BANK EXECUTIVE BUSINESS OUTLOOK SURVEY 2015, Q2

BANKS SHOWING SIGNS OF OPTIMISM As banks enter year seven of economic recovery. BANK EXECUTIVE BUSINESS OUTLOOK SURVEY 2015, Q2 1

INTRODUCTION BANKS SHOWING SIGNS OF OPTIMISM As banks enter year seven of economic recovery. For over a year, we heard from banks and others that funding costs would increase. More recently, we heard anecdotal news from larger institutions that they expect their deposit costs to rise more quickly when overall interest rates start to go up. But the big question has remained: when will banks start to feel the effects of rising rates? There s now evidence that a shift to a tighter funding environment is starting to happen. As this quarter s survey highlights, 20% of respondents have seen their funding costs increase over the past year; that s 7 percentage points higher than respondents indicated in last quarter s survey. Combined with call report data from the second quarter that shows the cost of funds rose at 20% of banks since last year, evidence is mounting that the price of deposits is trending upwards. We will continue to track this question closely in future surveys so that banks across America have the information they need to plan accordingly. If you have thoughts or questions about the results, please contact Steve Kinner, Senior Managing Director, Sales, at (866) 776-6426, x3445 or Phil Battey, Senior Vice President, External Affairs, at (866) 776-6426, x3357. Sincerely, Mark Jacobsen CEO & President Promontory Interfinancial Network, LLC Arlington, Virginia 1

EXECUTIVE SUMMARY Concerns about funding costs mount as deposit competition increases. Until now, the primary evidence that we re reaching the end of cheap funding for banks has been anecdotal. Statements from large banking-industry bellwethers have predicted an impending scramble for certain deposits and a steep rise in funding costs. Now, we re seeing some early indications that the shift to a tighter funding environment is starting to happen. In Promontory s Q2 2015 Bank Executive Business Outlook Survey, which includes the responses of 269 CEOs, presidents, and CFOs of banks across the country, 20% of bankers indicated that their institutions have experienced an increase in their cost of funds. Just three months ago, in the firstquarter edition of this survey, only 13% of survey respondents indicated they had experienced an increase in their cost of funds compared to the same period the prior year. Banks expect that these early signs of rate activity forebode a widespread increase in funding costs. Nearly three-quarters of all respondents believe that funding costs will rise in the next 12 months, and a large majority of those who expect deposit costs to increase, expect the increase to be driven by the cost of retail deposits. The rise in funding costs (in particular retail deposits), while attributable to a number of factors, suggests that the new Liquidity Coverage Ratio (LCR) is beginning to have an impact. The largest banks in the country have publicly stated that they plan to adjust their funding mix significantly in response to LCR rules and that includes a significant focus on bringing in more retail deposits. Other notable highlights from the Q2 survey include: Bank optimism on lending fades. Most responding banks (69%) expect loan demand to increase over the next 12 months. That is 7 percentage points higher than those that report seeing loan growth over the past 12 months. But their overall expectation for loan growth is below what was reported in the Q1 survey. Borrower credit and cash flow are primary obstacles to CRE lending. According to respondents, the biggest obstacle to CRE lending is finding borrowers with sufficient cash flow or credit quality, an indication that even as loan demand grows, there is still a shortage of qualified borrowers. Small banks expect to retain a majority of their residential loans on balance sheet. Despite a significant shift away from residential loan originations by large banks, community banks continue to see residential loans as a component of their asset portfolios. Smaller banks, those with less than $1 billion in assets, reported that they expect to retain over half of all of their residential loans on balance sheet, while banks with between $1 billion and $10 billion in assets expect to hold nearly 40% of residential loans they qualify. Banks continue to expand investment in digital. The explosion in digital banking services has become nearly universal for banks. Ninety-nine percent of responding banks expect to maintain or increase investments in their online banking services, while 97% of responding banks expect to maintain or increase their investment in mobile banking. Meanwhile, two primary areas of reduced investment are front-line staff and physical branches. 2

