Balance-Sheet Management: Maintaining Financial Stability

Is it any wonder that most bankers today feel as though they’re trapped in a Ray Charles ballad about rainy nights in Georgia? The sluggish U.S. economy has cut the demand for business loans, while declining interest rates have trimmed the returns on most securitiesu00e2u20ac”resulting in the worst margin squeeze for banks in years.

“I hear that everywhere I go in the country today,” says Charles Miller, managing director of investment banking at Alex Sheshunoff Management Services. “You can’t get it on the loan side. You can’t get it on the securities side. Those are the only two legal ways of getting [a return] that I know of.”

Unfortunately there is no miracle picker-upper for the industry’s margin blues. By definition, banks are creatures of the economy, and they are inevitably affected by the business cycle. The wisest strategy, according to a variety of investment bankers and consultants who specialize in balance-sheet issues, is to look for ways of eking out as much incremental revenue as possible without taking excessive credit or interest rate risk. Times like these pose serious dangers for bankers who, in their desperation to find top-line growth, can end up doing things they’ll regret.

The best advice might be this: Don’t take a risk with your balance sheet if you can’t live with the consequences of being wrong later on.

In an effort to stimulate a slumping U.S. economy, the Federal Reserve has reduced its key short-term interest rate to 1.25%u00e2u20ac”the lowest level in several decades. Unfortunately, all this pump primingu00e2u20ac”the central bank has cut its federal funds 12 times since early 2001u00e2u20ac”has failed to revive the economy. And the financial industry’s balance sheet is beginning to show signs of strain.

According to research at investment banking firm Keefe Bruyette & Woods, banks with assets of between $1 billion and $20 billion have seen loans as a percentage of total assets drop from 65.8% at year-end 2000 to 62.3% at the conclusion of 2002. While this was happening, securities holdingsu00e2u20ac”which typically provide banks with a lower yield than loansu00e2u20ac”rose from 24% of total assets at year-end 2000 to 27% at the end of last year. The result: a margin squeeze.

To make matters worse, the industry’s capitalization also has been on the rise. Though it may seem counterintuitive, the industry’s profitability improved during the same two-year period, in part because its overall loan quality has remained relatively strong despite the weak economy, contributing to a 0.4% increase in equity capital. While this growing capital account gives the industry a stronger balance sheet, it may, in fact, be stronger than necessary given the steady decline in loan volume, and could actually erode the return on equity at many banks.

Worse still, the margin squeeze could tighten further before the situation improves. The market has been bracing itself for yet another rate cut should the Federal Reserve decide to make a preemptive strike at its most recent concernu00e2u20ac”the risk of deflation. This would put even more pressure on margins unless the economy rebounded sharply and U.S. businesses responded swiftly by again borrowing money. “For most commercial banks, margins have peaked and we’re looking at a downward pull,” says Matthew D. Pieniazek, president at Newburyport, Massachusetts-based Darling Consulting Group. “We’re just seeing the tip of the iceberg in terms of margin pressure. [Next year] is going to be a catastrophe.”

So what should you do? Pieniazek says banks ought to start with an honest assessment of what their organic loan growth is likely to be over the next year or so, then make decisions about how to make up the shortfall. Pieniazek estimates that most banks will need to achieve organic loan growth of between 5% and 7% in 2004 to offset the effects of margin compressionu00e2u20ac”a performance that seems most unlikely should the current environment continue or worsen. “Many banks, [when] looking forward, have a huge hole in front of them,” he says.

While finding commercial loan growth is difficult, one strategy that smaller institutions should be actively pursuing is to target their larger competitors in an effort to steal market share. Tom Michaud, vice chairman and chief operating officer at New York-based KBW, says that small banks still need to be price competitive, but they often provide a superior service proposition that wins over local businesses. “Large banks make it easier for smaller banks just through [poor] service,” says Michaud. “I think a lot of market share has been moving just for that reason.”

Miller at Sheshunoff says it also may be possible for some banks to shift a portion of their capacity into other lending categoriesu00e2u20ac”putting, say, more emphasis on mortgage lending while the housing market remains strongu00e2u20ac”or moving further out on the risk curve by lending to customers that pose a higher credit risk.

Banks must also decide how to structure their securities portfolios within the context of what might happen with interest rates. While it has always been difficult to handicap the Federal Reserve’s monetary policy decisions, this is a particularly difficult time to predict the future direction of rates. Up until this summer, the financial markets seemed to be expecting a gradual tightening of rates by fall as the global tension over the Iraqi war subsided and the economy gradually improved. But recent pronouncements by Fed Chairman Alan Greenspan about the potential danger of deflation now have people thinking that the central bank may actually cut rates further.

