By Keri Crooks, managing director, Darling Consulting Group
Today’s environment has bankers sprinting on a treadmill, trying to stay on the performance track while meeting the increasing challenges imposed by low interest rates, intense competition for loans, and regulatory expectations.
Can you—and how can you—win the ALCO race? This breaks down into many facets. Below are three of the most common questions community bankers have been asking Darling Consulting Group.
“What do examiners zero in on now?”
1. In what part of the asset/liability management process is DCG seeing heightened focus during examinations?
Without hesitation, my answer is model assumptions—in particular, those assumptions within interest rate risk models that relate to non-maturity deposits.
I’ve had extensive experience in the creation and use of asset/liability management models. I can tell you that the results of the two most prevalent interest rate risk management tools—net interest income (NII) simulations and economic value of equity (EVE) analysis—can each look incredibly different from one period to the next by altering a few key assumptions.
The assumptions that create the greatest degree of variation are pricing betas and average life/stability assumptions for non-maturity deposits.
Or, stated more plainly:
• How each bank will price its deposit products, and
• How long the deposit dollars are expected to be available, especially as rates increase.
There are broad variations in these assumptions among different banks. These inconsistencies may well be warranted. They can be driven by differences in market place, product mix and pricing, and depositor demographics. But they can also be the result of management’s uncertainty over deposit behavior.
These factors—combined with the industry’s rapid deposit growth trend over the past six years and the significance of non-maturity deposits as a percentage of total industry funding—legitimately have regulators on high alert. Consequently, we see increased scrutiny on the process and documentation supporting each bank’s development of these key assumptions.
To adequately prepare for your next exam, while ensuring that your risk management models are accurate and contribute to your strategic focus, use history as a starting point. Analyze historical non-maturity deposit behavior at your bank.
This type of analysis can run the gamut. This can range from a simplified look-back at the longevity of accounts and pricing behavior in the last rising rate cycle (2004-2006) for each product type, through to a full-blown deposit study using quarterly deposit data over rising and falling interest rate cycles to quantify potentially volatile deposits vs. core funding, average life assumptions, and deposit pricing adjustments.
The results of either analysis will provide you, your board, and management team, and regulators with a more solid launch point than just “going with your gut.” And such preparation also fits nicely into strategic discussions on rising rate deposit products, pricing, and potential hedging opportunities.
“Lending activity is fairly stagnant. Is anyone doing better?”
2. What type of trends and volumes are you seeing at other banks for loan growth in 2014?
Generally speaking, loan growth remains anemic in most markets.
Certainly some banks “buck the trend,” and all markets vary. However, the typical bank appears to be budgeting for less than 5% net new loan growth in 2014.
The concern out there is that even 5% may be optimistic in the absence of a resurgence in housing activity this spring.
With the slowdown in refinancing activity given higher interest rates, most mortgage pipelines have come to a screeching halt over the past two quarters. In the absence of significant new purchase activity in 2014, mortgage lending will again be a much smaller piece of the pie when compared to prior years.
This has most banks looking hard at opportunities to grow commercial real estate and C&I lending. In most instances competitive pressure requires a much sharper pricing pencil and a comfort level with longer maturities and/or repricing intervals than have been the norm.
Some banks are even forgoing meaningful lending covenants and/or moving down the credit quality spectrum. “Logical” market pricing and structuring is clearly not prevalent given that benchmark interest rates are nearly 100 basis points higher on the intermediate points of the yield curve (5 & 10 years, as examples) over the past year.
These trends are indicative of a continued sluggish economy in which businesses remain reluctant to borrow for funding needs given concerns over future revenue prospects and growing expenses.
We continue to hear from many community banks that the majority of commercial lending activity generated is existing credit being stolen from other banks as opposed to new project financing or draws on lines of credit.
To add some positive perspective, some niche lenders and market areas (sustainable energy, agriculture, as two examples) are experiencing meaningful growth and strong borrower balance sheets.
Community banks that consistently generate loan growth in excess of the “norm” have also made a concerted effort not to fall into the trap of simply throwing up their hands and blaming the sluggish economy and competitive environment for the lack of activity.
Instead, these bankers have actively encouraged their lenders to discuss at ALCO the “hurdles” to getting deals done. Acceptable strategies can often be developed based on the overall risk position of the bank … and, more often than not, they do not involve just giving the borrower a lower rate.
Additionally, community banks that outpace their peers on the loan growth front have often created focused growth strategies within new markets, under-banked markets, or through the acquisition of lenders who are already active and well known in specific market areas (frequently bringing over a book of new business to the bank).
If you are struggling to move the needle on your loan portfolio, take an honest look at whether the cause is 100% a consequence of the environment or if it might be driven to any degree by not having the right people, products, and discussions.
