Arizona Bankers Association 2015

2015

CYBER SECURITY TECHNOLOGY AND REGULATION TOP LIST OF THINGS TO WATCH IN 2016

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Arizona Bankers Association

Banking on change From regulatory reform to cyber security to funding legalized marijuana, there will be a lot to watch in 2016

By MICHAEL GOSSIE

R

ight now, Arizona’s banking industry is like a sunny sky after a monsoon.

“Our industry is good, but it’s not on fire,” said Paul Hickman, president and CEO of the Arizona Bankers Association, which has been the voice of Arizona’s banking industry for more than 100 years.

“We came out of one of the most severe economic downturns we’ve had in Arizona since the Depression — maybe even greater than the Depression because we weren’t that evolved as an economy in the 1930s. It took a toll.”

But there is more good news than bad news heading into the new year for the more than 40 banks and credit card operations that are members of the Arizona Bankers Association. Hickman sat down with Az Business magazine to talk about the trends and issues facing his industry and what we can expect to see in 2016.

Az Business: How does your industry look going into 2016?

Paul Hickman: The banking industry took a hit during the recession and that hit was largely housing driven because Arizona has had a housing economy for the last two generations. We lost 15 banks in five years; but beginning in 2012, we started to gain healthy footing again. The FDIC’s troubled bank list is way down, profits are up, net interest margin is still problematic because of the interest rate, but lending is good and it’s aggressive and multi-faceted. The industry in Arizona is pretty good going into 2016. We are optimistic.

AB: Are there trends in lending that are indicators of Arizona’s economic health?

PH: We are seeing more commercial real estate, industrial and small business lending, so all of those are indicators of better economic health in Arizona. If you track the unemployment rate, that validates that picture because we are about a point above the national average, which, according to most economists, is almost at full employment.

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AB: Did your industry learn anything from the economic downturn to make it better equipped to handle a future crisis?

PH: The regulatory reaction will make the industry stronger. The lesson — when it comes to any bubble — is to not get caught up in that competitive environment because that’s essentially what 2008 and 2009 were all about — a residential real estate bubble. Banks were competing against non-banks and they took the bait. They went in and made risky loans. So the lesson is don’t get caught up in the hype. In terms of the regulatory reaction, it has been a huge overreaction in my view. It has stifled what may have been a faster recovery.

AB: How has the increased regulatory climate impacted your industry?

PH: It’s been very difficult. Dodd-Frank was not supposed to apply all the way down, but the Consumer Financial Protection Bureau applies to the entire financial services industry. Mortgage regulations in particular hit Arizona hard because we’re a housing-centric state.

We’d like to see some of that stuff reformed because the community banks in Arizona that are engaged in small business lending and residential real estate lending were not the problem in 2008, but they’ve been impacted the most because they don’t have the scale to absorb the increased regulatory burden. When a bank has to bring in two new people and all those two people are going to do is compliance, it’s tough because they’re not growing the bank and they’re not putting capital out on the street and they’re not growing the economy.

AB: Can we expect any easing of those regulatory burdens?

PH: There are several bills at the margins that are going to move through the House and end up in the Senate. There’s not going to be a wholesale repeal of Dodd-Frank. I do think we can expect to see lawmakers consider a fairly comprehensive retooling of Dodd-Frank. It’s going to make politics and banking fairly interesting.

INDUSTRY LEADER: Paul Hickman is president and CEO of the Arizona Bankers Association, whose mission is to engage its members in industry issues and be the catalyst for creating a unified voice.

PHOTO BY MIKE MERTES, AZ BIG MEDIA

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Arizona Bankers Association AB: How has consolidation in the banking industry impacted Arizona?

PH: It remains to be seen. It’s not over yet. The industry is on a long-term consolidation trend. Twenty years ago, there were twice the number of banks that there are in the United States today. Some people will say that has a profound impact on the rural economy because it creates near monopolies and creates an upward price. In suburb and urban environments, I’m not so sure given a better technology. Millennials don’t want to go into a bank, so you don’t need branches everywhere. You can use your cell phone to deposit checks and pay bills. So some of the consolidation was necessary, but some is being driven by increased compliance costs and that’s why we’re seeing mergers and acquisitions rather than new De Novo applications being filed for new banks. The other reason for that is the interest rate. If you’ve got folks looking to put venture capital onto the street and they’re going to get maybe two percent to capitalize a bank, they are going to find much better returns in a lot of other places.

