banks Ready for Thin Branch Networks?

2 CANADA

CANADA

CONTENTS

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20

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Efficiency vs. Transformation:Striking the Balance in a Shifting Terrain

Canadian banks remain healthy but face challenges from a wobbly economy, digital disruption and restrictive regulation — all pointing to restructuring ahead.

Deposit Promotions in Canada – A Race to the Bottom?

Banks need to clarify their deposit needs over the next few years and overhaul the metrics, skills and strategies used to drive deposit gathering.

Net Stable Funding Ratio: Preparing for a Game-Changer

To cope with forthcoming regulatory requirements for long-term stable funding, banks should be working now on measurements, funding plans and business strategy.

Big Data Overload: Call for Business Metadata Governance

Business metadata governance is receiving way too little management attention at many banks, increasing the risk that new analytics will become shaky guidance systems.

Adel Mamhikoff, Steven Luckie and Lee Kyriacou

Adel Mamhikoff, Hank Israel and Andrew Frisbie, with Chris Musto and Adam Stockton

Steve Turner and Adel Mamhikoff

Rich Solomon and Kaushik Deka

Adel Mamhikoff and Brandon Larson, with Chris Musto

VOL. 7 NO. 3 | 2016

Progress in repositioning networks will be slowed if the most digitally-receptive customers are lost along the way, underscoring the need for channel segment strategy.

Digitally Savvy Customers are Ready for Thin Branch Networks — but are Canadian Banks?

Energy Loan Risk Modeling: Why Simulation Makes Sense .................................................................... 14

Treasury Management: The Case For Improved Value-Based Pricing ....................................................... 32

Digital Lending Detour: Roadblock or Fresh Opportunity for Banks? ...................................................... 37

CANADA

3October 2016

LETTER FROM THE EDITOR

Welcome to Novantas Review Canada, our journal on strategy and management for executives in banking and financial services. These timely articles focus on competitive dynamics in Canadian banking, as well as themes with a broad North American view.

Our cover story — “Digitally Savvy Customers Are Ready for Thin Branch Networks — but Are Canadian Banks?” — examines changing Canadian channel preferences, as revealed by Novantas consumer research. Digital orientation and usage has progressed to the point that the newly-dominant customer group is “Thin Network Ready,” or people who only want branches as an occasional backstop. Another small group neither uses nor values the branch. This type of digital disruption is upsetting the balance in chequing acquisition, as the largest banks are not winning their usual share of accounts from the digitally savvy, underscoring the criticality of smart channel segment strategy.

Meanwhile Canadian banking industry profitability is tightening, constricted by flat rates, new regulation and slower GDP growth. In “Efficiency vs. Transformation: Striking the Balance in a Shifting Terrain,” we pick up the conflict between improving returns, rationalizing the branch network and investing to shore up primacy in customer acquisition of digital-first segments.

And on the subject of transformation, one key area in need of change is deposit promotion. Here again digital banking is making its influence felt, both in changing customer shopping behaviors and new competition. As discussed in “Deposit Promotions in Canada — A Race to the Bottom?” institutions will need a more selective form of promotional pricing strategy that improves the odds of attracting loyal deposit balances and carries less risk of disturbing established accounts.

Two other North American-themed articles of particular interest in Canada focus on modeling energy loan credit risk and preparing for net stable funding ratio (NSFR) regulations. Rounding out the issue are articles on treasury management pricing, digital lending and business metadata governance for Big Data.

Lee Kyriacou Editor-in-Chief

EDITORIALEditor-in-ChiefLee Kyriacou

Managing EditorSteve Klinkerman

NOVANTAS CANADAManaging DirectorAdel [email protected]

DirectorSteven [email protected]

Toronto Office181 University Avenue, STE 1600Toronto, ON M5H 3M7Phone: 416-479-8336

CONTRIBUTORSAdam StocktonAdel MamhikoffAndrew FrisbieBrandon LarsonBrett FriedmanChris Musto Dave RobertsonDavid Shimko Hank Israel Kaushik DekaLee KyriacouRich SolomonScott MusialSteve TurnerSteven Luckie

DESIGNDesign and ProductionAdrienne Cohen & Brigid Barrett

MARKETINGMarketing Communications ManagerKatharine [email protected]

NOVANTAS, INC.Co-CEOs and Managing DirectorsDave KaytesRick Spitler

Corporate Headquarters485 Lexington AvenueNew York, NY 10017Phone: 212-953-4444Fax: [email protected]

SUBSCRIPTIONS [email protected] 212-953-2712

Setting Sail in Digital Winds of Change

LKyriacou

4 CANADA

The Big 5 Canadian banks have had a dazzling run in retail branch banking, operating profitable fortress networks over a period of years.

But the foundation is trembling as profit headwinds prevail and consumers delve deeper into digital banking. In three short years, the overall industry concentration of Branch Traditionalists — people who tightly focus both their daily banking activities and loyalty on the branch — has tumbled to 12% from 23%, according to Novantas surveys (Figure 1: Shifting Channel Segment Composition).

Meanwhile the growing ranks of digital-leaning customers are redirecting more of their primary everyday banking account purchases to smaller institutions. In turn, account acquisition among major players is being skewed toward customers who are more strongly attached to traditional physical presence.

As reflected in a recent Novantas shopper survey, 56% of recent chequing purchasers at big Canadian banks fell into cat-egories reflecting high attachment to the branch, compared with only 32% for smaller banks. Meanwhile at smaller banks, 53% of purchasers fell into the lowest categories of branch depen-dence, versus 28% for the big banks (Figure 2: Segment Trends in Chequing Acquisition).

It is a delicate situation at a time when the major players are turning more attention to network consolidation and re-posi-tioning. Strategically, the high ground lies in capturing the new-ly-dominant customer category in Canada — “Thin Network Ready.” These consumers turn first to digital channels for most daily banking activities and would accept a thinned physical presence so long as it provides a visible backstop “just in case.”

Reflecting a powerful surge in consumer digital orientation,

BY ADEL MAMHIKOFF AND BRANDON LARSON, WITH CHRIS MUSTO

Progress in repositioning networks will be slowed if the most digitally-receptive customers are lost along the way, underscoring the need for channel segment strategy.


COVER STORY

this Thin Network Ready group has risen to a dominant 38% represen-tation in Novantas surveys. Yet the Big 5 are coming up short with this group — garnering only 26% of their new chequing accounts from this segment in recent years, In contrast, smaller Canadian banks and niche players are acquiring Thin Network Ready right at 38%.

To be sure, the Big 5 continue to dominate primary chequing acquisition overall, and each competitor is committed to a vision of acquisition and service beyond the branch. Yet progress in repositioning networks will be slowed if the most digitally-recep-tive customers steer their business elsewhere. Under-penetration of chequing purchasers who are Thin Network Ready will cause real challenges for any bank that does not work more quickly to reverse this trend.

An immediate management implication is the need to understand and speak to channel-based segments of customers and prospects. By viewing shoppers through the lens of chan-nel segments on a market-by-market basis, the bank can more clearly assess opportunities and threats and gain clarity on the strategies required to compete and win.

The shift to channel segment strategy could first play out in new marketing messages and offer strategies, and in near-term digital investments designed to attract segments that will happily join the bank in its transformation journey. Longer term, channel segment guidance will be indispensable in reposition-ing distribution, particularly in sculpting branch networks to free up resources needed to support the digital agenda.

DEPENDENCE VS. ATTACHMENTThe Thin Network Ready customer segment is one of five cohorts derived from an analysis of consumer branch dependence and branch attachment in Novantas surveys. Along with collecting demographic information, the surveys probed consumer chan-nel attitudes and preferences, particularly the role and value of the branch.

Given the rapid digital technology changes in alternative banking channels, consumer reactions to the traditional branch are especially relevant today. But as it turns out, Canadian consumer views on branch necessity do not primarily reflect

variations in demographic traits such as age or income. Rather, branch sensitivity is an attitudinal dimension that must be under-stood in its own right.

As a complement to behavioural questions about functional dependence on the branch, therefore, we asked a second set of attitudinal questions about branch attachment.• Branch dependence — a set of behavioural questions, ask-

ing how often each customer visits the branch, and the spe-cific banking tasks the customer designates for the branch versus other channels; and

• Branch attachment — a set of attitudinal questions, examin-ing the extent to which the customer values the branch in a primary banking relationship.One of the headlines from the resulting matrix is that Branch

Traditionalists — people who conduct most of their banking activities via the branch and prefer it that way — are a vanishing species (Figure 3: Channel Segmentation Matrix). In a similar Novantas survey conducted only three years earlier this group was twice as large, representing one of every four respondents. Now at 12% (and presumably still falling), the former core cus-tomer group that guided Canadian branch banking decisions for decades is a smaller piece in a much larger and different type of distribution puzzle.

But where do former Branch Traditionalists turn when they hit the exits? As underscored by survey results, there are multiple flavours of digital preference and behaviour. Sound


Figure 1: Shifting Channel Segment Composition

Viewing Canadian primary chequing customers by branch dependence and branch attachment, a profound shift toward digital channels is clear.

Source: Novantas 2012-2015 Canada Multi-Channel Surveys. The most recent study is based on interviews with 2,024 Canadian chequing customers across six census metropolitan areas.

2012 2015

23%12%

2012 2015

27%32%

34%

38%

Biggest Decline Fastest Growing

Branch Traditionalists Heavily rely on branch; prefer it that way

Thin Network ReadyStrong digital orientationlingering branch preference as a fallback

Channel MixersSignificant use of digitalbut still want and usebranches as well

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strategic planning will adjust for key differences in the preferred banking experience among emerging segments.

NEW CENTRE OF GRAVITYAs highlighted in the Novantas survey breakout of five channel segments, the new Canadian consumer banking centre of gravity is 70% composed of people who are either: 1) Channel Mixers, who extensively use digital channels in active combination with the branch; or 2) Thin Network Ready, having moved a step fur-ther to adopt a true digital centre of gravity, but still wanting the branch as a mostly-unused backstop.

Thin Network Ready (38%). The largest segment — and potentially most worrisome for the Big 5 — is the Thin Network Ready consumer, who has little actual dependence on the branch but still considers branch access when selecting a bank.

Reflecting lingering emotional attachment to physical touch-points, Thin-Ready customers still list convenient branches and automated teller machines among their top requirements. But given their lower actual branch usage, they are less interested in convenient hours and more interested in digital capabilities.

Thus a strong digital offering with a much smaller but still-con-venient branch network will attract these consumers. This puts Thin-Ready shoppers in play for banks that lack traditional dense branch networks but can provide the necessary elements of brand, product, digital convenience and targeted physical presence.

The Thin Ready crowd is shifting away from the Big 5 a bit,

leaving these banks more heavily weighted with consumers who are not only attached to the branch but more heavily dependent on it as well — in other words, with the highest cost-to-serve and the most resistance to change.

Channel Mixers (32%). As the name reflects, customers in this segment use all channels to some degree, including moderate branch usage. And like the Thin Network Ready, they exhibit a relatively high attachment to the branch.

Channel Mixers account for much of the advantage Big 5 banks have enjoyed in primary chequing acquisition. Comprising 39% of recent purchasers among the largest players, they had only a 26% representation among smaller banks and niche players.

Compared with Thin Ready customers, Channel Mixers place much greater emphasis on physical convenience. Highlighting the difference, they are 50% more likely to say placing a branch nearby is the one thing a bank could do to be most convenient, and 50% less likely to say “really useful online/mobile banking” would do the most to make a bank most convenient for them.

POLAR OPPOSITESThe remaining 30% of customers in our channel segmentation are either stuck with the branch for now (either happily or unhappily), or almost completely divorced from it.

Branch Traditionalists (12%). These customers exhibit both high branch usage and high emotional attachment to the branch.


Strongest Branch Orientation

Strongest Digital Orientation

Figure 2: Segment Composition in Chequing Acquisition

Among Canadian consumers that recently opened primary chequing accounts, big banks are attracting more people with lingering strong branch attachment.

Source: Novantas 2015 Canadian Shopper Study, which interviewed 1,744 recent chequing purchasers and prospective switchers.

Traditionalists Channel Mixers Innovation Seekers

Thin Network Ready Digital Only

Top Five

Smaller Banks,Niche Players

17%

6% 26% 38% 15% 16%

39% 26% 2% 17%

Like Channel Mixers, they tend to gravitate toward the Big 5 — a recent primary chequing acquisition at a Big 5 bank is three times as likely to be a Branch Traditionalist than one acquired elsewhere.

Given their preferred and frequent branch usage, Branch Traditionalists also value convenient hours. For both Traditionalists and Mixers, marketing should reinforce superior physical conve-nience as well as rapid funds availability.

The larger strategic question for the Big 5 is the implication for cost-to-serve and competitiveness. In an industry contending with profit headwinds and digital disruption, it becomes harder to broach network consolidation if the bank is pulling an outsized share of consumers who are wedded to the branch in both atti-tude and dependence.

Innovation Seekers (10%). Customers who express little emo-tional attachment to the branch continue to use it are dubbed Innovation Seekers. This segment is on the move: While compris-ing only 10% of current account holders, Seekers represent an outsized 17% of recent chequing acquisitions, as well as 17% of prospective switchers (those already thinking about changing banks or receptive to the idea).

Innovation Seekers do not care about convenient branches

as much as the typical shopper and appear to be attracted to competitors who can differentiate on product and service deliv-ery. When prospective switchers from this group were asked to choose the one thing a bank could focus on to be most convenient to them, more picked “really useful online/mobile banking” than picked “a branch near me” — the reverse of prospective switchers in the Traditionalist and Mixer categories.

Innovation Seekers seem to be branch-dependent customers who would clearly be happier if they could find a comfortable path into the digital space. Successful migration would lower the burden on the physical network and provide more latitude for reconfiguration. The key going forward may be to limit the num-ber of Innovation Seekers by better meeting the emerging prefer-ence for empowering digital banking solutions.

Digital Only (8%). Finally — and smaller than the digital enthusiasts might think — are Digital Only consumers who neither use the branch nor value it. While this group has doubled from a small base over the last three years, it remains a decided minority of chequing customers. This highlights the challenge that branch-less players have faced historically: a reluctance on the part of consumers to completely sever ties with the branch even after they


Little actual dependenceon the branch; want somebranches "just in case"

Neither use nor valuethe branch; receptiveto niche player offerings

Attached to the branchbut use a well-roundedmix of channels

Want something betterbut still use the branch;prone to switching

Use the branch often fora variety of transactions;prefer it that way

Figure 3: Channel Segmentation Matrix

Diehard branch customers are a vanishing species, supplanted by customers who are embracing digital channels. The Thin Network Ready segment is of special significance.

Source: Novantas 2012-2015 Canada Multi-Channel Surveys. The most recent study is based on interviews with 2,024 Canadian chequing customers across six census metropolitan areas.

