By Joe Kennerson, managing director, Darling Consulting Group
One can argue that strategic balance sheet decisions executed today are more critical to a bank’s risk profile than any other time in the history of the banking industry.
• Market rates are near historic lows.
• The yield curve is the flattest it has been since 2007.
Inevitably, margins are under pressure. In a penny business—every basis point counts.
Given the business pressures, ALCOs must consider the impact of the entire risk position when strategically positioning its balance sheet. Whether the bank is considering extending assets; leveraging the balance sheet; lengthening liabilities; or shifting from investments into loans, all elements of financial risk must be analyzed in order to fully understand the impact on the risk profile.
This includes, but is not limited to:
• Capital at risk
• Interest rate risk
• Liquidity risk
• Credit risk
In other words, managing financial risk in silos is no longer sufficient in today’s dynamic banking industry. ALCOs must integrate interest rate risk, liquidity, capital, and credit in conjunction with a robust stress-testing platform to truly understand risk tolerances and drive effective strategy decisions.
Let’s review what we are up against in today’s banking environment. We recently hit historic lows in treasury rates. The last rising rate cycle occurred over ten years ago. Credit underwriting is weakening in some markets. Loan pricing and term structures are at levels never seen before. On-balance-sheet liquidity levels are declining. Loan growth is outpacing deposit growth. Asset extension is inevitable in a historically low-rate environment.
Most importantly, banks are battling just to sustain net interest margin. Sometimes we need to remind ourselves why we got into this business.
This intersection of an uncertain and volatile market with the need to increase (or just maintain) margin makes every balance sheet decision critical. Therefore, the execution of strategy ideas at ALCO meetings must consider the impact to all areas of risk.
Regulatory pressure to integrate the risk management process is taking shape, in conjunction with immense changes in the overall landscape since the financial crisis.
In this decade we have witnessed the evolution of stress testing in the community banking sector for liquidity, interest rate risk, capital, and credit. Additionally, the pressure to develop bank-specific assumptions continues to strengthen while, more recently, there has been a focus on credit-related concerns such as commercial real estate concentrations and underwriting standards.
The conclusion is that managing risk in silos is no longer acceptable. Instead, best practice would suggest an integrated risk management process.
Let’s share an example. Most banks are performing deposit studies today to identify potential “non-core” or “surge” customers. The result of the deposit study should be used to develop assumptions for interest rate risk models (think rate betas and average lives).
However, the results should also be leveraged into stress-test models to understand disintermediation risk (both interest rate risk and liquidity); help position wholesale funding (i.e. stay short or extend); and, ideally, to help make future product and pricing decisions.
Do this before your next exam and expect high marks.
Bringing it together
The plethora of risk modeling performed on an annual basis has been growing exponentially this decade. Furthermore, it is not uncommon to see a bank reach out to many providers for the following risk analyses:
• Interest rate risk models are performed in-house or can be outsourced.
• Liquidity analyses are generally built in a separate report (along with liquidity stress testing).
• Deposit and prepayment studies are typically a popular service to outsource.
• Capital plans are generally produced annually.
• Credit stress testing is now trickling into the community bank sector.
Sounds overwhelming for risk management teams. The good news is that examining the impact of strategic ideas on all risk positions can only enhance your ALCO process and bring your management team closer together.
Putting concept into practice
Let’s walk through a couple of strategy topics discussed today:
1. What is the capacity to add fixed-rate loans to the balance sheet in order to protect against a sustained low-rate environment?
In this first example, many banks today are faced with loan pricing pressure which is causing the margin-roof to cave in. To understand the capacity to extend assets in today’s balance sheet you must analyze and model the following:
a. Understand customer behavior patterns:
• Account-level prepayment analyses can determine the true average life of specific loan portfolios so the bank understands what type of extension risk is being considered.
• Utilizing the aforementioned deposit study results can identify what the true “core” funding position is, to help support the growth of longer-term assets.
b. Interest rate risk: Run various “what-if” simulations to show the potential impact of holding onto fixed-rate mortgages or commercial real estate loans to see what the exposure could be 6-12 months down the road. Further, focus on a more practical approach of “gradual” interest rate ramps vs. immediate rate shocks to get a clearer view of interest rate risk.
c. Liquidity: Determine the liquidity impact of the growth and identify the most prudent funding strategy: shifting investments into loans, raising deposits, or utilizing wholesale funds. Answer the following question: “How low is too low for on-balance sheet liquidity based on my balance sheet and risk profile?”
The answer could determine the ability to focus more on loan growth versus purchasing investments, and drive margin higher.
d. Loan pricing: Identify the risk/return by holding longer-term commercial real estate deals that the bank would historically walk away from (e.g. 7-10 year fixed deals). Also, analyze the break-even analysis of fee income potential lost from loan sales if the bank leans toward holding more in the portfolio.
e. Earnings/Capital: Open the discussion to understand the importance of hitting income goals this year versus setting up for a higher-run rate of net interest income in 2017.
2. If your bank is exposed to rising rates, should the bank extend funding at today’s ultra-low rates?
A similar approach should be taken on this second example of extending funding to protect against rising rates:
• Understand customer behavior patterns: In most cases, the amount of checking, savings, and capital provides enough “core” funding to allow for the wholesale funding position to stay shorter on the curve. Determine this “core” factor. Run stress tests to examine the potential risk if you are wrong.
• Interest-rate risk: All banks should know how much insurance they need and how far out on the curve to extend. (Hint: For most banks it is not 5+ years.)
• Liquidity: Understand the best option for protection (cash market vs. derivatives). Consider the various wholesale funding options outside of just FHLB advances (e.g. brokered deposits and national CDs).
Important: Consider the use of derivatives if extending funding due to the rate advantages. Ensure that your board is educated, policies are established, and all risks are analyzed.
• Deposit initiatives: Understand the risk of declining liquidity levels if loan growth outpaces deposit growth and whether deposit pricing and marketing initiatives need to be addressed early in the strategy discussion.
Both strategic ideas bring all of the risk elements into play and engage all levels of senior management. The dynamic conversations that will be ignited from Lending, Credit, Finance, Treasury, and Retail will drive ALCO to the next level. Most importantly, the discussions and analysis will get the bank to a point of execution.
The 10-year Treasury rate is down 73 bps since year-end. The pressure on asset yields is not going to fade away any time soon. The strategy discussions within ALCO circles have never been more critical than they are today.
Every balance sheet decision must be analyzed and modeled through all areas of risk management. Execution of strategies could be the difference in making your earnings goal or not. After all, in a penny business—every basis point counts.
About the author
Joe Kennerson is a managing director at Darling Consulting Group, working with financial institution executives to improve the effectiveness of their asset-liability management process. He provides tailored solutions for managing interest rate risk, liquidity risk, and capital. Joe is also expert in the overall balance sheet management process, including risk model design and implementation; regulatory compliance; and executive-level education. He is a frequent speaker and author on ALM topics.
Kennerson has been with DCG since 2005, and is a graduate of University of New Hampshire with a degree in finance.