AB: How has technology impacted banking in Arizona?

PH: It’s made it more efficient, but it’s made it more expensive to operate. Mobile banking isn’t cheap. If you’re a $2 billion bank, it’s a lot more expensive to go mobile than it is if you’re a $30 billion or $40 billion bank.

AB: How has the focus on cyber security impacted banking in Arizona?

PH: Cyber security is sucking all the oxygen out of the room right now in terms of policy both internally and externally. It’s really expensive, but it’s not something you cannot do. You’ve go to take prophylactic measures because if you don’t and you get malware placed on your system or you get hacked somehow, it costs a lot of money to remediate that, plus risk to reputation. So banks are staffing up with IT folks and the further down you go at the asset level, the less they’re doing it because the less able they are to do that.

AB: Should people be worried about cyber security?

PH: We need to watch what’s going on with cybercrime and the evolution of expertise. There’s a bill percolating that requires information sharing. Right now, there’s a liability associated with information sharing on cyber threats. Our industry and the retail industry ought to be able to share information with the government on potential threats. With regards to cybercrime, whoever left the system vulnerable ought to be responsible for remediating the damage caused by the hack. Right now, the banks take the responsibility. But look at Target. That was malware. The banks had to remediate any accounts that were hit and money was taken. Banks also had to replace all of those cards. That’s not insignificant. So if a retailer doesn’t want to go to a chip and PIN because it’s expensive to buy that hardware and they get breached, then they should pay the banks back when the banks have to put money back into their customers’ accounts and replace all of those cards. There shouldn’t be different standards in terms of security for a retailer than there is for a bank and banking standards are the highest.

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Arizona Bankers Association

AB: Why do banks make so many headlines for their philanthropic efforts?

PH: There’s something about banking that they just want to give back. At the community bank level, they are not rich by any stretch. They are small businesses like anything else, but they really want to give back.

It’s rooted in the history of the industry. If you look around America and Arizona, as we evolved from an agricultural economy to an industrial economy and now to an informational economy, the nicest building in every town was always the bank. The bankers were in the Rotary, Elks Club, on the school board and members of the Cancer Society. That was just rooted in the industry’s history. I’m really heartened by the fact that it remains that way today. Given all the negative press this industry has gotten, to see that people who populate the banking industry still give back to their communities and volunteer their time, it speaks well for this industry.

AB: Are banks trying to prevent the legal marijuana industry from gaining financial traction?

PH: It’s not that the banking industry is averse to getting involved in the industry, it’s that marijiana is illegal under federal law and we are a federally regulated industry. Our insurance company that we all have to belong to is a federal agency. Banks want to bank a legal multi-billion-dollar industry, but they are afraid that if the FDIC can come in at any time and revoke their insurance, they’re out of business. It’s not that they’re afraid they are going to jail; they’re afraid that they cannot stay in business if an unpredictable agency comes in and decides, “Guess what? We don’t care 78

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what the attorney general says. Under the Controlled Substances Act it’s illegal and if you’re banking it, so you’re in violation of federal law.” It’s clear in the insurance contract that banks cannot do that. Former Attorney General Eric Holder issued several memoranda that tried to make it clear that the legal marijuana industry is bankable if you’re doing it in a state where it is legal, but that doesn’t give the banking industry a lot of comfort because he is no longer the attorney general.

AB: How do you think the issue shake out in Arizona?

PH: It’s going to be fun to watch. It’s likely to get on the ballot. In the presidential election cycle, it will be likely to pass, so we will join the small group of states that permit recreational marijuana. Once that happens, we go back to the same argument and there is going to be a lot of pressure on the banking industry in Arizona to bank it and some banks probably will, but most won’t. To fix that, we have to change the federal law.

AB: What is the most important thing to keep an eye out for your industry?

PH: The first thing we’ve got to watch is what the Fed does with the interest rate. If you’re a homeowner, you might see that as a threat. If you’re in the banking industry, we really need to raise the rate. It’s been flat now for eight years. That is somewhat troubling because it’s highly volatile right now. We know that a 25-basispoint increase is very modest, but that increase could shake the markets. But a a 25-basis-point increase will increase earnings for banks because it would increase our net interest margins. A 25-basis-point increase would be meaningful and it’s justified right now.