Branch AttachmentLow High

Bran

ch U

seO

ften

Rare

Innovation Seekers(10% down from 13%)

Branch Traditionalists(12% down from 23%)

Channel Mixers(32% up from 27%)

DigitalOnly

(8% upfrom 4%)

Thin Network Ready(38% up from 34%)

7October 2016

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have largely abandoned it in favour of other channels.Still, it is significant that one of every 12 Novantas survey

respondents fell into the Digital Only segment, essentially express-ing complete resonance with digital and zero resonance with the branch. And these are not just tech enthusiasts with low banking potential: survey demographics reveal a healthy representation of customers with annual incomes of at least $75,000, concentrated in both the 18-34 and 35-54 age groups.

Today the Digital Only segment constitutes 4% of primary chequing relationships at the Big 5 — half the concentration in the national consumer base. And they represented only 2% of the Big 5 chequing account origination stream in recent years, sug-gesting that the largest Canadian banks are struggling to attract and retain what little share they have of this segment. As this most channel-progressive consumer banking segment continues to grow, the acquisition challenge for the Big 5 will grow with it.

TURNING POINTIt is clear that the Canadian banking industry has reached a turning point in distribution. More consumers are transitioning from “receptive to digital banking” to “solidly anchored in digi-tal banking.” As this attitudinal and behavioural shift progresses, the decision criteria for bank selection is changing as well, with differentiators such as a superior digital banking experience and resonant marketing gaining in importance over traditional factors such as branch presence.

Meanwhile channel economics are in flux. Facing continuing profit headwinds and steadily declining branch usage, many bank management teams are actively considering programs for network efficiency, consolidation and repositioning. Some of the Big 5 banks have started announcing staff and branch cuts. We expect further announcements going into 2017, probably more aggressive over time.

Channel segment insights will be essential in managing digi-tal transitions and network transformation. By linking segments to branches, banks can better determine how to optimize branch resources, encourage channel migration by segment, and link sales force calling efforts.

Behavioural analysis. Looking strictly at branch balances and profitability will not provide a clear view of the impact of net-work changes A detailed understanding of how major customer

segments utilize the network today and will likely do so in the future is needed, along with modeling of potential customer impact as the bank continues to transform the network (by evolving branch formats and/or consolidating sites).

Reinvestment. An increasingly important factor in network transformation is reinvestment — careful redeployment of some portion of freed-up resources in marketing and other forms of dis-tribution (digital, call centre, ATMs, alternative branch formats). Segment insights are needed to evaluate highest-return opportuni-ties and guide reinvestment of freed up resources.

New-form customer acquisition. To rise above all the potential branch-related buzz surrounding network consolidation, banks should develop marketing- and innovation-driven growth cam-paigns to target Thin Branch Ready customers. These campaigns will shift the emphasis away from the branch toward other factors, such as exceptional online/mobile banking, helping to build the type of convenience imagery that is more relevant to digitally-ori-ented consumers.

Proactive channel migration. Branch reconfiguration efforts can be improved by understanding which of the bank’s geo-graphic markets can attract the right customers with a thinner branch network, versus others where more caution is required given customer segment mix. To that end, the real opportunity with Channel Mixers and Branch Traditionalists, especially for the Big 5 banks, may lie in encouraging transaction migration and attachment to other channels, so as to engender greater flexibility in local branch planning.

Retention. From the perspective of customer relationship con-tinuity, branch consolidation can be a hazardous exercise. A sig-nificant retention program is needed for best success. But as our surveys underscore, different levers (messaging and positioning; migratory paths to alternative channels) work with different cus-tomers. This reinforces the importance of gathering behavioural and segment insights to guide strategies and resource allocation.

Adel Mamhikoff is a Managing Director in the Toronto office and Brandon Larson is a Director in the New York office of Novantas. Also contributing was Chris Musto, a Director in the New York office. They can be reached at [email protected], [email protected], and [email protected].

“It is clear that the Canadian banking industry has reached a turning point in distribution. More consumers are transitioning from ‘receptive to digital banking’ to ‘solidly anchored in digital banking.’ As this attitudinal and behavioural shift progresses, the decision criteria for bank selection is changing as well, with differentiators such as a superior digital banking experience and resonant marketing gaining in importance over traditional factors such as branch presence.”

Canadian bankers have acknowledged the dual challenge of cost control and digital transformation. In recent investor rela-tions calls at several institutions, executives have emphasized the need to free up resources to invest in digital technology and improve mobile and online offers.

The question is how to accelerate the process in stressed profit conditions — with minimum further strain on sharehold-ers. Although profitability at the six largest Canadian banks remains head and shoulders above large banks in the U.S. and other countries, Canadian returns on equity and price-to-book multiples have slipped from prior peaks. Competitors want to put a floor beneath that trend and then reverse it.

In simpler circumstances, blunt cost-cutting would be the obvious coping mechanism. Setting aside structural issues and looking strictly at current market headwinds — flat interest rates and margins; credit worries for the energy

and consumer sectors; contracting GDP and slower revenue growth — the traditional response is to hunker down and put a choke on risk and expenses.

But locking down is of limited help if the business model is slipping out of sync with a changing market. Pure cyclical coping tactics are losing effectiveness, not only in Canada but globally, as two major structural transitions envelope the banking industry:

Digital disruption. Dense physical branch networks are facing accelerating obsolescence as customers relocate transaction, shopping and purchase activity online. The world-class branch networks constructed over decades by Canadian banks now must be carefully — but ultimately heavily — thinned to reflect the realities of declining usage. Meanwhile digital value propositions must be strengthened to meet the onslaught of disruptive niche players.

BY ADEL MAMHIKOFF, STEVEN LUCKIE AND LEE KYRIACOU

Canadian banks remain healthy but face challenges from a wobbly economy, digital disruption and restrictive regulation — all pointing to restructuring ahead.

Efficiency vs. Transformation:Striking the Balance in aShifting Terrain

FEATURE

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10 CANADA

Constrictive regulation. Balance sheet flexibility and corpo-rate profitability have already been affected by the constraints and implementation costs imposed by stricter international banking standards. And there is more to come — the Basel III Net Stable Funding Ratio (NSFR) is a potential game-changer, which will further pressure spreads and require strategic reas-sessments of assets, funding and certain lines of business.

Putting all of this together for 2017, the essential stra-tegic questions revolve around the transformation agenda, including:• Network realignment — Pare the branch network without

harming core customer relationships and deposit acquisi-tion; free up resources for reinvestment.

• Digital value proposition — Shift the marketing stance from local branches and pricing to product functionality and brand.

• Relationship expansion and profitability — Anchor and expand core customer relationships to stabilize channel transitions and grow profitable market share.

• Funding and balance sheet management — Build/revise metrics and analytics needed for NSFR; identify strategies and tradeoffs; incorporate into governance.In each area, success will depend on analytically-guided

strategies. Canadian banks are navigating this transitional

period from a position of strength, not having gone through the recession-driven turmoil seen in the U.S. and elsewhere. But they do have a lot at stake, requiring coordinated ini-tiatives that will advance the transformation agenda while upholding performance in stressed conditions.

CYCLICAL HEADWINDS Profitability and trading multiples have retreated over the past two years, and 2017 will not likely offer much relief. At 16.3%, the average return on equity for the six largest Canadian banks during the third quarter of 2016 was down 200 basis points from two years ago, when ROE reached a stellar 18.3%. During the same 24-month time period, the median price-to-book multiple fell by 20%, to 1.6x from 2.0x (Figure 1: Return and Valuation Trends in Canadian Banking).

While assets and revenues have continued to grow, so too has expense — both interest expense (rate environment; digital competition for deposits) and operating expense (expansion; restructuring; regulatory compliance). Provisions for credit losses (PCL) have also jumped as plummeting prices rocked the energy sector. Meanwhile new regulations ratch-eted up capital formation, increasing strength but reducing financial leverage and earnings per dollar of equity.

Looking ahead, the overall growth outlook for the

Efficiency vs. Transformation: Striking the Balance in a Shifting Terrain

Figure 1: Return and Valuation Trends in Canadian Banking

Third quarter 2016 profitability rebounded on easing energy loan concerns, but the recent trend for the six largest banks has been downward.

Source: Bank disclosures, Novantas analysis

Results for the Six Largest Banks

Wei

ghte

d Av

erag

e Re

turn

on

Equi

ty Median Price-to-Book at Period End

19%

17%

15%

13%

2.1x

1.8x

1.5x

1.2x3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16

Price/Book(right axis)

Return on Equity(left axis)


Canadian economy remains tepid and hopes for an export-led recovery, supported by a weak Canadian dollar, have yet to materialize. Energy prices will not remain at basement levels, but are not expected to recapture former peaks anytime soon, posing a further drag on GDP and employment in an economy still highly dependent on energy and commodity sectors.

Turning to the rate environment, Brexit-exacerbated mar-ket uncertainty has prompted the Bank of Canada to freshly consider monetary easing — even the prospect of negative rates is back on the table. This is an important change in pos-ture by the central bank, which had been expected to remain on the sidelines until well into next year.

Consumer leverage is a high-visibility issue, already above U.S. pre-crisis levels and still climbing. According to a recent report by the Office of the Parliamentary Budget Officer, Canada’s household debt-to-income ratio is the highest among G7 countries. The World Bank and the Organisation of Economic Cooperation and Development (OECD) have both expressed concerns about housing afford-ability for Canadians, given both high debt levels and high residential prices. Yet prices and debt continue to climb.

In the corporate sector, cash positions are high and cor-responding borrowings are low. Credit has deteriorated, albeit primarily in the oil and gas sector. While portfolio performance has stabilized (at least temporarily), the outlook remains cautious and prospects for corporate loan growth are muted.

In the scheme of things, cutbacks and restructuring charges announced thus far have been modest and manageable rela-tive to the size and strength of the institutions involved. More aggressive action appears likely going into 2017, tying into the structural challenges facing the industry.

BREAKING THE MOLD Going forward banks will have to operate differently. One driver, digital disruption, eventually will require profound changes, yet holds plenty of upside potential for adept play-ers down the line. The other driver, constrictive regulation, is the result of an international movement sparked by the 2007-2008 U.S./European market crash.

Canada’s banks are not immune to the digital innovations

that are disrupting conventional banking models, lowering barriers to entry and limiting the effectiveness of traditional competitive responses. While non-traditional competitors carve inroads in online lending and payments, fundamental changes in customer preferences and behaviour are accel-erating the replacement of the branch with digital channels.

As technology enables choice, changes in consumer channel preference have followed — including how consum-ers want to do their banking, where they go when a prob-lem arises, and how they shop for bank accounts and open them. These changes have sparked a series of interrelated distribution issues:• Former branch-centric customers are shifting more solidly

to banking digitally. In particular, rapidly-growing seg-ments include those who neither use nor feel the need for branches, and those who turn first to digital and just want some degree of branch presence as a backstop. As the pace of change accelerates, these segments will pose significant transition challenges for branch-based incum-bents (See companion article in this issue: Digitally Savvy Customers are Ready for Thin Branch Networks — but are Canadian Banks?).

• Mirroring an international banking trend, branch transac-tion activity is declining in Canada, we estimate by 4% to 6% annually.

• Online shopping is now prevalent. Among recent Cana-dian chequing purchasers surveyed by Novantas, more than a third said they had visited bank web sites and con-ducted other online/mobile research in preparation for their purchase.

• Online competition is ratcheting up, as reflected in digital rate-shopping for deposits and, increasingly, consumer and small business digital lending.

• Online functionality and products are becoming more prominent influencers in customer acquisition and reten-tion. Among recent chequing purchasers, one of every 10 Novantas survey respondents cited “leading online/mobile banking” as the single most important factor in selecting their primary bank.As these trends progress, they raise increasingly seri-

ous questions about: the required network density going

“Canada’s banks are not immune to the digital innovations that are disrupting conventional banking models, lowering barriers to entry and limiting the effectiveness of traditional competitive responses. While non-traditional competitors carve inroads in online lending and payments, fundamental changes in customer preferences and behaviour are accelerating the replacement of the branch with digital channels.”

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forward; how to thin networks with minimal customer impact and maximum future productivity; how to revise the sales model (particularly for small business); the shape and scope of digital investments; and how to revise the overall marketing stance.

Turning to regulation, Canadian banking regulators were early adopters of stricter international banking stan-dards, which has led banks to raise capital and provision levels, shift their asset mix to more liquid instruments and lengthen funding duration. But the cumulative impact has also been to drag down ROEs. Going forward, banks will have less flexibility in balance sheet management, plus they will incur higher compliance expenses, given ongoing requirements for data compilation, analytics and reporting.

And there is more to come. On the horizon is the next round of liquidity regulation, focused on long-term fund-ing. The Net Stable Funding Ratio (NSFR) requirement of Basel III will have wide-ranging impacts on balance sheet management and core earnings (See companion article in this issue: Net Stable Funding Ratio: Preparing for a Game-Changer).

STRATEGIC AGENDACanadian banks have a full plate to restore profitability lost to cyclical headwinds and structural disruptions. One course of action is to simply take a defensive posture and wait for a fuller economic recovery when interest rates, margins and credit quality eventually normalize. But to regain prior levels of profitability, growth and competitiveness, banks will need to tackle underlying structural issues as well.

While each Canadian bank has unique considerations relative to its specific market position, strategic priorities and performance goals, management teams face a common balancing act with efficiency vs. transformation. Short-term cost-cutting is a sensible response to tightening conditions, but teams also have to think about how to transform delivery channels, meet changing consumer preferences (or even lead the evolution), and leverage scale for more permanent cost reduction (Figure 2: Strategic Priorities for Canadian Banks).

Manage the digital transition. The industry is standing at the edge of a new transition phase that might be termed “definitive channel migration.” It is no longer strictly about providing a fully-configured multi-channel experience so that customers feel

Source: Novantas

Figure 2: Strategic Priorities for Canadian BanksIn an era of digital disruption and restrictive regulation, winners will cope with tyclical challenges but also pursue a multi-faceted transformation agenda.

Customer CentricityRelationship expansion and cross-sell; segment strategy; multi-product solution sets

Customer experience and customer journey mapping

Digital Strategy Major focus on electronic payments, digital wallet and loyalty; meet new online competition; refocus marketing

Efficiency & ProfitabilityImprovement

Efficiency and productivity initiatives, including organizational and structural changes

Improve profitability and derive more value from risk and balance sheet analytics

Re-thinking DistributionSignificant ongoing focus on digital and mobile offerings

Migrate to thin branch networks with the right outlet design and placement to sustain sales; closures looming

Data & AnalyticsInstitutionalize data governance (e.g., Basel risk data aggregation); leverage Big Data technology

Monetize data and analytics

comfortable using all available options. Rather, it is increas-ingly about closing off underutilized physical capacity as more customers establish a digital centre of gravity.

