Time for Boards to Clean House and Recession-Proof the Bank

Written by

Bank boards can prepare for potentially tough economic times by becoming well versed in the balance sheet and cultivating a culture of credible challenge, said speakers throughout the first day of Bank Director’s Bank Board Training Forum, held in Nashville on Sept. 11-12.

In the wake of the spring regional bank failures of Silicon Valley Bank, Signature Bank and First Republic Bank, the industry has revisited whether or not directors can really govern risk. While they have redoubled their efforts on liquidity, they now need to contemplate what might happen to their institution’s balance sheet over the next four quarters and beyond. 

“2023 is a lost year for banks,” said Dan Flaherty, a managing director at the investment bank Janney Montgomery Scott. “If you have to make an investment or strategic decision that can accelerate getting to greener pastures, this is the time to do it.”

Balance sheet management and interest rate risk are urgent areas of focus for many banks. High interest rates have finally appeared in deposit costs. The spring banking crisis accelerated a deposit exodus and ignited greater competition. This is on top of the “huge” unrealized losses that banks are carrying on securities and fixed-rate loans, some of which may resolve themselves during the next two to five years depending on the direction of the federal funds rate, Flaherty said.

Boards should be asking management about the outlook for the underlying cost of funding and asset yield that go into the projected 12-month return on assets, said Brian Leibfried, partner and managing director at the investment bank Performance Trust Capital Partners. He gave the example of a bank that had projected a 70 basis point cost of funds; the actual cost of funds was 1.2%. This skewed metrics like the bank’s net interest margin, earnings and return on assets.

“The balance sheet could produce different returns,” he said. “Can the bank weather those different returns?”

Given that, boards and management teams should have a sense of how fast the assets and deposits on their balance sheet could reprice, and how long it could take unrealized losses to accrete back. Some banks may need to take dramatic action, said Eve Rogers, an audit partner at the public accounting, consulting and technology firm Crowe LLP.

“Now is the time to clean house,” she said. “There’s no reward in being more profitable [this year] versus building profitability for future years.”

Rogers added that banks may want to launch market expansion efforts in order to compete for deposits or grow a customer base. Some banks may decide to consider limited balance sheet restructuring that monetizes their unrealized loss but gives them cash and flexibility to reinvest those funds into higher-yielding opportunities or preservation of capital. Flaherty said he expects the fourth quarter may be peppered with announcements of banks selling loans or securities and booking their loss. 

Forward-looking banks should also think about mitigating losses and making their balance sheet “recession-proof,” said Sydney Menefee, a former regulator at the Office of the Comptroller of the Currency and a partner at Crowe. Bank boards may expect to record losses in a recession, but losses flow through other line items on the balance sheet. Have they explored what might happen to the balance sheet if the economy enters a long period of slow growth? 

The way for boards to get at those answers is by asking questions, said Leslie Schreiner, the director of diversity and inclusion at Federal Home Loan Bank of Atlanta.

“Questions are the tools of the board,” she says. To that end, it will be crucial for directors to press management on the assumptions and processes they used to model returns or come up with strategic decisions going into 2024.

Don’t Rely on Inertia to Manage Deposit Pricing

Written by

After a year of steadily increasing interest rates, bankers may be feeling hopeful that the Federal Open Market Committee will soon slow its pace so deposit pricing can get under control.

But even if the Fed’s rate-setting body eases up on raising the federal funds rate, it’s unlikely that will immediately translate into lower deposit costs, simply because liabilities and assets will reprice at different times and frequencies.

“The Fed may stop raising rates at some point, but the cost of deposits of banks most likely will keep going up, only because they’re catching up,” says Christopher Marinac, director of research at Janney Montgomery Scott. “Some of it is just timing: If you have [certificates of deposits], and they are renewing in the third and fourth quarter, those are generally going to be higher than they were a year ago.”

Deposit betas, or the portion of change in the fed funds rate that banks pass onto their customers, occupy a good deal of bankers’ attention right now. Higher deposit betas mean higher rates paid on deposit accounts, and lower deposit betas mean lower funding costs. Banks that want to improve their net interest margin generally want to know how to keep their deposit betas lower without sacrificing liquidity.

A recent analysis by S&P Global Market Intelligence showed that a sample of 20 banks with lower deposit betas in the fourth quarter of 2022 were generally more likely to let money walk out the door in search of higher rates. That in turn allowed those banks to expand their margins more substantially through the end of the year.

Broadly speaking, however, inertia has worked in a lot of banks’ favor when it comes to deposit pricing, Marinac says. Though some high net-worth or commercial customers with significant deposits are increasingly asking for higher rates, which is leading bankers to implement exception pricing, most deposit clients simply don’t bother.

