By Mark Haberland, managing director, Darling Consulting Group
We’ve all heard the song “Happy Days Are Here Again”—a song that came out in the early 1930s and has been used innumerable times to inspire hope after a long period of challenges. Most notably, FDR used it as his campaign song to lead America out of the Great Depression.
Many bankers may feel like the industry is emerging from its own “Great Banking Depression” as we have not seen three consecutive Fed hikes since the summer of 2006.
But hope alone is not sufficient to truly make a difference. This time is different. Everyone is looking for answers. But how will we know when we find it?
Stop looking for the “quick fix”
Interestingly, when I visit bankers throughout the country doing ALM training and workshops, one item that frequently comes up in discussions is that “time and expertise” are the biggest deterrents in their banks for bringing asset liability management (ALM) to the forefront.
They know it’s important, and will often look to articles, blogs, and even social media to find recommendations and “quick fixes” to help.
But what’s good for the bank across the street may not be the right fit for you. There is no quick fix to be had.
Rather than looking for instant solutions, bank ALCOs must focus on strengthening their internal decision-making process in a way that fits their institution. While each bank will have its individual approach to managing its balance sheet, there are several issues that should be at the forefront of all discussions around your ALCO table:
• Deposit pricing and stability
• Liquidity management and contingency planning
• Strategic discussions that fit your risk profile
Let’s look at each of these.
Deposit pricing and stability
Everywhere you turn, you are hearing about the importance of deposits as we head into the next rate cycle. Yet deposit management is a very bank-specific topic. Where trouble usually arises is when banks use the competition as a means to determine products and pricing, reacting to the market, rather than looking deeper into their customer base to be more proactive.
When examining your deposit base, it is important to gain a better understanding of the makeup, tendencies, and trends of your deposits, such as:
• Segmentation—The best way to determine the stability of your depositors is to look deeper into each customer relationship.
What makes a customer more stable? Those with direct deposit or auto bill pay? What about those who have multiple relationships with the bank or a loan linked to their deposit account? And what about those customers with more than one of these indicators?
Identifying factors that keep your customers at your bank (besides rate) will help in the decision-making process when the time comes to raise your deposit rates. Knowing who is more rate-sensitive and who is more locked into your products and services will be vital. It will help you decide when and how much to raise rates—or if it makes sense to offer new “premium” products to a certain segment of your customer base to retain the relationship.
• Marginal cost of funds—As banks look to offer “premium” products or specials in an effort to either maintain or grow deposit balances, it is important to understand the “true” cost to the bank.
Analyzing the impact of migration from other accounts and how much that changes the real cost can help determine the overall success of a deposit campaign. Also, when considering whether to raise the rates on your existing deposit base, having an indication of the “at risk” balances is extremely helpful in your pricing conversations as to whether to increase an entire account or focus on the balances most likely to migrate out if the rates are not to their satisfaction.
You may be surprised to see how insightful this analysis can be—and how much it can save your bottom line.
• Large Depositor Behavior—Your largest customers can provide great benefits to the bank. Yet such valuable relationships can also be cause for great stress when they leave you for another institution.
Utilizing segmentation analyses as discussed above makes it easier to identify those accounts that are more stable. For those that are at greater risk to move, how best to manage those relationships?
While it is always beneficial to cross-sell your customers into other products and services, for those that are more single threaded it becomes vitally important to monitor behavior more closely.
We have found that with these larger accounts, there are usually several consecutive periods of balance declines before the account closes. Armed with this type of information, it becomes easier (and more necessary) for your retail/marketing group to get in front of these relationships as they begin to see balances decline in consecutive periods.
Statistical deposit studies provide useful information regarding assumption support, yet getting into the more granular analysis of your deposit base truly allows for a more thorough understanding of your customers. This leads to more valuable discussions on interest rate risk and liquidity management at your ALCO meetings.
Liquidity management and contingency planning
Liquidity is once again at the top of most regulatory exams—whether you think you have sufficient levels of liquidity or not.
As discussed, the potential for deposit outflows as rates begin to rise will only place additional pressure on liquidity levels. So your ability to continually monitor liquidity levels (and needs) and have an effective contingency funding plan (CFP) in place will provide your ALCO with key strategic insight. But beyond that, honing that ability and demonstrating it will help give the regulators some comfort that you have liquidity under control.