Canadian banks so far have been quite cautious about reducing branch count. But to keep up with changing cus-tomer transaction patterns, they are going to have to pick up the pace. Successful consolidation will require looking ahead, looking locally and looking at customers:• Looking ahead entails foreseeing what digital banking

will look like in the next five years and the likely pace at which consumers and businesses will migrate, then laying out a game plan to build/buy/partner for the necessary functionality, product bundles and digital marketing and sales expertise.

• Looking locally entails reviewing current distribution and marketing assets in each geographic market, and then laying out market-specific plans to restructure those assets — taking down branches but also reinvesting in digital marketing (search engine optimization, online messaging and advertising, social media, sponsorship of community web sites, etc.) and local assets (ATMs, kiosks, billboards, local advertising).

• Looking at customers entails developing an effective seg-mentation to understand which customers have already left the branch, which are ready to move, and how to serve them and acquire others like them.There are multiple balancing acts here: knowing where the

right investments are needed; when costs can come our versus shifting between markets or to other expense categories such as marketing; which savings need to be reinvested elsewhere versus hitting the bottom line; and how to migrate customers to other channels or branches depending on their preferences.

Deepen customer relationships. To offset lower spread revenue, Canadian banks will need to keep building stronger customer relationships — on both the consumer and commer-cial sides — that generate higher balances and fee revenue with each customer The theory of the case is that it should be easier and cheaper to sell more products and services to a current customer than to win a new one. The hard part is execution, with each bank at a different point in optimizing the relationship journey.

A core requirement is having the right systems, both to see the entire customer relationship across businesses and to manage contact efforts. A second is analyzing all available customer data — descriptive, product, transaction activity including payments — to develop segment insights that will inform offers and pricing.

From a management perspective, one ongoing priority is organizing operations and processes around the customer

(as opposed to fragmented internal business silos). Another is staff sales performance optimization via training, goal-setting and incentives.

BALANCE SHEET MANAGEMENT, CAPACITY REALIGNMENTTwo additional items on the transformation agenda are bal-ance sheet management and the all-important task of capacity realignment.

Rethink balance sheet management. The frequency and extent of regulatory changes affecting intermediation — capital, liquidity, interest rate risk and loss reserves — necessitate a hard look at the metrics, processes and assumptions underpinning the asset-liability management activities of the treasury units.

Is the right data being captured on assets and liabilities? How good are the models for determining duration, liquidity and total loss-absorbing capacity (TLAC)? How will NSFR be determined and integrated into various metrics and processes? And, given all the changes, have funds transfer pricing (FTP) methodologies kept up, and are they sending the right signals to the business units?

Addressing these and other questions will require strate-gic perspective — starting with an overall assessment that can guide the recalibration of bank-wide balance sheet activities as well as business line performance measurement.

Reengineer the infrastructure. Short-term cost reductions, such as tightening expense policies and third party spending, may buy time but will not alone correct the rising bank effi-ciency ratios that are hurting profitability.

On the agenda for the Canadian banks are process and systems re-tooling initiatives, both to reduce cost and to pre-serve competitiveness in changing market conditions. For example, with non-bank players offering rapid approval lend-ing, the loan origination process at banks must keep up in terms of speed, digital reach and credit quality — and the real-ization of lowered operating cost after the initial investment.

Certainly, a large portion of cost reduction will come from branch network consolidation over the next decade. Meaningful and sustainable reduction of efficiency ratios is not possible with-out rightsizing the network. The companion priority is reinvest-ment in digital to fuel future growth, keep the innovative upstarts at bay and improve profitability. Striking the right balance is specific to each bank and will require rigorous monitoring and likely many course corrections along the journey.

Adel Mamhikoff is a Managing Director and Steven Luckie is a Director in the Toronto office of Novantas; Lee Kyriacou is a Vice President in the New York office. They can be reached at [email protected], [email protected] and [email protected].


13October 2016

14 CANADA

Recent turbulence in the energy industries has sent shock-waves across North American banks, triggering a cascade of questions from investors, regulators and boards of directors. Stakeholders are clamoring for more information on lending exposures, compounding the pressure on senior management to justify decisions on loss reserves.

But what about decision-making and communication tools for commercial lending risk? In most cases they fall far short of what is needed. On the one hand, current risk models reflect years of expert development and consider credit implications in good and bad market scenarios. On the other hand, most have a critical weakness — they do not assign any probabili-ties to the wide range of possible energy pricing developments.

Unsupported by a dynamic and statistically sound view of potential outcomes, the typical energy loan risk model paints a blurry picture of loan valuation and loss exposure. Even the better renditions struggle to keep up with a changing market,

given their heavy reliance on a trailing series of dry internal credit ratings.

This is an unacceptable handicap at a time of serious energy lending challenges for North American banks. For a period of years prior to the oil price collapse that began in mid-2014, energy loan underwriting was based on market prices ranging from $75 to $110 per barrel for the bench-mark West Texas Intermediate crude (WTI). While prices have recovered somewhat from the $26 nadir seen earlier this year, they remain seriously underwater relative to prior market conditions and business assumptions.

To put it in perspective, based on a mid-July 2016 price of roughly $45 per barrel, all of the energy loans booked during the four years ended mid-2014 were originated when market prices were 67% to 144% higher than today (Figure 1: Collapsing Price Support for Yesterday’s Energy Loan Decisions). This is not to suggest a hopeless situation, as it is

BY BRETT FRIEDMAN AND DAVID SHIMKO

Facing continued energy price volatility and tightening requirements for risk estimation and disclosure, banks need stronger analytical guidance to make their way.

Energy Loan Risk Modeling:Why Simulation Makes Sense

FEATURE

thought that most borrowers can eke by if prices stay in the $40s. But given the outlook for further global over-production and energy price volatility, it does suggest continuing tight circumstances for borrower and lender alike. Banks will need improved information to:• Diagnose expected losses for risk management and share-

holder communications;• Optimally modify problematic loans that come up for

reegotiation;• Value loan contracts in the event of elective or forced sales;

and• Meet new accounting standards on the horizon, which

will force an earlier recognition of impaired loans. These include the Current Expected Credit Losses standard (CECL), as specified by the Financial Accounting Stan-dards Board, and the International Financial Reporting Standard 9 (IFRS 9), as promulgated by the International Accounting Standards Board.To meet this analytic challenge, a new type of modeling

framework is needed, one that takes fuller advantage of the rigorous simulation techniques now used in many areas of science and industry. In contrast with today’s energy loan risk modeling, which typically considers a handful of best- and worst-case scenarios to deliver qualitative estimates at a

single point in time, simulation can continuously project the interaction of key risk variables across thousands of potential scenarios, identify major patterns, and rigorously evaluate the probability of potential outcomes, both good and bad.

PARTIAL GUIDANCETo be sure, energy lenders are quite thorough in the applica-tion of their current risk models. They develop expert views on reserves, anticipate revenues by matching conservative production estimates with various price forecasts and upside/downside scenarios, and net out production costs and the impact of derivatives to forecast the earnings and free cash flow of the enterprise. Essential in initial underwriting, this work is replicated/refreshed to varying degrees when banks conduct their periodic portfolio reviews and update internal ratings of credit quality.

The problem, as exposed by the collapse in market prices, is that the conventional management dashboard pro-vides only partial guidance (Figure 2: Questions that Most Bank Models Typically Cannot Answer). It is not designed, for example, to independently generate and evaluate various emerging risk scenarios based on the observed variability of key performance factors, or to assign probabilities to those potential outcomes. It does not provide continuously refreshed

Energy Loan Risk Modeling: Why Simulation Makes Sense

$140

$110

$80

$50

$209/09 3/10 9/10 3/11 9/11 3/12 9/12 3/13 9/13 3/14 9/14 3/15 9/15 3/16

Figure 1: Collapsing Price Support for Yesterday's Energy Loan Decisions

Prior underwriting assumptions about borrower cash flow have been undercut by collapsing energy prices, increasing the need for dynamic modeling of bank risk exposure.

West Texas Intermediate Crude at Month's End

5 Years of Peak Conditions

New RiskEnvironment

Source: U.S. Energy Information Administration

15October 2016

16 CANADA

and statistically robust estimates of default risk. Nor does it provide mark-to-market insights on impaired loans, or those considered for sale.

Properly constructed, modern simulation models help to address these and other questions by sorting through hun-dreds or thousands of computer-generated scenarios, each representing a unique set of variations in market indices and key risk factors, to identify emerging patterns and their implications for today’s portfolio. And while this may come across as technical mumbo-jumbo to veteran energy lenders, the fact is that simulation techniques are already carrying a heavy workload elsewhere in many of their own banks, and also among their client energy companies:• Capital markets — Energy analysts long have used simula-

tion analysis to assess the risk and valuation of all types of energy supply contracts; derivative contracts; counterparty peak future credit exposure; and credit instruments, such as credit default swaps for energy assets and companies. Simulation also forms the bedrock for energy risk reporting in market risk and credit risk functions, as well as front

office pricing and structuring decision-making.• Reserve estimation — Popular software tools already in

use at major banks (e.g., PHDWin) offer thousands of re-serve simulations, allowing bank loan analysts to evaluate energy company strategic responses to volumetric surpris-es. The effects of volumetric uncertainty are incorporated into modeled borrower pro formas and used to assess the likelihood of loan repayment.Even in the face of these compelling examples, some

executives still may argue that “We don’t need this level of sophistication because the worst is over, the market is com-ing back and risk is being reduced.” But we disagree for two main reasons:

First, many of the factors that drove the price collapse are still in play, and while a return to the depths of the cellar may not be likely, the sector is facing an extended period of market volatility, sluggish pricing and heightened risk expo-sure (Sidebar: Likely Turbulence Ahead). Second, tightening accounting and regulatory standards will ultimately force greater sophistication in energy risk modeling — no matter


Source: Novantas

Figure 2: Questions that Most Bank Models Typically Cannot Answer While traditional risk models for energy loans consider default risk for a few scenarios, they omit a wide range of questions that simulation could help address.

Downside Probabilities

What is the likelihood that market prices will fall to a given lower level? Is our lower bound conservative enough?

Looking at borrower cash flows relative to debt service, what is the probability of various distress/default scenarios?

How would derivative positions be valued in a downside scenario at the time of borrower default?

Pricing / Underwriting

Are we adequately incorporating market volatility into energy loan pricing and underwriting risk assessment?

How should loan pricing be adjusted to reflect the bank’s advantages/disadvantages under different loan covenants?

Risk Quantification

How can we quantify our energy loan risk for senior management, shareholders and regula-tors, and keep the analysis fresh?

How do changing oil prices affect accounting risk metrics (PD, LGD, EAD, EL)?

Impact of CovenantsWhat is the specific impact of current loan covenants on loan valuation and risk exposure?

In renegotiating with distressed borrowers, how would loan value and risk change under modified covenants?

Portfolio HedgingWhat is the potential to use futures and options to hedge our energy loan portfolio against extreme fluctuations in market prices?

Loan ValuationIn reviewing our options, if we wish to sell a loan, what is its likely value to a potential third-party buyer?

the future price environment. Why wait to build these tools when they are needed now?

A TALE OF TWO COMPANIESBanks have voluminous information about energy clients and loan contracts, but most of it is loaded into static risk models that are refreshed only occasionally. The main output of these periodic reviews is an updated internal credit rating based on a simplified version of the bond rating scales used by Moody’s and Standard and Poor’s. Some credits are con-firmed in their current category (e.g., “AA, BBB, BB+”), and others are reclassified upwards or downwards. Then the bank rolls up all the credits in each ratings category for a view of portfolio risk.

While this work is rigorous in its own way, it errs on the side of being more of a static reference system than an active tool for decision-making and communication. When pressed by bank stock analysts or regulators about energy portfolio risk and loss reserve adequacy, executives necessarily must stick to a narrow script. Their models are not set up for a multi-faceted review and forecast of risk variables and proba-bilistically-handicapped outcomes, either for individual cred-its or the composite portfolio.

For a glimpse of how the progressive bank will address these questions in the future, consider a sample cash flow simulation for two energy companies (Figure 3: A Tale of Two Companies — Free Cash Flow vs. Debt). The two companies

were hit by the same tidal wave when energy prices col-lapsed, yet their cash flow simulations paint very different pictures of resilience in the face of future market volatility.

Company A — This energy company has a track record of production efficiency, avoids heavy debt leverage, and is skilled in the use of derivatives to hedge its exposure to fluc-tuating energy prices. By examining the varying influences of key performance factors over period of years, and then extensively modeling how these factors might interact in com-bination with various price scenarios, the lender can see that Company A has a low probability of default. By no means is it immune to distress, to be clear, but it likely will be able to service its debt in a variety of scenarios.

Company B — This energy company aggressively expanded at the top of the market, incurring a heavier debt load to mobilize the higher-cost production resources avail-able in peak market conditions. While simulation indicates that it still has a chance of staying afloat in the emerging market, it also shows much higher default risk.

Once the bank assembles this type of analysis for each borrower, the results can be rolled up for a portfolio-level view of the emerging risk environment. For senior manage-ment, the benefit is a rolling five-year forecast that includes a month-by-month summary that plugs into formal account-ing/regulatory classifications, including probability of default (PD); loss given default (LGD); exposure at default (EAD); and expected loss (EL). This type of modeling also provides


Energy firms and their bankers can expect volatility shocks for the next several years, driven by geopolitical production influ-ences, exchange volatility and technology shifts.

In prior eras of energy surplus, producers could expect a gen-eral contraction in global output, helping to rebalance supply and demand and shore up pricing. Not this time around. In the Mideast, OPEC reaffirmed its policy of unrestricted production at its June 2 meeting. Iran has continued to reject any limit on out-put as it ramps up volumes following the removal of international trade sanctions in January, hoping to supply 6 million barrels per day to the market by 2020.

Total OPEC output grew from 29.2 million bpd in June of 2010 to 32.7 million bpd in May of 2016. With this powerful bloc competing on price to win market share, the clouds of global over-production are likely to linger for quite some time.

Exchange volatility also is an ongoing concern. Following the Brexit referendum, for example, oil prices fell by 6.8% in one day.

Why? Investors’ flight to dollar assets increased the cost of dollars to non-dollar buyers. Since oil is sold globally on a dollar basis, this hurt the demand for oil significantly. No matter how Brexit plays out, the incident is a sobering reminder that energy lenders also bear significant foreign exchange risk in the form of exposure to a global dollar-linked oil price.

Improved production technology is also playing a role. The new generation of highly efficient horizontal drilling technology has been so successful in driving down costs that U.S. producers can now produce more cheaply than OPEC. Meanwhile, storage facilities are nearing full capacity and quasi-storage such as rail-road cars, oil freighters and pipelines are becoming more costly and scarce. Exacerbated by storage scarcity, further dumping on the global market may cause serious further price declines.