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Arizona Bankers Association

2016 OUTLOOK While profitability and earnings are up, technology and regulation are changing the business By MERYL FISHLER

T

he banking industry in Arizona has improved since the the Great Recession; profitability and earnings are up, the number of the FDIC troubled banks list is down and the number of troubled loans and foreclosures are both down. Things are looking great, right?

Larger institutions in Arizona are doing well because of their relationship to depositors, according to Michael Thorell, chairman of the Arizona Bankers Association and president and CEO of Pinnacle Bank president and CEO. But the state of the industry is a tale of two stories.

Smaller community and regional banks, although improving, are growing fewer in numbers.

TREND OF CONSOLIDATION The long-term trend of consolidation in the banking industry became accelerated due to the dramatic impact of the Great Recession. This distressed economic climate led to owners’ fatigue and banks were strung out from the depth of the recession and looking for an exit strategy, said Ed Zito president of Alliance Bank Arizona.

This caused Arizona’s banking industry to shrink in terms of the number of competitors. Before the recession, there were approximately 80 banks operating in the state. Now, that number is 67.

Chase, Wells Fargo and Bank of America dominate the banking landscape in Arizona, holding 70.6 percent 80

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Arizona Bankers Association

Mike Brown

Jerry Ernst

Michael Thorell

Ed Zito

“...the state of the industry is a tale of two stories. of statewide deposits, according to the FDIC. The concentration of market share among just a few companies potentially could lead to less competitive rates and fees.

“We are not over-banked, we are over-branched,” Thorell said.

Another cause of the acceleration of consolidation is the abundance of regulation on the banking industry because of the Dodd–Frank Wall Street Reform and Consumer Protection Act , passed in 2010 in response to the recession. It brought the most significant changes to financial regulation in the United States since the regulatory reform that followed the Great Depression. It laid out changes in financial regulation that affect all federal financial regulatory agencies and the financial services industry.

Post Dodd-Frank regulation provide additional costs as banks are forced to deal with the regulatory burden. Some banks were forced to make proactive mergers to deal with the additional costs, said Horizon Community Bank CEO Jerry Ernst.

“It makes it necessary for smaller banks to hire additional people to handle the regulation burden,” said Arizona Regional President Mike Brown of Washington Federal, something some smaller banks cannot afford to do.

Another driver of consolidation was the intense competition among banks in a post-recession world, Brown said. People have a larger war chest of cash on hand to tackle the next phase, meaning the same number of banks are fighting for less, he added.

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Lastly, there hasn’t been any additional new bank charters, Ernst said. Usually, when banks fail, there are new banks that replace them.

EARNINGS UP IN ARIZONA The economic environment since 2010 has improved and earning are up among Arizona banks.

The economy is not robust, but it is doing well, Brown said. Consumers are confident it is heading in the right direction. However, some believe the economy is improving too slowly. But, the economy is more sustainable because of the slowly improving nature, Zito said.

A driver of this improvement is that since the economic downturn banks, have improved their efficiency, driving up profits and earnings, experts said. Technology has played a role, making banks more efficient and cost effective. Additionally, the economic diversification of the state’s economy, evident in the increases in loan demand, is another factor driving up profits, Zito added.

Profitability has also risen due to the fact that problem loans in Arizona banks have resolved themselves, Thorell said. Problem assets were eating up earnings and relieving that stress has opened doors for earnings. And profitable banks help perpetuate a healthy economy because there is more available capital, Thorell said.

POSITIVE SIGNS Banking experts said trouble loans are down,

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Arizona Bankers Association foreclosures are down and the number banks on the FDIC troubled banks list is down “Time heals most wounds is probably relevant here,” Zito said.

These decreases are due to economic improvement having a positive impact on the industry as a whole.

Drops in these numbers can be attributed to an improvement in real estate loans and to an increase in bank capital due the increase in earning, according to experts. Also, with the recovery, people have the option to refinance troubled loan at another bank “The economy is doing better, real estate is doing well, which get some of the banks on the list out of the dog house,” Brown said. The economic recovery has resulted in property values going up and people having equity in their homes again, Ernst added.

