Despite continued regulatory challenges and a sluggish economic environment, most financial institutions have seen their situations improve in recent months. How will banks keep the momentum going? We outline three areas to focus on.
Priority #1: Increasing Capital
Capital drives so much right now from the regulators’ perspective. Excluding statutory requirements, capital is the regulators’ be-all and end-all.
So how much is enough? In recent stress tests of the banking system, the results show that all but one of the top 30 banks—Salt Lake City, Utah-based Zions Bancorp.—would have ample capital to survive the exceptionally poor economic conditions and continue to lend. However, regulators failed four other banks based on qualitative concerns about their capital plans. The latest Comprehensive Capital Analysis and Review took some industry observers by surprise, as the Federal Reserve objected to five of the 30 participants’ capital plans, and approved another two banks only after they resubmitted.
The regulatory scrutiny clearly remains intense, and banks should not expect this level of oversight to ease anytime soon. To stay ahead of the curve, banks should examine their capital levels and ask a number of questions, including:
- How will my capital ratios be impacted by changes in risk weights?
- How will I respond to those changes?
- Do I need to change my product mix or my underwriting? Should I even consider a strategy where the bank’s assets shrink in the short term?
- Do I need to adjust my risk tolerance in lending?
- Should I consider outsourcing certain functions or decrease operating expenses?
At a minimum, banks will need to integrate into their capital planning and strategic planning processes an analysis of where they stand relative to Basel III requirements. This will ensure they are well-positioned to address any capital needs.
Priority #2: Managing Credit Quality
The continued low-rate environment has compressed the net interest margin for most institutions. As a result, bank executives are turning to new, expanded or modified product offerings and service lines to improve performance.
As with any new opportunity, it’s critical to make sure that the risks are appropriately assessed and priced. New products and services may have a totally different risk profile than the bank’s traditional fare—and the bank may be ill-equipped to manage the risks of the new products and services. Banks may lack the necessary controls, risk-management processes, expertise and appropriate information systems needed to effectively monitor and manage these new products and services.
As banks look for new sources of income, it is imperative that they demonstrate the ability to manage the associated risks. Banks should not only be extremely diligent about following their underwriting standards, but also should be looking for new ways to shore them up.
A well-managed plan for expansion into new products, services or markets will include the following:
- Clearly communicate the growth strategy to regulators and the board.
- Develop risk plans that address risks particular to any new areas.
- Ensure sustained board and senior management oversight.
- Manage and monitor credit risk.
- Clearly document lending policies and procedures.
- Confirm that diversification/concentration management and controls align with established risk tolerances.
- Undertake stress testing and risk monitoring.
- Strengthen underwriting and documentation standards.
- Confirm that adequate loan review programs are separate from credit extending units/personnel.
Priority #3: Managing Interest Rate Risk
Interest rates remain low, compressing net interest margins and creating fierce competition among banks for higher yielding assets. Many banks are now turning to aggressive interest-rate strategies, such as extending asset or loan maturities or increasing holdings of riskier investments. However the OCC cautions that when interest rates increase, “banks that reached for yield could face significant earnings pressure, possibly to the point of capital erosion.”
While managing interest rate risk is highly complex, doing the following will help ensure a well-managed program:
- Be prepared to demonstrate to regulators your interest-rate-risk management plans and to support key assumptions used in modeling.
- Maintain documentation of how the bank considered the results of the models.
- Establish risk controls and limits.
- Monitor and report risk.
- Ensure adequacy of internal controls and audit.
- Consider whether to add certain expertise to your board or management team.
- Banks that are not already stress testing should begin to do so.
- For public banks, evaluate whether your interest rate risk disclosures appropriately tell your story.
This article is adapted from Grant Thornton’s 2014 Banking Report.