— Brett Friedman and David Shimko

Likely Turbulence Ahead

17October 2016

18 CANADA

mark-to-market insights — increasingly needed but unavail-able at many banks today.

BUILDING THE MODELThe key to simulation modeling is extracting detailed risk insights from a statistical study of historical performance driv-ers (and their variability) and projecting these factors into future market scenarios. In energy borrower risk modeling, much of the work lies in preparation. This includes building a proper foundation of historical and current information, establishing the right variability assumptions for each performance factor, and linking market data and projections for dynamic modeling.

The model drivers should include borrower characteristics, loan terms including covenants, reserve economics, dynamic energy prices, energy volatility and energy price probability distributions. They also should consider hedging programs and the knock-on effects of changing energy prices, such as costs of energy services and transport (since the cost of these services also varies with energy prices).

The model outputs should include expected losses, loan valuations, and sensitivities of losses and valuation to changes in inputs. Finally, the models should also be able to include covenant valuations in order to guide the lender in modifica-tion, restructuring and sales decisions.

All of this preparation comes together in the mark-to-market

energy loan model, which differs from today’s basic pro forma models in three major ways:

Knock-on effects. Most pro forma spreadsheets are based on static analysis, where a few variations are introduced (e.g., energy price and foreign exchange scenarios) while all other factors are held constant. Potential offsetting factors and consequent developments are not considered. The first step is to assure that changes in energy prices and foreign exchange rates ripple correctly through the pro forma; e.g., lower energy prices and output would imply reductions in capital expenditures at some point.

Price scenarios. Robust scenarios must be generated for major capital markets inputs, including forward curves, implied volatilities and correlations. This must be done in a way that ensures consistency with the current market pric-ing environment while considering the full range of possible future settings.

Simulation analysis. Once the model is equipped to han-dle dynamic linkages, then it can be put to work in generating a cascade of probability-weighted upside and downside sce-narios, typically 1,000+ iterations. Each scenario processes a unique combination of input variables to assess occurrence and timing of default, loan balance and asset revaluation at default, and recovery at default.

Once a full library of 1,000+ cases is populated, the


Start Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Start Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

Figure 3: A Tale of Two Companies — Free Cash Flow vs. Debt

With simulation, thousands of scenarios for market prices and borrower cash flow impact can be evaluated, often revealing sharp differences (simplified example).

Company A Company B

Source: Novantas

Debt ServiceDebt Service

weighted results are compiled to determine overall default frequency by month, EAD by month, LGD by month and EL by month. These metrics can be further aggregated to deter-mine annual averages for regulatory reporting purposes. The model also evaluates loan cash flow, which is discounted to determine the value of the loan at inception under each sce-nario. The weighted average of the 1,000+ cases implies the value of the loan contract, and the probability distribution of the present value can be taken as a risk measure, similar to value-at-risk.

BENEFITS OF SIMULATION MODELING Why should banks use a mark-to-market style model instead of their current static models? The first benefit is improved scenario analysis. The bank can use a comprehensive set of scenarios based on projections of emerging market prices, and assign probabilities to these scenarios. It can also assess whether conservative scenarios are conservative enough. These insights rely on the incorporation of market probabil-ities implied by forward curves and option prices.

Second, periodic internal credit ratings do not work well for companies whose cash flow distributions hinge on rapidly changing oil prices and their attendant volatilities. Key met-rics, such as the probability of default and loss given default, should be based on probability distributions of changing oil prices over time.

Third, the mark-to-market approach can accommodate changing forward curves and implied volatility curves. While a conventional bank model can accommodate changing oil price forecasts, it usually does not reflect price volatility — a critical consideration for banks, given that the benefit of a price surge is capped at full repayment of principal and inter-est, while downside exposure can be devastating. Higher vol-atility means higher expected losses, and few bank models capture this.

Fourth, the mark-to-market approach provides real-time loan contract valuation, along with dynamic risk assess-ments. Over the life of the credit, this is far more useful than conventional bank models, which are not built to value loans past inception.

Fifth, the mark-to-market approach provides a methodol-ogy for evaluating covenants. This is useful at origination,

where alternative loan covenants can be evaluated for effec-tiveness in risk reduction. Further, upon renegotiation of terms, new covenants can be evaluated to determine how bank protections can be maximized.

Sixth, production and capital expenditure (CAPEX) option-ality can be built into a simulator and valued explicitly.

CALL TO ACTIONThough energy lenders may have caught their breath as prices retraced from their lowest levels, volatility shows no signs of permanent abatement in the wake of Brexit; increas-ing political challenges in the Middle East; and rising U.S. production strength. Falling oil prices are not only a geopolit-ical exigency, but the obvious market response to a stronger dollar caused by investors seeking safe havens. Oil, like most dollar based commodities, shrinks as the dollar swells.

The oil markets and currency markets have jointly exposed a widening gap in the analytic models that banks critically rely upon for answers to their loan portfolio questions. Just as a general should not go into battle unequipped, bank exec-utives should not face their constituents without a foundation of cogent analysis.

Today, simple and reasonable shareholder questions like “What is the liquidation value of the bank’s energy loan port-folio?” or “What would a $10 drop in oil prices mean for expected losses?” or “How has the bank managed the risk of its energy loan portfolio?” largely go unanswered. Wall Street analysts and investors are tempted to assume the worst, and share value suffers.

It is not enough to try and make do with today’s limited energy credit risk models and hope that oil prices rise (or at least stabilize) so that constituents stop paying attention and the bank can return to business as usual. Facing contin-ued energy price volatility and tightening requirements for risk estimation and disclosure, banks need stronger analytical guidance to make their way. Simulation modeling should be part of the answer.

Brett Friedman and David Shimko are Directors in the New York office of Novantas. They can be reached at [email protected] and [email protected], respectively.


“The oil markets and currency markets have jointly exposed a widening gap in the analytic models that banks critically rely upon for answers to their loan portfolio questions. Just as a general should not go into battle unequipped, bank executives should not face their constituents without a foundation of cogent analysis.”

19October 2016

20 CANADA

Bank liquidity has been a top regulatory concern following the financial crisis, and now the focus has turned from short-term liquidity to a longer funding horizon of one year and beyond. To further safeguard liquidity solvency in all market conditions, banks will be required to maintain minimum specified levels of long-term stable funding.

The new standards are embodied in the net stable funding ratio (NSFR), targeted for implementation in January 2018. They follow the implementation of the liquidity coverage ratio (LCR), a plank of Basel III, which requires banks to maintain standby levels of reliable funding, in the form of high quality liquid assets (HQLA), sufficient to weather any contingency within 30 days.

NSFR will apply to the very largest Canadian and U.S. banks, including U.S. institutions with at least $250 billion of assets. A less stringent version will apply to mid-tier U.S. banks with

assets of $50 billion to $250 billion. Many bankers have called NSFR a game-changer, given the wide-ranging impact on bank management. That will likely prove to be an understatement.

Unlike LCR, which is a short-term 30-day metric, NSFR compliance will broadly affect long-term funding requirements and provoke structural changes in the business and the balance sheet. To cope with the transition, executive teams must be disciplined, anticipatory and proactive in assessing and solving compliance-related shortfalls.

In addition to requiring considerable lead time, NSFR-related actions could well affect compliance with other regulatory requirements and constraints, such as capital and leverage. New metrics and forecasting tools will be needed. Banks not only must be able to reliably measure current-period NSFR, but also to model the forward NSFR position for individual business lines and the institution overall.

BY STEVE TURNER AND ADEL MAMHIKOFF

To cope with forthcoming regulatory requirements for long-term stable funding, banks should be working now on measurements, funding plans and business strategy.

Net Stable Funding Ratio:Preparing for a Game-Changer

FEATURE

DIFFICULT TRANSITIONThis rule introduces asymmetries in funding and collateral usage that will be difficult to manage and likely impact profitability. For example, NSFR requires expensive long-term funding for many high-value banking activities involving short-term investments and extensions of credit (Sidebar and Figure 1: Liquidity Strengths and Requirements under NSFR). Regarding collateral, top-qual-ity liquid assets used as collateral in certain repo transactions will see their required stable funding increase from 5% when unencumbered to 50% during the life of the repo transaction.

The NSFR ratio calculation also introduces “cliff effects” — abrupt transitions that will be difficult to manage — when term liabilities hit the 12-month and six-month marks in their remain-ing term to maturity.

Consider, for example, a long-term wholesale funding issu-ance that initially receives 100% ASF credit. When its remaining term to maturity rolls down below the 12-month threshold, it will only receive a 50% credit. In a few instances ASF credit falls to zero at the six-month mark. For large issuances, these cliffs could provoke significant unfavourable swings in the NSFR ratio.

In the current climate of super-low rates and ample mar-ket liquidity, NSFR compliance could perhaps be viewed as hugely inconvenient but ultimately manageable. All bets are off in a future normalized market, however, when growth and

regulatory pressures will surely place banks in a costly battle for core deposits. And while NSFR is intended to shield banks in the event of a future liquidity crisis, it could make a bad situation worse during an actual outbreak of market turmoil.

Among the largest U.S. and Canadian banks that will be fully affected by NSFR, we expect most to encounter constraints on balance sheet management because of this regulation. The NSFR-adjusted operating flexibility and standalone profitability of several business lines will be crimped — most notably cap-ital markets and commercial banking — raising thorny ques-tions about maximizing shareholder value through cross-subsi-dization from the deposit-rich retail side of the house.

To prepare for a likely difficult transition, there are three priorities that senior management should be working on now:1) Measurement. Enhanced data, methodologies and systems

will be needed to optimize NSFR compliance by taking advantage of the most favourable treatments available. Also, given the long-term nature of NSFR and the required lead time to address shortfalls, it is critical that banks have the capability to robustly model forward NSFR positions, along with monitoring current status.

2) Funding plan. The very core of asset-liability management will be touched by NSFR. Treasury must reconstitute the tar-get funding profile for the bank, looking ahead three to five


Source: Various regulatory agencies

Figure 1: Liquidity Strengths and Requirements Under NSFRFor the largest banks, the minimum NSFR (ratio of available to required stable funding) is 100%, but most will target at least 110%.

Regulatory capital;

> 1-year liabilitiesCurrency, reserves, trade date financial receivables

Stable non-maturity retail and small business deposits

Unencumbered Level 1 & 2A securities and inter-bank loans with < 6 month residual maturities

Less stable non-maturity retail & small business deposits

Level 2B securities; operational interbank loans; most loans with residual maturities < 1 year

Operational deposits; non-fi-nancial entity funding; and other funding with less than 1-year maturity

Unencumbered loans with residual maturities > 1 year; derivative collateral; non-HQLA securities; commodities

All other liabilities and equityAssets encumbered > 1 year; net derivatives exposures; all other long-term assets

100% 0%

95%

5%to

15%

65%to

85%

90% 50%

50%

0% 100%

ASFWeight

RSFWeightFunds Source Funds Usage

Available Stable Funding Required Stable Funding

21October 2016

22 CANADA


years in order to provide steady navigation and uphold shareholder returns.

3) Business strategies and governance. A framework will be needed to balance the various NSFR considerations at the business line level. For accurate decision-making, advanced funds transfer pricing metrics will be needed to assess the impact of NSFR compliance on funding and profitability.Time is running out for preparation. Banks that fail to exe-

cute on these three priorities risk being caught in reactive mode when NSFR rules take effect, constantly applying hasty patches to the balance sheet to meet compliance in changing conditions. Consequences include paying too much for fund-ing and mis-valuing lending decisions in ways that are likely to be detrimental to returns.

EFFECTS ON BANK BUSINESSESNSFR will have a significant impact on bank balance sheets, profitability, and even the viability of certain businesses (Figure 2: Pervasive Impact of NSFR). From a bank management per-spective, particular areas of concern include capital markets; lending; use of non-core funding; and balance sheet manage-ment and hedging.

Capital markets. Securities sales and trading businesses will be affected. Securities inventories held short-term for sale must be 50% backed by longer-term stable funding, increasing the cost of inventory financing. In one extreme example, secu-rities normally held for only a few hours must be at least 50% backed by one-year funding.

Affected banks will have strong motivations to trim their securities inventories, denting fixed-income market liquidity.

New issuance of corporate debt will become more costly and difficult, as banks will want to be compensated for the risk of having unsold inventory linger on their books with required costly long-term funding until it is sold off.

Lending. Lending businesses will see NSFR effects on loan profitability, primarily at the shorter end of the maturity spec-trum, and on most unused commercial lines as well.

One of the fundamental benefits that banks provide to the economy is “maturity transformation” – packaging various and changing combinations of non-maturity deposits, time deposits, debt and other liabilities to provide credit facilities that meet a diverse range of borrower needs with different maturities and interest rates.

It is a balancing act that must be managed to avoid tilting to an over-reliance on transient liquidity. Unfortunately, NSFR over-compensates for potential funding imbalances by taking a stress scenario view that the bank must always fund with liabilities hav-ing terms that equal or exceed those of the assets being carried.

The real headache is at the short end of the maturity spec-trum, where NSFR requires banks to maintain combinations of long-term deposits and other liabilities to support short-term credit facilities – creating negative maturity transformation. Most loans of 6-12 month maturities, for example, must be backed by some combination of funding that includes 50% over one-year term funding.

What would it take to meet this requirement in practice? Consider a 12-month loan for $100,000, which under NSFR needs to be backed at all times with $50,000 of funding that can be counted on for at least year.

In one scenario, the bank draws on core savings or

Under the Net Stable Funding Ratio, large banks must use an assigned regulatory formula to handicap the stability of each fund-ing component on the balance sheet.

In assessing available stable funding (ASF) over a rolling one-year time horizon, for example, some categories of retail and small business deposits receive a high weighting for stability – 90% to 100% – while certain categories of retail brokered deposits with a term of six months or less are given zero credit for stability (Figure 1: Liquidity Strengths and Requirements under NSFR).

Next, banks must review their loans, investments and busi-ness activities to determine levels of required stable funding (RSF), again using an assigned regulatory formula. The most common forms of residential mortgages must be at least 65% backed by stable funding as defined by regulation, for example, while certain

categories of highly liquid assets, like central bank reserves, have an RSF set at zero.

These two factors are combined into the net stable funding ratio, a seemingly simple formula that expresses what is available as a percent of what is required (ASF/RSF). Calculated at the organizational level, NSFR has a compliance floor of 100% for top-tier North American banks and 70% for mid-tier U.S. banks.

In practice, banks will target a visibly higher level than the regulatory minimum, not only as a display of strength – since the ratio must be disclosed quarterly – but also to cushion against fluc-tuations in the normal course of business and dislocations the rule itself introduces.

