Q2 Holdings, Inc. (QTWO) Earnings Call Transcript & Summary

Good afternoon to the East Coast. Good morning to the West Coast. Good evening to those joining us from Europe and happy middle of the night to those joining us from Asia. My name is Tim Shanahan, Senior Vice President of Customer Success at Q2. Thank you very much for joining today's webinar, the state of Commercial Banking, hosted by Q2. Just a few quick housekeeping items before we jump into the webinar. This session is being recorded and will be sent to all registrants following the webinar.[Operator Instructions] We will try to answer all questions that come in. But if we do not get to yours, we will respond to you via e-mail after the session. If you're not already familiar, Q2 PrecisionLender is the sales and coaching platform that drives profitable growth by delivering actionable intelligence to commercial bankers. It is part of the Q2 Catalyst suite of commercial solutions. Q2 PrecisionLender is used globally by more than 26,000 bankers for more than 150 banks of all sizes to optimize banker performance and deal outcomes for both clients and banks and ultimately, to help banks grow faster and build stronger, more profitable relationships. More information about Q2 Catalyst and PrecisionLender is available at q2.com/commercial. Now it's my distinct pleasure to introduce our speaker, Gita Thollesson. Gita is a manager in Q2's Strategic Advisory services, where she helps clients maximize relationship profitability through actionable market intelligence. She has more than 35 years of experience in the financial services industry, most of which has been in the commercial banking space. Some of you may know Gita not only from PrecisionLender, but also from her 12 years at S&P Global Market Intelligence, where she was Director of Analytics for S&P's commercial loan, middle market and lower middle market information and advisory business. During that time, Gita was charged with growing bank's top line revenue through proprietary fee income, interest income and ROE-enhancing initiatives within the constraints of competitive markets. As both the current colleague as well as a former customer of Gita, I can state with absolute confidence that there is no one that knows the dynamics of middle market loan pricing and renewals better than Gita. Gita, I'd like to turn it over to you.

Okay. Thank you, Tim, and thanks, everyone, for joining today's webinar. It's been quite a first half of the year. to say the least, in terms of all that's happened since our last date of commercial banking webinar. So we wanted to do this midyear update to share some intel around what our proprietary data is saying about how banks are faring in this market. And so what I'd like to do is to share with you some of the metrics based on the 150-plus financial institutions that Tim mentioned as well as pulled together some industry research and other public data from the Fed and FDIC to really paint a picture of where we are. And then we'll also do some live polls to get a read from you folks as to some of the qualitative aspects of what you all are dealing with. But before we do that, I want to just start by just addressing what's happened since we last met in January. And I'm sure all of you on this call are very well aware of the events. This chart is looking at the top 10 banking failures based on asset size. So here, the yellow are some of those failures from the 1980s. We've got the financial crisis here in red, the big Washington Mutual failure, $200 billion during the financial crisis. And then these ones over here on the right in blue are all what's happened since then. And we'll talk in a few minutes about why these failures that happen this spring are really not representative of the industry as a whole. But before we do that, I wanted to get a read from you folks as to how these failures have impacted your strategies this year. And so Tim, I'd like to ask you to walk us through this first live poll.

Yes, absolutely. So the terms of a live poll, have your strategic priorities changed as a result of 2023's banking failures? Yes, significant change in strategic direction since the start of the year; no change in priorities but increased urgency and/or focus; or three, no change in strategies or tactics. Again, heavier strategic priorities changed. Yes, significant change since the start of the year. Maybe no change but increased urgency or focus and no change in strategy or tactics. So we go ahead and launch that poll. If you could please answer that would be wonderful. The single answer that best fits your financial institution would be great. All right. Tania, if we have it available, if you could go ahead and share those results, that would be great. All right. Here we go. So have your strategic parties change because of 2023 bank failures. It looks like 57% saying no change in priorities, but certainly increased urgency and focus. And certainly, that's very much in line with the different financial institutions that we talk to. And then it's a change -- or it's a tie from there, either significant change or no change amongst financial institutions. So thank you very much for responding there. And Gita, I'll turn it back to you.

