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

Hello, everyone, and welcome. Thank you for joining the State of Commercial Banking webinar hosted by Q2. Just a few quick housekeeping notes before we jump into the webinar. This session is being recorded, and we will send out a link to the recording after the webinar, along with a link to download our State of Commercial Banking white paper. We also have a link directly on the screen, if you'd like to download that report now. And if you have any questions, you can ask them in the Q&A button that you'll see on your screen. We will do our best to answer those questions as they come in. But if we don't get to yours, we will follow-up afterwards by e-mail. Now for those of you that are not already familiar, Q2 PrecisionLender is a sales-enablement and coaching platform designed to drive profitable growth by delivering actionable intelligence to bankers. It's used by more than 25,000 RMs globally and is part of the Q2 Catalyst suite of Commercial Solutions. More information is available on our website at q2.com/commercial. So without further ado, let me introduce our speakers. My name is Gita Thollesson. I am the Manager in our Strategic Advisory Services business. I'm joined by 2 of my Q2 colleagues today, Anna-Fay Lehn, who is the Senior Strategic Business Adviser; and Debbie Smart, a Senior Product Marketer. All of our bios can be found in the speaker bio section on your screen. So before we jump into the content today, I'd like to just put up the survey results. You all were asked this question as you registered for this webinar, so you may recall answering this question. And the question was, what is top of mind entering 2024? And this was meant to be both a reflection of your key strategic objectives as well as perhaps the challenges that you're facing. And you can see here in the responses that #1 by leaps and balance was deposit growth and retention. Not a big surprise given where we are in the current environment. The second highest priority was revenue or relationship expansion and cross-selling, which has certainly become very, very important in today's environment given the high cost of funding. And so we'll talk about that as well. Back-office efficiency came in third. We're really going to cover off on all of these topics as we go through today's webinar, including talking about things like risk and pricing and so on. Okay. So a few key takeaways before we jump into the details. The first, as you just saw in that survey, liquidity management has taken center stage. And when we talk about liquidity management, it's not just about deposit growth or deposit retention anymore. It's really evolved into a matter of how do you deploy scarce capital? How do you really optimize capital deployment. And we are seeing financial institutions really work with both sides of the balance sheet to accomplish that. To the second point, we're seeing pressure on capital, not only from the outflow of deposits, but also from pending regulatory changes. So we're now in a position where Basel III end game is on the horizon. It's still in the proposal phase. We don't yet know what the final version of that will look like. But the expectations industry-wide is it should have an impact on capital. We'll measure that for you, quantify exactly how much of an increase we're anticipating. To the third point, even though the Fed has paused on rate hikes, rates still are elevated compared to historic norms. And those elevated rates are driving repricing risk on maturing deals. And we'll measure for you exactly how much repricing risk or repricing shock we're seeing in our data on fixed rate deals that are coming due in the coming years. Next, on the digital side, we're seeing a renewed focus on automation and ERP integration that's starting to move down market. And so this is no longer just a must-have for larger customers, it's now actually moving into the middle market space. We're seeing technology, including AI, helping to bridge the talent gap at financial institutions. As newer RMs are coming on board, that's been a key differentiator to try to bridge that talent gap. And then finally, we're seeing opportunities to drive growth, and that's growth in terms of both deposits as well as other fee-based business from small businesses. So we'll show you exactly where we're seeing that growth. Okay. So a few quick points on methodology. Most of the data that we're presenting today stems from the PrecisionLender proprietary database that covers commercial relationships. So it's credit, it's deposits, it's other fee-based business, and we're focusing in on 2023 for the most part. The PrecisionLender data stems from more than 160 financial institutions across the U.S. Those are geographically diverse institutions really spend coast-to-coast and range in size from the smallest community banks up to top 10 U.S. institutions. You'll also see that we've supplemented that data with some other public data, Fed-FDIC as well as some published industry research. So I'd like to maybe start by talking about just the context of how we got to where we are. So I want to sort of take a 10,000-foot view at the overall economy and talk about what sort of led to the liquidity crisis that we're facing today. This chart is a look at the GDP forecast for 2023 and how those forecasts had evolved over time. So if you all think back to where we were at the beginning of last year, the first Fed meeting at March of '23, there was the expectation for GDP to only hit 0.4%. Now as the year evolved with each quarterly meeting, those estimates became more and more optimistic. But that optimism was really a double-edged sword because with the improving economic outlook that kept inflation high, at least higher than the Fed targets, and that kept the Fed tightening going for a lot longer than folks had anticipated as of the beginning of last year. So really right through July of last year, we were seeing these consistent increases in the Fed funds rate. And those rising interest rates kept the deposits flowing out of the system, which ultimately led to the couple of bank failures that we saw in the spring of last year and really elevated liquidity to the top of the priority list as you saw just a moment ago in that survey. So let's talk about liquidity management and what we're seeing in the data. So I'd like to start by sharing with you a survey that we conducted recently of just senior bank executives where we asked the question, how are you managing your loan-to-deposit ratios and optimizing capital deployment. And so really, the question was, is it just about trying to preserve these excess deposits, the interest-bearing deposits? Is it about trying to grow core deposits, so the primary operating count, the low or no-cost deposits. Or are you looking at the other side of the balance sheet, the asset side of the balance sheet in terms of being more conservative in extending credit. You'll see the results here, really tied for #1 was attracting or retaining the excess deposits as well as being more conservative with regard to extending credit. Now interestingly enough in terms of the core operating accounts, what we're seeing in the data is that some of those funds are also flowing out into the