— Steve Turner

Calculating NSFR


chequing deposits, which have no term to maturity. They can be held to satisfy RSF during the term of the 12-month loan and then immediately redeployed into other assets, which seems tidy, but there is a catch — opportunity cost. The bank is being forced to skip other liquidity options and tie up valuable core funding which potentially could have been used elsewhere to support higher-yielding longer-term assets.

In another scenario, the bank locks up term funding, possibly certificates of deposit. But to satisfy RSF, the CDs need to have at least one year remaining until maturity over the life of the loan, meaning they need to be booked with at least a two-year term at deal inception. Then when the loan rolls off, the bank would still need to hold a year’s worth of liquid assets (not requiring additional term funding) against the CD balances over their remaining term. Clearly an opportunity cost.

Another burden imposed by NSFR is that 5% of all undrawn committed credit and liquidity facilities must be backed by avail-able stable funding. Based on recent figures for North American banks, it is estimated that this translates into a total funding requirement of approximately $125 billion for the largest U.S. banks and $90 billion for the largest Canadian banks.

Just as with our short-term loan example, banks will at a

minimum incur an opportunity cost by encumbering core depos-its that could have been used elsewhere. Plus they may need to use term funding with stretched maturities to assure an ongoing collective remaining life of at least one year. Either way, compli-ance will come at a cost — and that added cost must ultimately be passed along to borrowers, else lending returns will decline further.

Restrictions on non-core funding. Like the liquidity coverage ratio, the net stable funding ratio emphasizes core funding and penalizes the use of alternatives. Compared with non-maturity retail and small business deposits, 90% to 95% of which will be classified as available stable funding, corporate and most commercial deposits will have only a 50% ASF attribution. This further pressures large banks to pursue retail and small business deposits and shun non-operational deposits from corporate and financial entities.

Balance sheet management and hedging. Pre-crisis, bank treasuries would respond to interest rate risk and funding chal-lenges as they arose, with limited perspectives on how future changes to the balance sheet would affect their positions. There were fewer ricochet effects inside the bank, as solving for one problem — say, interest rate risk — seldom exacerbated other situations.

Source: Novantas

Figure 2: Pervasive Impact of NSFR NSFR requirements will impact multiple areas of the bank, imposing significant constraints on balance sheet management.

Balance Sheet MixRequires increased use of term funding for loans, including short-term loans

Shifts securities portfolios further toward high quality liquid assets (HQLA)

Risk AppetiteCompliance will reduce structural liquidity risk

May encourage riskier, yield-seeking behaviour in other areas

Funding & Liquidity

Interferes with intermediation - limits maturity transformation (in some cases, creates negative maturity transformation)

Encourages use of maturity ladders and over-funding to avoid cliff effects, increasing complexity and cost

Profitability

Increased funding costs will lower returns on equity

Crimps trading income by forcing the use of more costly term funding for inventory

Limits yield curve arbitrage opportunities via maturity transformation

Capital Further drives balance sheet expansion and capital leverage

23October 2016

24 CANADA


Today, bank treasuries must contend with a host of complex and interrelated post-crisis regulations, of which NSFR may well be the capstone. The compliance waterfront will be absolutely covered — liquidity, capital usage, interest rate risk and portfo-lio funding characteristics — where solving a problem in one sphere creates headaches in others. When using derivatives to hedge transactions, for example, treasury groups often will encounter compliance cross-currents with liquidity buffers, term funding and capital leverage.

MANAGEMENT PRIORITIESThere are three major priorities that bank chief financial offi-cers, treasurers, and business line leaders should be should be focusing on now in preparation for NSFR implementation (Figure 3: Establishing a Formal NSFR Program):

Get the measurements right. Banks have been working with draft rules for some time, so the NSFR measurement chase has started. But it is not nearly finished. As with other cascading and overlapping regulations, managing the bank within a complex

compliance regime will require an ability to look across individ-ual business silos to recognize and manage the composite pic-ture. Today’s typical patchwork of silo-based data and metrics will not suffice.

To get the measurements right, management should:• Contrast NSFR’s pro forma requirements with today’s reality

to pinpoint data and methodology gaps and develop reme-diation plans. North American banks can draw a sharper picture when the rules are finalized, likely later this year.

• Get to work closing the gaps in methodology, data and systems, with a focus on taking advantage of the most fa-vourable compliance treatments available. Some relief will come in the area of data assembly, as NSFR keys off of LCR definitions for many of its calculations. However, NSFR creates some new definitions and uses data differently than LCR. And NSFR intersections with other rules (e.g., capital leverage, LCR) make cross-silo integration a critical priority, not only with data but in financial management overall.

• Establish rigorous internal monitoring and external re-

Source: Novantas

Figure 3: Establishing a Formal NSFR ProgramBank chief financial officers, treasurers and business line leaders should be working on three major priorities in preparation for NSFR implementation.

Update NSFR Metrics Address Funding Plan Implications Evaluate Strategic & Governance Implications

Assess current state, remediate gaps to meet NSFR compliance deadline

• Perform gap assessment, current state vs. pro forma NSFR requirements

• Diagnose identified data and methodology gaps, develop remediation plan

• Execute required projects to remediate methodologies, data and systems

• Establish robust internal monitoring, external reporting

Update the bank’s funding strategy and plans to meet NSFR rules

• Evaluate how each product and business line is currently funded, assess required NSFR changes

• Incorporate NSFR into FTP for business evaluations

• Model forward scenarios to assess binding constraints

• Optimize funding strategy within regulatory limits, risk appetite and bank objectives

Align with Effective Balance Sheet Management

• Funding /Liquidity Management

• Funds Transfer Pricing

• ALM / Interest Rate Positioning

• Capital Management

• Balance Sheet Optimization

Assess NSFR impact on business lines and the overall bank, develop strategic options

• Segment impact - Wholesale banking - Retail banking - Commercial banking - Foreign operations

• Develop framework for organizational tradeoffs to optimize corporate ROE

• Develop strategic options - Repricing, restructuring - Cross- subsidization - Grow, maintain, exit


porting. Long-term liquidity strength now matches capital strength in importance, not only for regulators and share-holders, but in the court of public perception as well. Robust external reporting will be essential in demonstrating com-pliance and liquidity strength. From an internal monitoring perspective, banks should revisit their risk appetite and limits framework, incorporating metrics that allow them to more proactively manage the term structure of their balance sheet — particularly given cliff effects in NSFR calculations — such as incorporating wholesale funding maturity con-centration limits.

• Develop robust modeling of the forward NSFR position over a reasonably long planning horizon — ideally three to five years. This requires treasury to have a disciplined pro-cess for managing the funding plan, and more importantly, requires finance to collaborate with the business lines to develop a reliable forecast of the evolution of the balance sheet over the planning horizon.Establish new target funding profile and plan. Based on

global standards, starting in January 2018 each marginal asset will have funding rules attached to it. Banks will need to completely rethink their funding strategies and plans to meet NSFR requirements. Further complicating implementation is the interaction between NSFR and other regulatory rules on liquidity, capital, interest rate risk and total loss-absorbing capacity (TLAC).

Treasury management approaches will need to change, especially given the challenge of balancing complex regula-tory constraints with management and shareholder objectives. To get on top of the situation, progressive teams will:• Establish an optimal future target funding profile for the

bank, balancing multiple (and sometimes conflicting) regu-latory constraints, the bank’s risk appetite, and growth and profitability objectives;

• Develop a funding plan to move toward the optimal profile;• Evaluate how each product / business line is currently be-

ing funded and assess changes required for NSFR;• Incorporate NSFR and the new funding profile into FTP to

refine business evaluations and decisions;• Model forward results to assess binding constraints; and• Optimize the funding plan within regulatory limits, risk ap-

petite and bank objectives. Integrate NSFR into business strategies and management

processes of the bank. NSFR will create winners and losers at the business line level. Some units and types of activities may well become unprofitable on a standalone, fully-costed basis. Others will see their values maintained, or possi-bly even enhanced. To evaluate the strategic implications bankers should:

• Assess the impacts on each banking segment. Executive management will face dilemmas on cross-subsidization, as overall corporate returns may benefit if NSFR resources are shunted to one business line when in excess at another. For example, will (and should) retail deposit gathering subsi-dize corporate and capital markets businesses to benefit shareholders? To manage these trade-offs, overall bank performance metrics must be integrated with business line metrics, using advanced funds transfer pricing that will provide both business line and shareholder perspectives.

• Model forward results to assess binding constraints. Bank treasuries will need to think forward over a three- to four-year horizon to establish funding strategies that are bal-anced within regulatory constraints, and that optimize mar-ket opportunities and balance sheet resources.

• Develop strategic options that reflect business line and corporate impacts. A shareholder perspective may imply different strategies from those set at the business line level. Questions/actions will range from the tactical to the strate-gic, from repricing and product redesign; to business line restructuring; to cross-subsidization; and even to potential business line exits.

COMPLEXITIES AND CONSEQUENCESExecutive management is just now developing an appreciation for the many aspects of banking that NSFR rules will affect. But given the complexities and potential performance consequences, there is no time to waste — new arrangements will need to be established and field-tested well before January 2018.

For large banks, treasury will have much more complex funding strategies to design and execute. Lending businesses will need to be revised to align strategies with required funding structures. Deposit businesses will have to understand the real value of deposits, given how competitively certain deposits will be fought for. And sales and trading businesses will have to be rethought to support higher inventory funding costs.

Many other banks outside of the top tier will be affected by a less rigorous imposition of NSFR. Even at these mid-tier banks, treasury will need to demonstrate a level of sophistica-tion needed to manage more complex balance sheet strategies. Deposit-gathering businesses will need to develop tools to under-stand how to prudently use the likely influx of large wholesale deposits that larger banks may wind up releasing.

Yes, game changer seems right.

Steve Turner and Adel Mamhikoff are Managing Directors at Novantas, respectively in the New York and Toronto offices. They can be reached at [email protected] and [email protected].

25October 2016

26 CANADA

Historically, deposit gathering followed a familiar pattern for Canadian banks: prices were set franchise-wide, creat-ing a closely-followed national market for the largest institu-tions and a relatively tight band of deposit rates. With most players essentially casting the same nets, advanced pricing skills were not an absolute requisite.

But multiple forces are shaking the picture. Consumers are making much greater use of web and mobile chan-nels to shop for banking products and providers, increas-ing general price sensitivity and the propensity to switch. Meanwhile disruptive players such as EQ Bank and Zag are making headlines with high-rate offers, influencing customer expectations at major institutions as well.

These digital influences have led to a situation where a handful of Canadian direct banks and smaller financial insti-tutions have used the web to attract outsized public attention for their promotional deposit rates. In turn, the largest banks have felt compelled to quickly match these offers. Where rate promotions were almost non-existent roughly four years

ago, now they are prevalent, and as a result far less effec-tive than in the past.

In a market where consumer deposits are relatively con-centrated with the major banks, the potential for easy balance growth through promotional rates is fairly limited. Instead of making collective progress, players only succeed in denting each other, and meanwhile rate competition puts downward pressure on interest margins. The situation is exacerbated by the current environment of low rates and consumer lending that far exceeds the base of consumer deposits.

To get off this treadmill, institutions will need a more selec-tive form of promotional pricing strategy — an approach that improves the odds of attracting loyal deposit balances and carries less risk of disturbing the current portfolio of established accounts. The answer is precision targeting, learning to direct rate offers in a more disciplined manner: where needed to attract/retain customers; and to the extent that is financially realistic, given the upside potential for long-term balance retention and the downside potential for

BY ADEL MAMHIKOFF, HANK ISRAEL AND ANDREW FRISBIE, WITH CHRIS MUSTO AND ADAM STOCKTON

Banks need to clarify their deposit needs over the next few years and overhaul the metrics, skills and strategies used to drive deposit gathering.

Deposit Promotions in Canada –A Race to the Bottom?

FEATURE


Figure 1: Crisis in Promotional Deposit Pricing Traditional deposit promotions are losing effectiveness as more customers are influenced by online rate information and aggressive direct bank offers, and national banks press harder to keep pace.

Source: Novantas, Inc.

Portf

olio

Bal

ance

sPo

rtfol

io B

alan

ces

Portf

olio

Bal

ance

s

Traditional Deposit Campaign

PERIOD 1 PERIOD 2 PERIOD 3 PERIOD 4 PERIOD 5 PERIOD 6

Declining Response

Declining Response + Higher Runoff

Portfolio growth is driven by two effects — Response Rate and the Decay Curve.• The Response Rate is the amount of deposit

balances obtained by each campaign.• The Decay Curve is the runoff of these

balances over time.Historically, these effects were relatively fixed and predictable, primarily influenced by network presence and brand affinity.

To grow in a more competitive environment, the bank may first try stepping up the frequency of campaigns. While cumulatively garnering more balances, the response rate declines with each successive campaign.

To combat declining response rates, the bank may begin to lean more heavily on price. But above-market rates tend to attract customers who are more price elastic, willing to yank balances when a better offer comes along. As a result, balance runoff increases, with only spikes of growth, acquired at great cost, with little lasting benefit to the bank.

PERIOD 1

PERIOD 1

PERIOD 2

PERIOD 2

PERIOD 3

PERIOD 3

PERIOD 4

PERIOD 4

PERIOD 5

PERIOD 5

PERIOD 6

PERIOD 6

27October 2016

28 CANADA

cannibalization of current accounts.Along with improved financial modeling that carefully

considers the upside and downside potential of rate pro-motions for deposits, banks will need a deeper analytical understanding of the customer base. New metrics will be needed to identify sources of strength, areas of vulnerability and high-value priorities. Adapting to the new framework will require tighter coordination among business units as well, with the product and treasury groups agreeing on the value of balances that potentially can be acquired and delivery channels upholding the analytically-guided target-ing framework.

RUNNING IN PLACE In the new environment of digitally-enabled rate shopping and disruptive competition, Canadian institutions have increasingly turned to limited-duration promotions to com-pete for consumer deposits.

In the beginning this seemed like a good idea. From the isolated perspective of an individual bank, a limited dura-tion high-rate promise has a two-fold potential benefit. Not only can a successful rate promotion attract new custom-ers and fresh balances, but it also can provide longer-term opportunities for relationship expansion. Indeed, the first banks to use such promotions saw some success, inspiring others to follow.

But the collective result, not surprisingly, has been a lot of running in place. After the first movers left the gate, other banks became fast followers, determined to match or exceed the disrupters in market-leading promotional rates. Promotional effectiveness rapidly decayed, with falling response rates and rising runoff of acquired balances.

If all banks increase their promotional rates — and the industry seems to be heading quickly in this direction — no institution sees meaningful incremental balance growth. But all see increased deposit costs in the long run. Particularly


Figure 2: Digital Research and Shopping for Non-Checquing Deposit ProductsAs consumer shopping behaviours and preferences go digital, direct bank deposit promotions and national bank responses are disrupting traditional pricing strategies.