Thank you so much, Tim. And yes, I think that those responses very much represents what we're hearing in the market. Clearly, the issues that led to the failures that we talked about were brewing for some time. We talked quite a bit with our customers about the need to grow deposits back in the middle of last year. And so it's no surprise that, although the tactics haven't changed and the strategies haven't changed, there's definitely a greater sense of urgency. So with that, let's talk about how we got here. Clearly, as you folks well know, we've been in this situation of constant rate increases. This just happened so much faster than historically we've seen. And so this is a look at the past 30 years of that tightening. And so here, what we're looking at is the cumulative rate increase on the vertical axis versus how long to get there on the horizontal axis. And I'm sure most folks on this call will remember the most recent period effect tightening just prior to the pandemic started in late 2015, ended about late 2018. And over that 3-year period, rates increased by about 2.4%. Some of the earlier periods of tightening were maybe a little bit shorter or a little steeper in terms of the increases, but really nothing compared to what we've just experienced. This chart actually doesn't even reflect yesterday's rate increase of 0.25 point. This is just through early May. And you can see over this period of a little bit more than a year, rates climb by about 5%. You'd to go all the way back to 1982 to find another period where the Fed raised rates by 5%. And so really what's behind that, clearly, we've had this unstoppable inflation and even throughout 2022, as the Fed was raising rates, inflation really didn't see any reprieve. It was really only this year that we started to see those numbers come down, signaling a potential end to this Fed tightening. But now if we look at the impact of those rate increases on the supply-demand picture, we've had a lot of ups and downs over the past couple of years. And so you folks, I'm sure, will remember when we had this massive infusion of capital into the system during the pandemic, we had deposits rising that continued into 2021, a continued climb in deposits, really, a lot of excess liquidity in the market. But as rates started to increase in '22, we started to see deposits start to leave the banking system. And this was really a combination of a couple of things. We had a really significant increase in the cost of borrowing, which meant that your customers would rather tap into their deposit reserves than to go out and seek loan financing. But then the other piece of this is, as rates continue to climb just so, so much, folks were looking for that -- those excess balances to really deliver some yield. And the faster those rates climbed, the faster the deposits left the system. And so really, as early as the middle of last year, a lot of you folks, I know were looking as strategy is to preserve those excess deposits, start to think about raising deposit pricing, but it all transpired just so, so quickly due to both the combination of technological advancements and just expediting money movement as well as the development of social media in transmitting information, those deposits just started to flow out. And it was almost a mirror image of the climb that we saw in the prior period. But now the other impact of these shifts has been what's happened to the balance sheet of the industry as a whole. So this is looking at the asset side of the balance sheet. And the yellow portion of this chart is looking at the securities that banks have on their balance sheets. And then these are primarily treasuries and mortgage-backed securities. So there's not a lot of risk there. But in effect, what happened was when we had this disconnect between supply and demand, all this excess capital really back in '21. A lot of those funds were parked into treasuries, as you saw this portion climb. Well, there was really not a -- no negative impact from a risk perspective. But really, those securities came along with some liquidity risk. And so as a whole, the industry had about half of those securities in held-to-maturity securities so not highly liquid and then the other half available for sale. Now contrast that overall industry metric with where these 3 banks have failed this year stand. And this was as of year-end 2022, it was actually about 3/4 of their securities were held to maturity. So very, very difficult to liquidate those assets when folks were looking to take their deposits out. Can be very costly to do that. Now this is not the only difference that we saw between the banks that didn't survive this year versus the industry as a whole. This chart is looking at securities as a percentage of assets and here as opposed to comparing them to all banks, we just looked at banks with assets over $1 billion. And you can see that the 3 failed banks combined had about 1/3 of their assets in securities only about 20% for the peer group. Now you can also see the difference here in the held-to-maturity securities. So again, much, much higher for the failed banks versus the industry as a whole, again, taking out some of the smaller community players. And then perhaps the bigger difference was just the focus on commercial customers with a comparatively smaller proportion of retail. Deposit accounts over 250, about 90% of the portfolios of the failed banks, only about 58% for the larger commercial banks. And that clearly, that translates into a pretty significant difference here in terms of insured deposits, only about 18% insured. So again, when a press release turns into a viral