interest-bearing deposits. We heard from one of our clients and executive Head of Treasury Management at a large regional bank recently that there has been this outflow and part of the impetus for that outflow is that treasury management fees are perhaps not as high as they need to be to offset the amount of earnings credit that the customers are being given. So in other words, if your fees are too low, then you end up with a lot of excess ECR and no real incentive to keep those funds in the primary operating account. So and in fact, customers would rather move those funds into interest-bearing accounts, earn a higher interest on those accounts and then just pay for the treasury fees out of pocket. So that's been one of the key challenges that the industry has faced. So let's talk about how the industry has gone about this effort to attract or retain those interest-bearing accounts. I'm going to start by just looking at the overall picture of rates. What we've seen in terms of both the Fed funds increases as well as deposit pricing on commercial accounts. This data is all based on the Q2 PrecisionLender information. You can see that blue line is the Fed funds curve, which really flattened out as of the last increase in July of last year. And then this orange dotted line shows the rise in commercial deposit pricing, so just commercial accounts, not consumer. Now you can see how that curve has steepened over time, started out very flat during that period of excess liquidity and then very quickly started to rise, including even after the Fed pause on its rate hikes, we continue to see that climb. Now another way of looking at the same data is in this view, where we're looking at these semiannual periods and we're looking at the aggregate increase in the Fed funds rate versus the aggregate increase in the commercial deposit rates. So the blue bars or Fed funds, the orange bars are commercial deposit rate increases. And then those red squares show the deposit beta. And as you can see there how the deposit betas have been steadily increasing by the end of the first half, so really right on the heels of these large bank failures. For the first time, commercial deposit betas actually crossed the 100% threshold. So dramatic increase and really a renewed sense of urgency in holding on to those deposits given what happened in the spring of last year. By the second half of '23. So remember, the Fed only had that one rate hike in July of 0.25 point, and yet, you can see that commercial deposit rates continued to climb, reaching a deposit beta of about 250%. So you can really see the urgency for the industry as a whole in maintaining those accounts. Now even this doesn't tell the whole story because this is a look at the aggregate increases in deposit pricing. What we see in our data is when we look at deposit rates based on the size of the deposit account, the larger the deposit account, the more the industry is paying for those deposits. This is a look at deposit rates on accounts, excluding the primary operating accounts. We've taken out the 0 deposit accounts here and looking at the average rate paid as of the end of the year. So you can see how, for those larger, more impactful accounts, the rates have just skyrocketed. Now let's contrast that with where we were as of midyear. This is a look at the same view, but now these lighter bars show the June 2023 figures for the same size deposit accounts. Now remember, there was only that one increase of 0.25 point over this time period. And yet, you can see that for those larger accounts, the increase in deposit pricing was really materially higher than 25 basis points. Those largest accounts, a good 80 basis points in rate increases over this time period. But higher rates are only one of several tactics that we see in the data in terms of measures that financial institutions are taking to grow or retain deposits. So to share with you some of the other tactics that we're seeing, I'd like to pass the baton to Anna-Fay to talk about some of the other tactics we're seeing in our data. Anna-Fay?

So a second tactic we've seen in play on deposit strategy is the speed with which these rate increases are being adopted. Here you have groups of financial institutions that were able to expand their deposit balances during this time period, and they also adopted a high beta strategy, a contraction group of financial institutions also with a high beta strategy. It was executed differently and their outcome was different. So the financial institutions, the expansion group led the charge with rate increases in terms of speed and magnitude and front ran reaching their new run rate of deposit costs sooner than the contraction group, which lagged and followed and did not move with as much magnitude, both were high beta strategies. So the FIs that utilized the high betas and did so sooner were more agile with rates, had greater success with growing deposits compared to the banks who waited to adopt their rate increases. Another tactic that we've seen, the third element in deposit strategy is the proactive management of the funds transfer credit rate. This is the measure of value that the institution puts on deposits, and it is the leadership's way of signaling deposit value to the organization, including commercial relationship managers who are driving that deposit behavior. The FTP credit rate captures that value. And overall, you've seen that PrecisionLender clients have increased at nearly doubling since July of 2022. This message reinforces 2 things that Gita cited; the appetite for new deposits as well as the appetite for retaining deposits that has value as well, even in the face of rising deposit costs. Looking at it from that higher value proposition that we just mentioned, let's take a look from the RMs vantage point. So this is looking at the comparison value of deposits versus loans over the same time period. We saw on the prior slide and we see still that the financial institutions are putting a higher value on deposits as compared to loans. Loans have remained flat at about 240 basis points, while the deposit value is now in excess of 300 basis points at this -- as we leave 2023. So again, this is management sending a message to the RMs to go after both new and retained deposits during this period of Fed rate hikes and scarce liquidity. This particular picture is the overall industry. So we're going to transition to those 2 groups of FIs we spoke about a moment ago, the expansion and contraction groups. With respect to the proactive management of the funds transfer credit rate, the expansion group has a key distinction from the contraction group. It is the level and the convergence of the valuation for both interest-bearing deposits and noninterest-bearing deposits has reached a very similar result, management's message is that both these deposits are immensely valuable to the organization. Meanwhile, the contraction group continued to place a premium of value on that core operating account Gita mentioned, with those dynamics compared to the interest-bearing account. As a result, this is possibly out of sync with deposit customer account goals in terms of those excess funds. It's messaging around deposit value is less clear than the expansion group messaging. Gita, back to you.