*Canadian consumer channel preferences for research and purchase of savings accounts and GICs. Results are for serious shoppers, or respondents who say they are either highly likely or definitely going to open an account in the next 12 months. Source: Novantas Canadian Cross-Sell Survey

PREFERRED CHANNEL FOR RESEARCH*

Social MediaTablet

3.6%2.8%

Other WebsitesSmart Phone

13.0%4.5%

Individual Bank SitesDesktop/Laptop

29.5%35.6%

Branch

Branch

20.6%

50.8%Phone

Phone

10.5%

3.9%

Print Ad/Offer 6.1%Roving Rep 4.9%

OtherOther

17.5%2.9%

PREFERRED CHANNEL FOR PURCHASE*

with overlapping geographical footprints and national-level pricing, the market has quickly reached an unsustainable point — a “race to the bottom” with ever-increasing promo-tional frequency and rising rate premiums (Figure 1: Crisis in Promotional Deposit Pricing).

What led us here so quickly? The core driver is chang-ing consumer behaviour in a digitizing marketplace for banking and financial services:

Shopping. Banks traditionally advanced their deposit promotions “offline,” via local advertising, branch staff and collateral, and in response to phone calls from the occa-sional diehard shopper. With distribution and rate informa-tion bounded by the local activities of a few major players present in most markets, most banks adopted a national strategy on deposit pricing. Rate offers could be consistent, largely irrespective of geography or client circumstance.

The embrace of digital by banks and consumers alike has radically changed information access. With the prolif-eration of online ads and deposit offers, consumers need not look up at billboards, read local papers or even step into a branch. The availability and aggregation of online rate information makes rate comparison shopping easier and more transparent. In turn, more consumers are becom-ing active and informed shoppers.

In a recent Novantas survey of Canadian consumers, roughly 40% of respondents said they prefer to use digi-tal channels to research savings accounts and guaranteed investment certificates (GICs). The top search destination is individual bank websites, followed by independent sites where banking-related information is available. Social media is also continuing to emerge as a consumer influence (Figure 2: Digital Research and Shopping for Non-Chequing Deposit Products).

Origination/switching. In the pre-digital world, con-sumers had to invest sig-nificant effort to shop for a higher-yielding account and switch deposit balances, providing a natural barrier to deposit churn. Deposit shoppers had to monitor their current deposit rates and GIC expiry, research local rates, venture out to a competing bank to open an account, and wait for the funds to clear.

Rate differentials between institutions seldom were large enough to offset the consumer opportunity cost of manag-ing deposit rates more closely.

But digital deposits have reduced these switching costs, easing the friction that limited deposit movement and account churn. Consumers are becoming more will-ing to open new savings accounts online — and to venture beyond traditional banking companies. The new compet-itive universe includes digital and direct banks, non-bank mortgage lenders, and other innovative institutions and FinTechs that show up in web search engines and aggres-sive ad campaigns.

Among respondents to the Novantas survey, roughly 45% cited digital channels as the preferred way to open new savings accounts and GICs. Within this category, the majority of respondents said they conducted their online shopping via desktop or laptop computers, with others using tablets and smartphones.

Surveyed consumers also expressed much higher pref-erences for digital purchase, though far exceeding actual digital account opening volume today. This is not a sudden tilt, but more of a relatively rapid evolution. Directionally, strong consumer feedback on digital purchase preference does underscore a changing market. Indeed, non-tradi-tional institutions are making a bigger splash these days. And the major banks feel the pressure to respond to these promotional rate offers.

The upshot with digital shopping, aggressive promo-tional offers and the increasing cascade of responses is that broad deposit promotional campaigns are increasingly

High

Figure 3: Setting the Agenda for Promotional PricingEach bank must map out its expected core deposit funding needs, and understand the role and impact of rate promotions.

Source: Novantas, Inc.


Exposure to Promotional FatigueLow

Low

High

Depo

sit G

row

th N

eeds Early start on test-and-learn

treatment developmentRadical overhaul of current

practices and skills

Use promotions sparingly “Get off the treadmill”of frequent promotion

29October 2016

30 CANADA

prone to upward rate pressure and unintended conse-quences. Online information and aggressive offers are sen-sitizing consumers to rates, making it harder to stand out in the crowd. Among Novantas survey participants who said they had skipped their primary bank and gone elsewhere to open a savings account or GIC, for example, the top swing factor was “attractive rates,” cited by nearly 40% of respondents.

Customer rate sensitivity has an impact even when cus-tomers stay with their banks. Our research shows a grow-ing potential that promotions will catch too much attention within the established cus-tomer base, encouraging accountholders to transfer balances to capture higher rates on new offers. In such circumstances, the cost to carry increases for the provider and meanwhile there is no balance growth.

HOW BAD IS IT? THE MEASUREMENT IMPERATIVETo understand the magnitude of the issue at hand and iden-tify potential solutions, a core task is to develop the right measures of promotional cost and effectiveness. A warning and avoidance system is needed to help the bank steer away from ill-fated promotions with diminishing returns. Two key measures are deposit balance retention and the true marginal cost of promotional deposits:

Balance retention. Banks have always expected some runoff after a promotional period ends and rates move lower, especially from “hot money” depositors. But balance runoff can be excessive for certain customer segments, negating portfolio growth even as the bank churns through a series of different offerings.

Understanding deposit decay patterns among exist-ing accountholders, and not just with new money, is now even more important. Customer segmentation by deposit retention rates provides clear direction on which segments the bank should value most, and what offers to make to preserve and grow stable deposit balances. Measuring “stickiness” versus “runoff” has profound implications on which deposits have long-term value and are worth the promotional effort.

In fact, leading institutions globally are starting to incor-porate these measures of deposit retention into their liquid-ity valuations, and even advancing their funds transfer

pricing capabilities to differentially account for the lower liquidity value of “hot money” and higher valuations for more stable relationship deposits.

Marginal cost of promotion and cannibalization. Savvy institutions must monitor the effects of promotion “cannibal-

ization,” occurring when cur-rent accountholders see their bank offer higher promotional rates in the general market-place and transfer balances internally to take advantage.

All too frequently, cam-paigns invisibly sink under-water when this dynamic is omitted from deposit plan-ning. The true marginal cost of promotional deposit bal-ances takes into account: likely new deposit runoff, an

estimate of cannibalization of existing balances at higher rates, and the overall long-term retention of promotional deposits.

Internationally, our research shows that the unwanted repricing of current balances is increasing at a rapid rate. The only way that banks can recognize their individual exposure is via in-depth analysis of promotional and core balances — not a snapshot, but rather a granular time series analysis that digs down to the customer level.

CHARTING A COURSECanadian financial institutions share a common challenge of meeting higher growth needs for core deposit funding in an increasingly digital marketplace. This is a concern not only for the executives responsible for deposit gathering, but also bank treasury units.• On the regulatory front, the Basel III liquidity requirements

— in particular, the anticipated impact of the new Net Stable Funding Ratio (NSFR) — are ratcheting up the pressure for core deposit funding and constraining the ability of banks to continue using short term unsecured borrowing to fund their lending activity.

• Wholesale funding is becoming costlier, reflecting energy sector’s strains on credit quality, and rating agency actions earlier this year.

• Housing prices and household debt have spiked in recent years; a real estate bubble burst and/or worsening consumer credit would heighten liquidity needs. In this unfolding scenario, each institution needs to

map out its emerging needs for core deposit funding and

“A core task is to develop the right measures of promotional cost and effectiveness. A warning and avoidance system is needed to help the bank steer away from ill-fated promotions with diminishing returns. Two key measures are deposit balance retention and the true marginal cost of promotional deposits”


realistically assess the role and influence of promotions — both offensively and defensively. Does the institution under-stand the extent of its exposure to promotional fatigue? This knowledge then shapes the deposit agenda (Figure 3: Setting the Agenda for Promotional Pricing).• For the bank with high growth needs but low exposure

to promotional fatigue, the agenda is to pair traditional promotional practices with a test-and-learn program for new product structures and offerings — and do so before fatigue sets in. Banks with this fortunate profile still have headroom to use standard promotions, but not indefinitely. They need to build analytic muscle so that new approaches can be proactively deployed as needed, not as emergency responses. Options include targeted use of rate offers to segments with better potential for balance retention, and product innovation to capture rate-sensitive customers with a differentiated proposition.

• For the high-needs/high-fatigue bank, the agenda is daunting. There may be little choice but to maintain traditional promotional practices in the near term, albeit with diminishing returns. Yet banks in this category have the greatest opportunity for payback by testing their way into more advanced pricing approaches. Specifically, the customer learnings gleaned from current promotions provide a wealth of data to segment customers by their cost and retention characteristics.

• For the low-needs/low-fatigue bank, the historical agenda can continue for now, with sparse use of traditional promotions — measuring balance runoff and the marginal cost of funds to ensure portfolio health.

• For the low-needs/high-fatigue bank, the agenda is to “get off the treadmill” of endless promotions with declining results. Moving to a value exchange logic (e.g., an “everyday good price” rate while the customer is in core cash management) while excluding segments or geographies from promotions can improve the cost/runoff equation with minimal detriment to the deposit growth trajectory.

COMMON THEMESSo what are the common themes across these agendas?

First, financial institutions will need to invest in the ana-lytics and technology needed to capture the effectiveness of traditional promotions and develop and deploy more advanced approaches. This will require more granular cus-tomer data, including transaction-level history and shopping behaviour, to better target pricing (this data also allows for segment-level pricing for those with the capability).

Applying analytics to deeper data will equip the bank to assess strategies on a real-time basis, allowing the insti-tution to dip into and out of promotional approaches by market and customer segment when circumstances warrant.

Second, capabilities need to be aligned with promo-tional philosophy. Some institutions believe in “segment-of-one” targeting, using specific price points that are not broadcast to the broader customer base. Others worry about customer and front-line acceptance of these differen-tials and instead opt for transparent, give-for-get logic — providing rate incentives tied to the acquisition and reten-tion of core balances.

Third, the organization will need to evolve its rhythms on how the product and marketing teams interact with the front-line in the preparation, delivery and measurement of campaigns. Old measures around aggregate uptake rates and balance inflows need to be upgraded to measures of promotional impact, net of cannibalization-adjusted mar-ginal costs and balance runoff. Marketing must become more nimble to deliver more targeted offers, more fre-quently. The front line will need the right proof points to deliver the new reality with conviction.

Fourth, whatever the tactical agenda, analytic develop-ment should be supported by an aggressive test-and-learn program for new field applications — leveraging technol-ogy and omni-channel offer delivery to maximize returns on these efforts. For many institutions, progressing beyond tra-ditional promotions will allow them to maintain structurally lower deposit costs while achieving required funding levels.

Finally, there is an issue to consider at the treasury and bank level — especially if actions such as those above are not sufficient. That is whether to question the traditional asset/funding growth logic, which focused more on set-ting loan growth targets and then tasking the deposit units with funding the expansion. Increasing promotional deposit fatigue may well call into question whether shareholder value is better maximized with analytically-derived deposit growth serving as a governor on asset growth, especially in a high consumer loan-to-deposit ratio environment, rather than the other way around.

Adel Mamhikoff is a Managing Director in the Toronto office of Novantas Inc. Hank Israel is a Director and Andrew Frisbie is a Managing Director in the New York office. Also contributing were Chris Musto, Director, and Adam Stockton, Principal, both in the New York office. The authors can be reached at [email protected], [email protected], [email protected], [email protected], and [email protected], respectively.


31October 2016

32 CANADA

Treasury management (TM) has long been an integral and valuable component of commercial banking, providing everything from basic chequing and payments services to an increasingly sophisticated solution set that helps clients to optimize working capital. But a revenue-dilutive imbalance has crept in as the business has grown, in that the position-ing and pricing of TM services has not nearly kept pace with improvements in value provided by those services.

Many players now provide comprehensive web-based payments services and liquidity options, for example. Yet most have not established a well-constructed pricing contin-uum that reflects the progression from basic everyday ser-vices, where aggressive promotional pricing may be more appropriate, to custom-tailored services, where premium pricing may be amply justified.

These and other significant pricing disconnects abound in treasury management across the industry. Especially given the continued profit pressure in commercial banking, fresh management attention is needed on understanding and capturing the upside potential from matching TM pric-ing to value.

While commercial loan growth has been on a multi-year upswing at North American banks, net interest mar-gins have been steadily retreating, throttling spread income even as balances have climbed. Overall challenges include a flat rate climate, rising funding and compliance costs stemming from new regulation, and in energy portfolios, rising loss provisions as market prices have collapsed.

In this setting, treasury management price optimization rises to a high priority in commercial banking, one of the

BY SCOTT MUSIAL AND DAVE ROBERTSON

To optimize pricing in a way that preserves long-term franchise value, winning treasury management teams will learn to make precision tradeoffs within a systematic framework.

Treasury Management: The Case For Improved Value-Based Pricing

FEATURE

few available levers for incremental revenue improvement at a time when most other facets of the business are being squeezed. Blunt action, how-ever, is not the answer. Rather, com-mercial bankers will need to take a more nuanced approach to strike the right balance between protecting long-term franchise value and maxi-mizing fee income.

For methodical improvement in treasury management pricing, progres-sive teams will focus on three areas:

Price/value segmentation of TM services — Looking across the menu of services, offerings should be mapped by value they provide to the client versus cost-to-serve and current pric-ing. This framework allows for a more robust form of “pricing to value” and becomes the basis for client communi-cation and managing field execution.

Robust benchmarking — Instead of simple averages, knowledge of full price distributions (high/low, 25th percentile, 75th percentile, etc.) is needed for precision competitive responses. The bank also needs to be able to draw correlations between pricing variations and key client traits, such as size, geography and industry sector.

Client response modeling — Corporate clients often place high value on bank treasury management services, as reflected in low price elasticity of demand, and also may face high switching costs if they relocate their accounts. These and other factors affecting likely pricing responses should be mapped across the client base.

ALL OVER THE MAPWhile North American banks have provided payment processing and related services to their commercial cus-tomers for over a century, treasury management has oper-ated as a formal standalone fee-generating business at larger banks for only about 40 years. Capabilities have dramatically evolved during this time, from basic process-ing and reporting services to a robust solution set that helps companies to optimize their working capital. Banks, however, have not fully realized the value of their consid-erable TM service improvements, with unrefined pricing a main culprit.

As underscored by Novantas research, organizations primarily prepare for TM pricing decisions by reviewing sales force input and the client portfolio. In a recent survey of treasury management units at 38 U.S. banks drawn from a variety of size categories and regions, 80% of respon-dents said they consider sales force feedback in setting new price points, and 70% said they consider client rela-tionship depth.