While it has been commonplace for banks to manage liquidity through monitoring of key ratios (i.e. loan-to deposit, LCR, etc.), it is more important than ever to be able to identify actual cash availability when discussions about managing the balance sheet take place.
Knowing your levels of on-balance sheet liquidity (cash, security collateral, etc.) is important. But it is also, unfortunately, where many banks (and examiners) tend to stop when identifying liquidity levels. You must also factor in loan-based collateral availability at the Federal Home Loan Bank (FHLB) and Federal Reserve (FRB), Fed Funds lines, and brokered (or national market) deposits.
That total liquidity position allows you to identify how much cash you can raise in a short time, with no principal losses (or asset sales) and at market rates. This information is extremely important when discussing funding for your loan pipeline or security purchases.
But don’t stop there.
You will need to analyze your ongoing liquidity levels under a variety of stress situations. Determine what the potential impact could be for your available funds. Identify what you will do if liquidity reaches uncomfortably low levels.
Implementing an early warning system will allow for continuous monitoring of your key liquidity metrics and should help prevent liquidity crises from occurring.
These are important elements of an effective, forward-looking liquidity management process that, along with the analysis of your deposit base, provide your ALCO with information upon which to facilitate strategic discussions.
Once you are confident you understand the stability of your deposit base and how much liquidity you have (and need), your ALCO is armed with critical pieces of the puzzle to determine the right strategic direction for your bank.
Strategic discussions that fit your profile
Once you have a comfort with the stability of your deposit base and have factored pricing and migration assumptions into your IRR and liquidity models, you will be presented with an indication of your risk profile.
This analysis should include:
• A longer-term net interest income analysis—one that provides insight into both your near-term and longer-term exposure to changes in rates. This must be computed under a variety of rate scenarios.
• Liquidity analysis that includes two key elements. The first concerns the total availability of liquidity (on-balance sheet, access to FHLB, FRB, and brokered/national deposits). The second is a liquidity forecast that anticipates how changes to the balance sheet will impact liquidity sources going forward.
• Capital analysis to determine if current capital levels are sufficient to meet growth expectations of the bank’s business plan or potential losses within the bank’s portfolios
These three factors should be incorporated into every strategic discussion your team has at its ALCO meetings. Too often ALCO meetings get overlooked. Bankers treat them more as a review of the past than a look into the future.
Incorporate the analyses described above into your discussions. Take a more forward-looking view of your bank and think, “Where do we want to go, and how do we want to get there?”
Then your ALCO meetings can progress more like mini-strategic planning sessions, and your bank will truly begin to reap the benefits.
Strategies that work for one bank may not be a good fit for yours, so identify your overall risk profile; determine your strategic direction and risk tolerance; and involve all key stakeholders in your discussions.
And these meetings are not to be done occasionally or when time allows. Only those banks that put the focus on continually evolving and finding strategies that fit their position will be prepared to navigate through the ever-changing economic environment.
It is different this time
The challenges that lie ahead for bankers are like none the industry has experienced before. This rising-rate environment cannot be viewed in the same light as the last, with so many changes to the industry, economy, and daily life (hello smartphones!).
Bankers need to take the long view when looking at customers. Their wants, needs, and options are greater than ever before. But the good news is that this period of rising rates brings with it opportunities that we have been longing for since the economic crisis began nearly a decade ago. So…
• Take a more forward approach to your ALCO meetings.
• Take control of your deposit pricing and product strategy by better understanding the behavioral tendencies of your customers.
• Make the most effective use of your liquidity resources to manage ongoing balance sheet growth.
A bank that is involved in the details—going beyond the ratios and regulatory requirements to really understand its position and opportunities—and that looks at ALCO as a “profit center” will be singing “Happy Days Are Here Again” in 2017 and beyond.
About the author
Mark Haberland is a managing director at Darling Consulting Group. In this role, he works directly with financial institutions to strengthen their asset/liability management process. He provides support to clients in the areas of liquidity risk management, capital, ALM modeling and reporting, and regulatory compliance.
Haberland has been with DCG since 1997 and oversaw the operations of the company’s Financial Analytics Group for many years. He has over 20 years of experience in the banking industry in the areas of asset liability management and bank auditing.