Mind the gap!

By Darnell Canada, managing director, Darling Consulting Group

Much has been written over the past few years about the prospects of and the related risks associated with rising market rates, especially since last summer when the Federal Reserve revealed that economic activity warranted a reversal of its quantitative easing program and the possibility of a 2015 increase in the short-term funds rate. As a result, there has been an aggressive charge against rising rate risk, with particular emphasis on economic value sensitivities on bank balance sheets.

Many of my colleagues have recently written that community banks should be careful not to dedicate ALCO energies solely to rising rate risk mitigation—and especially economic value exposures. They argue that models based on margin and earnings actually reveal that flat- and falling-rate scenarios are still plausible and present significant challenges for most. (This pattern would be a reversal of last year’s steepening of the yield curve.)

Actually, for several reasons, higher market rate conditions actually appear to present the best long-term earnings performance scenario for many small to mid-sized community banking institutions. 

The debate between advocates of “economic value based” models and advocates of “earnings based” models has endured for decades. It arises most often during exams.

The problem: Bankers can’t have income and hedge value also.

For bankers to best position themselves to respectfully and successfully combat pressures to manage to a value-based (EVE) metric, it is important to first understand the common contradiction between these two models.

To accomplish this, it might be worthwhile to travel back in time.

Remember gap analysis?

The origins of interest rate risk modeling began with gap analysis, which attempted to capture the timing of cash flows and repricing activity on both sides of the balance sheet.

A balance sheet is defined as having a positive gap when asset cash flows and repricing (rate-sensitive assets, or RSA) exceed liability maturities and repricing (rate-sensitive liabilities, or RSL).

This would indicate that assets on the current balance sheet turn over more quickly than funding sources when rates rise and fall, leading to a direct correlation between margin/earning performance and market rates.

The opposite is true for negative gap balance sheets, which have rate-sensitive liabilities that exceed rate-sensitive assets. Margin and earnings performance would be inversely related to market rates for these institutions.

With limitations in technology, gap analysis at one time was the best methodology that banks could use in gauging rate risk. However, even then, bankers understood that there were many critical flaws in gap analysis. These shortcomings limited the ability to accurately measure both volume and direction of potential sensitivities in future income.

You say “tomato,” I say “tomahto”

Advocates for the value-based model will argue that EVE should be viewed as an indicator of financial strength or weakness under a variety of rate scenarios. In a short explanation, the EVE model quantifies cash flows and repricing from the existing balance sheet and reports this information in present value and economic value terms.

Said a different way: The EVE model effectively reports the gap analysis using complex financial mathematics.

Without discussing the mechanics behind present-value modeling, keep in mind the following:

1. Sensitivity in economic value is directly correlated to duration/term/life.

Therefore,  assets and liabilities with long cash flows will exhibit greater “value/price” risk than asset and liabilities with short/variable cash flows.

2. Equity equals assets minus liabilities.

Thus, the economic value of equity (EVE) = Economic Value of Assets (EVA) minus Economic Value of Liabilities (EVL).

Accordingly, if our existing assets have a longer life (i.e. less cash flow) than our liabilities, the EVE will be inversely related to market rates (i.e. EVE falls as market rates rise and EVE rises as market rates fall). Second, if our existing liabilities have a longer life than our assets, the EVE is directly related to market rates (i.e. EVE rises/falls with market rates).

Sound familiar?

IMPLIED EFFECT ON NET INTEREST MARGIN (NIM)

EVE SENSITIVITY

In this regard, the EVE analysis presents some of the same well-documented challenges as gap analysis in measuring future earnings performance (both volume and direction) and related sensitivities to market rates.

Bridging the “gap” with examiners

A wise man once told me the best approach to winning a debate is to understand and appreciate the viewpoint of your opponent. Keep this in mind during your next exam.

The primary mission of regulators is preserving capital within the banking system.