“Underwriting is more stringent than it was five, six, seven years ago,” Ernst said. One of the outcomes of Dodd-Frank is that it tightened up the definition of an acceptable income-to-debt ration, Ernst said.

The consolidation trend also is a factor in bringing down the number on troubled banks. “Some problem banks have been acquired and simply don’t exist anymore,” Thorell said.

The impact of this is that there is a nice confidence

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in Arizona’s economy right now, letting a lot of banks do quality loans, Brown said.

IMPACT OF TECHNOLOGY Technology and FinTech are expected to have a big impact now and down the road.

“This will be the Uberization of the financial services industry,” Ernst said.

This digital revolution in financial services will change the role and relevance of today’s banks.

“Electronic banking is going to force us to change and adapt to the newest trends,” Brown said. Electronic banking, including online banking, ATMs and smartphones, are going to force banks to analyze brickand-mortar banks, Brown added.

Additionally, experts foresee FinTech — financial technologies software that provide financial services — as a trend expected to have a huge impact on Arizona’s banking industry and the industry nationally in the next five years. However, just because it may be the easiest way to borrow money, doesn’t mean it is the best, Ernst said.

There is a trend of overpaying interest with FinTech. But, the speedy nature of FinTech will force banks to move faster towards the “Uberization.”

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Banks and technology companies need each other

W

hen news breaks about the funding of a hot new technology company, the words “venture capital” or “angel investor” are almost invariably attached. If you were to read headlines alone, you would conclude that banking institutions play a minimal role in providing the technology sector with capital. While it’s true that banks are historically accustomed to providing loans to business with physical collateral assets, it would be a mistake to downplay the important relationship between banking and technology companies.

It’s important to understand that all banks are not created equal.

Different types of banks have different priorities. While global banks can have internal lending criteria that are not always tailored Steven G. Zylstra to local business needs, some multinational banks differentiate Banking themselves by working with the technology sector. Wells Fargo has done tremendous work for Arizona technology companies.

Meanwhile, specialized and local banks can cater their goals and policies to match their surrounding ecosystems. Silicon Valley Bank, which serves venture capital firms, multinational companies and entrepreneurs alike, came to Arizona in 2012. According to a company spokesperson, they chose Arizona due to the “area’s great quality of life, talent pool and affordable living for employees.” Having enjoyed success here, they have continued to expand and announced plans in 2014 to lend at least $100 million to Arizona-based tech and life science companies during the five years that followed.

As another great example, the parent of Alliance Bank of Arizona recently acquired Bridge Capital Holdings specifically to increase its ability to serve midsize and multinational technology companies.

It’s also crucial to remember that the capital needs of a technology business go beyond raising startup cash. A line of credit is immensely important to technology companies with cyclical business models, allowing them to use the credit during a slow period and pay it down during a growth period. And when a technology company expands its physical infrastructure, as when opening a new facility, bank loans are a perfect solution.

There is no denying that in the period immediately after the great recession, banks and technology entrepreneurs could find themselves at odds. Under tremendous pressure to make conservative investments and operating under new legislative mandates like Dodd-Frank, banks were often hesitant to lend to a company without physical assets. A manufacturing company with specialized machines to serve as collateral had a 86

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far easier time dealing with banks than a Software-as a-Service company whose primary assets were intellectual property and top talent. Fortunately, the chilling effects of the recession have begun to reverse in recent years.

Interestingly, banks are becoming more and more like technology companies themselves. With a growing need to leverage technology that provides services and security to customers online and through mobile devices, banks have begun filing for patents as never before in their histories. And banks themselves require a lot of technology talent to support those innovations. Worldwide spending on banking and securities IT is projected to hit $563 billion by 2017, according to market analyst firm Gartner. As the importance of intellectual property, the draining effect of patent trolls and the need for IT talent are woven into the culture of banking institutions, you can expect to see a new banking culture that is amenable to finding ways to support technology companies.

Technology companies comprise an unparalleled engine of economic growth in contemporary America. Apple is the world’s most successful company. Google is an economic juggernaut with value that comes primarily from intellectual property. It is state banks, with both global and local reach, that will continue to expand their lending to technology companies so they remain an essential part of Arizona’s technological economic engine.

Steven G. Zylstra is president and CEO of the Arizona Technology Council.

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