The investigation of supplemental decision factors is far less prevalent. Only 56% of respondents said they look at purchased market data, which typically consists of simple averages of posted prices. Half take the time to develop estimates of value provided to the customer (commodity services vs. value-added vs. significantly customized).

Still lower in pricing decision influence is the level of client credit commitment, which is considered by 40% of respondents. Finally, and reflecting a major oversight in our view, only 20% of respondents said they consider imputed customer switching costs, which can pose a signif-icant barrier to exit in the event that price revisions cause some clients to considering relocating their accounts.

Treasury Management: The Case for Improved Value-Based Pricing

Figure 1: Radical Dispersion in Price Revisions

In a recent survey of TM units at 38 North American banks,targeted price increases ranged from under 3% to over 17%.

Source: Novantas

(40% of respondents)



(8% of respondents)

(4% of respondents)

22.0%

16.5%

11.0%

5.5%

0.0%Group 1 Group 2 Group 3 Group 4 Group 5

Range Estimates

Average

33October 2016

34 CANADA


The disparate focus translates into what can only be described as a wild dispersion in competitive pricing. Asked about recent overall price revisions within their respective TM units, 40% of respondents reported muted increases that fell at least 45% below the survey average (Figure 1: Radical Dispersion in Price Revisions). In our experience, such revisions usually are overly modest rela-tive to value provided to the client, often driven by a desire to avoid “rocking the boat.” Money is left on the table.

At the other end of the spectrum, a fourth of respon-dents reported price hikes ranging from 25% to 80% higher than the average. Another eighth of respondents reported increases that ranged from 100% to more than 200% higher.

Here the problem is client backlash. Some teams allow time to slip by and then try to implement a large “catch-up” price increase all at once. Others respond in haste to pres-sure from the top of the house.

Either way the result is the same: the extreme price hike becomes a visible event that can be fraught with repercus-sions. Suddenly the sales staff starts granting substantial discounts from the new price list generated at the corporate level. Alternatively, at the extreme, clients look elsewhere and some actually leave.

While competitive disparities in treasury management pricing revisions are far less acute in Canada, pricing is far from optimized. Overall, Canadian banks have tended toward over-caution in pursuing price increases in recent years, which is to say that a careful lid is kept on total monthly and annual billings for each client.

This posture typically is heavily influenced by traditional management approaches and sales practices — a chang-ing blend of hand-selected posted prices and discounts — with less analytical cohesion in the pricing of specific items within the service set offered by each bank. Looking bank-by-bank at various core treasury management services in a recent Novantas multi-bank survey in Canada, for exam-ple, the highest posted price for a particular type of service often represented a 2x to 3x multiple of the lowest price.

Such wide disparities suggest a lack of market context

in pricing decisions. In this sort of information vacuum, sub-jective concerns about client price sensitivity take prece-dence, leaving the bank unable to optimize pricing across the service set.

BUILDING THE ANALYTIC FOUNDATIONWhile we have used examples of pricing outliers to make a point, the goal is not “run with the herd” convergence to a narrow bandwidth that somehow seems safe. Rather, the goal is to learn how to make precision tradeoffs within a systematic framework.

Sales representatives will still provide important input and exercise their discretion in the field. Clients certainly will have their sway. But ultimately the central team needs an analytic foundation — a basis to evaluate all of the key influences on pricing; make decisions according to a con-sistent logic; and communicate and manage implementa-tion for best effect and with minimal repercussion.

In building this foundation, management teams have three main priorities:

Price/value segmentation of TM services — Pricing at many units is either monolithic across the portfolio or differentiates only by product line. Providers often give short shrift to the extra value embedded in their advanced offerings.

Basic commodities — chequing accounts, cheque deposits and ACH payments — can be found on every street corner, so to speak, and should be price competi-tively to market. The situation is quite different with custom services, such as cash flow management applications for specific industries and/or clients. They rightfully should be priced more aggressively to reflect the unique value the bank provides to its clients.

While the rationale is crystal clear, in practice it often fails miserably, as reflected in a Novantas analysis of dis-counting practices across 11 national and regional U.S. banks. Most of the banks discounted customized services at the same levels as core services — or higher. And across all value tiers, discounts soared above reasonable norms (Figure 2: Discounting — Target Caps vs. Actual).

“Sales representatives will still provide important input and exercise their discretion in the field. Clients certainly will have their sway. But ultimately the central team needs an analytic foundation — a basis to evaluate all of the key influences on pricing; make decisions according to a consistent logic; and communicate and manage implementation for best effect and with minimal repercussion.“


The upshot is that significant fee revenues are being left on the table. Discounts of up to 53% were seen on core services, for example, far above a reasonable outer limit of 30%. Discounts on value-added ser-vices ranged up to 47%, and the peak discount on custom services reach an eye-popping 70% — basically a giveaway.

Such anomalies are seen in Canada as well. In our pricing survey of 24 basic treasury management ser-vices, for example, scattered instances of zero discounts from the posted price were seen — but myriad instances of chunky price concessions, some ranging above 40%. Worse, in some instances, the provider that came to market with the lowest posted price on a particular item also was found to be extending the largest discounts, rais-ing questions about sales governance.

These are revenue-consequential disparities. To address them, treasury management teams should apply a price/value segmentation to their own service sets. The idea is to sort offerings by the level of distinctive value provided and then adjust both market pricing and maxi-mum allowable discounts accordingly. The more valuable the service, the higher the list price and the smaller the window for sales discounts. Portfolio-level or product-line pricing approaches do not fully capture these dynamics.

Robust benchmarking — While benchmarks are widely available, often the data does not provide enough detail to support nuanced pricing strategies. Instead of a full distribution, most third party sources of external data focus on “standard” prices, presented as averages or medians. This benchmark data is often sourced via mystery shopping and only represents list prices, not the actual negotiated market rates.

For fuller competitive context and a window into price elasticity of customer demand, banks need to understand the full distribution of actual prices in the market — not only the average and median, but the 20th percentile, 80th percentile, etc. A variation of 5 percentage points above the mean in a 50-point dispersion is something quite different from being 5 points above the average in a 15-point dispersion.

Even richer context can be had by correlating var-ious market price points with client attributes, such as sales volume and relationship size. Absent this context, banks often wind up discounting more aggressively than is warranted.

Client response modeling — Finally, banks do not suffi-ciently consider likely client responses when making pric-ing decisions. All too often, treasury management teams fall into practices and assumptions that take on a life of their own:• Large, valuable clients are automatically considered to

be price sensitive, reflexively offered the most competi-tive pricing via deep discounts.

• Pricing is tamped down over fears of attrition, over-looking the fact that the costs and complexities of switching often give clients strong reason to stay.

• Pressured by tightening competition, teams lose sight of the high value of services provided to clients and settle for a dovish posture on pricing.In each of these examples, a reasonable concern got

out of hand because it went untested against actual client response. In fact, there are specific and measurable vari-ables that can be used to model potential client responses

Figure 2: Discounting - Target Caps vs. Actual

Sales discounts on treasury management services typically exceed recommended limits, especially for high-value items.

Source: Novantas

100%

80%

60%

40%

20%

0%

Range of TM Service Discounts at 11 National & Regional U.S. Banks

30%

20%

10%5%

Target Limits

Higher Value & Pricing Power

Less Need to Discount

CoreServices

ValueAdded

Custom Services

ExceptionServices

35October 2016

36 CANADA


to price changes (Figure 3: Client Response Modeling). Many of these variables are based on data that already resides in many treasury management units.

A prime example is modeling potential switching costs. Some clients try to strengthen their hand in price negotiation by raising the possibility of switching their business elsewhere, but often that is not even necessary — scars from past experiences with lost accounts are enough to keep the TM sales team on edge.

But there is another side to the story. The bank has leverage in negotiations as well, in the form of switch-ing costs. Relocating a treasury management relationship to another bank is a complex and expensive effort for most enterprises, with transitions costing up to $100,000 for a large commercial client and taking from six months to a year to complete. In the Novantas U.S. survey, it was surprising to hear 80% of respondents say they do not model client switching costs as one of their pricing decision factors.

SWING FACTORWhile competitive pricing and deep discounts are war-ranted for specific services and clients, the lack of

precision in treasury management pricing has limited the ability to capitalize on situations where banks do have pricing power.

We have seen many instances where key clients are outright exempted from periodic price increases or even pricing reviews, largely on the basis of traditional business practices and spoken and unspoken concerns. These are not arguments to be won or lost. Rather, they are situations to be modeled, with data and analytics helping to inform management judgment and sales practices.

As commercial banks lean more heavily on their trea-sury management units for fee revenue lift, winning teams will be sure to review their pricing skills and strategies. In many cases there is much more analytic context to be had, including expanded market context; price elasticity of cus-tomer demand; models of client switching costs; and per-spective on the extra value that advanced services provide.

As an advanced pricing framework comes into view, it provides further benefits in orienting the sales force, com-municating and negotiating with clients, and managing overall field implementation, including discounts. For exam-ple, estimating the value of the bank’s services to the client — essentially putting a dollar value on the extra value rep-

resent in unique service capabilities, premium deposit rates and advisory support — can be helpful to sales officers in conveying the context for price increases to their clients.

To be sure, moving to a more robust pricing framework entails some level of effort and expense. But even net of transition outlays, preci-sion pricing is still a top avenue for revenue improvement in commercial banking, providing both a lever for short-term lift and a long-term tool for managing competitive position and field execution. Ultimately it is about maximizing pricing power relative to the valuable array of treasury management services already being delivered to clients.

Scott Musial is a Principal and Dave Robertson is a Managing Director in the Chicago office of Novantas. They can be reached at [email protected] and [email protected].

Figure 3: Client Response ModelingThere are specific, measurable variables that help to predict a client’s likely response to a price change.

Client Engagement,Strength of Demand

Switching Costsand Propensity

Degree ofValue-Added

• Bank services used• Level of discounting• Client credit quality• Credit line / utilization

• Relationship breadth• Use of customized services• Bank accounts, interfaces• Collection points

• Unique capabilities• Sales advisory support• Credit pricing / commitments• Current account pricing

Source: Novantas

Just a short time ago, digital lenders were being hailed as the vanguard of financial technology, destined to

change small business and consumer finance forever. Now the sector is under assault and sentiment has shifted from one extreme to the other.

Following the revelation of internal control issues at Lending Club and the sudden resignation of its CEO, longstanding issues with the sector, mostly ignored by its supporters over the last few years, were suddenly cast front and centre. Is digital efficiency and speed in loan origination being achieved at the conspicuous expense of credit quality? Is a business model

dependent on a narrow fee revenue stream and slippery funding viable?

These and other pressing ques-tions have created a cloud of doubt around digital lending, resulting in a contagion that disrupted market funding and stock valuations for several players. Banks should rightfully tread with caution in considering their options in this space. But we believe it would be a mistake for bankers to dismiss emerging trends and possi-bilities in digital lending just because some first movers got into a pileup.

Over the next five years it is still highly likely that a growing stream of U.S. loan origination volume will

be funneled through online channels and digital lenders. From a strate-gic perspective, banks should not only consider various market entry options—acquire, partner, white label, licence, build—but also key ques-tions about customer demand. Who are the future customers, what are their profiles and needs categories, and where should the bank place its emphasis for profitable growth?

Two major value propositions are in motion today:

SME small-dollar loans. It is widely recognized that banks have a hard time making money on branch-origi-nated loans of less than $250,000 to

BY BRETT FRIEDMAN

Recent turbulence among digital online lenders does not change the overall direction of this growing market. Banks should stay focused on entry options and customer demand.

Digital Lending Detour: Roadblock or Fresh Opportunity for Banks?

COMMENTARY

37October 2016

38 CANADA

small and medium-sized enterprises. And from the customer perspective, the traditional paperwork require-ments are lengthy, time-consuming and needlessly complex. With appropriate safeguards, digital lending can provide profitable access to the SME customer base. JPMorgan Chase and OnDeck Capital, as an example, have been jointly in pursuit of this segment since last year.

Consumer refinancing. Most consumer digital lenders are assisting households in refinancing debt, most notably student loan and credit card balances. This is a market share play with significant further potential for savvy competitors.

Today many bankers will tell you that they specifically do not want to participate in these categories. Why? Mostly it is concern about adverse selection, or the potential to over-attract weaker borrowers who cannot get credit elsewhere. Why originate and hold more easy credit that may collapse all over again in the next down cycle?

Yes, this is a risk to be managed. But it is not grounds to abandon the field, at least one can sift the wheat from the chaff. Digital lending dove-tails with the overall customer migra-tion to virtual channels, particularly with the trend in new online services that millennials demand. Millennials shop online for just about everything these days; loans are no different. Convenience, speed and funding time are the main considerations.

Seen as a niche play today, digital lending is heading mainstream, bring-ing more possibilities as it reaches a broader and younger customer base. Borrowers will not come out of desper-

ation, but because of superior credit arrangements and convenience. Banks should be actively considering the strengths they can bring to this space.

LEVERAGING STRENGTHSSo how can today’s challenges for digital lenders be converted into tomorrow’s banking opportunities? Let’s look at some key factors at work in the market today and how banks are fitting into online lending:

Brand and relationship strengths. Few digital lenders enjoy broad recognition, and those that do pay a fortune in marketing expenses to maintain it. By contrast, banks have extensive market presence, customer ties built up over decades, and perhaps most important, legit-imacy. These strengths are already being leveraged in digital lending, at institutions both large and small.

On the website of Birmingham-based Regions Bank, for example, the landing page for small business loans says: “We’ve teamed up with Fundation … a trusted online busi-ness lender with a new streamlined online application process for small business loans … Application site available 24/7 … Funds available

in as soon as 3 business days … Complete application in as little as 10 minutes.” Regions announced its agreement with New York-based Fundation Group in the fall of 2015.

Elsewhere, grassroots institutions are being presented with options to licence technology platforms that keep the entire digital lending operation in-house. In promoting its digital lending technology platforms, for example, Louisville-based BSG

Financial Group, leads off its web site presentation with “Your loans … Your underwriting … Your brand … Your control.”

We could go on with other digital lender/bank examples:• Lending Club and BancAlli-

ance, a consortium of roughly 200 community banks with as-sets ranging from $200 million to $10 billion;

• Scotiabank and Kabbage;• CIBC and Thinking Capital;

and• Prosper Marketplace and

Radius Bank.Each arrangement has

its unique aspects worthy of review and debate. But the main takeaway is that the possibilities for leverag-ing bank brands, relationships and legitimacy are real and growing. This is a place where banks bring an extra dimension, beyond what most pure digital lending play-ers can achieve on their own.

Balance sheet funding. In better times, just-in-time retail and wholesale investor funding was hailed as an innovative advancement in digital lending. But clearly it also has its drawbacks. For one thing, there is not a scintilla of loyalty in market funding. Pipelines can be shut down in a nanosecond at the first sign of trouble, as painfully experienced by digital lenders this summer.