In this regard, we unearth the central source of conflict in the earnings vs. EVE debate—it’s the difference between looking at the business as a going concern and looking at the balance sheet with the concern that liquidation of assets and liabilities can result in lost capital.

To our dismay as well as theirs, examiners have to be concerned with both issues.

The unfortunate reality is that the greatest risk(s) to our business are usually not readily apparent until they become increasingly fatal, which explains the post-crisis indoctrinated stress testing requirements as well as the emergence of enterprise risk management (ERM) concepts that hold the key to alleviating regulatory concerns regarding your approach to controlling economic value risks.

While Darling Consulting Group is a strong advocate for an “earnings-based” focus when analyzing interest rate risk, we are very careful to recognize that market rate exposures can have more far-reaching implications than margin and earnings sensitivities. Financial risks on a bank’s balance sheet are all interlinked and should not be examined in silos.

In this regard, banks should have systems that help quantify the degree to which interest rate risks may impact liquidity and capital and appreciate that potential deterioration in asset quality often will accelerate all downside financial risk exposures.

Presently, this has growing implications for community banks that have neglected liquidity risk exposures in the current environment. A recent poll taken by another reputable firm identified that the top three concerns for executives in the community banking industry are regulatory climate, interest rate environment, and loan growth. This is not surprising. However, this poll also revealed that deposit growth and liquidity was ranked as #9 in a list of 10 items.

What assets to bulk up on?

Many banks have focused on loan growth to combat the current rate environment, minimizing bond purchases where possible in an effort to increase the loan to asset ratio.

Additionally, we have observed a growing overweight in corporate and municipal bonds as a component within investment portfolios. These assets have less collateral flexibility and therefore offer less liquidity than bonds issued by the US Treasury and sponsored agencies. Meanwhile, parked deposits and related liquidity surpluses have helped banking institutions justify strategies that undermine the importance of core deposit gathering by leveraging their ability to employ short-term wholesale funding at near zero cost levels. This broad strategy has worked well in helping these institutions maintain and strengthen margin and earnings levels.

Although heightened, in many cases risk levels continue to appear modest—adequate liquidity, modest potential earnings sensitivities, solid capital ratios, and manageable asset quality indicators.

In other words, there doesn’t appear to be many things to worry about ... or are there?

There are subtle interest-rate-related risks that should be recognized and monitored by these institutions. In the event that market rates do rise, these banks should be aware that residual collateral values will depreciate and therefore reduce market liquidity.

Additionally, slower mortgage prepayments and call options that go unexercised will diminish cash flow liquidity as well.

It is also worth noting that higher debt service costs and diminished loan collateral values may impact asset quality. Should credit also negatively impact your financial condition, access to wholesale markets may diminish further (or at least become more costly).

In turn, these issues increase the probability that corporate and municipal bond sales—at depreciated values—will be required to satisfy funding needs. Any combination of these risks under rising rate conditions could have serious implications for the financial strength in your organization and therefore deserves serious consideration in your financial risk analysis.

In this regard, stress testing should be an exercise taken seriously, and not viewed as task solely undertaken to satisfy examiners.

This kind of perspective may help you appreciate the “big picture” viewpoint of the regulators. If bankers, in earnest, apply a holistic approach to understanding the manner in which financial risks are interrelated, integrate operational risk metrics, and incorporate their overall risk assessment in their strategy development process, they will be less likely to fall short of addressing worst-case scenario solvency concerns of the examiners and therefore diminish the need to focus on the EVE metric in the interest rate risk discussion.

About Darnell Canada

Darnell Canada worked at Darling Consulting Group since 1996. As a managing director, he has experience working directly with community banks and credit unions, providing guidance and advice on strategies to strengthen overall performance through proactively managing balance sheet risks and prudently making use of capital markets instruments. Additionally, he offers counsel to financial institutions that seek independent third-party advice on enhancing the overall effectiveness of their ALM function. Prior to joining the firm, Canada was an FDIC field safety and soundness examiner.