But some banks already feel that exception pricing has become unsustainable, says Neil Stanley, founder and CEO of The CorePoint, a consulting firm focused on deposit pricing. Because exception pricing decisions are made on an ad hoc basis, it can be difficult for banks to anticipate scenarios and build forward guidance. Exception pricing can become a problem if those decisions are too frequent, and are seen as random and even discriminatory.

Stanley also points out that compared to past periods of Fed tightening, a much larger proportion of bank deposits are now noninterest bearing demand deposits, meaning that while they may cost the bank next to nothing, they can also walk out the door at any moment.

“How long will those deposits stay on your books at no interest? That is a huge question,” Stanley says. “Without a really good answer to that, we’re left in a very vulnerable spot.” The advent of open banking may change the game this time around. Open banking gives people more control over their finances, allowing them to leverage application programming interfaces to move funds. Google and social media also give customers an additional window into which banks offer better rates, adding a new layer of complexity. In response, Stanley generally advises that banks maintain a good mix of time deposits like CDs that have a bit more staying power compared to noninterest bearing checking accounts.

Bank boards play an important oversight role in asset/liability management at their financial institutions. Stanley recommends that directors ask management for a list of the bank’s largest deposit holders, and know who is in charge of tending to those relationships. Bankers should check in with those clients and make sure they aren’t feeling neglected, especially if they could pull their money at a moment’s notice. Directors might also consider establishing a chief deposit officer or otherwise centralizing some authority over the bank’s deposit gathering efforts, including exception pricing decisions. And bankers should have a clear line of communication to that person so they can quickly respond to requests for exception pricing.

Banks have grown accustomed to a low-rate environment with little competition for deposits. That’s changed. “When we had a surplus of deposits, it didn’t make any sense to put time and energy into it,” Stanley says. “Now, [banks] don’t want to be laissez-faire. They want to be intentional.”

Along those lines, bank leaders should evaluate their current suite of deposit products and services, and understand how those compare with nonbank competitors. And they can think about how to emphasize the value of keeping cash in accounts insured by the Federal Deposit Insurance Corp.

Finally, while it’s ostensibly on the other side of the balance sheet, bank leaders could consider the importance of commercial and industrial lending as part of their broader asset/liability management strategy. C&I loans reprice faster, which can prove beneficial in a rising rate environment. Those clients — many of them small businesses — can also become a source of stickier, lower cost deposits.

“C&I customers have deposits, and they tend to put deposits with banks,” Marinac says. “That’s kind of the secret sauce.” And financial institutions should view building core relationships as something that happens in good times and bad. “Some organizations are wired that way, so it’s not a problem,” he says. “Other organizations are not.”

Responding to Uncertainty by Focusing on Bank Fundamentals

Written by

In the face of a novel environment and great economic uncertainty, community banks should focus on their fundamentals — and their customers.

That’s the message from speakers throughout the first day of Bank Director’s 2023 Acquire or Be Acquired conference. More than 1,700 attendees started off Sunday with an overview of the challenging economic landscape, coupled with encouragement that there are opportunities for nimble operators.

“No way do I believe that size alone is a determinant of success,” says Tom Michaud, CEO of investment firm Keefe Bruyette & Woods, in the conference’s opening session. “Size hasn’t ensured success. Some of the finest banks I know are under $5 billion in assets.”

It all comes down to execution, and there is reason for banks to be cautious. It’s not clear if the economy will go into a recession or land softly, although Michaud says his firm is projecting a “softer” landing for 2023 and single-digit loan growth. The Federal Reserve has raised rates at a pace that most bankers have never experienced — a dramatic turnabout two years after the industry was deluged with $2 trillion of stimulus spending to address the coronavirus pandemic. But even with the prospect of slower growth, Michaud advises banks to keep their balance sheet clean and find opportunities to build capital. 

“An industry that is catching its breath but remains profitable is a good place to be,” he says.

For now, this rapid whipsaw is the new normal in banking. Ahead of the conference, former Comptroller of the Currency Gene Ludwig told Bank Director that one truism in banking from the last half-century is that “the ups and downs come more frequently, and probably more severely, in shorter periods than they have in the past.” Technology and globalization have accelerated the pace of change, and banks need to be prepared for the volatility. 

Ludwig speaks from experience. In addition to serving as comptroller in the 1990s, he founded IntraFi, a reciprocal deposit network formerly known as Promontory Interfinancial Network, and is now a managing partner of Canapi Ventures, a bank-focused venture capital fund that invests in financial technology companies.

Having seen a variety of economic and credit cycles, Ludwig advised management teams to operate their institutions for the long haul and resist the noise of one quarter or the next. For the former comptroller, this comes down to the fundamental focus on customers, community and deposits. “Is what I am doing, and how I’m operating, best for my customer? Am I doing that in fundamentally a safe and sound manner?”

