By Steven J. Boselli, managing director, Darling Consulting Group
Bankers continue to face the unfortunate challenge of preparing for rising interest rates, while living in the midst of a falling rate environment. And that’s not all.
Take continued global economic uncertainty—flight to quality/safety/higher yields with longer term U.S. bond purchases increasing every day. Combine this with the Federal Reserve continuing to reinvest bond cash flows coming off of its artificially ballooned balance sheet. Both have contributed to a considerably flatter yield curve.
The 10-year treasury yield recently hit a historic low point. And the current spread between the 2-year treasury yield and the 10-year treasury yield is meaningfully tighter than the historical average.
Finding assets yielding a reasonable return grows more and more difficult. With limited options for yield in the bond market, more and more institutions getting more aggressive on the lending side. This has caused some of the most irrational pricing and terms that we have ever seen. But beyond that, more and more institutions are moving into types of lending where they have no experience.
Or they may be loading up on current concentrations of riskier assets.
Regulators go to yellow alert
Capital planning, concentration risk and stress testing continue to be hot buttons in recent regulatory exams.
Per Comptroller of the Currency Thomas Curry, during the recent release of the agency’s Semiannual Risk Perspective:
“CRE lending and concentration risk management has become an area of emphasis for regulators … At the same time we are seeing this high growth, our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements, and deficient-stress testing practices.”
All regulatory roads are going in the same direction, where banks are expected to expand the breadth and depth of their overall capital planning and stress testing process. This entails determining how interest rate risk, liquidity risk, and credit risk could impact capital.
Interest rate risk
For the past several years, many management teams and board members have been scared to death of rising rates. These groups have kept their asset duration as short as possible and/or extended funding to position themselves for the eventual sizeable increase in short-term interest rates.
This shift in balance sheet mix at many institutions has exacerbated the potential exposure of earnings if rates were to decline meaningfully at the long end of the yield curve.
At the end of 2013, the 10-year treasury hit 3.04%. Note that the 10-year treasury recently hit 1.35%.
Whether you believe that yours is an asset-sensitive or liability-sensitive institution, for the vast majority of financial institutions, the greatest potential long-term exposure is to falling interest rates.
The unfortunate reality is that this is the exact scenario that has materialized at the long end of the yield curve over the past 12 months. With the recent strong rally in the bond market, our experience indicates that many community bankers have not fully grasped the implications of where interest rates are today and the overall impact on their balance sheet and on the banking industry as a whole.
For those who make projections regarding where they believe capital ratios could be based on their plan, where do the ratios go if you layer in a 100-basis-point decline in long-term rates over 6-12 months? What is the potential reduction to net interest income—and ultimately, net income—and how does that impact the expected path of your capital ratios?
If you believe you have earnings exposure to significantly higher rates, have you quantified the potential earnings impact if short-term interest rates moved rapidly higher and the yield curve flattened? How does this earnings impact flow through your capital ratios?
Have you quantified the potential earnings impact if 10%-15% of your entire non-maturity deposit base shifted into higher-cost CDs (if rates were to rise)?
What if they left your balance sheet altogether and had to be replaced with considerably higher-cost wholesale funding alternatives? How about 25% of your deposits?
Notwithstanding the actual amount of liquidity you would have after this potential migration, what would the potential earnings impact be? How would that flow through your capital ratio projections?
On the other hand …
What if the U.S. dipped into a recession, short- and long-term rates dropped meaningfully, additional liquidity flowed into your institution, and your asset footprint ballooned materially over a very short period?
Does your bank have enough capital today if that scenario were to arise?
Those institutions that have high concentrations of asset classes that are deemed to be “riskier” and are not currently doing some sort of credit stress testing (account level or portfolio level), here is your warning!
Having an elevated level of riskier assets does not necessarily mean you need to change your current strategy; however, needing to document—and defend—on paper why you are comfortable with the concentration and your current capital position is becoming a norm.
An institution with non-owner-occupied commercial real estate at 350% with a 12% leverage ratio is a much different story than the same concentration level and a 7% leverage ratio.
Many institutions have found that they are better off investing the time and effort into creating a robust credit stress-testing process and capital plan to help defend their current and planned concentrations.
Going through that rigorous process sooner, rather than later, may save you more than some anxiety in a regulatory meeting. Understand that there could be an astronomical cost to exiting or slowing the pace of growth in various types of loans that may be your bread-and-butter business, considering the potential give-up in higher yielding assets.
Here are some common and very important questions your bank should be answering:
1. From a credit perspective, how did your institution fare in the last crisis? How about the crisis before that?
2. If your institution has historically had very few losses, how does it look if you applied a national loss rate to your various loan portfolios (CRE, residential, C & I, etc.)? And how would that flow through to the capital ratios?
3. How about a regional loss rate? How did your region compare vs. national loss rates? If your institution has historically had very high losses, when compared to your region or national loss rates, what have you done over the past 7-8 years since the last crisis to ensure your institution will never be in that position again?
Such questions need to be addressed and documented accordingly.
“Perfect storm” of what-ifs
Looking at all of these financial risks in silos, regardless of the probability that you may put on them, can be a very valuable exercise.
More importantly, the most telling story is when you can simulate a “perfect storm” type scenario.
Examiners simply want to know, “What scenario or combination of scenarios will break your institution? And how are you going to fix it … before it happens?”
When you sit down and really think about it, is that too much to ask? Examiners do not think so!
The 2016 Fed DFAST/CCAR* “Severely Adverse” scenario looks at a quickly deteriorating economy with a decline in short-term and long-term interest rates and a sizeable expected increase in credit-related loan losses.
What is the potential impact to your bank’s capital ratios in such a combination of conditions? And what is your ability to grow? And could you, if necessary, face additional losses if all of these scenarios simultaneously occurred?
Demonstrating and quantitatively defending that you have more than enough capital to absorb or offset the potential interest rate risk, liquidity risk, and credit risk impacts all at once can be a very powerful exercise to not only show to your examiner but also your management team and your board.
Why these practices rank so important
For those bankers out there that can’t sleep at night, this exercise helps. Let’s say the numbers in your capital plan and stress testing regimen show that you may not have enough capital to withstand one or a combination of the stress tests’ posited events, as unrealistic as some of them may be. Wouldn’t you rather know now, when you can address the risks?
Documenting relief strategies is becoming the norm in an effective capital planning process. Consider these questions:
1. What actions would you need to take if adverse scenarios were to materialize today and how would I prioritize the relief items?
2. What is your timetable for implementing these various relief strategies?
3. Are management and the board on the same page with respect to the specific relief strategies at their disposal and the priority of these relief strategies?
4. Does the bank need to change its base plan—including the business model and budget—for the upcoming year if you think capital ratios are getting too tight?
All regulatory roads are leading to more robust capital planning and stress testing processes. Institutions doing it most effectively are not doing so strictly to appease the regulators. They are doing it as part of a sound risk management process that enables them to defend both the current mix of their asset base and their overall strategic plan for the next few years.
* DFAST stands for Dodd-Frank Act Stress Testing. CCAR stands for Comprehensive Capital Analysis and Review.
About the author
Steve Boselli is a managing director at Darling Consulting Group, where he consults with financial institutions of all sizes across the country on balance sheet management strategies. Since joining the firm in 2005, he has held various positions within DCG, assisting clients in all aspects of ALM, including quarterly ALM modeling/consulting for advisory clients, process reviews, model validations, policy development/reviews, strategy development sessions, capital management/planning, and contingency liquidity planning. Prior to joining DCG, Steve worked for a small investment firm for three years.