By Jeff Reynolds, managing director, Darling Consulting Group
Once a month, we have an internal meeting at Darling Consulting Group where all of our consultants get together to clear administrative items and, more importantly, discuss the current banking environment. These discussions can range greatly and can sometimes be difficult to manage as a result, but it serves as a clearinghouse of experiences gained and an opportunity to learn by the power of many.
Recently, the topic was negative interest rates. The Federal Reserve mandates that the "Severely Adverse" capital stress test economic scenario—performed by all CCAR and DFAST banks—employs a recession so severe that the Fed takes rates negative. Ever since that scenario was added, community bank directors have been asking questions prompted by it at ALCO meetings.
Questions we have received have included:
• What would cause negative rates?
• What’s the probability of negative rates actually happening?
• Can our bank’s systems deal with negative rates?
• What legal issues would arise in a negative interest rate period?
• What earnings exposure would negative rates thrust upon community banks?
Let me start with this thought. Yes, negative rates have become a reality in other parts of the world. But before even thinking about negative rates in your bank, start with something a bit closer to home.
By that I mean, first put a lot more thought into how your bank will live in a sustained lower-rate environment. Is your balance sheet exposed to falling rates? If the 10-year Treasury dropped to 75 basis points, would you lend or invest long?
This would probably give you a reasonable proxy for answering many questions about how you would operate in a negative rate scenario. Considering such issues now could save you tying up resources involved with going too far down the rabbit hole of actually running a negative interest rate scenario. That’s because actually running it is likely a lot more involved than your board and management team might think.
With that as a backdrop, what if we actually did drift into negative rates? What would the world look like for the typical community bank?
The following is a summary of thoughts and some of the discussion we had at our staff meeting that day.
The negative interest rate scenario
What do negative rates look like? First you have to get that picture nailed down.
The scenario we discussed at DCG was the Fed's "Severely Adverse" for 2016 stress tests. This makes a good basis for discussion because it is a regulator-defined scenario, and the item that is causing all the chatter to begin with. (If you want to read the “playbook,” I’ve included a link at the end of this article.)
Here are the basics of the scenario, which runs many pages. In it, the global economy plummets into a recession. GDP growth goes negative for a year, with a low water mark of -7% or so. Unemployment hits double digits. Credit spreads widen as a result of increased default probabilities. Equities get hit hard (the Dow gets cut in half). And real estate values decline sharply (the home price index declines by 25% and the commercial real estate pricing index declines by 30%). The 3-month Treasury hits -50 basis points, the 5-year Treasury goes to 0%, and the 10-year Treasury goes to 50 basis points. Prime goes to 2.6%. Mortgage rates do not track with the Treasury— they come down by 70 basis points for a short period of time, but bounce back quickly.
There’s much more detail in the actual documents, but you probably get the idea.
Think “big picture”
Trying to comprehend negative rates and the impact on the community banking business can cause quite a headache, so it is best to think "big" and get down into the weeds later (if you find the exercise is worthwhile).
This Fed severely adverse scenario posts a number of variables that are designed to place a severe stress on operations, similar in nature to the environment back in 2008. A main difference between 2008 and the current Fed "Severely Adverse" scenario is the level of current market rates. If we actually saw this environment, the FOMC does not have as many levers to pull to try to steer the economy out of a tail spin.
Having worked with a lot of banks in the more affected areas during the last recession, I can convey that the last concern banks had in the midst of 2008 and 2009 was interest rate risk. Credit losses and provision expenses quickly cut capital levels in half, and finding the floor on credit issues seemed elusive. Because of that, credit migration, capital planning, and contingency liquidity planning became the focal points of all ALCO meetings.
Capital planning came into vogue even for banks not hit hard by credit issues, recognizing a new world order was emerging for the unofficial rules around "capital adequacy." Similarly, management at all banks were required to focus energy on upping their game for contingency liquidity planning.
Here’s an important point to understand: If reality followed this Fed negative rate scenario, I would submit that the focus will remain credit, capital, and liquidity.
Interest rate risk—at least initially—will be a distant fourth place on the concern list. Accordingly, if your ALCO is not prepared to include a credit stress test and full capital planning exercise in the overall analysis of negative rates, there really isn't a lot of sense in spending much more energy on it.
Understood, but what if ... ?
During that recent consultant meeting, we tried to table that part of the discussion as best we could. We ran down a chart of accounts and put a number of asset and liability classes on the table for discussion. While the following summary of some of this discussion is just that—a summary—this may be useful if your ALCO tackles the question of negative rates.
Life as we know it is over: It was agreed that if we actually were to dip into negative rate territory and stay there for a long time, the business would probably change for many community banks once the dust settles.
Because of that, you need to avoid the trap of saying "we would never do that." The reality is if the rate environment did something it had never done before, everything should be on the table for a potential response to it.
Cash & Investments: In the early stages of most banking crisis scenarios, having a stockpile of cash (or access to it) is almost always an enviable position to be in. A key problem with cash is the cost of carry (historically low or zero yield to other market alternatives). Another is how channels to access cash can evaporate in the face of a crisis.
In this scenario, the cost of carry on that stock pile of cash will not be based on a zero interest rate floor. The cost of cash reserves would move to (for argument’s sake) -0.50%. Would the desire to hold cash reserves still hold true to historical biases if we actually had to pay the Fed to hold cash?