Increasingly, low-cost deposits are an important aspect of those customer relationships. Technology has made it easier for deposits to move, creating competition for those once-sticky funds. “Bankers that cultivate good customer relationships and use modern tools are able to have more stable and lower cost funding than banks that don’t,” Ludwig said, adding that banks have a variety of methods and tools to encourage existing companies to keep their deposits. 

The environment has shifted from unprecedented levels of liquidity flowing into banks to outflows. Total deposits in the banking industry declined for the second consecutive quarter, down 1.1%, or $206 billion, from the second quarter of 2022 to the third quarter, according to the Federal Deposit Insurance Corp. Driving the shift were accounts with balances above $250,000.  

“Banks in general are going to have to start thinking about funding loans as they go along,” Michaud told Bank Director ahead of the conference. “Previously, they had this reservoir of excess funding that made it easy to make an incremental loan. Now they’re going to have to fund it marginally, and that’s why we’re seeing deposit costs rise.”

Many institutions consider themselves “relationship lenders,” but Mac Thompson, founder and president of analytics firm White Clay, points out that many bankers struggle to quantify the depth of their customer relationships. That is one imperative for community bankers to grasp ahead of a potential recession.

“Who is using your liquidity, who is using your capital and what are you getting paid for it?” he says during a lunchtime presentation. Relationship managers should know the answer to those questions by analyzing a customers’ loans and deposits. Thompson urges banks to focus on bringing customers’ operational accounts to the bank — the accounts that pay their bills — because those accounts may be harder to move in response to interest rates. 

Customer loyalty goes both ways in relationship banking, and Michaud said this is one approach banks leverage when navigating the uncertain environment. 

“Now’s the time for banks to be there for their best customers,” he said, especially as access to credit tightens. “Typically when they are, their best customers tend not to forget it.” 

A Proactive Approach to Risk Adjusted Performance Management

Written by

Banks need to assess their lending practices to get a clear view of how the financial climate, and emerging economic uncertainty, will impact their corporate clients and the growth and performance of their business.

To do that, they need to fully understand their exposure to interest-rate and liquidity risk, and proactively manage their balance sheets to maintain growth and enhance profitability. They need to analyze their lending practices, identifying sources of funding and qualifying loan targets to ensure proper loan management. All of this necessarily entails a re-evaluation of their internal systems’ ability to respond to changes that can impact balance-sheet risk and returns. And many banks have concluded that legacy point solutions are not up to demands from the risk and finance departments to model numerous business and risk scenarios.

For these banks, the solution is an overhaul: combining the modeling capabilities of asset and liability management systems with the governance and reach of planning systems and the analytical power of advanced business intelligence tools.

As part of this approach, banks no longer limit asset liability management to regulatory compliance. They are moving beyond compliance, toward creating business value though flexible scenario modeling for a holistic view of the risk factors impacting the future performance of the business.

To benefit from this kind of proactive approach to risk-adjusted profitability management, banks need to implement several key capabilities. These include methodologies and processes for interest-rate management and balance-sheet optimization for fast and efficient advanced scenario modeling. Banks also the analytical power to rapidly evaluate the results and options available to them. Finally, banks need to act on this analysis. This requires them to put in place the information tooling needed to enable frontline staff to execute the selected options, as well as processes and metrics that allow management to assess the impact of any given measure.

As they move toward a holistic risk-adjusted performance management platform, bankers should ask themselves the following questions:

  • What factors are impacting earnings and liquidity within the changing environment?
  • Is the bank incorporating input from market-facing staff related to growth, spreads and potential losses?
  • Is the bank taking a credit hit? If so, how much?
  • Is the bank managing based on its current balance-sheet composition, without considering future events? Is it counting on cash flows that might disappear?
  • Are the bank’s system capable of handling different interest-rate scenarios, including high volatility and negative rates? Can the bank measure the impact of these scenarios on liquidity and earnings?
  • Is the bank’s current asset liability management solution supporting decisions that will maximize stakeholder value?

Any solution should combine three key attributes. First is that it should include an asset/liability management system capable of quickly computing multiple scenarios from the bottom up. Second, the solution needs to include business analytical tools to compare and contrast the rapid reaction plans for prioritization and execution. And finally, it needs a risk-adjusted performance management (RAPM) tool to measure and manage the results.

Attempting to build a solution in-house with this breadth of capabilities can itself be a risky business. Banks often cobble together a fragmented solution, since legacy point systems are typically focused on addressing just one aspect or requirement. This approach lacks a comprehensive or holistic view of the bank’s true risk position. Indeed, manual processes based on spreadsheets of general ledger data may provide a current view of the business, but fail to model for unforeseen risks or changing behaviors. The result can be a disconnect between the bank’s view of the risks it faces and the true factors impacting the bank’s performance going forward.