Okay. Thank you so much for that, Anna-Fay. So, so far, we've talked about 3 key tactics to winning deposits that we're able to observe from the data, raising deposit beta, so paying up for those deposits. Anna-Fay talked about the timing of those rate adjustments, of the agility in raising deposit rates and then proactive management of FTP credit to send a very powerful message to RMs as to the value that your institution places on those deposit accounts. In addition to those 3 tactics, we've gleaned some additional insights from discussions that we've had with our clients. And so I'd like to share a few of those tactics here as well. So the first being agility in communicating changing strategies and tactics to RMs. So if we think about just how quickly the market turned from being in this period of excess liquidity, where banks and other financial institutions were just sitting on so much excess capital, didn't know what to do with it to them being in a position of being liquidity-constrained. Being agile and being able to deliver those messages to RMs and really coaching bankers in the moment has been a differentiator. Second, using technology to identify where specific customers may be rate shopping and then being proactive in reaching out to those specific clients to really try to ensure that you can preserve those deposit accounts. The third increased accountability. So we know that many of you have already baked into your loan agreements covenants to ensure the capture of these deposit balances. But the challenge for the industry overall has been in monitoring compliance with those covenants. So really holding your customers accountable to make sure they're delivering on what they promised. Next, leveraging the spreading system to identify deposit accounts that your clients may have with other financial institutions. And so you're doing this analysis anyway as part of your credit review. A lot of times, these systems just don't talk to each other. And so you folks have insights or had visibility into the deposit accounts your clients may have with other institutions. The opportunity here is to leverage that data and to use that really as a calling plan to see what you can bring over. Next, good old-fashioned calling efforts. We've heard about some institutions that have set quotas for RMs and said, make 5 calls a day or 8 calls a day to really make sure that those deposits are solid. And then finally, RM incentives can be very powerful drivers of behavior so can really get you what it is that you're looking for. Now those are key tactics to win deposits. But I did mention at the outset that managing liquidity is not just about growing deposits, it's also about looking at the asset side of the balance sheet. So here's a look at the overall commercial banking market based on Fed data, looking at what's happened to deposit balances over time versus what's happened to loan volume. And so you can see here on the left-hand side, deposits have started to flow out of the system really since the beginning or I'd say maybe the middle of '22 is when we started to see that very slow bleeding that then accelerated. And by the spring of '23, really at that time that we started to see a few fairly sizable banks go under, you can see just that deposit balances just fell off a cliff. Now since that time, with the renewed sense of urgency that we've seen for the industry as a whole, deposits have stabilized, but they really haven't grown since then. So despite all of the best efforts, the best case scenario here is just treading water in effect. So as a result of that, institutions have had to look to the other side of the balance sheet and really try to be more judicious with regard to capital deployment. So you see that here on the right-hand side, when we look at C&I loan volume, and you can see how loan volume has been trending lower, really since the beginning of last year. Okay. So a lot of conservatism there on the supply side. So when you look at overall loan volume, you can't really tell from this how much of this is supply driven versus how much of it is demand driven. So let's unpack that a little bit. This chart is looking at the Fed survey of senior loan officers where bankers were asked, what are you anticipating in terms of loan demand, so specifically on the demand side. The left-hand chart is looking at C&I. The right-hand chart is looking at CRE. All of the bars that are south of that horizontal line show declines or expectations for declines in loan demand. You can see here how the right-hand chart, the CRE picture is much more negative than the C&I picture. And on a relative basis, you can see a little bit of an improvement in the C&I numbers, at least for the larger companies, still down, still negative but less negative than what they've been in the past. But those are really just opinions. Let's now look at some actual data. So here, a better indicator of loan demand is really looking at utilization rates on existing credit lines. And this is a pure indicator of loan demand because it takes originations out of the equation. It's just looking at existing lines of credit and looking at how customers have been utilizing those funds. So in this view, what we see is that at the beginning of this period, really late '22, when Fed tightening first started, there was a fairly sharp drop-off in utilization rates and not too surprising given how expensive the bank loan market had become at that point, started to show some signs of stability until right on the heels of those couple of large bank failures in the spring, we saw another dip. And since that time, it started to recover a little bit, but certainly no dramatic increase in loan demand. So best case, it's been relatively stable over the last several months, not necessarily improving. But now let's turn to our data on originations and pricing activity to look at the overall market for volume. And for that, I'd like to turn it back over to Anna-Fay.

