Crisis Accelerating Digital Banking Transformations

Crisis Accelerating Digital Banking Transformations Banner Image

The financial crisis of 2008 caused banks to lose money on mortgage defaults, interbank lending froze, and credit to consumers and businesses ceased. It spawned new regulatory actions internationally through Basel III and Dodd-Frank that protected customers but added operational costs and squeezed bank margins. This led to 465 banks failing from 2008 to 2012. In contrast, from 2003 through 2008, only 10 banks failed. The Temporary Liquidity Guarantee Program (TLGP), established by the FDIC, guaranteed deposits and Congress raised the insurance limit to $250,000 to increase depositor confidence. Recent Bank failures have been rare in the last few years with no banks failing in 2018 and only four banks failing in 2019.

What will be the impact of Covid-19 pandemic?

Covid-19 is a pandemic, not a financial crisis. But it is having similar impacts on the banking industry. When people are scared, they want cash and federal law allows customers to withdraw as much cash as they want. But not all customer deposits are available for immediate withdrawal. Banks may lend or invest around 90% (depending on their size) of deposits and only keep 10% in reserve. This model works perfectly well most of the time. Customers don’t typically need their money at the same time. In times of crisis, there is often a run on the banks and the demand for cash can be overwhelming. To meet their cash demands, banks are often forced to sell off long-term assets or investments, incurring considerable losses….especially, in a down market. Banks that do have deposits sources available may offer emergency funds to customers. Banks can also delay loan payments or restructure loans in order to minimize defaults and protect their customers’ investments.

In 2008, the financial crisis fear caused the demand for imported goods to plummet contributing to a global recession. Confidence in the economy took a nosedive and so did share prices on stock exchanges worldwide. Covid-19 is having a similar impact on the markets with record declines after an 11-year bull market.

The recent Paycheck Protection Program (PPP) loans are an attempt to keep small business a float and mitigate the liquidity crisis. The PPP loans incents small businesses to keep their workers on the payroll. SBA forgives loans used on payroll, rent, mortgage interest, or utilities loans if all employees are kept on the payroll during the eight-week period. The success of the program will be determined by how well SBA defines the requirements and how quickly banks can distribute the money and mitigate fraud.

In an attempt to limit the spread of Covid-19, most retail and entertainment establishments have been shut down. Closing branches, to increase social distance, may actually be a blessing for banks. Customers can still access their money through digital banking but digital payment services often have lower daily or weekly withdraw limits and can slow the cash demand. Without having access to the branches, there will be an increased dependency on digital banking. FinTech’s are seeing record adoption. Blend is receiving 15,000 to 20,000 applications a day and processing loan values as high $8 billion (American Banker).

In a recession, the most efficient businesses survive. A bank's efficiency ratio is a quick and easy measure of a bank's ability to turn resources into revenue. An efficiency ratio of 50% or less is considered good which means it takes $0.50 to generate a $1. The lower the percentage the more efficient.

Small Banks, less than $5B in assets, are less efficient than Big Banks, and Big Banks are less efficient than Digital Banks on average. Big Banks benefit from scale and digital banks benefit from automation and reduced overhead.

Efficiency Model Diagram
After the financial crisis, bank efficiency ratios increased because of additional legal and compliance resources and investments dedicated to the new regulations and new fee restrictions. However, over the last ten years banks have made significant efficiency improvements with their technology investments and branch closings. On average, banks have improved their efficiency (reduced percentage) by almost one percent per year for the last decade.

Efficiency Ratio Model

Crisis accelerates the trends that were already in motion. People are more willing to change their behaviors if they feel it is important. Web and Mobile banking have consistently increased in adoption over the past 2 decades. Adding to the trend, FinTech investments have skyrocketed providing both strategic partnership opportunities and competitive business models to the legacy banking. After the pandemic, the Covid-19 virus will inevitably have a profound impact on remaining banks. The small banks that have invested in digital banking, leverage FinTech partnerships, and have the necessary deposits will continue to thrive in the new normal post pandemic.