On top of that, dealing with multiple systems and suppliers introduces its own risk into the situation, including miscommunication, lack of clarity over ownership of key functions and poor interoperability that can potentially disrupt work flows. The bank may need to maintain multiple project teams with various specializations and vendor points of contacts for multiple individual suppliers, introducing complexity and expense.

That’s why banks increasingly are turning toward a more integrated approach combining risk, compliance and analytics to meet the challenge of risk-adjusted performance management. Adopting a consolidated platform can give banks the consistency and agility to gain a true view of their risk situation. The result is a realistic, holistic view of the bank’s business trajectory, accessible and managed through a single point of contact, ensuring consistency of approach and operational efficiency.

Banks Inherited a Wholesale Balance Sheet During the Pandemic. Here’s What to Do.

Written by

Bank managements and directors must recognize how cash has changed significantly over the past seven quarters, from the fourth quarter of 2019 to the third quarter of 2021. The median cash-to-earning assets for all publicly traded banks has grown to 10% in recent quarters, up from 4% pre-pandemic. This is a direct impact of the Covid-19 pandemic on deposit flows from government stimulus and the reluctance to deploy cash in a time of historically low interest rates.

The result is a healthy “wholesale” balance sheet that is separate and distinct from banks’ normal operations. This must be factored into growth plans for 2022 and 2023. We think it may take several quarters to properly deploy the excess liquidity. Investors already demand faster loan growth and their tolerance towards low purchases of securities may wane. The pressure to take action on cash is real, and it should be seen as an opportunity and certainly not a curse. We see excess cash as a high-class problem that can be met with a successful response at all banks.

We expect financial institutions will become far more open about their two balance sheet positions in the near future. First, let’s talk about the “normal” operation with stated goals and objectives on growth (e.g. loans, earnings per share and returns on tangible equity). Next, segment the “wholesale” balance sheet, which contains the cash position and any extra liquidity in short-term securities. Using our industry data above (10% cash in earning assets, up from 4% pre-pandemic), a $3 billion community bank has $300 million in cash instead of the usual $120 million it carried two years earlier — this establishes a $180 million wholesale position. Company management should directly communicate how this separate liquidity will be used to enhance earnings and returns in future quarters. Likewise, boards should stay engaged on how this cash gets utilized within their risk tolerance.

Late in the fourth quarter of 2021, certain company acquisitions disclosed the use of excess cash as a key rationale of the deal. An example is Ameris Bancorp, whose executive team stated in its December 2021 purchase of Balboa Capital that the transaction was funded by excess cash. Back in May 2021, Regions Financial (which is neutral-rated by Janney) acquired EnerBank with a home improvement finance strategy that would deploy its liquidity into new loans. Regions has since completed additional M&A deals with the same explanation. Many more small M&A transactions seem likely in 2022 using cash deployment as an underlying theme.

It has been my experience for three decades as an equity analyst that banks miss chances to explain their strategy in a succinct yet powerful manner. Remaining shy under the pretense of conservatism does not generally reward a higher stock valuation. Instead, banks who are direct and loud about their strategy (and then execute) tend to be rewarded with a stronger stock price. Hence, it is a far better idea to express a game plan for cash and a bank’s distinct “wholesale” balance sheet.

The current cash positions (which produced little to no earnings return in prior quarters) are now a superb opportunity to make a difference with investors. We encourage banks to be direct on how they will utilize excess cash and liquidity separate from their existing operations. The Janney Research team estimates banks can generate nearly a 10% boost to EPS by 2023 from managing excess cash alone. This is separate from any benefit from higher interest rates and Federal Reserve policy shifts that may occur.

Outlining a cash strategy in 2022 and 2023 is a critical way to differentiate the bank’s story with investors. Bank executives and directors must take advantage of this opportunity with a direct game plan and communicate it accordingly.

Why Community Banks Should Use Derivatives to Manage Rate Risk

Written by

As bank management teams turn the page to 2022, a few themes stand out: Their institutions are still flush with excess liquidity, loan demand is returning and the rush of large M&A is at a fever pitch.

But the keen observer will note another common theme: hedging. Three superregional banks highlighted their hedging activity in recent earnings calls.