SHIFT IN FUNDING COSTS EXPECTED, DRIVEN BY RETAIL DEPOSITS Funding costs already on the rise for 20% of respondents. Nearly three-quarters of respondents indicated that they expect funding costs to begin moving upward over the next 12 months, with 20% of banks indicating that they have already begun to experience a rise in funding costs. This reported increase comes despite the fact that overall interest rates haven t moved upward in the past 12 months, raising the possibility that funding costs may be increasingly influenced by the competition for deposits and potentially exacerbated by any interest rate increases that may be implemented by the Fed in the future. Going forward, two-thirds of responding banks expect funding costs to be driven primarily by pricing for retail deposits. Sixtyeight percent of banks with less than $1 billion in assets, and 58% of banks with between $1 billion and $10 billion in assets indicated that they expect retail deposits the vast majority of their deposit holdings to be the primary driver of an overall rise in their funding costs. Corporate deposits were the second most likely source of funding cost increases and are expected to play a more substantial role in the funding costs of mid-sized banks, reflecting the relatively larger holdings of corporate deposits at these institutions. Significant Increase Moderate Increase Same Moderate Decrease Significant Decrease Funding Costs Experience & Expectation What are your expectations for your bank s funding costs 12 months from now? How are your bank's funding costs compared to 12 months ago? 0% 10% 20% 30% 40% 50% 60% 70% 80% Responses are not separated by asset size because of similarity in responses across all asset-size bands. 80% 70% 60% 50% 40% 30% 20% 10% 0% Of the following funding categories, which do you expect to be the primary driver behind a change in funding costs? Retail deposits Corporate deposits Non-deposit liabilities Public funds deposits Other Banks with less than $1 billion in assets Banks with $1 -$10 billion in assets All asset sizes Responses from banks with assets of more than $10 billion are not displayed because of a lack of statistical representation within that asset-size band. See methodology on page 10 for details. 3

COMPETITION LIKELY TO CREATE PRICING CHALLENGES FOR BANKS Growing demand for retail deposits could force banks to raise rates quickly. Forty percent of survey respondents reported that they experienced an increase in deposit competition over the past 12 months. By the middle of 2016, 68% of responding banks expect the competition for deposits to have increased, and 11% of respondents expect the increase in competition to be significant. In the past, banks experiencing a concurrent rise in loan demand and deposit competition could reprice assets to keep pace with with rising retail deposit costs. However, pent-up customer demand for rate and new LCR rules, which have increased the relative value of retail deposits for the largest banks, could contribute to a more dramatic shift in the price of these funds. Growth in deposit competition could create challenges for banks that rely heavily on rate to retain retail depositors, as opposed to banks that have greater capacity to cement relationships with other services. Among banks that expect deposit competition to increase over the next year, 46% of banks with less than $1 billion in assets reported that their primary method to retain customers is to increase rates. Significant Increase Moderate Increase Same Moderate Decrease Significant Decrease Deposit Competition Experience & Expectation What are your expectations for deposit competition for your bank 12 months from now? How is deposit competition for your bank compared to 12 months ago? 0% 10% 20% 30% 40% 50% 60% 70% Responses are not separated by asset size because of similarity in responses across all asset-size bands. As deposit competition increases, how do you plan to reduce deposit run-off? 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Increase deposit rates to keep pace with competition Deepen customer relationship through additional non-deposit services Increase quality/ convenience of deposit services (e.g., mobile/online, rewards programs) Nothing. We are are planning for a certain amount of run-off as competition increases Banks with less than $1 billion in assets Banks with $1-$10 billion in assets All asset sizes Responses from banks with assets of more than $10 billion are not displayed because of a lack of statistical representation within that asset-size band. See methodology on page 10 for details. Other 4