“That rising rate scenario might not be six to nine months out,” says Michaud. “That rising rate scenario might be 12 to 18 months out.” And if this is the case, banks may want to invest in higher-yielding securities with somewhat longer maturities. Says Michaud, “If I feel that I’m going to be in this economy longer, or [see it] go down [further], I may be comfortable going out a little further.”

Pieniazek says many banks are so awash in liquidity that they’ve been selling their excess cash flow in the fed funds market at rates as low as 1%, in part because they were reluctant to lock that money away in longer duration securities in anticipation of a tighter monetary policy by the Federal Reserve. But if industry margins are indeed on a downward slope, as he believes likely, Pieniazek says that banks may want to consider entering into leveraged trades where they actually borrow money to finance their securities investments. While they are taking on a degree of interest rate risk with such a strategy, the yield curveu00e2u20ac”or difference between short- and long-term ratesu00e2u20ac”is still steep enough that they can earn a higher return than in the federal funds market.

Banks that have not already done so may want to consider a stock buyback program as well. By reducing the number of common shares they have outstanding, banks can increase their ROE by, in effect, reducing the denominator in that calculation. Stock repurchases are especially useful in environments were there is little revenue growth and rising capitalization, which can strangle a bank’s financial return over time. According to Michaud, 38 of the 50 largest U.S. banks bought back their stock in 2002. Says Charles Crowley, a managing director in the Cleveland office of Friedman, Billings, Ramsey & Co., “It’s probably the best investment a company can make with its stock.”

Although the current interest rate environment makes it difficult for banks to generate revenue growth, it’s quite favorable when it comes to issuing long-term debt. For example, banks may want to consider issuing trust-preferred securities to finance their stock buyback programs, or to finance a portion of an acquisition (see page 68). Brian Sterling, co-head of investment banking at New York-based Sandler O’Neill & Partners, says long-term rates are very low and that most institutions that have gone to the debt market recently ended up raising more money than they originally intended. “Financial institutions are viewed as fairly good credits right now,” he says.

Probably the greatest virtue during a margin squeeze is prudence. Miller at Sheshunoff says that in past years when their margins were under pressure, small banks have gotten themselves into trouble when they bought complex securities that offered a higher rate of return than that offered by plain-vanilla instruments, because they ended up being too complicated for them to manage when the interest rate environment eventually changed. “I really don’t think it’s good for banks to do that,” he says. “If you’re that desperate, just shrink the balance sheet.”

And while banks need to have an informed opinion of where interest rates might go over the next several months, they need to be careful not to bet too heavily on that view. “I may believe that rates are going to go up, but if I can’t live with being wrong, I have no business making that bet,” says Pieniazek at Darling Consulting.

Caution is appropriate on the lending side as well. Competing too aggressively on price when trying to steal market share from a larger institution, or moving into another asset class where a bank doesn’t have enough expertise, can lead to trouble. While over aggressively positioning its balance sheet can hurt a bank’s profitability over several quarters, serious credit quality problems can have an even greater impactu00e2u20ac”including jeopardizing its very existence as an independent company.

Sometimes when it seems like it’s raining all over the world, all you can do is hunker down and ride out the storm. As FBR’s Crowley puts it, “You really can’t create growth if it’s not there.”

Who Do You Call?

Alex Sheshunoff Management Services

Austin, TX


Charles I. Miller


Friedman, Billings, Ramsey & Co.

Arlington, VA


Charles Crowley


Darling Consulting Group Inc.

Newburyport, MA


Matthew D. Pieniazek


Hovde Financial LLC

Washington, D.C.


Jeff Warlick


DD&F Consulting Group

Little Rock, AR


Randy D. Dennis


Keefe Bruyette & Woods Inc.

New York, NY


Tom Michaud


FinPro, Inc.

Liberty Corner, NJ


Donald J. Musso


Sandler O’Neill & Partners, L.P.

New York, NY


Fred Price


First Manhattan Consulting Group

New York, NY


James McCormick


Young & Associates Inc.

Kent, OH


Gary J. Young


Join OUr Community

Bank Director’s annual Bank Services Membership Program combines Bank Director’s extensive online library of director training materials, conferences, our quarterly publication, and access to FinXTech Connect.

Become a Member

Our commitment to those leaders who believe a strong board makes a strong bank never wavers.