  • Birmingham, Alabama-based Regions Financial Corp. repositioned its hedging book by unwinding $5 billion of receive-fixed swaps and replacing them with shorter-term receive fixed swaps. Doing so allowed the $156 billion bank to lock in gains from their long-term swaps.
  • Columbus, Ohio-based Huntington Bancshares increased its noninterest income in a scenario where rates increase 100 basis point from 2.9% to 4%. The $174 billion bank terminated certain hedges and added $6 billion of forward starting pay fixed swaps.
  • Providence, Rhode Island-based Citizens Financial Group executed $12 billion of receive fixed swaps in 2021, including $1.25 billion since June 30, 2021. The $187 billion bank’s goal is to moderate their asset sensitivity and bring forward income.

These banks use derivatives as a competitive asset and liability management tool to optimize client requests, investment decisions and funding choices, rather than be driven by their associated interest rate risk profile.

Why do banks use derivatives to hedge their balance sheet?

  • Efficiency. Derivatives are efficient from both a timing and capital perspective. In a late 2021 earnings call outlining their hedging strategy, Citizens Financial’s CFO John Woods said, “We think it’s a bit more efficient to do that (manage interest rate risk) off-balance sheet with swaps.”
  • Flexibility. It’s more flexible than changing loan and deposit availability and pricing.
  • Cost. It’s often less expensive when compared to cash products.

Why are some banks hesitant to use swaps?

  • Perception of riskiness. It’s easy for a bank that hasn’t used derivatives to fall into the fallacy that swaps are a bet on rates. In a sense, though, all the bank’s balance sheet is a bet on rates. When layered into the bank’s asset-liability committee conversations and tool kit, swaps are simply another tool to manage rate risk, not add to it.
  • Accounting concerns. Community banks frequently cite accounting concerns about derivatives. But recent changes from the Financial Accounting Standards Board have flipped this script:  Hedge accounting is no longer a foe, but a friend, to community banks.
  • Fear of the unknown. Derivatives can bring an added layer of complexity, but this is often overdone. It’s important to partner with an external service provider for education, as well as the upfront and ongoing heavy lifting. The bank can continue to focus on what it does best: thrilling customers and returning value to shareholders.
  • Competing priorities. Competing priorities are a reality, and if something is working, why bother with it? But growth comes from driving change, especially into areas where the bank can make small incremental adjustments before driving significant overhauls. Banks can transact swaps that are as small as $1 million or less.

For banks that have steered clear of swaps — believing they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help separate facts from fears and make the best decision for their institution. The reality is community banks can leverage the same strategies that these superregional banks use to enhance yield, increase lending capacity and manage excess liquidity.

Bank Profitability to Rebound from Pandemic

Written by

The Covid-19 pandemic has been a defining experience for the U.S. banking industry — one that carries with it justifiable pride.

That’s the view of Thomas Michaud, CEO of investment banking firm Keefe Bruyette & Woods, who believes the banking industry deserves high marks for its performance during the pandemic. This is in sharp contrast to the global financial crisis, when banks were largely seen as part of the problem.

“Here, they were absolutely part of the solution,” Michaud says. “The way in which they offered remote access to their customers; the way that the government chose to use banks to deliver the Paycheck Protection Program funds and then administer them via the Small Business Administration is going to go down as one of the critical public-private partnership successes during a crisis.”

Michaud will provide his outlook for the banking industry in 2022 and beyond during the opening presentation at Bank Director’s Acquire or Be Acquired Conference. The conference runs Jan. 30 to Feb. 1, 2022, at the JW Marriott Desert Ridge Resort and Spa in Phoenix.

Unfortunately, the pandemic did have a negative impact on the industry’s profitability. U.S. gross domestic product plummeted 32.9% in the second quarter of 2020 as most of the nation went into lockdown mode, only to rebound 33.8% in the following quarter. Quarterly GDP has been moderately positive since then, and Michaud says the industry has recaptured a lot of its pre-pandemic profitability — but not all of it. “The industry pre-Covid was already running into a headwind,” he says. “There was a period where there was difficulty growing revenues, and it felt like earnings were stalling out.”

And then the pandemic hit. The combination of a highly accommodative monetary policy by the Federal Reserve Board, which cut interest rates while also pumping vast amounts of liquidity into the financial system, along with the CARES Act, which provided $2.2 trillion in stimulus payments to businesses and individuals, put the banking industry at a disadvantage. Michaud says the excess liquidity and de facto competition from the PPP helped drive down the industry’s net interest margin and brought revenue growth nearly to a halt.

Now for the good news. Michaud is confident that the industry’s profitability will rebound in 2022, and he points to three “inflection points” that should help drive its recovery. For starters, he expects loan demand to grow as government programs run off and the economy continues to expand. “The economy is going to keep growing and the pace of this recovery is a key part of driving loan demand,” he says.

Michaud also looks for industry NIMs to improve as the Federal Reserve tightens its monetary policy. The central bank has already begun to reverse its vast bond buying program, which was intended to inject liquidity into the economy. And most economists expect the Fed to begin raising interest rates this year, which currently hover around zero percent.