BANK EXPECTATION ON LOAN DEMAND POSITIVE, BUT CAUTIOUS CRE market expected to be primary driver of steady, but gradual loan growth. Loan Demand Experience & Expectation Sixty-two percent of survey respondents reported that they have experienced an increase in loan demand over the past 12 months, and 10% indicated that the increase in demand was significant. Significant Increase Moderate Increase What are your expectations for your bank s loan demand 12 months from now? How is your bank s current loan demand compared to 12 months ago? By comparison, 69% of respondents expect loan demand to increase over the next 12 months, but the number of banks that believe that growth to be significant is just 3%. The level of expectation for future loan growth is also lower than was reported in the first-quarter survey. In the first quarter of 2015, 74% of respondents expected loan demand to increase over the following 12 months, and 7% expected a significant increase. Expectation for the source of growth in loan demand varies by institution size. The majority (62%) of banks with under $1 billion in assets expect the change in demand to come from the commercial real estate market, while banks with between $1 billion and $10 billion in assets expect C&I to play a larger role alongside CRE. Same Moderate Decrease Significant Decrease 0% 10% 20% 30% 40% 50% 60% 70% Responses are not separated by asset size because of similarity in responses across all asset-size bands. 70% 60% 50% 40% 30% 20% 10% Of the following lending categories, which do you expect to be the primary driver behind a change in loan demand? 0% Commercial Real Estate C&I Residential Agriculture Consumer Other Banks with less than $1 billion in assets Banks with $1 -$10 billion in assets All asset sizes Responses from banks with assets of more than $10 billion are not displayed because of a lack of statistical representation within that asset-size band. See methodology on page 10 for details. 5

BORROWER QUALITY PRIMARY OBSTACLE TO CRE LENDING Limited availability of qualified borrowers limits growth opportunities. Commercial real estate lending makes up the largest portion of banks asset portfolios for institutions under $10 billion in asset size, and for the majority of respondents, CRE is expected to be the primary driver of loan demand in the coming year. However, despite recent increases in CRE lending by community banks and the expectation for future demand, it s evident that there s still a relative paucity of quality CRE borrowers. On average, respondents ranked borrower credit and cash flow as the two top reasons why they would choose not to make a CRE loan and by a large margin. According to call report data, CRE comprised 22% of loan portfolios at banks with assets of less than $1 billion and 30% of loan portfolios for banks between $1 billion and $10 billion in assets. 1 Please rank in order of likelihood the reasons why your bank most o en chooses not to make a loan to a poten al CRE borrower. (1 = Most likely; 8 = Least likely) Quality of borrower credit Insufficient borrower cash flow Insufficient assessment of property value Out of bank footprint Loan size is too large Lack of specialization in borrower industry Excess concentration on balance sheet Loan size is too small 0 1 2 3 4 5 6 7 8 Responses are not separated by asset size because of similarity in responses across all asset-size bands. Despite these numbers, asset concentration does not appear to be a significant concern for banks. The concentration of CRE loans within banks asset portfolios is at or below recent averages, reducing the importance of asset-concentration limits as a factor in making a CRE loan. 1 Source: FDIC Statistics on Depository Institutions 6

RESIDENTIAL LOANS REMAIN KEY COMPONENT OF COMMUNITY BANK PORTFOLIOS Community banks expect to retain sizable portion of residential loans on balance sheet. Despite massive changes in the residential lending market over the past decade, community banks continue to see residential lending as a method to grow their loan portfolios. Out of all the residential lending opportunities your bank qualifies, please indicate the approximate percentage that falls into each of the below categories. Originate and hold On average, respondents at banks with less than $1 billion in assets expect to hold 52% of the residential loans that they qualify on balance sheet. Meanwhile, banks with $1 billion to $10 billion in assets expect to retain nearly 40% of these residential loans. Over the past decade, the community banks that survived the financial crisis have consistently and gradually increased the total amount of residential loans on their balance sheet. 1 Originate and sell to a GSE or agency conduit Originate and sell in the private secondary market Qualify, package, and broker to another lender 0% 10% 20% 30% 40% 50% 60% Banks with less than $1 billion in assets Banks with $1-$10 billion in assets All asset sizes Responses from banks with assets of more than $10 billion are not displayed because of a lack of statistical representation within that asset-size band. See methodology on page 10 for details. Total Closed-End 1-4 Family Loans held by S ll-opera onal Community Banks Total Closed-End 1-4 Family Loans (in billions $600 $500 $400 $300 $200 Recession Begins Height of Crisis Recession Ends 2002 Q4 2003 Q2 2003 Q4 2004 Q2 2004 Q4 2005 Q2 2005 Q4 2006 Q2 2006 Q4 2007 Q2 2007 Q4 2008 Q2 2008 Q4 2009 Q2 2009 Q4 2010 Q2 2010 Q4 2011 Q2 2011 Q4 2012 Q2 2012 Q4 2013 Q2 2013 Q4 2014 Q2 2014 Q4 2015 Q2 1 Source: FDIC Statistics on Depository Institutions 7

