In January, Q2 released their 2022 State of Commercial Banking Market Analysis Report, which revealed a modest rise in commercial real estate loan volume in the second half of 2021, extending cause for cautious optimism in market recovery. Report author, Gita Thollesson weighs in on the findings.

At the beginning of the pandemic there was tremendous concern about the economy spiraling down into a free fall and potentially another great depression. At that time, people had no idea what was on the horizon; this was like no other recession experienced in our lifetime, as it was a complete shutdown of the economy. Compared to other recessions where unemployment rises and businesses suffer declining sales, this was different because even people who had money to spend couldn't spend it. So the outlook looked bleak in the beginning.

With the arrival of government stimulus, the PPP program, coupled with forbearance from banks, there was concern that we were essentially kicking the can down the road, and that as soon as PPP ran out and forbearance ended, we were going to see sudden, astronomical credit losses and delinquencies.

But that didn't happen. In fact, a lot of businesses figured out how to operate profitably in spite of the pandemic. For example, restaurants started to create new business models around curbside pickup and delivery. Then there’s corporate America, which used to have policies limiting remote work arrangements. By moving to a remote model, many businesses were still able to operate highly effectively and turn a profit. So even as stimulus efforts ended, many companies thrived.

The flip side is that industries that relied on in-person work and travel took a huge hit and may be permanently impacted by the changes in the economy — notably, the hospitality industry.

Excess Liquidity and Loan Supply/Demand Imbalance

A year ago, I would probably not have predicted that things would have turned out as well as they have at this phase of the cycle, but at this point I’m not surprised. At the beginning of 2021, we were already starting to see considerable improvement and optimism with very low losses and delinquencies.

However, loan demand is still fairly low. Much of that is simply because companies are sitting on so much excess liquidity. Their deposit accounts are robust, and an argument could be made that if anything, PPP was a little excessive. It injected the economy with a significant amount of capital, but instead of companies using that capital to keep the lights on, they took that money and parked it into deposit accounts — and now they’re flush with cash.

There's variance across the market of who's benefited and who stayed in business as a result of PPP, which was intended to pay salaries and critical expenses to keep people employed. In reality, a lot of the funds weren't used for that, but the loans were priced so inexpensively that even if the company used it for purposes that were not technically forgivable, they were still getting extremely inexpensive financing. Consequently, there were some companies that may not have actually needed the funds but took them to have cheap capital. Clearly, getting all that capital so inexpensively limits the need for going after the bank loan market (where you're paying 2% to 4%), when you just got a 1% loan from the government.

The good news is we’re starting to see the alleviation of the supply/demand imbalance. Our report found that funds are beginning to be moved from non-transaction accounts into transaction accounts, which is the signal that companies are getting ready to deploy that capital.

The logical next step is for companies to go back into the bank loan market as they continue to expand. And since we published the report in January, loan volume has actually rebounded. So, some of those signals that we were pointing to in the report have already come to fruition. Banks are still as competitive as ever, so the slight uptick in loan demand may still not be enough to mitigate this competitive pressure; everyone's still going out very aggressively after fairly limited volume, so the competitive climate could remain intense.

Inflation

Certainly inflation is yet another factor likely to drive loan demand. Inflation is most commonly a sign of a growing economy. As the economy improves and customers increase spending, prices rise; and as the economy becomes stronger, companies want to expand, they invest, and they need financing to fund that investment.

The other factor is that if rates rise, companies — even companies that are not looking to expand — will want to tap into the bank loan market more opportunistically, to lock in low rates before they rise. It goes to reason that with inflation rising (as of this writing it’s at 7.5% — a 40-year high), it's logical to assume that rates will rise and as they do, there could very well be a resurgence in loan demand. And the rising rates themselves will be good for banks from the standpoint of improving NIM (net interest margin).

Effects on Commercial Real Estate

Just as the prevailing thought at the beginning of the pandemic was that the economy would spiral downward, there was a belief that there would be long-term negative implications for the commercial real estate industry due to the move to remote work.

Again, we haven't seen that as of yet, which may simply be because those loans tend to be longer term and if a business decides to give up its office space, that’s not done overnight. It’s become clear that many businesses will either stick with remote work or move to a hybrid model, so there could be some real measurable implications for the commercial real estate industry in the longer-term. It’s important to note that the effects will also be felt downstream.

Tangential businesses that support workers have been and will continue to be impacted. Look at the Wall Street area or any central business district and you'll see a lot of shops and restaurants have closed down because employees are working remotely.

Primacy

Achieving primacy has never been more important than it is today. We're at a point now where if you had a credit-only relationship pre-pandemic and that relationship is still on the books today, it's a lot less profitable than it was a couple of years ago, simply due to low interest rates. It’s vital to not only have aspirational goals of achieving the full relationship, but to have specific tactics in place to ensure that that business comes to fruition. If you don’t, you end up with low profitability and relationships that don't have the necessary longevity.

Following the gathering of data, we conducted a round table where we only invited banks that had told us that they had a very deliberate strategy and key objectives to achieve primacy. But when we asked that same group of executives if they had a specific strategy in place to measure success and tactics, the majority said no.

That was the biggest surprise and eye-opener in the report, because one would have thought that banks would be a bit further along in that journey, especially given how instrumental primacy is to achieving profitability in the near zero rate environment. There are some banks that have been very successful at putting in place the right tactics to build out their relationships and achieve that status as primary, so we’re hopeful that this will improve for more banks in the coming year.

Evolution Towards Digital Transformation

Twenty years ago, companies were writing more checks than they were sending funds by ACH, and now it's flipped in the other direction. Certainly, the trend towards digital banking was already in the works but the pandemic greatly accelerated the need. Overnight, people could no longer walk into a bank branch, which meant a lot of processes that required branch presence had to change. For instance, KYC (knowing your customer) used to require that consumers and businesses couldn't open an account without physically showing up in a branch and presenting an ID, and that had to change because of the pandemic. Banks had to find a way to onboard clients digitally.

The shift to digital was further accelerated by the entrance of so many non-banks or direct banks (with no brick and mortar) requiring commercial banks to become much more agile and very quickly deliver solutions digitally that would meet customers' needs.

But having digital capabilities isn’t enough; speed has become critical as customers expect quick turnaround times for services like account openings, onboarding and loan approvals. And there’s a domino effect. As you do more digital banking it opens a specter of other needs that may not have been so prevalent earlier; things like fraud prevention, positive pay, and other challenges that come with more ACH and wire transfers.

As Q1 2022 comes to a close, the only thing we can say for certain is that the future of commercial banking will increasingly diverge from its past.