A third factor is Michaud’s anticipation that many banks will begin putting the excess deposits sitting on their balance sheets to more productive use. Prior to the pandemic, that excess funding averaged about 2.5%, Michaud says. Now it’s closer to 10%. “And I remember talking to CEOs at the beginning of Covid and they said, ‘Well, we think this cash is probably going to be temporary. We’re not brave enough to invest it yet,’” he says. At the time, many bank management teams felt the most prudent choice from a risk management perspective was to preserve that excess liquidity in case the economy worsened.

“Lo and behold, the growth in liquidity and deposits has kept coming,” Michaud says. “And so the banks are feeling more comfortable investing those proceeds, and it’s happening at a time when we’re likely to get some interest rate improvement.”

Add all of this up and Michaud expects to see an improvement in bank return on assets this year and into 2023. Banks should also see an increase in their returns on tangible common equity — although perhaps not to pre-pandemic levels. “We started the Covid period with a lot of excess capital and now we’ve only built it more,” he says.

Still, Michaud believes the industry will return to positive operating leverage — when revenues are growing at a faster rate than expenses — in 2022. “We also think it’s likely that bank earnings estimates are too low, and usually rising earnings estimates are good for bank stocks,” he says.

In other words, better days are ahead for the banking industry.

The Emerging Impacts of Covid Stimulus on Bank Balance Sheets

Written by

In the middle of 2020, while some consumers were stockpiling essentials like water and hand sanitizer, many businesses were shoring up their cash reserves. Companies across the country were scrambling to build their war chests by cutting back on expenses, drawing from lines of credit and tapping into the Small Business Administration’s massive new Paycheck Protection Program credit facility.

The prevailing wisdom at the time was that the Covid-19 pandemic was going to be a long and painful journey, and that businesses would need cash in order to remain solvent and survive. Though this was true for some firms, 2020 was a year of record growth and profitability for many others. Further, as the SBA began forgiving PPP loans in 2021, many companies experienced a financial windfall. The result for community banks, though, has been a surplus of deposits on their balance sheets that bankers are struggling to deploy.

This issue is exacerbated by a decrease in loan demand. Prior to the pandemic, community banks could generally count on loan growth keeping up with deposit growth; for many banks, deposits were historically the primary bottleneck to their loan production. At the start of 2020, deposit growth began to rapidly outpace loans. By the second quarter of 2021, loan levels were nearly stagnant compared to the same quarter last year.

Another way to think about this dynamic is through the lens of loan-to-deposit (LTD) ratios. The sector historically maintained LTDs in the mid-1980s, but has recently seen a highly unusual dip under 75%.

While these LTDs are reassuring for regulators from a safety and soundness perspective, underpinning the increased liquidity at banks, they also present a challenge. If bankers can’t deploy these deposits into interest-generating loans, what other options exist to offset their cost of funds?

The unfortunate reality for banks is that most of these new deposits came in the form of demand accounts, which require such a high degree of liquidity that they can’t be invested for any meaningful level of yield. And, if these asset and liability challenges weren’t enough, this surge in demand deposits effectively replaced a stalled demand for more desirable timed deposits.

Banks have approached these challenges from both sides of the balance sheet. On the asset side, it is not surprising that banks have been stuck parking an increasing portion of the sector’s investment assets in low-yield interest-bearing bank accounts.

On the liabilities side, community banks that are flush with cash have prudently trimmed their more expensive sources of funds, including reducing Federal Home Loan Banks short-term borrowings by 53%. This also may be partially attributable to the unusual housing market of high prices and low volumes that stemmed from the pandemic.

As the pandemic subsides and SBA origination fees become a thing of the past, shareholders will be looking for interest income to rebound, while regulators keep a close eye on risk profiles at an institutional level. Though it’s too soon to know how this will all shake out, it’s encouraging to remember that we’re largely looking at a profile of conservative community banks. For every Treasury department at a mega bank that is aggressively chasing yield, there are hundreds of community bank CEOs that are strategically addressing these challenges with their boards as rational and responsible fiduciaries.

Visit https://www.otcmarkets.com/market-data/qaravan-bank-data to learn more about how Qaravan can help banks understand their balance sheets relative to peers and benchmarks.

How to Prepare for an Unprecedented Year

Written by

Could anyone have prepared for a year like 2020?

Better-performing community banks, over the long run, generally anchor their balance sheet management in a set of principles — not divination. They organize their principles into a coherent decision-making methodology, which requires them to constantly study the relative risk-reward profiles of various options, across multiple rate scenarios and industry conditions over time.

