A recession is coming. The question is when. In a recent survey of economists conducted by the Wall Street Journal, most think it will arrive within the next 24 months, with many believing that it could start as early as this year. Leading financial indicators, such as falling durable goods orders and a reduction in capital spending, are sounding the alarm bells. Research from the financial data firm IHS Markit shows that manufacturing activity fell to a nine-year low in May.
There are other signs in the market pointing to a forthcoming change in the economy. Bond yields are falling, signaling that investors are beginning to safeguard their money. Businesses are starting to feel the effects of the trade war. And, charts like this one below from Morgan Stanley have investors on edge.
Given this outlook, banks should look at how they can protect themselves ahead of the next round of challenging economic times. Ideas on how they can prepare may come from Community Development Financial Institutions (CDFIs). CDFIs have a track record of absorbing shocks and thriving during downturns. From 2008 to 2015, more than 500 banks failed. During that same period, all of the 500 CDFI loan funds certified by the U.S. Treasury weathered the storm. In fact, while bank lending contracted, CDFI loan origination outpaced pre-recession levels.
To get through troubled financial times, CDFIs relied on their strengths, using tactics rooted in patience and flexibility. With many strategies to deploy, banks should look to learn from and partner with CDFIs to ready themselves for the next economic cycle.
Let’s explore four ways banks can partner with CDFIs to improve their rate of success during the next economic downturn.
1) Find new ways to serve 100% of small business depositors
Banks are fighting to grow their deposit base and become the main financial institution for small business owners. However, due to credit risk and regulation, they are only able to serve a fraction of their depositors through lending products, leaving small business owners to look for other options. Banks have the opportunity to systematically grow partnerships with CDFIs who have a larger risk appetite on their lending portfolios and maintain the primary relationship with the small business owner.
2) Buy and sell loan portfolios
The small business lending market has been disrupted since the last recession. There is billions of dollars of portfolios sitting on the balance sheets of organizations who are not recession tested. There will always be winners and losers through a recession. The winners will be the ones who are proactively buying and selling loan portfolios to diversify and pick up yield from organizations who are not battle tested. CDFIs and other alternative lenders will be a reliable source to execute loan transactions that alleviate pressure, add yield, and/or diversify balance sheets for both parties. Banks should seek innovative partnerships like the recently announced pairing of Key Bank and Opportunity fund.
3) Diversify Customer Base
Mainstream banks tend to source borrowers from the same wells, often focusing on the upper end of the market. CDFIs spend their energy on underserved populations often at the lower end of the market. Banks can partner with CDFIs to access new markets at a lower acquisition cost.
The collaboration between Lending Club, Opportunity Fund and Funding Circle is another great example of a CDFI partnership. Each organization is focused on growing their lending, but by working together they can create a stable pipeline of borrowers from an undercapitalized customer base.
4) Deepen Local Ties
According to Low Income Investment Fund, a California-based CDFI, many within the industry took “…the time needed to advise borrowers, restructure terms to best suit the situation, and postponed implementing legal recovery…to minimize balance sheet losses.” Thus, CDFI reputations and portfolios remained intact.
Deep ties, patience, and an ability to work with borrowers through the crisis led to increased recoveries and opportunities for increased loan origination post recession. By partnering with CDFIs, banks can bolster their reputation within local communities while gaining critical insights into local needs.