Does Your Bank Have a Deposit Strategy?

strategy-1-22-18.pngMany banks lack a clear, written deposit strategy and funding plan. For the last several years, that’s been somewhat understandable. After all, deposits flowed into banks and have now reached historic highs, even though banks on average pay little or nothing in interest on the vast majority of those deposits.

Now that’s changing. Deposits are an increasingly important topic for bank boards. We are on the front end of an environment bankers have not seen in almost a decade. The Federal Reserve raised the fed funds target rate by 75 basis points last year, and three more rate increases are expected this year.

Banks already are seeing deposit competition heat up. Close to 64 percent of bankers said that deposit competition had increased in the last year, and 77 percent expected it to increase during the subsequent 12 months, according to Promontory Interfinancial Network’s Bank Executive Business Outlook Survey in the third quarter of 2017. Although in the past banks have had to compete in rising rate environments, we’ve never seen a point in history quite like this one, and it would be wise to assume rising rates will impact deposits, as well as your bank’s funding mix and profit margins.

There are a couple of reasons why the environment has changed. Historically, big banks ignored the rate wars for deposits, a game that was left to community banks. But this time, the new liquidity coverage ratio requirement that came out of the Basel III accords could encourage big banks to get more competitive on deposit rates. The ratio, finalized in the U.S. in 2014, requires banks with more than $250 billion in assets to keep a ratio of 100 percent high-quality liquid assets, such as Treasury bonds, relative to potentially volatile funds. Banks that move toward more retail deposits will have a lower expected level of volatile funds.

Also, banks have a majority of their deposits in liquid accounts while term deposits, such as CDs, are at historic lows. There’s no hard-and-fast rule to know how much of those non-term deposits will leave your bank as rates rise.

As the economy has improved, surging loan growth has put more pressure on the need to grow deposits. Loan-to-deposit ratios are rising, and as banks need to fund further growth, demand for deposits will rise. What this will do to competition for deposits and, therefore, deposit rates, is unclear. We have found that many banks aren’t raising rates on their loans, and the best borrowers can easily shop around to get the best rates. This will put pressure on margins if banks don’t raise rates on loans as interest rates rise.

Still another factor is that people have had a decade since the financial crisis to get comfortable with the benefits of online and mobile banking. Online banks, not incurring costs associated with physical branches, often offer higher interest rates on deposits than traditional banks.

One of the best ways to prepare for the changing environment is to make sure your bank has a written, well-prepared deposit strategy. We’re not talking about a 100-page document. In fact, the asset/liability committee (ALCO) of the bank may need a five- to 10-page report highlighting the rate environment, the bank’s deposit strategy, and alternative funding plans and projections. The bank’s full board may just need a three- to four-page summary of the bank’s deposit strategy, making sure that management is able to address key questions:

  1. Who are your bank’s top 10 competitors, and what are they doing with rates? What new products are they offering?
  2. How will the Federal Reserve’s expected moves in the coming year impact our rates, our margins and our annual net income?
  3. What is our bank’s strategy for contacting our largest depositors and determining their needs?
  4. What new deposit products do we plan to offer, and how will we offer them only to our best customers? Not all customers or deposits have equal value to the bank.
  5. What is our funding plan? In other words, what are our alternatives if we need deposits to grow, and what will they cost? This is perhaps the most difficult question to answer.

While it’s important not to be caught off guard in a rising-rate environment, rising rates can be a good thing for a bank with a solid deposit strategy in place. For the first time in a long time, the wind will be in the sails of bankers. They just need a plan for navigating the changing environment ahead.

Banks May Get Capital Relief

regulation-10-6-17.pngFederal banking regulators are trying to make life easier for regional and community banks by making changes to Basel III capital rules, particularly in areas that have been subject to banker complaints. Whether the changes provide real relief may be up to the bank.

Last week, the Federal Reserve Board, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency issued a proposal to “reduce regulatory burden” by simplifying regulatory capital rules that dictate how much capital banks must maintain. The rules mostly apply to banks subject to what’s known as “standardized approaches,” so it will generally impact banks and thrifts with less than $250 billion in total consolidated assets or less than $10 billion in total foreign exposure. Comments on the proposal are due within 60 days of publication in the Federal Register, which hadn’t occurred as of Thursday morning.