Thank you. So this is a picture of new loan activity. Gita just showed us about the existing use of credit. This is a picture of new loan volume as measured by banker activity for pricing purposes. So we indexed that back to January of 2023. And most of 2023 was a very consistent year in terms of volume, and we saw a significant reduction in activity beginning in September of 2023 and through the end of the year. So we view this as a leading indicator on where the market is going. It certainly reinforces Gita's remark on declining loan demand. And anecdotally, we've heard from many of our bankers that new loan volume is adequate to meet the loan production goals and sustainable organic deposit funding. So all of this works in a picture to give us a picture of the next few months being lower loan originations.

Okay. Thank you for that, Anna-Fay. And I mentioned at the outset here that the challenges from a capital perspective are really not just about the deposit outflows or the challenges in raising deposits, but they're also stemming from the regulatory changes that the industry is facing. So I'd like to talk a little bit about what we're seeing around the Basel III reforms. Right now, there's just a tremendous amount of uncertainty as to what form those regulations will ultimately take. So let's look at some detail here. Here, we're looking at a time line of the Basel accords, dating back to the first accord in 1988. And then we've had a few different iterations of the Basel accords over time. And it was really at the end of 2017 that the Basel Committee came out with the Basel III finalized guidelines. 2 years later, the standards for market risk capital came out in 2019. But for a number of reasons, not the least of which was a global pandemic, there were delays. And so it was really only in 2023 that we started to see some level of adoption of those Basel III reforms. Canada and Australia, a few other countries adopted Basel III finalized outright in 2023, the U.S. did not. And so really, it was after the spring 2023 crisis, those bank failures in the spring that the U.S. regulators came out with their proposed version of Basel III finalized or what a lot of folks are calling Basel III end game. And that was in the summer of last year. And those regulations or that proposal rather really was a substantial deviation from the Basel Committee's recommendations. There were some significant changes, including the complete elimination of the advanced internal ratings-based approach to measuring RWA, risk-weighted assets and which really had a disproportionate impact or stands to have a disproportionate impact on the larger institutions, the G-SIBs. Not surprising that those proposed regulations have met with a tremendous amount of pushback from industry leaders. There is the expectation that the U.S. will adopt some version of those regulations by 2025, but still the final form is yet to be determined. You folks have all seen the headlines out there about just how much additional capital is anticipated if those proposed regulations were to be implemented, some estimates in the 16% range, some in the 25% range, it's all over the map, but the expectation is that there will be an increase. Now we've done some analysis of our own base on our data. We've looked at about $110 billion worth of commercial loans. And we've estimated, just based on the credit risk component of the capital increases, not including operational risk or market risk, somewhere in the neighborhood of a 10% to 13% increase in RWA and corresponding increase in capital requirements. If you layer in operational risk and market risk, you can definitely see how you could be north of 20% at the end of the day. So let's look a little bit more specifically at where those increases are anticipated. What we've done here is in this chart, we've looked at 2 different groups of financial institutions. The top charts are looking at primarily the G-SIBs, so institutions that are currently using internal models or the AIRB approach to measuring risk. And then the bottom chart looks at institutions that are still impacted by Basel III finalized, but that -- in other words, over $100 billion in assets, but that are coming from a starting point of using standardized capital. And what we're looking at in the chart is, in effect, the before versus after view of ROE. So in other words, as capital increases, you see this corresponding drop in ROE based on what's currently been proposed. 2 different scenarios here. We look to add a plain vanilla commercial real estate deal with loan-to-value in the 60% range versus an investment-grade BBB rated deal. Now you can see here is that for the G-SIBs, if the proposed regulations were implemented as is, there would be a substantial increase in capital leading to a considerable decline in ROE, and that would be for the bilateral deal. For the BBB rated deal, still a decrease, but maybe not as dramatic. Now on the other hand, for the smaller institutions that are currently using standardized capital, there could potentially actually be an increase in ROE. So in other words, a decrease in capital. And the reason for that is because of new concepts that are being introduced in the current regulations around things like loan-to-value and external ratings. But even if those institutions do get a little bit of a benefit on the credit risk side, they still do face higher capital for operational risk and market risk. So the expectation is still that there will be higher capital required for really all banks over $100 billion. So how is the market dealing with these proposals? We really don't see a standard across the industry in terms of the way of addressing these increases. We really see a couple of different approaches. So there are some institutions that we work with that are talking about just implementing the regulations as prescribed. That could be quite dangerous because of the disconnect between the proposed