Let's start with this: If the world economy is blowing up and your stakeholders and regulators are super concerned about liquidity, would you flinch at paying $4,200 a month to have safe access to $10 million via the Fed?
We discussed ordering a bunch of $100 bills for the vault, but between limited vault space and security concerns over holding high levels of cash, that interest charge seemed like the lesser of a few evils.
Bond cashflow: What you have for cash entering the crisis is one thing, but what would you do with portfolio cashflow over time?
In this scenario, you have to consider extending duration on reinvestment (remember: the 5-year Constant Maturity Treasury is 0%) or find an alternative to defray the cost.
Given how reluctant bankers were to invest cash in the beginning and middle of the last crisis, I suspect that community banks would be more inclined to stay short on investments and cash and try to slow the margin drag via other actions.
Loan Pricing: The best example of what will happen is probably the early stage of the last crisis in 2008 through 2011.
• Mortgages: If you remember, mortgage spreads widened out to the Treasury and refinancing was not that big of a deal until the start of TARP, so it is difficult to predict what would happen here because one would assume the government would once again want to prop up housing.
• Commercial real estate spreads will widen by a lot, refinancing will decelerate, and banks will be in the driver's seat on pricing of existing deals in their portfolio that do not sour. In the last crisis, spreads did not seem to "normalize" until three years or so after the start of the crisis.
• On commercial loans, short-term credit facilities would likely be frozen, rollover spreads will widen, and outstanding lines will decrease. With the economy in the tank, the typical reason for someone drawing a line will be survival, and most banks will not extend credit under those circumstances.
• Consumer finance will freeze up, with auto manufacturers bearing the responsibility of finding a way of extending enough credit for new purchases.
Other thoughts on loans: While creditworthy customers might want to lock in lower rates, banks will not likely play ball, at least not early on in the credit deterioration cycle as banks willing to lend will likely be fewer, and thus able to command higher pricing. Terms offered on rollovers would likely shorten as well.
Another point raised in our meeting was that banks that have floors on adjustable-term resets and prepayment penalties will find themselves in real positions of strength.
Do you put reasonable floors on your adjustable and variable rate products today? Not useful, you say? Well, remember to never say never.
Wholesale funding costs: This was an interesting one. Would Federal Home Loan Banks lend money at a negative rate? Only if their cost was significantly less than that rate and they could make a spread off it. So never say never, but in our war game we were not counting on it.
We did consider the ability to lock in ridiculously low-rate funding for a longer term as being a viable strategy in this scenario, potentially utilizing derivatives to craft the strategy. This served as a good reminder to stay up to date on the ins and outs of plain vanilla interest rate derivatives, and not allow the aspect of education and policy development to be the roadblock standing in the way of executing on a good strategy.
Recent history has shown the demand for term money will likely be low because most banks have been awash with cash and struggling to find quality assets. The same could well be true in this new hypothetical economic world.
Deposit costs/fees: One comment we have heard a couple times from some banks is that they would never apply or increase fees to deposits because, culturally, their customers will not accept it.
To that, we say "hooey."
Remember, under this scenario, it now costs you money to park cash at the Fed. So there is going to be a ceiling on how much cash you will take before you are forced to pass costs back to the customer. That ceiling might not be that high when you consider investing into a 5-year Treasury only gets you to a 0% yield.
The logistics/security issues we outlined above for the bank would hold true for your deposit customers. The number of institutions increasing fees would likely afford your deposit customers few alternatives for their safety and soundness of liquidity.
Think about it: 20 basis points over the next year to keep $100,000 secure and accessible is about the cost of a decent safe at Walmart.
We surmise that most banks will increase fees and, because of that, customer pushback would be limited.
Systems: Can your core processing system actually function in a negative rate scenario? How about other support systems? We have received a wide range of answers to that question. Might be worth researching that question, given all the hysteria Y2K created.
Okay, back to the present
At the end of a good hour on the subject, we wound down the discussion and concluded our meeting. The value of the exercise was two-fold.
First, we identified some actions community banks could take today to improve their balance sheet posture for low rates (e.g. loan floors) that likely would not cause a big stir among customers. This is likely the best value in the exercise of looking into the impact of negative rates.
Second, we feel that in doing this exercise, we laid out a decent rational path for defusing the question, "Can we run this?"
Do the larger banks do it? Absolutely they do.
But remember, they are forced by regulation, and the cost of doing this correctly should not be underestimated.
Can a community-sized bank run a similar process? Absolutely they can. But doing so without addressing the biggest risk variable of credit would make it an exercise in futility and likely not worth the resources to answer.
Hopefully this article will help shorten your path of discovery on the matter.
This article was adapted from the Darling Consulting Group monthly newsletter DCG Bulletin. For a free subscription, visit DCG’s subscriptions page.
About the author
Jeff Reynolds is a managing director at Darling Consulting Group. After serving as an auditor in the insurance and banking industries, Jeff joined DCG in 1996. His analytical and managerial skills led him on a career path within DCG that culminated in his current role as Managing Director. In this capacity, Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions. Jeff is a frequent author and speaker on a variety of balance sheet management topics and has served as a guest faculty member for the ABA’s Stonier Graduate School of Banking.