“This is an effort to make lives for community banks a little bit easier,’’ says Luigi De Ghenghi, a partner in Davis Polk’s Financial Institutions Group. The big picture on all of this is that as the industry approached the 10-year mark for the start of the financial crisis, regulators are looking at ways to update rules as the health of the industry has improved. Still, regulators are sensitive to accusations that they may be exposing the industry to another financial crisis by rolling back rules too enthusiastically, industry observers say.

The U.S banking agencies are walking a bit of a tight rope because on the one hand they want to be seen as simplifying the capital rules and giving an appropriate level of capital relief,’’ De Ghenghi says. “On the other hand, they don’t want to be seen as substantively weakening capital standards,” especially since lack of capital and risky loans were a factor in the failure of hundreds of community banks during and after the crisis.

It would be wrong to assume that this is coming out of the new Trump administration’s drive to provide financial regulatory relief, as detailed in the Treasury Department report in June. Although politics is always a factor, the latest proposal comes out of an Economic Growth and Regulatory Paperwork Reduction Act, which requires banking agencies to review regulations every 10 years and to get rid of “unduly burdensome regulations” while ensuring the safety and soundness of the financial system. The review kicked off in 2014 and concluded earlier this year.

One of the most important of the proposed changes deals with the definition and risk weighting of high volatility commercial real estate (HVCRE) loans, which are considered among the higher risk loans that banks make to developers and builders, such as non-recourse loans. But community bankers had complained that the HVCRE loan definition and exemptions were too complex to apply and that the risk weightings were too high for the risks these loans posed.

“The banks were pushing the trade associations to push members of Congress to say, ‘We need a fix here,’’’ says Dennis Hild, managing director at Crowe Horwath and former bank examiner and supervisory analyst with the Federal Reserve. “’We think we know what falls under the purview of a high volatility real estate loan and the regulators come in [for an exam] and there is a disagreement on certain sets of loans.’”

To respond to the need for clarification, the proposal creates a new high volatility loan category for loans going forward that focuses less on underwriting criteria and more on the use of the proceeds, according to De Ghenghi. It potentially includes a wider array of commercial real estate loans, but lowers the risk weight from 150 percent to 130 percent, meaning banks have to hold slightly less capital against these loans. Also, banks will be able to include higher amounts of mortgage servicing assets and certain deferred tax assets as common equity Tier 1 capital, a new tier of regulatory capital that was created after the financial crisis as part of the global agreement known as Basel III.

This will help “the institutions that have substantial amounts of mortgage servicing assets or deferred tax assets,” says Hild.

The agencies have summed up the proposal’s impact on community banks here. The 10-year review details several other changes already made or in the works to reduce the regulatory burden. Among them, the agencies made changes to provide institutions with up to $1 billion in assets, instead of the $500 million limit, with the opportunity for an 18-month exam cycle instead of a 12-month exam cycle, if they score highly on their exams. The agencies also proposed this summer to increase the threshold for requiring an appraisal on a commercial real estate loan from $250,000 to $400,000.

BASEL III: The Final Rules are Here and It’s Time to Get Ready

7-26-13-Bryan-Cave.pngOver the past year, my colleagues and I have spent an untold number of hours researching, writing and speaking about the Basel III capital rules. We felt it important to help bankers focus on the proposed rules in order to help them prepare and to help facilitate an appropriate response to the proposed rules. Because the rules were in proposed form, however, many bankers, bank directors and industry participants did not focus on these capital rules, instead waiting until they were finalized. Well, we’re here.

Earlier this month, the regulatory agencies finalized their revisions to the capital and risk-weighting rules, commonly known as the Basel III rules. Even though the rules will not be effective for most banks until Jan. 1, 2015, the finalizing of these rules presents the call to action to begin the dialogue about how the new rules will impact your bank. Of course, given the fact that the final release for the rules was almost 1,000 pages long, many bankers contemplating a board presentation are left to ask, “Where should I start?” Below are a few suggested areas of focus to begin to enhance your directors’ understanding of the new rules.