regulations and market realities. Then there's a second group that's considering this is just a top of the house reporting requirement. Those that are using the AIRB approach today, some are thinking about just maintaining that for pricing purposes. Others are looking at this as an opportunity to build new bespoke models that will ultimately sum to the same capital that will be required, but still maintain the risk sensitivity and possibly even vary their assumptions by LOB. So lots of different approaches out there. And jury is still out on how much capital will be and how institutions will address it. So we've talked about the capital component here. We've talked about the cost piece. Let's now look at the revenue side. And I'd like to look at the overall pricing trends in the market, really asked the question, has revenue kept up with these rising costs and the rising cost of capital that's out there. And so to talk about pricing trends, I'm going to start by looking at the Fed survey and then we'll drill into what our proprietary data is staying about pricing. But this chart is looking at the Fed survey. And really, there are 2 questions that are addressed here. One is what are you doing around credit standards? Are you tightening or loosening, you can see that the bars for the last several quarters have all been in the tightening camp. And then the second question was around pricing. So what are you anticipating in terms of loan pricing? And again, north of the horizontal axis is increasing margins. And so you can see that really both sides of this picture are telling the story of continuous conservatism and higher pricing, perhaps less so in the fourth quarter survey than what we had seen in the third quarter results, but still folks are at least saying that they are expecting to raise pricing and tighten up on credit. So that's the expectation. Now let's look at our own proprietary data, and we'll show you what folks are actually doing. Anna-Fay?

Thank you. So this is a picture. This chart captures the very unusual market environment that commercial bankers faced in 2023 and moving into 2024. And with just 2 lines on a chart, we kind of get the basics of pricing. The SOFR index, the SOFR rate has increased, as Gita told us through the Fed rate hikes, up 100 basis points on the year. This is a kind of instrument that would be focused on a floating rate deal tied to SOFR, for example. On the other hand, we have fixed rate structures that are often tied to points on the curve medium term, that chosen a 5-year treasury in this case. And we can see that the force of the Fed rate hikes during 2023 has created an unpredictable and persistent yield curve inversion that's affecting the 5-year treasury rate. In fact, the direction of these 2 lines has moved in opposite ways during the course of 2023. The -- these are new conditions for many commercial bankers in their pricing managers and has affected the economics of loan pricing. We've been told by bankers and price directors that there are challenges in originating new loans at prices that make sense for the institution, again, caused by this very persistent and unpredictable conversion on the fixed rate side in big regard. Let's see how they've taken matters to make things clearer. Here, we have dug into the fixed rate costs of originating a loan. And we've decomposed it into the 3 categories of expected funding. The base reference rate, which is shown as the Federal Home Loan Bank, 60-month rate, the fixed base cost, which is typically a function of that Federal Home Loan Bank rate and then an incremental liquidity costs summing up to a total expected funding cost for fixed rate loans. What we noticed is the historical benchmark relationship between the green line and the blue line, that being the FHLB reference and the fixed rate funding cost has shown a divergence here in the late 2023 period where bank management has reasons that the Federal Home Loan Bank reference is no longer appropriate for their funding reference for fixed rate loans. Here's a 30 basis points of extra cost for the bankers. In addition, the liquidity costs have increased during this period. So at the end of the day, the bankers are in a position of having funding costs for fixed rate loans, 70 basis points higher than they were at the end, beginning of the year, and yet the Federal Home Loan Bank reference rate is largely unchanged. Another piece of headwinds on the cost side of the equation for bankers is the increase in liquidity premiums. In response to the liquidity scare in March, PrecisionLender clients move quickly upward with their liquidity costs and pricing from about a 30-basis point base in early 2023 to a 50-basis point run rate towards the back half of the year. Bankers are tasked with covering these additional expenses through negotiating loan terms as well as relationship pricing techniques. So let's recap from the banker standpoint, what is -- what comprises the headwinds for 2023. It's 100 basis points in the raw rate have to pass on to borrowers plus an increase in the base rate curve of, in our example, 30 basis points and another 20 basis points in liquidity premiums, plus a directive to increased liquidity through deposit retention and growth. How are bankers fared with this landscape? On the revenue side, we looked at the spreads to the relevant indices for the loans that are being priced. Here, the SOFR and Prime and fixed rate, all were able to maintain their spreads. This is an indication that they were successful in recovering the 100 basis points of market rate increases. Next, the SOFR lenders, the SOFR structures peaked out a little bit more, gaining about 15 basis points on the year in their spreads to the index, partially offsetting some of that increased liquidity costs. Prime and fixed rate structures were less successful in making any headway against additional costs other than just the base 100 basis points. So Gita, I'll pass it back to you.