BANKS FOCUSING DOLLARS ON DIGITAL TECHNOLOGIES Commitment to online and mobile banking nearly universal among respondents. Bank spending priorities are now distinctly aligned towards digital technologies. Out of seven operational priorities, mobile and online technologies ranked highest among responding banks as to where they expect to increase their investment. The investment in mobile and online banking technologies was nearly universal. Seventy-four percent of respondents indicated they plan to increase their investment in mobile banking and another 24% plan to maintain their current level of investment. 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Mobile banking tech Online banking tech Increase Investment Regulatory management Marketing Physical branch locations Wealth management Front-line staff Banks with less than $1 billion in assets Banks with $1-$10 billion in assets All asset sizes For context, in a 2013 community banking survey conducted by the consulting group KPMG, 17% of respondents indicated that they had no plans to offer mobile banking services. All respondents indicated that they would either increase or maintain their investment in online banking. Some portion of this investment in digital technology appears to be coming at the expense of physical infrastructure. The biggest areas for reduced investment were front-line staff and physical branches. 40% 35% 30% 25% 20% 15% 10% 5% 0% Front-line staff Physical branch locations Reduce Investment Regulatory management Marketing Wealth management Mobile banking tech Online banking tech Banks with less than $1 billion in assets Banks with $1-$10 billion in assets All asset sizes Responses from banks with assets of more than $10 billion are not displayed because of a lack of statistical representation within that asset-size band. See methodology on page 10 for details. 8

BANKS NOT COUNTING ON ELECTIONS TO ALTER CONDITIONS Majority of banks don t expect 2016 to alter conditions for banking. While nearly one-third of banks expect that the 2016 general election will positively impact the economic environment for banking, 41% believe that the election won t ultimately make a difference in their industry, while 19% expressed no opinion. Mid-size banks were a bit more pessimistic about the impact of the upcoming general election, with 15% of banks with between $1 billion and $10 billion in assets indicating that they expect conditions to worsen as a result of the election, compared to just under 6% for bankers with less than $1 billion in assets. How do you think the results of the 2016 general election will impact the economic environment for banking in this country? No opinion, 19% Worsen, 7% No difference, 41% Improve, 32% In general, it appears that the plurality banks believe (at least in the short term) any improvements in their business conditions will likely not be attributable to actions at the polls. Banks with less than $1 billion in assets Banks with $1-$10 billion in assets Worsen 6% No opinion 19% No difference 43% Improve 32% Worsen 15% No opinion 19% No difference 34% Improve 32% Responses from banks with assets of more than $10 billion are not displayed because of lack of statistical representation within that asset-size band. See methodology on page 10 for details. 9

SURVEY METHODOLOGY AND RESPONSE Promontory s Bank Executive Business Outlook Survey was conducted online over the course of two weeks from June 22, 2015 to July 3, 2015. However, the responses of these larger banks are included in any analysis related to the banking industry as a whole and in charts that do not segment by asset size. The survey was delivered via email to bank CEOs, CFOs, and Presidents at 4,805 banks throughout the United States and garnered a 5.6% response rate with leaders from 269 banks completing the survey. Of these 269 respondents, 111 were CEOs and/or Presidents (41%) and 158 were CFOs (59%). As a representation of the overall banking industry, the sample of respondents skews slightly towards mid-size banks, banks with assets between $1 billion and $10 billion. Due to the small number of responses received from banks with more than $10 billion in assets, when asset-size segments are represented graphically in the charts in this report, responses from banks with more than $10 billion in assets are not included as a distinct segment. 10

ABOUT PROMONTORY Promontory Interfinancial Network offers unique services that bring banks and other institutions together in a way that allows each to benefit from the power of many enabling them to offer services that otherwise might be too difficult or costly to offer on their own and providing them with new opportunities for growth, efficiency, stability, and flexibility in the management of their balance sheets. Promontory Interfinancial Network s services include Insured Cash Sweep, CDARS, Bank Assetpoint, Residential Mortgage Network SM, IND, and Yankee Sweep. For more information about Promontory Interfinancial Network and its services, please call (866) 776-6426 or visit Promnetwork.com. 11