But far too many community bankers look through the wrong end of the kaleidoscope. Rather than anchoring themselves with principles, they drift among the currents of economic and interest rate forecasts. Where that drift takes them at any given moment dictates their narrowly focused reactions and strategies. If they are in a reward mindset, they’ll focus on near-term accounting income; if the mood of the day is risk-centered, their framework will be liquidity. At Performance Trust, we have long argued that following this approach accumulates less reward, and more risk, than its practitioners ever expect.

Against this backdrop, we offer five decision-making principles that have helped many banks prepare for the hectic year that just closed, and can ensure that they are prepared for any hectic or challenging ones ahead.

  • Know where you are before deciding where to go. Net Interest Income and Economic Value of Equity simulations, when viewed in isolation, can present incomplete and often conflicting portrayals of a bank’s financial risk and reward profile. To know where you are, hold yourself accountable to all cash flows across multiple rate scenarios over time, incorporating both net income to a horizon and overall economic value at that horizon. Multiple-scenario total return analysis isn’t about predicting the future. Rather, it allows you to see how your institution would perform in multiple possible futures.
  • Don’t decide based on interest rate expectations — in fact, don’t even have expectations. Plenty of wealth has been lost by reacting to predictions. Running an asset-sensitive balance sheet is nothing more than making a levered bet on rising rates. So, too, is sitting on excess liquidity waiting for higher rates. The massive erosion in net interest margin in 2020 supports our view that most community banks have been, intentionally or not, speculatively asset sensitive. Banks that take a principle-based approach currently hold sufficient call-protected, long-duration earning assets — not because they knew rates would fall, but because they knew they would need them if rates did fall. As a result, they are in a potentially better position to withstand a “low and flat” rate environment.
  • Maintaining sufficient liquidity is job No. 1. Job No. 2 is profitably deploying the very next penny after that. In this environment, cash is a nonaccrual asset. Banks with a principle-oriented approach have not treated every bit of unexpected “excess liquidity” inflow as a new “floor” to their idea of “required liquidity.” One approach is to “goal post” liquidity needs by running sensitivity cases on both net loan growth and deposit outflows, and tailoring deployment to non-cash assets with this in mind — for instance by tracking FHLB pledgeability and haircutting — and allowing for a mark-to-market collateral devaluation cushion. Liquidity is by no means limited to near-zero returns.
  • Don’t sell underpriced options. Banks sell options all day long, seldom considering their compensation. Far too often, banks offer loans without prepayment penalties because “everyone is doing it.” Less forgivably, they sell options too cheaply in their securities portfolio, in taking on putable advances or when pricing their servicing rates. The last two years were an era of very low option compensation, even by historical measures. Principle-based decision-makers are always mindful of the economics of selling an option; those who passed on underpriced opportunities leading into 2021 find their NIMs generally have more staying power as a result.
  • Evaluate all capital allocation decisions on a level playing field. Community banks, like all competitive enterprises, can allocate capital in just four ways: organic growth, acquisitions, dividends or share repurchases. Management teams strike the optimal balance between risk and reward of any capital allocation opportunity by examining each strategy alongside the others across multiple rate scenarios and over time. This approach also allows managers to harness the power of combinations — say, simultaneously executing a growth strategy and repurchasing stock — to seek to enhance the institution’s overall risk/return profile.

So what about 2021 and beyond? This same discipline, these same principles, are timeless. Those who have woven them into their organizational fabric will continue to benefit whatever comes their way. Those encountering them for the first time and commit to them in earnest can enjoy the same.

Whipsawed by Interest Rates

Written by

One of the things that bankers hate most is uncertainty and abrupt changes in the underlying economics of their business, and the emerging global crisis caused by the COVID-19 pandemic is confronting them with the perfect storm.

You can blame it all on the Federal Reserve.

Indeed, the higher rates that the Fed gave in 2018, it is now taken away — and that is creating a big challenge for banks as they scramble to adapt to a very different interest rate scenario from what they were dealing with just 15 months ago.

On March 3, as the economic impact of the coronavirus both globally and in the United States was becoming more apparent and fears about a possible recession were mounting, the Fed made an emergency 50 basis-point cut in interest rates, to a range of 1% to 1.25%. The Fed’s action was dramatic not only because of the size of the reduction, but also because this action was taken “off cycle” — which is to say two weeks prior to the next scheduled meeting of the Federal Open Market Committee, which is the Fed’s rate-setting body.

And as this article was being posted, many market observers were expecting that the Fed would follow with another rate cut at its March 17-18 meeting, which would drive down rates to their lowest levels since the financial crisis 12 years ago. Needless to say, banks have been whipsawed by these abrupt shifts in monetary policy. The Fed increased rates four times in 2018, to a range of 2.25% to 2.50%, then lowered rates three times in 2019 when the U.S. economy seemed to be softening, to a range of 1.50% to 1.75%.    