Okay. Thank you, Anna-Fay. And so clearly, with the revenue side of the equation showing only minimal increases and the cost side rising significantly as we saw earlier. Let's take a look at what's happened to NIM for the industry. So this is a look at NIM for the overall commercial banking industry over the past several years. That's the blue bars that you see here. In the past, historically, NIM has moved in lockstep with rates. So as rates increase, NIM increase, and it's really because financial institutions really never passed along the full Fed rate hike over to customers. So your beta was always less than 100%. And therefore, there's always a little bit of a funding boost. That's no longer the case. So you can see here that the last several quarters, even as we've been in this period of Fed tightening, NIM has actually been under pressure. NIM has been flat to declining over the past several quarters. And so what does that mean in terms of overall profitability? Well, it really means that on a credit-only basis, your ROE numbers are really not going to be adequate. This is a look at the proprietary PrecisionLender data. And here, we're looking at risk-adjusted return on equity based on the depth of the relationship. So this lighter bar is credit only, then we're looking at credit plus deposits and then deeper relationships that include some cross-sell include treasury management with or without credit. And so you can see, I mean clearly, the credit-only accounts are producing far lower returns. And even when you layer in deposits, if you don't have other fee-based business, you're not getting that much of a boost from those deposits. So really, the name of the game is getting the core operating account and then the accompanying treasury management business that goes along with it in order to get to those higher levels of return. And as I mentioned earlier, a lot of you folks have the covenants in your loan agreements but have faced some challenges in terms of just measuring compliance. And so cracking that nut is really the key to getting that all-important treasury management business. So we've talked about the credit component, the revenue, the cost, the capital. Let's now look at the risk piece of this, which is obviously a very important component to looking at relationship profitability. So I want to start by looking at the overall industry and then we'll drill into what our proprietary data is saying. This is a look at Fed data, looking at overall delinquencies and charge-offs for the industry as a whole. And you can see that here are the top charts for C&I. The bottom charts are CRE. And it's really the commercial real estate market is the one that's been facing these headwinds. So we've seen rising delinquency rates, a big spike in charge-offs as well. But clearly, by the time you get into the status of being delinquent, the problems have been growing for some time. So we wanted to look at what our data is saying on performing loans about risk migration. So here, we're looking at downgrade incidents. Again, C&I on top, CRE on the bottom. And what you can see there on the bottom, there's been a pronounced increase in the incidence of downgrades, really across the size spectrum on the commercial real estate deals. Here's a survey that we conducted recently of bank executives where we asked where specifically are you seeing or expecting credit stress. Not a big surprise that 100% of the executives said the office space sector. Perhaps more surprising that the incidence was so high even in other segments within the commercial real estate market. So if you think about the increase in hybrid work arrangements, you've got less commuter foot traffic that will have a negative impact on retail and other sectors as well. And you see that definitely here in the data. Positive news on the C&I side, not so much stress, not even pockets of stress being reported at this point. But clearly, the commercial real estate market is facing these headwinds, and these headwinds are being exacerbated, if anything, by repricing shock or repricing risk, given how elevated rates have been relative to when these deals were first put on the book. So to quantify that, I'd like to ask Anna-Fay to walk through that analysis. Anna-Fay?

Thank you. So along those lines, we examined the fixed rate portfolios and their roll off over the next few years. And much of that C&I -- CRE portfolio that Gita just referred to would be inside this fixed rate bundle of loans. So what we have here is the expected outstanding balances rolling off is fairly even over the next few years here, but the rate shock, the rate risk reset is not. We see that the current situation is that rates are between 5.25 and 5.80 on these books of business maturing over the next several years. And the right-hand side of the bar is telling us an implied rate reset risk for those loans. It ranges about 220 basis points overall. The rate reset gap is a moving target. It's a moving number, and it's influenced by the current fixed rate loan yield, which for fourth quarter 2023 production was about 7%. And this, in turn, may be affected by the degree of the yield curve inversion. So if or as interest rates fall in the coming months, this rate reset risk could, in fact, narrow and certainly would change. And I'll pass it back to you, Gita.

Okay. Great. So just as a way of a recap, we're in a situation now where we have elevated funding costs, at least until if and when the Fed reverses course. We've got potentially higher capital from regulatory changes, a plateau on the revenue side with stable pricing and pockets of risk in the commercial real estate market. So lots of challenges ahead, not to mention what Anna-Fay just talked about in terms of this interest rate shock. So we're going to shift gears now and talk about some of the challenges and opportunities on the digital side. And for that, I would like to pass it over to Debbie.