tweet, you've got a lot of uninsured deposits here. It's really a recipe for disaster in terms of those funds leaving the system that's not representative of the rest of the industry, okay? So how banks reacted to the outflow of deposits. During this period, when liquidity really was abundant, banks were in no big hurry to raise deposit pricing. They had more deposits than they knew what to do with. And so this chart is looking at, first of all, the Fed funds rate, that's this blue line versus the commercial deposit rate. Now these commercial deposit rates are coming from the Q2 PrecisionLender data. This is not the FDIC rates that are published for consumers. This is what you folks are paying in your commercial customers. And so you can see here how in the first half of '22, banks really didn't pay up much at all for their commercial deposit accounts. That started to change later on in the year. Another way of looking at the same thing is now looking at the deposit betas. So here what we're doing is we're looking at different time periods. The blue bars show the aggregate increase in the Fed funds rate and then the orange bars show how much banks increased their pricing on commercial deposit accounts. And so here in the first half of '22, the Fed raised the Fed funds rate by 1.5% and banks only raised commercial deposit pricing by 10 basis points, so really pennies. By the second half, where there was clearly a realization that deposits were starting to leave the system, the Fed raised the fed funds by 2.75% and then banks raised deposit pricing by 70 basis points, so about a 25% deposit beta. And then into early this year, although the increases have been much more modest, the deposit betas have really climbed up to the 65%, 75% range. So clearly, a realization that we need to pay up to maintain these deposit accounts. Now another way of looking at it based on our proprietary data, is in this view, we're here, we're really looking at what you folks are paying your commercial customers based on size. And so here what we've done is we've taken out DDA accounts, so the 0% ECR accounts, we've taken out CDs, and we're just looking at interest-bearing checking and money market. And this is based on the size of the deposit accounts or deposit balances. And so here, you can see that for those largest accounts, banks are now paying close to 4% on those interest-bearing checking and money market accounts. So dramatically higher than where things were even just a few months ago. So let's talk about risk. Last time, we talked about risk in the market. There seemed to be a perception that things were heading south. And so this is a look at the Fed survey. We wanted to see if given all the strong indicators, if there was any change in sentiment. So here are the Fed as senior bankers, where do you stand in terms of credit standards as well as pricing expectations? And if anything, the numbers have continued to trend in the same direction they were last time that banks are at least saying that they're tightening credit standards and they're planning on increasing pricing, and that's across the board, both larger and smaller firms. I'll show you in a second what our actual data suggest. But now looking at actual risk, we've taken a few different views of actual risk. So in this view, we're looking at delinquencies and charge-offs. The blue charts show C&I, the green charts on the bottom show commercial real estate. And the delinquency rates have remained really fairly modest in historical terms, and that's the case for both C&I and CRE. There's been a little bit of an uptick here in terms of charge-offs suggesting that banks are recognizing more of those losses, especially more on the CRE side, but still modest by historical standards. But now these charts really don't tell the full story because we are seeing pockets of stress within the market. And so in this view, we're looking at some Trepp data, where what Trepp did was they took a look at their latest month of data. This was April of '23. That's also the lighter bars and then compare that to the 12-month average by sector. And what their data shows is that the overall commercial real estate market actually saw a little bit of an improvement there in terms of delinquencies. Overall, the segments that were hardest hit during the pandemic, so hospitality, retail have actually improved quite a bit over time. But the flip side of that is that there has been some deterioration here in multifamily and then more so in office. Shouldn't be a big surprise as these long-term leases come due. A lot of folks are reevaluating hybrid work arrangements, and that's leading to some of these delinquencies. Here, we're looking at vacancy rates in the office space industry, and you can see how those have been steadily climbing over time. And so not a big surprise here that there would be some negative impact on the lending space. So let's talk about conservatism on the part of the banks. In this view, we're looking at loan loss provisions quarter-by-quarter. And here again, even though the overall credit metrics have stayed fairly strong, you folks have been raising your loan loss provisions, the first quarter of '23, we saw about the same level that we've seen in the fourth quarter of '22 at about 35 basis points or so but definitely not coming down off of that increase that we started to implement last year. Now another indicator of credit risk is the incidence of downgrades. And so here, we wanted to use our proprietary Q2 PrecisionLender data to measure for performing loans how much deterioration there is occurring. And so I just want to call your attention to these red