2 Truths for the New Year

The steady march toward community bank consolidation is not slowing down. In the coming years, more communities will lose their independent financial partners, driven by concerns over shareholder liquidity and management succession. The underlying root cause of both drivers is the same: unattractive long-term return on investment, stemming from mediocre performance in capital allocation. Regrettably, conventional tools and methods, amplified by single-scenario-based thinking, fuel this persistent, pervasive problem. 

The antidote lies in successfully adopting, believing in and acting on two irrefutable truths:

1. 1.) No one can predict the future, be it in terms of interest rates, economic outcomes or political tides. 
2. 2.) Risk and reward are relative. They are interconnected and mutually-reinforcing. Capital allocators must focus on how much marginal risk they’re taking for every marginal unit of reward.

Over the past two years, I have visited with scores of community bank boards around the country, helping them examine their balance sheets through a multi-scenario lens. Far too often, within the first hour together, we discover that both these truths have been abandoned.

Violating Truth #1: Guessing Interest Rates
Far too many banks try to divine future interest rates and economic conditions. These forecasts drive budgets, compensation programs and even investor earnings guidance.

Nobody can predict rates, not even the Federal Reserve’s Open Market Committee (FOMC), the body in control of the overnight rate. 

Yet even slight differences between predicted rates and reality can result in significant deviations from budget. Pressed to deliver, managers often adopt strategies usually based on near-term accounting income, liquidity or capital. But following this approach accumulates measurably less reward and more risk than its proponents expect.

Violating Truth #2: Conventional Asset/Liability Management
Community banks rely on net interest income (NII) simulation to quantify short-term earnings risk and economic value of equity (EVE) to assess long-term earnings risk. These conventional measures offer important insights but are structurally impaired. 

Imagine three instruments, each with a different yield (an accurate but incomplete measure of reward) and duration (an accurate but incomplete measure of risk). NII simulation prefers the highest yield, whereas EVE opts for the shortest duration. Facing conflicting portrayals of risk, many bankers choose to dismiss EVE. While imperfect, EVE accounts for both current income and future income — measuring all the cashflows resulting from a decision. 

Thankfully, profitability metrics are recovering from their recent lows, as maturing and resetting asset cash flows reprice to market rates. Don’t forget the experiences of the past eight years through a complete rate cycle. If in the past your asset/liability reports encouraged you to seek risk when your objective was to mitigate it, perhaps by pushing into long bonds at the lows and tights of rates, recognize that reverting to business as usual is not an option.

The Way Forward
The key to overcoming mediocre performance is to adopt a comprehensive decision-making process that examines multiple scenarios and counts all cash flows over time.

Challenge yourself to the following in the New Year:

• Steer by a strategic North Star. Principles-based decision-makers frame each marginal capital allocation in the context of the enterprise’s shape profile, reflecting total returns to shareholders across multiple possible futures through time. This profile frames the future of the allocation decisions you’ve made in the past to evaluate the impact of a decision being made today. This dynamic approach shines a bright light on performance exposures that conventional asset/liability cannot detect.
• Price options appropriately by asking, “Compared to what?” Banks sell options all day, every day, seldom considering the compensation. Far too often, option-laden loans are priced to win the business rather than in comparison to wholesale alternatives. Know who owns the option, how much you are getting for it, and whether it rewards you enough for its risk by judging it dispassionately against alternatives. 
• Evaluate risk and regulatory positions prospectively. Assess the prospective risk and regulatory effect of capital allocation decisions through an enterprise risk management platform that offers an objective assessment of your current capital, asset quality, liquidity and sensitivity to market risk positions and simulates the same on a prospective basis, including under stress scenarios. Alignment with management’s unique risk tolerance relies on clarity and confidence around a strategy’s effect on pro forma risk and regulatory posture. 

Concluding Thoughts
Experience suggests that 2026 will be another challenging year, but it needn’t be exhausting. The choice is yours: Embrace a more complete analytical view rooted in the laws of math and logic, or find an excuse not to. 

*Performance Trust has been advising community banks for 30 years and is a registered broker/dealer, member of FINRA/SIPC. This is intended for educational and informational purposes only and is not intended to be legal, tax, financial, or accounting advice or a recommended course of action in any given situation. This is not an offer or solicitation to purchase or sell securities. The Information is subject to change without notice.