Thanks so much, Gita. So what I'd like to do is start out talking with trends around the importance to your commercial customers of back-office efficiency and automation as well as payments modernization, and we'll start with efficiency and automation. The importance of integration between digital banking and their ERP or accounting systems has increased significantly for commercial customers. And as Gita mentioned at the beginning of our presentation, this is no longer the realm of just large corporate customers. It's moving down market to midsized businesses. DataInsights highlighted this trend in October of 2023, sharing research that showed 90% of midsized and large businesses say it's important or very important to run their banking operations from their ERP system. The reason it's so vitally important to them is that they live and breathe in their ERP systems every day. And as they try to improve efficiency, they don't want to have to log into digital banking to manually load payment files or download transaction information that's critical for managing cash positions. And the problem just gets worse for customers that are larger, that have multiple banking relationships. Now interestingly, many financial institutions are now getting requests from even lower middle market and larger small business customers for this type of service. So it is moving down market and it's becoming table stakes. In fact, we've heard from several banks that they're starting to hear from their customers that if this isn't at least on the bank's road map, that the customer will consider switching FIs. So prioritizing this service in 2024 is pretty important and will definitely provide a competitive edge over those who don't. So now I want to talk about another area of importance, at least for large businesses, which is payments modernization and specifically, real-time or instant payments. A survey conducted by AFP in 2023 shows that 98% of companies over $1 billion in annual sales, so larger companies for sure, plan to adopt real time for sending payments within the next 5 years and benefits they cite are payments efficiency, improved cash flow among others. Now when looking at the data here, the current use and time frames, this survey includes Fedwire, which skews the numbers some. But in other areas of the study, they look at current use by industry, and there are a lot of industries that are covered. So we didn't pull all that in. But just to give you some clarity there, in those industry-specific survey questions, they separate between wires and instant payments. And while it varies by industry, on average, 15% of the 37% shown here is specific to instant payments. They're being used today for B2B payments, B2C payments. One of the strong use cases on the B2C side is same-day payroll. Now on the B2B side, one of the biggest drivers for interest in the use of instant payments is really to reduce the number of those payments that are made by check, which is still high, 33%, right? We just have not been able to solve this problem with other rails. Although adoption of instant payments has been slower than expected, it's important to remember that it takes time for a true understanding of the benefits to reach the masses. The RTP network is only slightly over 6 years old now and FedNow just launched last year. So the ACH network, which is now over 50 years old and was previous to instant payments, the most recent payment rail launched in the U.S. took decades to reach ubiquity. With the rapid pace of change that we're experiencing in the industry and our lives today, the instant payment rails won't take nearly that long. Now right now, just to give you some specifics on participants, there are only about 500 financial institutions enabled on the RTP network and approximately 400 on the Fed -- actually it's 430 on the FedNow network. And most of these are only receiving transactions not sending. But even with this low level of adoption, there were 74 million transactions on the RTP network during the fourth quarter of 2023, and that's been growing pretty consistently at about 15% per quarter. And the RTP network now reaches about 70% of all DDA accounts in the U.S. Now in order to increase adoption, it's on all of us to help educate customers and help them understand the unique capabilities of instant payments that just aren't available on other payment rails. Things that can help drive efficiency and automation and payments. These capabilities include things like the rich messaging. So for example, the request for pay message allows a supplier to send a request for payment that includes invoice details or a link to the image of the invoice to a payer. And so the payer knows exactly what they're being billed for. And then if they have questions, they can send a request for information back across the network. The beauty of this is that the invoice details now stay coupled with the messages and ultimately, the payment throughout the workflow is kind of like a conversational payment. Now once the payer is ready to pay, they can choose to pay it immediately or they can schedule a payment. And this is a critical piece that not all businesses understand and for that matter are not all bankers, right? The term real time or instant payments leads some to think that the payment always happens immediately, which would definitely be a deterrent from a cash flow management perspective. But the truth of the matter is that these payments can be timed with better precision than on any other rail. Like literally, I can schedule a payment to happen as late as 11:55 p.m. on the day I want it to go out, you just can't get that level of precision with any other rail. And remember, the holy grail of instant payments, especially for commercial customers is the data, not necessarily the immediacy of the payment. Now a couple of other things to note relative to instant payments, what is starting to happen on the consumer side is that as they learn about instant payments and the fact that they may not be able to receive them through their financial institution, they're starting to consider changing institutions. I'll give you an example of something we're seeing in the same-day payroll space. If I'm a Grubhub driver in the Grubhub app, it will say to me, would you like to receive your pay instantly, oh, but your bank doesn't support it, click here for a list of banks that do. So consumers are starting to become educated on the fact that they can get this stuff instantly as long as their bank can do it. And what we've seen overall with digital banking evolution over the years is we see demands on the consumer side first that start making their way over to the commercial side. One other thing that's important to recognize is that another aspect of the instant payment rails. The message structure is really well suited to aid in the march towards better efficiency and automation. So as ERP systems begin to support instant payments, the rich messaging that allows the data to stay coupled with the payment along with the integration between banking and accounting systems on the ERP side is just going to further improve efficiency and automation and true straight-through processing. These are things that corporate customers have dreamed of for decades. So