“Seen as a niche play today, digital lending is heading mainstream, bringing more possibilities as it reaches a broader and younger customer base. Borrowers will not come out of desperation, but because of superior credit arrangements and convenience. Banks should be actively considering the strengths they can bring to this space.”

Bank funding stability can make a real difference. Although caveats abound—risk management, regu-latory, contractual—reliably-funded banks with the right credit screening will have growing and attractive opportunities to acquire earning assets via the digital lending conduit, espe-cially given current market conditions.

Customer retention and cross-sell. The business model for most digital lenders is a “transaction factory,” dependent on quarterly originations and associated fee income for earn-ings. To most of these factories, today’s borrower is tomorrow’s non-entity.

Any bank worth its salt in targeted marketing should be able to do a far better job of engaging digital borrowers to build an ongoing book of business. In particular, millennials do not yet have deep banking relationships and are notorious for changing banks. Digital lending can be viewed as one more technique to attract, retain and earn the loyalty of what has become the country’s largest demographic.

MANAGEMENT CONSIDERATIONSBefore we briefly go over the options to get in the game, a few issues should be tackled head-on. One is risk; the other is customer focus.

On risk, there is an underwriting disconnect between digital lenders and traditional banks, with major differ-ences of opinion on long-term viability. The idea of near-instant turnaround on credit decisions is a major red flag for traditional bank lenders, who are used to lengthy application forms and lock-step origination processes. Meanwhile digital lenders race ahead, promoting

simplicity and speed backed by ana-lytics and computer algorithms. Who is right? Is there common ground?

Banks are right to raise credit concerns, but in fairness to digital lenders, their overall track record on credit quality has been good in recent years. The catch phase, however, is “in recent years.” There is great concern in the regulatory community that a significant amount of rapid-fire credit will pile up just in time for the next economic contraction and trigger a cascade of defaults—lit-tering the financial landscape with distressed assets and befouling securities markets and bank balance sheets. Worried imaginations recall the mortgage crisis of a decade ago, with the lack of “skin in the game” for originators who rely on someone else’s balance sheet for funding.

The situation is cautionary but not dire in our view. In the absence of other market disruptions, digital lending is not yet large enough to present a genuine threat. Also digital lenders price up for the risks they incur in rapid-fire underwriting. But bank management teams do need to consider what kinds of risk bridges need to be built, such that the appeal of quick digital responsiveness is balanced with the bank’s need to protect the balance sheet and sat-isfy rising regulatory pressure.

For instance, one technique is a “right of first refusal.” The bank gets the first shot at booking loan applica-tions garnered in the digital net, with the remainder (not meeting its credit criteria) shunted to the digital partner for possible funding by other means.

On customer focus, management also needs to consider how online lending might help to reach target customer segments and meet business line strategy. For example, in a 2015 small business credit survey conducted by regional Federal Reserve banks, 20% of respondents said they had applied to digital lenders as part of their search for financing. Digital lenders are making a strong push in the SME space, and this ups the pressure on regional banks, which are already hustling to overhaul the framework for small business sales as branch networks are tightened.

Where does digital lending fit in the emerging customer outreach, not only small businesses but other sectors like consumer finance and even mort-gage? Setting the right top-level context is critical, both in evaluating the opportunities and following through.

ADVERSITY YIELDS OPPORTUNITYDetractors of digital lenders have questioned the quality and resiliency of digital processes, underwriting and origination for some time—specifically whether many of the players have the necessary experience to operate an efficient and well-functioning back office. Lending Club’s disclosure concerning improper loan allocation realized the industry’s worst fears. Although a comparatively small dollar value of loans was involved, the inci-dent raised questions as to whether other, more serious problems are present—not only in Lending Club, but among its competitors as well.

While recent events have largely put several critical aspects of the


“Where does digital lending fit in the emerging customer outreach, not only small businesses but other sectors like consumer finance and even mortgage? Setting the right top-level context is critical, both in evaluating the opportunities and following through.”

39October 2016

40 CANADA

online lending model into a negative light, some interim turbulence and consolidation are to be expected in a new market sector. Impartial observers have been predicting industry consol-idation for some time as a means to strengthen the digital lending sector by eliminating poorly capitalized players and flawed business plans.

So instead of recoiling, this is a time when banks should still be

soberly examining whether and how to participate in this market (Figure 1: Bank Options in Digital Lending). In the current environ-ment, hard-pressed digital lenders will be especially receptive to new investment and relationships.

In well-negotiated acquisitions and partnerships, the benefits to both parties are reasonably clear. Banks can obtain valuable online marketing

origination, and fulfilment knowledge while build-ing their SME/consumer loan base. In exchange, digital lenders get stable funding and processing.

For banks looking to expand their lending operations, especially in the SME space, partnering with a digital lender may equip them with the speed and simplicity that new-age borrowers require. For those that abandoned the SME space altogether following the 2008 crash, or those that simply want to expand their footprint in SME lending, partnering with a digital lender may present a quick solution on attractive terms.

Other banks may want to take advantage of the digital lending sector from the wholesale side, or to diversify loan portfolios with SME or consumer unsecured paper. Rumors of funding problems were in the market even before the issues at Lending Club surfaced. While the worst of the ensuing sector crisis may be over, many of the usual funding sources have either cut back or fled

the market entirely. For banks that provide risk-controlled loan funding to hungry digital players, fee and rate structures present an even more attractive risk/reward balance than was available just a few months ago.

Brett Friedman is a Director in the New York office of Novantas. He can be reached at [email protected].


Figure 1: Bank Options in Digital LendingBanks have several options to enter digital lending; recent turbulence may help in negotiating better terms for deals.

Source: Novantas

• Timing is good, given current market valuations• Immediate traction; business continues undisturbed• Can serve as an incubator for new ideas and techniques

• Fully customizable to the bank’s needs• Leverage in-house resources, and possibly parent brand

• Leverage in-house resources, capabilities and parent brand

• Complementary strengths: digital skills + bank funding• Easier to set up; near-term traction• Learn from digital partner without permanent commitment

• More expensive than other options

• Long lead time; can be unexpectedly expensive• Need right talent and culture to build/manage the business

• Organizational inertia; less urgency; may lack the right talent

• Brand dilution; bank not building its digital credentials

PROS

PROS

PROS

PROS

CONS

CONS

CONS

CONS

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Have you ever been steered to a conclusion by a convincing analysis, only to see signifi-

cantly different findings a week later? Maybe the underlying data feeds changed, or someone revised a minor calculation. But there is no quick way to tell and meanwhile the credibility of the analysis is gone.

This frustrating scenario is but one of the information governance issues confronting banks as the use of big data proliferates. Across the industry, institutions are working to tap the power of large-scale data analysis, but stumbling into all sorts of traps and inconsistencies as various ana-lysts charge off in different directions:• Data streams are managed incon-

sistently across business silos, with scant central oversight or documen-tation on how they are cleansed, refreshed and combined.

• Techniques for calculating perfor-mance metrics and model vari-

ables diverge among analytical teams, leading to differing interpre-tations and/or representations of the same fact set.

• Definitions of foundational metrics (e.g., balances) are changed with-out regard to the cascade effect on dependent metrics, or the potential impact on statistical models based on other versions. A proper end-to-end analytical

governance structure is essential in controlling these risks. Strategically, data governance is a central tenet of a data-driven organization that values data as a corporate asset and knows it must ensure the delivery of trust-worthy, secure information to support informed decision-making and efficient business processes. From an execu-tion perspective, governance perme-ates all levels of data management within the enterprise, from databases to data models to applications.

Many organizations are in need

of a comprehensive review of the business metadata management framework. A coordinated effort is needed to establish and maintain a governance framework that ensures: 1) consistency and documentation of business terms and definitions; 2) tracking of “data lineage” from raw inputs to analytic output; and 3) version control and audit trails that show who made changes, when, and most importantly, why.

SHAKY GUIDANCE SYSTEM?Business metadata provides an organizational map for the conversion of raw descriptive data into metrics and models for decision-making. A simple example for this would be the documented technique for calculating and updating a customer’s average monthly product balance.

In projects and applications involving multiple teams, each with multiple analysts, flaws and inconsis-

BY RICH SOLOMON AND KAUSHIK DEKA

Business metadata governance is receiving way too little management attention at many banks, increasing the risk that new analytics will become shaky guidance systems.


COMMENTARY

41October 2016

42 CANADA

tencies in even one metric can wreak havoc. The stakes grow exponen-tially in a typical big data project that may rely on 500 to 1,000+ metrics. That is why the quality of data governance, especially with business metadata, has such a strong and growing impact in banking.

Currently business metadata governance is receiving way too little management attention at many banks, increasing the risk of building shaky guidance systems. Via big data platforms, players are sorting through huge libraries of internal and external customer information — everything from banking transaction patterns to gleanings from social media — to drive marketing, sales and product

development. Analytics also play a growing role in risk management and regulatory compliance.

But the more that advanced analytics proliferate, the harder they are to control. More data inputs are being harnessed to drive more sophisticated analytical techniques — and by larger teams, each of which can make changes. Unmanaged, this complexity is working against the organization in three major areas:

Reports and models. Especially in a multi-channel environment, there is a growing need for collaboration and coordination among business units. Executives bring their various perspectives for decision-making but still need to be reading off the

same page, analytically speaking. Banks do have model validation committees, but they are having trouble keeping up. The quest for flexibility and continuous improve-ment is winning out over the need for documentation and consistency.

Data democratization. An enter-prise-level initiative, data democrati-zation seeks to enable non-technical business analysts to easily extract their own data. The goal is to free up more staff resources for analysis, as opposed to data trench work. But unless it is firmly grounded in sound data governance, data democratiza-tion can spawn analytical anarchy. In particular, well-formulated and -executed metadata management

processes are needed for all met-rics and models that analysts create and share among themselves.

Regulatory compliance. Regulators are pushing large banking organiza-tions to be smarter and more anticipa-tory in their business practices, includ-ing capital and liquidity planning. Along with evaluating the robustness of predictive models, they are looking for precision in the compilation of source data and good documentation.

Sound data governance is essen-tial in meeting these requirements without reactively having to document how data sets were created after they have been put into use (the back-wards approach often seen today). Governance is also a swing factor

in leveraging regulator-mandated analytics for performance improve-ment in other areas of the bank.

REAL CONSEQUENCESBeyond the big picture issues, each major bank has its individual challenges with business metadata governance, slowing progress toward organizational goals. Conflicts are festering beneath the corporate radar, not coming to the attention of management. At one of the 10 largest U.S. banks, for example, a project was launched to optimize the use of promotional pricing for core deposit growth. Predictive models were needed to guide customer-level decisions about the selective use of rate offers, with much depending on a proper foundation of business metrics.

These metrics were to be derived from a variety of granular data sources, both internal and external to the bank, and ingested into a big data environment. The expectation was that when the data scientists got to the core work of model construction and refinement, they could sum-mon building block metrics from a robust and easily accessible library, which in this instance was slated to include more than 500 possible variables to analyse 10 years of data across millions of customers.

But three problems quickly surfaced:

1) Duplicative effort. Data scien-tists in various business silos wound up building their own versions of core metrics. Though some definitions were identical, others varied, and all were separately named. These redundancies left project managers in the position of having to sort through tons of code and adjudicate metric definitions and naming conventions that all would use. Ultimately a lot of expensive effort went to waste.


“The more that advanced analytics proliferate, the harder they are to control. More data inputs are being harnessed to drive more sophisticated analytical techniques — and by larger teams, each of which can make changes. Unman-aged, this complexity is working against the organization.”

2) Version control. As metrics were refined over a series of revisions, it became increasing difficult to track which changes were made at which stage. Were the latest revisions from one data scientist inadvertently made to an older version of the code issued by another, omitting interim work from someone else and embedding a flaw?

3) Tangled interdependencies. To verify a suite of new reports, project team leaders needed to be able to drill down and review not only how underlying models were constructed, but also all of the linkages within the overall library of metrics. In an environment where linked genera-tions of metrics and models were fast evolving, data lineage and depen-dency maps of the derived products became a major governance issue.

FOUR KEY QUESTIONSAs banks consume ever more data

they are creating ever more sophis-ticated metrics, often developed by a wide cross-section of users with various — and sometimes conflict-ing — business needs. At a technical level, banks have three metadata gov-ernance issues to work on: metadata catalog; data lineage tracking; and version control and audit trails (Figure 1: Fundamentals of Sound Business Metadata Management).

The bigger picture is about achieving better results in less time. As banks continue to build their analytical capabilities, executives should be asking four key questions:1) What proportion of our analysts’

time is being spent on data wran-gling, versus generating value-add-ed analytics?

2) What proportion of our models can be automatically (and reliably) val-idated and refreshed with the latest data, with minimal manual effort?

3) How well are we leveraging analyt-ics across projects?

4) How well are our analytics docu-mented, including the timely tracking of successive changes made during the course of model development and testing, and not as an after-thought or under regulatory duress?In many instances, these questions

reveal the need for improved data governance, not just incremental improvements here and there, but a comprehensive review and overhaul. Given that the required investments, complexity and performance impact of big analytics will only grow, the time to strengthen the foundation is now.

Rich Solomon and Kaushik Deka are Managing Directors in the New York office of Novantas. They can be reached at [email protected] and [email protected], respectively.


Figure 1: Fundamentals of Sound Business Metadata Management

Sound metadata governance is critical to ensure that the bank has the proper analytics to identify salient changes in the market — without getting drowned in a sea of data changes.

METADATA CATALOG

DATA LINEAGETRACKING

VERSION CONTROL, AUDIT TRAILS

A glossary of business terms, including standard terminology, description, context, owners, usage permission and linkages to reference data and/or other business terms. A critical guide for analysts and stakeholders in a business domain.

An ability to track both the flow of information and the derived data artifacts created on the journey from source data to the end analytical product — whether a report, a data feed or an application.

An ability to tell “who changed what data element, and when and why.” An implicit recording system, baked into analytical and business intelligence workflows, can provide the audit transparency mandated by the regulatory community.

Source: Novantas

43October 2016

ABOUT NOVANTAS

Novantas is the industry leader in analytic advisory services and technology solutions for financial institutions around the world. We create superior value for retail and commercial banks by delivering information, analyses, and automated solutions to improve revenue generation across pricing, product development, treasury and risk management, distribution, marketing, and sales management.

Novantas Review is published quarterly by Novantas, Inc., 485 Lexington Avenue, New York, NY 10017.

© 2016 Novantas, Inc. All rights reserved. “Novantas Review” and “Novantas” are trademarks of Novantas, Inc. No

reproduction is permitted in whole or part without written permission from Novantas, Inc.

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