VCM BLOG

Rethinking The Business Model For Community Banking, February 5, 2018

FebBlog

Community banks and credit unions have been a key part of the American economy since its beginning. These are the lending institutions that make loans to small sole proprietors, first time home buyers and dreamers of all kinds. Over the years, the business model for these institutions hardly varied.  A review of the loan portfolios of community banks across the country will include three similar components:

·        CRE– Commercial real estate loans have been one of the mainstays of the community banking business. These loans provide a viable, recognizable and reliable (usually) source of income. The return on investment for these loans have been the source of a large portion of the earnings for community banks for many years.  The drawback for this type of lending is that it ties up a large portion of the capital of a bank and the return on investment takes a significant amount of time develop. A loss from one of these loans has the potential to threaten the existence of a small financial institution

·        CNI – Commercial and Industrial loans have been the beating heart for community banks for many years. Very much like CRE loans, the income from these loans is recognizable and except for a few notable exceptions, reliable. Not only do these loans have the same concerns as CRE, the competition for these loans is fierce and smaller institutions often finds themselves left with the borrowers who present the highest level of risk.

·        Consumer products – In the past 15 years, consumer loans have also proven to be a good source of earnings. Interest rates for consumer products have remained well above the prime rate and for a financial institution that is properly equipped, consumer products can provide a strong stream of income.  Consumer products also tend to be for smaller amounts, have higher rates of losses and are heavily regulated.

This three-pronged approach to earning income has been a steady, tried and true method for earnings at small financial institutions. However, there are several factors that are coming together that have threatened this business model.

·        Fintech – Financial technology (“Fintech”) companies are those companies that use software to deliver financial products. Today one of the most recognizable fintech companies is PayPal. Using just a smart phone, PayPal gives its users the ability to make payments, pay bills, deliver gift cards and conduct financial transactions with people throughout the country.  For community banks, the knowledge of the existence of PayPal is interesting, but what is more critical is the reason that PayPal was developed. PayPal, and its fintech brethren exist to fill a specific need that Banks were not meeting.

·        NBFI – The Operation Chokepoint program was a program spearheaded by the Justice Department that was aimed directly at Non-Bank Financial Institutions, aka Money Service Businesses. At the time the program was started, a decision was made that money service businesses represented an unacceptable money laundering risk.  Ultimately, Operation Chokepoint fell into disrepute and was ended. Although Operation Chokepoint has ended, its legacy is still prevalent. MSB’s still have significant problems getting bank accounts.   Despite this fact, the amount of money moved through remittances continues to grow.  MSB’s continue to serve this market for a huge population of people who are unbanked and underbanked.

·        Underbanked and Unbanked– The number of unbanked and underbanked families continues to grow. Unbanked families are those without a bank account and underbanked families are those that use minimal banking services.  The number of people in these families totaled  approximately 90 million in 2016[1].  Equally as important as the sheer size of the unbanked and underbanked population is the reason that many of these potential customers remain that way. High fees, poor customer service and bad public image have all been contributing factors for the large population of unbanked and underbanked customers.

 

Customer Bases in the Future 

The combination of these forces will greatly impact the future of the business model for community banks. Customers will continue to change their expectations for their financial institutions.  The traditional balance has changed, instead of being forced to choose the products that financial institutions offer, customers have come to demand products from their companies.

The financial needs of customers have also changed. Electronic banking, online account opening, remote deposit capture and iPhone applications are now almost necessities.  Younger customers, who make up a significant number of the unbanked and underbanked population rarely use traditional forms of community banking such as branch visits. Fast information, fast movement of money, low costs transactions and accessibility are most desirable to the potential clients of today’s financial institutions.

Implications for the Small Bank Business Model  

Fintech companies, NBFI’s and the need for new and different services presented by the unbanked and underbanked population will all continue to put pressure on community bankers to begin to make a change. Change may be hard, but it is also inevitable and necessary. For community banks and credit unions now is a good time to consider NBFI’s as viable and important customers. They are a vehicle for consumers to meet their ongoing needs and they need bank accounts.

Fintech companies reason for existing is to fill the unmet needs of unbanked and underbanked.  These companies have developed applications that allow everything from alternate means of credit scoring to international transfer of funds using applications. A community bank or credit union that creates a partnership with the right fintech company can offer products and services that will greatly distinguish them in the market and allow for continued growth and alternate means of income.  2018 is a great time to start thinking about a new business model.

[1] In our most recent survey, published in October 2016, the FDIC reported that 7 percent of households were unbanked, lacking any account relationship at an insured institution. The survey also showed that an additional one-in-five (or 19.9 percent of) households were underbanked, defined as households in which a member had a bank account, but nevertheless turned to alternative financial services providers during the year to address one or more needs for transactional services such as check cashing or credit. Altogether, the survey reported that some 90 million Americans, or nearly 27 percent of households, are unbanked or underbanked.

What’s Hot in BSA

august16blogCompliance with the requirements of the Bank Secrecy Act and Anti Money Laundering (“BSA/AML”) laws will likely always be a “hot topic” when it comes to the ongoing operation of a financial institution. The fact is that our world is filled with people who are willing to do bad things and who must use financial institutions to move the cash that they receive for their activities. Because financial institutions are the nexus point for most criminal activities the role that compliance plays in BSA/AML enforcement will continue to be large and will likely continue to grow.