Now, it appears that interest rates might go even lower.

What should bank management teams do to deal with this unexpected shift in interest rates? To gain some insight into that question, I reached out to Matt Pieniazek, president of the Darling Consulting Group in Newburyport, Massachusetts. I’ve known Pieniazek for several years and interviewed him on numerous occasions, and consider him to be one of the industry’s leading experts on asset/liability management. Pieniazek says he has been swamped by community banks looking for advice about how to navigate this new rate environment.

One of Pieniazek’s first comments was to lament that many banks didn’t act sooner when the Fed cut rates last year. “It’s just disappointing that too many banks let their own biases get in the way, rather than listen to their balance sheets,” he says. “There are a lot of things that could’ve been done. Now everyone’s in a panic, and they’re willing to talk about doing things today when the dynamics of it are not very encouraging. Risk return or the cost benefit are just nowhere near the same as what they were just six months ago, let alone a year, year and a half ago.”

So, what’s to be done?

Pieniazek’s first suggestion is to dramatically lower funding costs. “No matter how low their funding costs are, very few banks are going to be able to outrun this on the asset side,” he says. “They’ve got to be able to [be] diligent and disciplined and formalized in their approach to driving down deposit costs.”

“In doing so, they have to acknowledge that there could be some risk of loss of balances,” Pieniazek continues. “As a result, they need to really revisit their contingency liquidity planning. They have to also revisit with management and the board the extent to which they truly are willing to utilize wholesale funding. The more you’re willing to do that, the more you would be willing to test the water on lowering deposits. I think there is a correlation to comfort level and challenging yourself to lower deposits and well thought out contingency planning that incorporates the willingness and ability to prudently use the wholesale market. Aggressively attacking deposit costs has to be accompanied by a real hard, fresh look at contingency liquidity planning and the bank’s philosophy toward wholesale markets.”

This strategy of driving down funding costs might be a hard sell in a market where competitors are still paying relatively high rates on deposits. “Well, you know what?” Pieniazek says. “You’ve got two choices. You either let village idiots drive your business, or you do what makes sense for your organization.”

Most banks will also feel pressure on the asset side of their balance sheets as rates decline. Banks that have a large percentage of floating rate loans may not have enough funding to offset them. As those loans reprice in a falling rate environment, banks will feel pressure to correspondingly lower their funding costs to protect their net interest margins as much as possible. And while community banks typically don’t have a lot of floating rate loans, they do have high percentages of commercial real estate loans, which Pieniazek estimates have an average life span of two and a half years. The only alternative to lowering deposit costs to protect the margin would be to dramatically grow the loan portfolio during a time of great economic uncertainty. But as Pieniazek puts it, “There’s not enough growth out there at [attractive] yield levels to allow people to head off that margin compression.”

Pieniazek’s second suggestion is to review your loan documents. “While I’m not suggesting [interest] rates are going to go negative, most banks do not have loan docs which prevent rates from going negative,” he says. “They need to revisit their loan docs and make sure that there’s lifetime floors on all of their loans that will not enable the actual note rate to go zero. They could always negotiate lower if they want. They can’t negotiate up.”

His final suggestion is that community banks need to strongly consider the use of derivatives to hedge their interest rate exposure. “If you think in an environment like this that your customers are going to allow you to dictate the structure of your balance sheet, you better think again,” he says. “Everyone’s going to want to shorten up … What you’re going to find is retail customers are going to keep their money short. In times of uncertainty, what do people want to do? They want to keep their cash close to them, don’t they?”

Of course, while depositors are going to keep their money on a short leash, borrowers “are going to want to know what the 100-year loan rate is,” Pieniazek says. And this scenario creates the potential for disaster that has been seen time and again in banking — funding long-term assets with short-term deposits.

“The only thing you can do is augment customer behavior through the use of derivatives,” Pieniazek says. “Interest rate caps are hugely invaluable here for banks to hedge against rising rates while allowing their funding costs to remain or cycle lower if rates go lower. In a world of pressure for long-term fixed rate assets, being able to do derivatives … allows banks to convert fixed-rate loans in their portfolio to floating for whatever time period they want, starting whenever they want.”

During times of uncertainty and volatility, Pieniazek says it’s crucial that bank management teams make sound judgments based on a clear understanding of their ramifications. “Don’t let panic and fear result in you changing your operating strategy,” he says. “The worst thing to do is make material changes because of fear and panic. Let common sense and a clear understanding of your balance sheet, your risk profile, drive your thought process. And don’t be afraid to take calculated risks.”