A Conversation with BDO’s Barry Pelagatti

bankIt’s no secret that the financial services industry has just come through a virtual meat grinder in terms of economic crisis, intense regulatory and legislative scrutiny, and scathing public opinion. Four years and fewer front-page headlines later, there is a sense that the industry has come to terms with its failings, implemented new regulatory oversights, and is poised for growth and prosperity.

Yet the road hasn’t exactly been an easy one. Larger lenders, who faced the brunt of the public and regulatory outcry during the early days of the recession, are still gun shy about lending and protective of their reputations. The trust that was given almost automatically has been slow to return.

That creates ample opportunity for community banks and lenders, who are well positioned to help shore up the country’s finances and speed recovery even further. At the recent Pennsylvania Banking Seminar in Exton, PA, I sat down with Barry Pelagatti, assurance partner with BDO USA in Philadelphia, who summarized the current climate in the financial services industry, and gave me some insight into what challenges the industry faces.

Q: A few years ago, all eyes were on the financial services industry, and not in a good way. How has that period of time, and the economy moving forward, changed the way financial institutions do business? What are some of the more fundamental shifts in the business model that were not regulation-driven?

Pelagatti: The primary shift we’re seeing is the chief lending officer has become much more important in the organization. Banks are still finding with the current low-rate environment, deposits are still coming in, there’s still an uncertainty about the stock market, so there’s a lot of cash that resides on the asset side of the banks. Their primary goal is to get that out into the loan world.

However, when you’re trying to lend at the onset of what’s considered a rising rate environment, the banks are very hesitant to lend fixed. They don’t want to lock in at a lower rate and have it on the balance sheet at a time of a rising rate environment. So the challenge for chief lending officers is to not only understand the need for volume to generate loans, but also to understand where the rate environment is and try educating the borrower on the different types of loans that exist.

What we’re probably going to see is a significant shift in banks lending and also how they integrate in derivative or interest rate swap strategies. They’ll possibly try to align themselves with counterparties that will allow them to convert fixed rate loans into floating rates by entering into some sort of interest rate swap agreement.

It’s an interesting concept, but it’s going to be challenging for community banks. These counterparties will probably look for a significant amount of volume to be able to do those types of transactions. While there’s an agreement that the economy is improving and balance sheets are much cleaner, the next challenge is how to do business when the rate environment changes and the liability side is going to re-price more quickly than the asset side.

What are the challenges for today’s banking industry? How are they/aren’t they equipped for those challenges?

Pelagatti: Our consensus within our group is that banks that made it through the great recession are equipped to do it. if you were able to navigate the regulatory and economic environments the last five years and you’ve come out the other side, you’re equipped to do it. We find the challenge is in acknowledging the fact that it’s no longer waiting for things to go back to normal but accepting the fact that this is the new normal. The returns you may have been accustomed to are not the returns that boards, shareholders, and management teams can expect any longer.

That’s a tough thing to swallow for the career bankers, isn’t it?

Pelagatti: It is. It’s having a collaborative form of communication with all the decision makers. To have them understand when you generate a business plan and a capital plan that even though things are better, the results being projected are not the results they’re used to seeing, and that it’s not due to an inability of management to get to them, but that the sector won’t support them.

We think the value of the community banking sector is strong, but the ratios that historically  we’re used to seeing just aren’t going to be there, at least for the foreseeable future because of this rising rate environment combined with the fact that the regulatory environment is reacting to some of the problems that created the bank failures. There’s a cost associated with that compliance. When you layer on a challenging rate environment and the cost economics of compliance, it’s a different way of breaking down your income statement. We believe it’s the community banking sector that’s going to continue to pull the economy into recovery. The bigger banks over $15 billion in assets with the onset of Basel III and onset of new allowance methodology will struggle to be able to come back to the community lending sector. Even though they’re wanting to and trying to, we think it will not be practical for them. That means the opportunities will be there for the community banks.

The next stage in recovery is going to be borrowers knowing they can go to their community bank and get the products they need in order to make investments in infrastructure and back to a growth model. As the rest of the sectors begin to recover, they’re going to need liquidity to do that. Banks have that liquidity. Very many of them are flush with cash and looking for somewhere to put it, but it’s a matter of setting up the right system to do that.

Where are the industry’s more impactful areas of risk these days? How are banks mitigating those risks?

Pelagatti: The biggest risk right now is the interest rate environment; not only that we think we’re in a rising rate environment, but also that no one can really predict when it’s going to start rising and how quickly. It’s like trying to throw darts. Secondly, I think most in our industry would agree, is the regulatory risk – the cost of not only complying but also the reputational costs of not complying. Most recently with the Consumer Financial Protection Bureau and with regard to anything that’s real-estate based, there’s going to be a lot of pressure to understand the requirements.

Another top concern is watching your capital levels. As you start to grow again and have the ability to convert cash into loans, that’s going to impact your denominator, which is going to impact your ratios. Basel III is requiring higher ratios, so banks don’t want to find themselves not well capitalized. It’s a very challenging environment because there are so many different moving pieces. We encourage our clients to expand their infrastructure, but that’s hard for a board to approve when earnings are so razor-thin.

It’s not been a great couple of years, or even an easy few years prior, has it?

Pelagatti: No it hasn’t. But if you made it through those earlier years, these will be strategically challenging, but hopefully banks will find themselves more stably positioned to deal with it. Be very candid communicators with your board and with your shareholders. A lot of people in this industry say capital is king, and I would agree. But strategically, communication is king.

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