Commit to Process and Framework in the New Year

The challenging last three years have done nothing but reinforce our belief that the best-performing community banks, over the long run, anchor their balance sheet management in a set of principles – not in divining the future.

They organize their principles into a coherent decision-making methodology that evaluates all capital allocation alternatives across multiple scenarios, over time, on a level playing field. Unfortunately, however, far too many community bankers rely on forecasts of interest rates and economic conditions, which are then engraved into budgets, compensation programs and guidance provided to stock analysts and asset-liability providers.

If we’ve learned anything recently, it’s that nobody can predict rates – not even the members of the Federal Open Market Committee. A year ago, its median forecast for fed funds today was approximately 0.80%; the reality of 4.50% is 370 basis points above this “prediction.”

Even slight differences between predicted and actual rates can result in significant variances from a bank’s budget, which can pressure management towards reactive strategies based on near-term accounting income, liquidity or capital. We’ve long argued that this approach will usually accumulate less reward, and more risk, than proponents ever expect.

Community banking is challenging, but it needn’t be bewildering. The following decision-making principles can clarify your path and energize your execution:

Know where you are.
Net interest income and economic value simulations in isolation present incomplete and often conflicting portrayals of a bank’s risk and reward profile. To know where your bank is, hold yourself accountable to all cash flows across multiple rate scenarios over time, incorporating both dividends paid to a horizon and the economic value of the bank at that horizon. This framework produces a multi-scenario view of returns to shareholders , across a range of possible futures. Making capital allocation decisions in the context of this profile is everything; developing and consulting it is far more inspiring and leverageable than a mere asset-liability exercise.

Refuse to speculate on rates.
Plenty of wealth has been lost looking through the wrong end of the kaleidoscope. Nobody can predict rates with any utility – not economists, not even the FOMC. Make each marginal capital allocation in the context of your shareholder return profile, avoiding unacceptable risk in any scenario while seeking asymmetric reward in others. The idea is to stack the deck in the bank’s favor, not to guess the next card.

For example, imagine your institution is poised to create more shareholder wealth in rates down scenarios than up, a common reality in the current environment. Should you consider trading some of this for outsized benefits in the opposite direction, or not? Assess potential approaches across multiple scenarios: compare short assets versus long liabilities, test combinations or turn the dial through simple derivative strategies to asymmetrically adjust returns or create functional liquidity.

Price options appropriately.
Banks sell options continually, but seldom consider their compensation. They often price loans to win the business, rather than in comparison to wholesale alternatives, and they often forgo enforceable prepayment penalties. Less forgivably, many banks sell options too cheaply in their securities portfolios, in obtaining wholesale funding or in setting servicing rates. Know who owns each option the bank is short, and determine whether it is priced appropriately by comparing it to possible alternatives and measuring the impact on the bank’s forward-looking return profile.

Evaluate risk and regulatory positions.
To make capital allocation decisions prospectively, principle-based decision-makers assess their risk and regulatory positions prospectively as well. The bank’s enterprise risk management platform should offer an objective assessment of its current capital, asset quality, liquidity and sensitivity to market risk positions, and simulate these on a prospective basis also. The only way to determine if a strategy aligns with management’s specific risk tolerance is to have clarity and confidence in its pro forma impact on risk and regulatory positions. For many, establishing secured borrowing lines and reviewing contingency funding plans in 2023 will be prudent steps.

These principles are timeless – only the conclusions they lead to will vary over time. Those institutions that have already woven them into their organizational fabric are facing 2023 and beyond with confidence; those adopting them now for the first time can soon experience the same.