How to Prepare for an Unprecedented Year

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

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.”

Rodge Cohen: Are We Preparing to Fight the Last War?


risk-3-1-19.pngHis name might not command the same recognition on the world stage as the mononymous Irish singer and song-writer known simply as Bono, but in banking and financial services just about everyone knows who “Rodge” is.

H. Rodgin Cohen–referred to simply as Rodge—is the unrivaled dean of U.S. bank attorneys. At 75, Cohen, who is the senior chairman at the New York City law firm Sullivan & Cromwell, is still actively involved in the industry, having recently advised SunTrust Banks on its pending merger with BB&T Corp.

Cohen has long been considered a valued advisor within the industry.

In the financial crisis a decade ago, he represented corporate clients like Lehman Brothers and worked closely with the federal government’s principal players, including Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke. His character even made an appearance in the movie “Too Big To Fail,” based on a popular book about the crisis by Andrew Ross Sorkin.

Eleven years later, Cohen says the risk to the banking industry is no longer excessive leverage or insufficient liquidity—major contributing factors to the last crisis.

The Dodd-Frank Act of 2010, passed nearly a decade ago, raised bank capitalization levels substantially compared to pre-crisis levels. In fact, bank capitalization levels have been rising for 40 years, going back to the thrift crisis in the late 1980s. Dodd-Frank also requires large banks to hold a higher percentage of their assets in cash to insure they have enough liquidity to weather another financial storm.

The lesson from the last crisis, says Cohen, revolves around the importance of having a fortress balance sheet. “I think that was the lesson which has been thoroughly learned not merely by the regulators, but by the banks themselves, so that banks today have exponentially more capital, and the differential is even greater in terms of having more liquidity,” says Cohen.

But does anyone know if these changes will be enough to help banks survive the next crisis?

“I don’t think it is possible to calculate this precisely, but if you look at the banks that did get into trouble, none of them had anywhere near the level of capital and liquidity that is required now,” says Cohen. “Although you can’t say with certainty that this is enough, because it’s almost unprovable, there’s enough evidence that suggests that we are at levels where no more is required.”

It is often said that generals have a tendency to fight the last war even though advances in weaponry—driven by technology—can render that war’s tactics and strategies obsolete. Think of the English cavalry on horseback in World War I charging into German machine guns.

It can be argued that regulators, policymakers and even customers in the United States still bear the emotional scars of the last financial crisis, so we all find comfort in the fact that banks are less leveraged today than they have been in recent history, particularly in the lead up to the last crisis.

But what if a strong balance sheet isn’t enough to fight the next war?

“I think the biggest risk in the [financial] system today is a successful cyberattack,” says Cohen. While a lot of attention is paid to the dangers of a broad attack on critical infrastructure that poses a systemic risk, Cohen worries about something different.

“That is a very serious risk, but I think the more likely [danger] is that a single bank—or a group of banks—are hit with a massive denial of service for a period of time, or a massive scrambling of records,” he says. This contagion could destabilize the financial system if depositors begin to worry about the safety of their money.

Cohen believes that financial contagion, where risk spreads from one bank to another like an infectious disease, played a bigger role in the financial crisis than most people appreciate. And he worries that the same scenario could play out in a crippling cyberattack on a major bank.

“Until we really understand what role contagion played in 2008, I don’t think we’re going to appreciate fully the risk of contagion with cyber,” he says. “But to me, that is clearly the principal risk.”

And herein lays the irony of the industry’s higher capital and liquidity requirements. They were designed to protect against the risk of credit bubbles, such as the one that precipitated the last crisis, but they will do little to protect against the bigger risk faced by banks today: a crippling cyberattack.

“That’s why I regard [cyber] as the greatest threat,” says Cohen, “because a fortress balance sheet won’t necessarily help.”