Developments in technology, continuing world events, expectations of regulators and political events all come together to impact expectations for BSA/AML compliance. The goal of BSA/AML compliance is to detect activity that is suspicious and does not fit with what one might expect from a particular customer. Why would a flower shop in downtown Los Angeles need to wire money to Serbia (or for that matter Miami)? Of course there may be a legitimate reason for this, but the idea is that your financial institution must have a system in place that allows for such a transaction to be flagged and for staff to document the legitimate reason.

With the basic principle of knowing your customer in mind, there have been recent developments that have or will soon change BSA/AML expectations for your institution. Here are a few recent developments that will impact BSA/AML:

Fintech
Financial technology, also known as Fintech, is a line of business based on using software to provide financial services. Financial technology companies are generally startups founded with the purpose of disrupting incumbent financial systems and corporations that rely less on software.
Fintech companies have developed many products that allow customers to have many of the same services and abilities as a bank account. Digital wallets for example, allow customers to receive payroll, reload debit cards, payment bills and purchase gift cards among other things. These platforms also allow customers to send wires, ACH’s or other transfers.

The very nature of fintech relationship are often that the customer and the provider are not in physical contact with one another. The identification process is completed through various means such as texts to telephones, IP address verification and scanned copies of documents. The ability of fintech companies to discern fraud and detect unauthorized use of an account has become increasingly adept.
In response to developments in fintech, the FFIEC BSA manual has been updated to include more information about expectations for electronic banking customers. In addition, FFIEC issued Interagency Guidance to Issuing Banks on Applying Customer Identification Program Requirements to Holders of Prepaid Cards in March 21, 2016. This guidance defines when the opening on a reloadable card account becomes subject to the CIP rules. The guidance recognizes that with fintech, many times accounts are opened without an actual face-to-face meeting. However, the basic concept remains; the account issuer must be able to establish that the person who is trying to open the account is who they say they are. Developments in fintech will continue to push and change the contours of BSA/AML requirements.

Beneficial Ownership
Probably the most talked about impending change in the BSA/AML area are the new rules that cover beneficial ownership. It is our intention to write an entire blog series on these new rules, so we will simply summarize here.

At its core, the beneficial ownership rule requires that when an account is opened for a legal entity, that information must be collected on the persons who either own or control the entity. Both the concepts of “own” and “control” the company are defined in the regulation. The final rule creates a new section in the BSA regulations at 31 C.F.R. § 1010.230 setting forth the beneficial ownership identification requirements for covered financial institutions, as well as a number of exclusions for specific types of customers and accounts. As a result, the beneficial ownership rule is widely being referred to as the “fifth pillar” of the BSA/AML program. The goal of this rule is to allow enforcement agencies such as Fin Cen to be able to track the flow of funds through commonly owned businesses and entities.

This fifth pillar of the BSA/AML program is expected to do more than simply collect information on the beneficial owners of entities. Once the information is collected, the nature of the relationship between the owner and the entity should be considered. The idea here is that the entity should not be a conduit through which an individual can funnel transactions that would otherwise be considered suspicious. The beneficial ownership rule will most definitely add an additional layer of customer due diligence for legal entities.

Geographic Targeting Orders
As the behavior of suspected money launderers continues to change and evolve, so do the tactics employed by the enforcement agencies. One area that Fin Cen has been watching is the practice of money launderers to buy high end real estate for cash. In many cases, the purchases are made through legal entities such as limited liability companies. This is the very type of transaction that made the beneficial ownership rules necessary.

To combat this practice, Fin Cen issues geographically targeted orders (“GTO”) which require title companies to identify all of the individuals involved in shell companies that purchase real estate for all cash. For some time, the GTO’s issued only applied to the Miami and Manhattan areas. In July of 2016, Fin Cen expanded GTO’s to include six metropolitan areas;
• (1) all boroughs of New York City;
• (2) Miami-Dade County and the two counties immediately north (Broward and Palm Beach);
• (3) Los Angeles County, California;
• (4) three counties comprising part of the San Francisco area (San Francisco, San Mateo, and Santa Clara counties);
• (5) San Diego County, California;
• (6) the county that includes San Antonio, Texas (Bexar County)
Although the GTOs apply directly to title companies, the cash purchase of real estate is the type of transaction against which financial institutions must be vigilant.

MSB’s with Agents
Yet another area that will be getting the attention of regulators is the ability of Money Service Businesses (“MSB’s”) to monitor and administrate the agents that they engage. Fin Cen has issued guidance that specifies the BSA/AML standards for MSBs. The guidance focuses on the need to establish standards for monitoring and review and to insist on proper independent testing.

Model Validation
It is not enough to simply test whether or not the data in your BSA/AML software has been properly mapped. You must also determine that the software is doing what the bank needs it to do to monitor suspicious activity.

OCC guidance points out that the use of models in any banking environment must fit within a risk framework. This framework has essentially four elements:
• Business and regulatory alignment – the model must fit the bank’s risk profile and regulatory requirements
• Project management – a proper and appropriate implementation is an ongoing project that is dynamic as the bank’s operation
• Enabling Technology – The use of the technology should facilitate the bank’s ability to meet its regulatory requirements
• Supporting documentation – As a best practice, documentation of the rational for using the model should be maintained.

For BSA/AML, monitoring software, the risk framework means that regulators expect financial institutions to know how its software works as well as the “blind spots” for transactions that may not be completely covered by the way the software operates. The expectations are that your staff will use monitoring software as a tool that is constantly being sharpened and improved. The model validation process is the means to ensure that the software is improving.
BSA and AML programs for financial institutions have to be nimble and flexible as changes in technology, world politics and schemes of people who launder money continue to change.

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