Danger from all directions
3. Earnings are under pressure today, sustained low or falling interest rates present the biggest earnings challenge for my bank, but everyone seems to be concerned with rising interest rates. How do I make sense of this and manage for today while still preparing for rising rates?
The perpetual downward trend evident in most NII models a year ago has diminished and many are showing a flat trend in today’s environment given the steeper yield curve.
However, bottom line income is under tremendous pressure, given additional compliance costs, regulatory changes, escalating employee costs, declining fee income opportunities, and an inability to further squeeze deposit rates.
At the same time, a falling interest rate scenario, wherein interest rates revert back to early 2013 levels (back to a flatter yield curve), presents the worst earnings at risk scenario for many banks.
This can pose a significant challenge, given that the regulatory community is increasingly focused on rising rate risks. If your bank is in this position, be prepared to explain the operating strategy, as it is likely that your bank will be moving towards a less asset-sensitive or more liability-sensitive direction.
First, you must be able to clearly articulate and support your bank’s capital, liquidity, and interest rate risk positions, recognizing that you cannot afford to have your position wrong or have weak monitoring and reporting tools.
Second, each bank needs to manage risk and direct strategies based on significant plausible exposures, not betting on interest rates or succumbing to fear.
To achieve this, you must ensure that you address a sufficiently wide range of meaningful and plausible interest rate scenarios. Combine this with the use of several interest rate risk scenarios and liquidity monitoring in addition to monitoring NII and/or EVE and liquidity ratios.
Examples include: Liquidity forecasting, bond portfolio market valuations under varying rate scenarios, and stress testing for adverse events.
Also ensure that adequate policies and procedures are in place surrounding balance sheet management. While these items may seem obvious, being able to tell the story of your bank’s position and invoke clear conclusions will be critical at your next exam and to managing your bottom line.
If your worst-case scenario is falling interest rates and you find yourself defensively positioning your bank for rising rates, you may be giving up meaningful income today and adding risk to your most challenging rate scenario—increasing your risk of potentially operating at a loss.
Model assumptions, back testing for the accuracy of earnings projections, robust risk management tools, and managements understanding of the risk management process all play key roles in combating this challenge.
In evaluating preparation for rising interest rates, it is interesting and natural that the current focus is centered on earnings and capital at risk. However, even if you have determined that your greatest risk to earnings and capital is falling interest rates and can adequately defend your position, you should also take a hard look at the strength of your liquidity profile
After all, an inability to support funding needs can quickly result in problems for banks—think back to 2007/2008. Now consider a rising-rate scenario combined with a true economic recovery, wherein loan growth opportunities accelerate and funding is needed.
Liquidity concerns have taken a back seat of late, as deposit growth trends have produced excess cash levels at many banks, resulting in an active reduction in wholesale funding positions, and leaving most feeling like their liquidity problem is that they have too much of it.
However, this trend can change rapidly for one of two reasons (possibly both): the potential for deposit outflows or for accelerated loan growth. This forms the basis for much of the recent increased regulatory emphasis on the areas of liquidity management and contingency planning.
Review the deposit trends at your bank since 2007 and review how many dollars have deposited themselves within non-maturity products despite the extremely low rates of return. If retail and/or business deposits appear to have grown meaningfully (and above longer-term trends) at your bank, stress test for a scenario where a meaningful portion of these dollars leave the bank.
For many banks it has made sense to redeploy investment cash flows into new loan demand or to pay down wholesale funding in an effort to improve income and/or steer away from the risks associated with buying investments. This will generally have resulted in a decline of on-balance sheet liquidity levels (cash and bond collateral).
To balance this, banks should ensure that their ability to access wholesale funding outlets is robust and reliable. Work with your Federal Home Loan Bank to improve borrowing capacity levels, ensuring that potential loan collateral is pledged and available to borrow against if and when needed. More often than not, levels of pledged loan collateral have not kept up with loan growth in this cycle as there has been a limited need for borrowing to date.
These wholesale strategies should be coupled with the development of potential deposit promotions to have “on the shelf” for combating competition in rising rates.
Finally, for those banks that are growing commercial loans, there is a renewed and successful focus on gathering business deposit relationships in an effort to strengthen core transaction accounts, which can be cost effective today and of great benefit when rates do rise.
The key takeaway from these common concerns is that bankers are under many different and competing challenges today.
As a result, actions taken must be based on good information and reflect a full understanding of each bank’s risk profile.
And, they need to be forward looking.
Simply sitting tight and waiting for rates to rise and a rational banking environment to return is not a viable strategy.
About the author
Keri Crooks joined Darling Consulting Group in 2002. She presently consults directly with ALCO groups and boards of directors in the area of asset liability management with the goal of enhancing high-performing institutions. Additionally, Keri remains actively involved in advancing Liquidity360°, DCG’s proprietary liquidity risk management software, and is a frequent author on balance sheet management topics.