Has The Fantasy of Relationship Banking Been Exposed?
Originally published in American Banker, Steven Sugarman
March 28, 2023, 4:31 PM EDT
Silicon Bank, Signature Bank, and First Republic Bank once represented the gold standard of Relationship Banking. Wall Street was enthralled by the ability of these banks to attract low-cost deposits that could not be explained, or justified, by economics. Investors became convinced that the value of the banker-client relationship at these banks justified premium valuations. Over the past decade, the fantasy of Relationship Banking was rewarded as if it was a form of financial alchemy.
Over time, these banks came to believe in the indestructibility of their client relationships. Banks refused to raise the rate of return on deposits, even as interest rates increased. Banks made incrementally fewer loans to their clients, preferring to simply invest excess deposits into outsized portfolios of Treasury securities. These relationship bankers reasoned that the value of a relationship with their bank was consideration enough. They bet that their bank's deposits would not transfer, their clients would not seek higher interest payments, and that their clients would not mind the lack of FDIC Insurance because they were part of the "club."
In the past few weeks, though, these relationship banks saw their businesses fail, their investors wiped out, and their relationships evaporate as quickly as they could say "T-Bill." Bankers, investors, regulators, and commentators have all been left scratching their heads, blindsided by the failure of the once vaunted "Relationship Banking" business model. One is left to wonder how so many people came to believe the illusion of Relationship Banking. Did people really believe bankers had such wit and charm that cut-throat venture capitalists would accept below market rates? Did people really believe that depositors did not need a value proposition that made economic sense?
As the Federal Reserve increased interest rates, investors came to realize that the success of "Relationship Banking" was simply a by-product of the Federal Reserve's easy money policies. When loans are easy to get, when interest paid on cash is negligible, and when all banks appear sound, it is easy for depositors to select their bank based on intangibles such as relationships. However, as money gets tighter and interest rates climb, investors look to receive fair interest rates, to have access to fair loans, and to be reassured about the safety of their deposits.
For America, the end of these relationship banks could not have come soon enough. They symbolized all that historically has been wrong with banking. These relationship banks excluded clients who were not rich enough, white enough, or connected enough. They exacerbated inequalities in the financial markets and prioritized the availability of loans to the connected over the qualified. Ignoring the public utility of FDIC Insurance, they exposed clients who had so called "relationships" to tremendous risk. Relationship banks marketed themselves as the "Bank of the Stars." They focused on venture capitalists, they served the elite, and only valued relationships with clients they deemed a "privilege to serve." Relationship banking bore all the worst traits of private country clubs – and Wall Street investors did not care.
Relationship banks have ignored fair lending rules, have done little to promote community development lending, and have heightened the systemic issues impacting the unbanked. Relationship banks do not lend to the public based solely on the creditworthiness of the borrower. They prioritize making loans to borrowers who are disproportionately wealthy, white, and connected.
As relationship banks recede into the junk pile of history, banking and finance leaders will need to focus on a more durable form of banking and lending. Banking needs visionaries who build their businesses on real tangible value propositions for their clients. Bankers are not running hedge funds and should not manage their banks as if they were.
Fair Banking will replace Relationship Banking. Investors will see that treating clients fairly is not only better for clients, but better for the durability of client relationships. Strong banks are built on trusted, fiduciary relationships not redlining.
Lending businesses based on the creditworthiness of the client is most profitable and safest when a bank is inclusionary – not exclusionary. When banks select loans from the broadest set of applicants and select the most credit-worthy loans, their portfolios are safer. Likewise, when loans and deposit rates are based on fair, market terms that benefit both the bank and the depositor – stronger, more durable, relationships are formed. Bankers may not feel the same privilege when financing a house in South Los Angeles as opposed to Beverly Hills, but the bank will be safer, sounder, and more profitable when its management is willing to serve everyone. Fair banking means fair rates on deposits, fair access to credit, and respecting their depositors by providing them with fair access to FDIC Insurance for all of their deposits.
Fair Banking has been tested and has proven to result in faster growth, stronger credit, more durable relationships and higher profitability. During my tenure as Chairman and CEO of Banc of California we built the fastest growing bank in America that, according to Forbes Magazine, was ranked the second most profitable bank in America.
It should have come as no surprise to Relationship Banks or their regulators that their unfairly treated clients would make a run for it when they saw the risk they were being exposed to and the unfairly low returns they are being provided. Banks that have foregone Fair Banking principles to pursue Relationship Banking are now sowing the fruits of their decision. Neither the Federal Reserve nor the FDIC should bail-out the investors in or the management of these exclusionary businesses. This will allow Fair Banking to emerge as the future of banking. It is a safer and sounder form of banking that will tear down the structural inequities that continue to plague our banking system.
Submitted by Steven A. Sugarman, Founder, The Change Company CDFI LLC