going into 2024, it's important for FIs to understand what their strategy is going forward. We're not only offering real-time payments, but to help with customer and industry education and then to keep that bigger picture in mind related to improving overall efficiency and automation. Okay. Now let's look at another trend that's happening relative to talent and challenges that FIs are experiencing in that space. We are hearing from financial institutions that they're really challenged when seeking talent for both treasury management sales and relationship managers. And it's not just finding the talent. So for many years, it was not uncommon for financial institutions to look for seasoned treasury professionals on the -- excuse me, seasoned treasury management sales professionals from within the industry, along with relationship managers. However, as technology has become more sophisticated, it's now really important, especially on the treasury management sales side of the house that calling officers understand it. So many financial institutions are choosing to hire people with strong expertise and technology and then teaching them the banking side of the house. Some are choosing to add solutions consultants, so a more technical assist role to help the calling officers. And for those going this route, we've heard from some that they expect to see these 2 roles merge back together in time. But there are experienced gaps on both sides of the equation. The seasoned treasury professionals don't necessarily understand the technology and the solutions consultants and the less experienced calling officers don't understand all the house and is of treasury management and AI can help play a role in this. So when we look at the overall impact of AI, a large majority of financial institutions are looking to boost their investment, and that makes sense. When we look at the focus of AI in 2023, there are areas of -- the 3 biggest areas of importance were fraud reduction, customer service, and helping to reduce credit risk. What we're hearing from financial institutions is that while these areas will remain strong going into 2024, another area of investment is going to be in the realm of using AI to help bridge that experience gap with AI-assisted coaching and training. Tools are emerging such as AI copilots that can help provide just-in-time coaching to supplement employee knowledge. An example would be helping an inexperienced sales officer, understand and explain the benefit of a product offering that will solve a specific problem for a customer, such as how positive pay can help with reducing check fraud. Okay. The last area I want to touch on is in the realm of small business, and particularly the importance of this market as an additional source of both deposit growth and noninterest income. When looking at these individually, what these customers bring from -- to an FI from a deposit perspective, isn't nearly as large as what large corporate customers can bring in, but they can be a very strong source of deposits. And if you're the primary FI and get their operating account, you can have reliable deposits and a loyal customer. The more products they use from you, the stickier the relationship will be. So let's look at this Javelin research, which shows some interesting dynamics within small business banking. The top 4 have 55% of the primary banking relationships, although it is worth noting that customer satisfaction is slightly higher for regional and community banks. And then if you look at the far right, the likelihood of small businesses to switch banks is much higher with the big 4, 38% in fact. Now regardless of bank size, there's definitely an opportunity to enhance the focus on the unique needs of small businesses to help potentially increase deposit growth and fee income. One of the challenges in the small business market for any financial institutions is the Goldilocks problem, where we put them on the retail product because that's all we have, and it doesn't necessarily meet their needs, especially if they need entitlements. So as an example, a bookkeeper that needs to access information, but not create transactions. And then conversely, if that same business now wants to do direct deposit payroll, they're put on a complex cash management system. And so hence, the Goldilocks problem, one is too small, one is too big. So thinking about how you rightsized your offerings for small businesses can be really important, bringing them the services that they need and want that are easy to use and tailored in a way that makes sense to them. Another really important factor with SMBs is looking at products and services that they currently get from fintech's. What's really interesting about this information is not only these are services that they go to fintech's to get. But astonishingly, 81% of small businesses would actually prefer to get this information from their financial institution. So partnering with fintech's to bring services to small business customers can be a win for everybody. The fintech is able to increase their market share. The financial institution is able to offer services that complement traditional banking services and again, make those relationships stickier, get additional fee income. Now as we get close to wrapping up, I'd like to discuss one other trend that we're seeing in the market. This is really interesting in the realm of positive pay. As many of you are aware, your large corporate customers are using positive pay and have been doing so for a long time. But this recent [ Dales Insight ] study focusing on businesses with under $50 million in revenue, shows some interesting statistics. First, as you can see here, a large number of community banks and credit unions, almost half don't currently charge customers for check positive pay compared to only 30% with larger institutions. But when asked, businesses who are receiving positive pay for free say they're willing to pay for it, 61% of them say that they'd be willing to pay for the service. So there's definitely an opportunity here to increase revenue with positive pay. Now I know that we're at time, but I just want to comment in the positive pay realm, another area is that small businesses, a lot of them don't understand what it is. In fact, 40% of them don't know what it is. So we have an opportunity to increase education, push this need for combating check-fraud down into smaller businesses and again, have an opportunity to grow interest income. If you're looking to tackle the check fraud problem, this is a great way to look at doing it in a way, again, that wins for everyone. I will comment -- I've heard some financial institutions expressed concern that if you're requiring customers to have positive pay, which some customers are starting to do now, they can't really charge for it, but we've heard opposite. The answer is, yes, they can charge. That concludes my comments on industry trends within digital banking. And with that, Gita, I will turn it back over to you.

Okay. Well, we are at time. We will follow-up for folks that had questions via e-mail, and we will also be sending out a link to the State of Commercial Banking reports and look for that in your inbox. Thank you, everyone, for joining today's webinar. Enjoy the rest of your day.