bars. These are looking at the incidence of downgrades on renewals that happened over these different time periods. The left-hand chart are smaller deals under $5 million. The right-hand chart are deals over $5 million. And really, it was a very, very modest uptick in downgrades. It was nothing really significant here for the smaller deals. And no change whatsoever for the larger deals. And so we're just not seeing the deterioration that folks seem to be expecting. Now that said, we are hearing anecdotally that where there has been some additional downgrade activity has been on office deals. So again, there may be some pockets of stress there that you all are seeing in your portfolios, but for the industry as a whole, still very, very strong metrics. Okay. So let's talk about loan demand. This is a look at the Fed survey where folks were asked what are you anticipating in terms of loan demand, both for C&I as well as CRE. It's very typical as you enter a period of economic weakness to see these numbers head south, and that's exactly what we've seen here quarter-by-quarter, the sentiment, at least is negative towards slower loan demand. Now some folks will tell you that it's not so much the demand side as much as the supply side that there is a greater degree of conservatism out there. And the banks are actually being somewhat more conservative in terms of their willingness to extend credit. But in either case, the numbers are heading south which is essentially showing some expectation of declines in overall volume across the board. Now we quite often like to look at our own proprietary data as well to measure activity in the market. And in this view, what we're looking at is the volume of deals priced on the PrecisionLender platform indexed back to 100 in July of '22. And so these lighter bars here on the right are all the '23 numbers month-by-month. Those numbers are all elevated. But we don't believe that these elevated numbers necessarily reflect a resurgence in volume. This, if anything, seems to reflect the greater degree of diligence that banks are placing in evaluating opportunities. So RMs are being challenged to really dig deep and look carefully at those opportunities, both on new business as well as renewing business to really find the deals we're going to past master. Look at the overall relationship profitability as opposed to necessarily just going out and trying to book more assets. So lots and lots of activity here reflecting that greater degree of scrutiny in today's environment. Okay. So let's talk about pricing. As you folks well know, there is a direct correlation or at least has been historically between NIM and rates. So typically, as rates rise, you see a boost in NIM and then as rates fall, NIM declines. For the first time since the tightening began, we actually did not see a rise in NIM even as rates were increasing. First quarter of '23 was the first time since rates started to rise that, that did not happen. And the reason it didn't happen was because of what we talked about earlier in terms of the aggressive raising of deposit pricing. So then this chart, we're looking at total interest income for the industry as a whole which rose over this period from the end of '22 through the first quarter of '23 by 36 basis points. This right-hand chart is looking at interest expense that rose even a little bit more. And so overall for the industry as a whole, net interest income actually declined by about 5 basis points. And so it really just shows that banks can no longer ride the wave of rate increases to preserve NIM and you really have to be looking at either strengthening pricing and/or looking at a cross-sell to try to boost overall relationship profitability. That will become even more important if and when rates eventually start to decline. So looking at the pricing that banks are charging customers, we heard in the Fed survey at least the expectation that, that margins over cost of funds would be rising. We're not quite seeing that so much in the data, but we are seeing that at a minimum banks are passing along the rate increases to customers. This first chart is looking at spreads over SOFR which have been relatively flat. This goes through April, the last couple of months, as you may see on our blog actually showed elevated pricing rates. And so we believe that people are at least attempting to raise that pricing, prime-based loans have been trending south. There's been some talk whether that could be because folks are chasing quality. But those tend to be the deals to the smaller customers. We've lost about 0.25 point or so over this time period. And then fixed rate pricing actually has improved, not necessarily because of anything that bankers are doing deliberately more a function of the inverted yield curve, but margins over cost of funds have actually strengthened a bit over this time period. But the other sign that banks are starting to at least ask their RMs to get better pricing is when we look at the assumptions that folks are putting into the PrecisionLender platform. So here, we're looking at the term liquidity premium within the cost of funds, and we've looked specifically at just the larger banks. So we took out any bank with assets under $7.5 billion, and looked at those larger regional banks and super regionals. You can see clearly, this upward trend, which is one of the ways that banks are asking their RMs to try to get better pricing.

And Gita, we actually did have a question come in as someone who was registering specifically on these liquidity premiums. Could you clarify if this is happening with all maturities or just a specific tenor or tenors?