  • The New Rules Limit Leverage. If there is only one sentence for directors to remember regarding the new rules, it is this one. By increasing capital requirements and ensuring that common equity represents a substantial portion of an institution’s capital structure, the new rules limit the leverage that banks may take on. A central premise of the new rules is that by decreasing leverage in the banking industry, a more stable economy will result. This stability was emphasized even at the risk of limiting economic growth. To the extent that your directors viewed the deleveraging of the industry as a cyclical matter, these rules allow bankers to dispel that notion. By the time the required capital conservation buffer is factored in, the required Tier 1 risk-based capital ratio will have increased from the current minimum of 4.0 percent to 8.5 percent under the new rules.
  • Maintaining the full capital conservation buffer will be important. In addition to a new Tier 1 common equity requirement, the new rules impose what’s called a capital conservation buffer equal to 2.5 percent of risk-weighted assets (subject to a phase-in period), making total capital minimums go as high as 10.5 percent for community banks. The failure to maintain the full buffer amount will result in restrictions on discretionary reductions in capital such as bonuses for executives, dividends and stock repurchases. Given investor demands for cash flow and the need to provide competitive compensation in order to attract and retain the best talent available, these restrictions could be very meaningful (particularly if an institution is forced to choose between compensating its executives and paying a dividend to shareholders). As a result, one might expect sophisticated investors and bank managers to focus on the maintenance of this buffer.
  • The new rules should impact the pricing of certain products. The risk-weighting components of the new rules will change the amount of capital that must be dedicated to certain products. For example, an acquisition, development, and construction loan that is deemed to be a high volatility commercial real estate loan will have a 50 percent higher risk weight and will therefore occupy 50 percent more capital. Therefore, it stands to reason that these products should be priced 50 percent higher in order to achieve the same return for the institution’s shareholders.
  • Return on equity is simple math. The ultimate bottom line of the new rules is that with less leverage, it is more difficult to produce optimal returns on equity. Bank management should study the aggregate impact of the new rules on the institution’s capital levels to determine if existing capital levels will be adequate. If not, directors will need to understand that return on equity is likely to suffer unless net income increases. As a result, directors’ expectations of returns may need to be managed and strategies may need to be implemented to become more efficient or to increase revenue.

The regulatory agencies are careful to reassure us that the vast majority of institutions would be in compliance with the new rules if the rules were in effect today. Even though the analysis used to arrive at that conclusion is a bit crude, this point should be emphasized to directors: Now is not the time for panic. It is, however, time for bankers and boards to roll up their sleeves and understand the impact of the rules on their institutions. The sooner bank management can begin a dialogue with directors about the new rules, the more likely it is that the board can develop an informed and effective strategy.

Managing Operational Risk is About Managing Your Business Well

7-1-13_Sutherland.pngChinese proverb:  “If we don’t change direction soon, we will end up where we are going”…

The Basel Committee on Bank Supervision, and global regulatory momentum around the Basel Accords catalyzed an operational risk discipline by giving us a formal definition for it: “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” It also created a finite scope for the risk by laying down distinct event categories and descriptions of cause and effect. This meant that operational risk no longer needed to be described in the abstract or in residual terms such as “anything other than credit or market risk” (which, by the way, was never a meaningful statement at all, considering that the administration and management of credit and market risk are themselves fraught with operational risk).

Notwithstanding definitions and regulatory exhortations, operational risk has not evolved as a discipline in the last ten years since the Accords. There has been arguably material progress in measuring it (against losses, scenario and stress analysis, capital postulations), but managing it has been far from easy. Reasons include the fact that it is largely idiosyncratic (in credit and market risk debacles, you tend to sink and swim with everybody else) and asymmetric, since the risk is not passed on to your client and not priced into your products. Operational risk may also be called introspective, as likelihood and severity are both internally determined; and unbounded, as there is no upper limit to potential loss. Traditional belief has been that no portfolio view can be formed, as operational risk is not transactional. You don’t take on the risk or avoid it. It simply exists.

The basic construct of any operational risk program is as follows:

  1. Identify the major risks, as your taxonomy of risks (the Basel event categories should be fine)
  2. Position your internal control environment as a hedge or mitigation for these risks
  3. Through a regime of self-testing, reviews, audits, and risk/control indicators, establish if both the design and effectiveness of your control framework are good and fit for purpose
  4. Ask if your unmitigated risks (and control gaps) are acceptable, and within your appetite for risk

Do all this, and everybody is happy—even the regulator. Do too much, and you have wasted a lot of money, created a big bureaucracy and throttled the business. Do too little, and you have bet your whole business on one big accident.

The real key to managing operational risk lies in recognizing that it simply requires managing the business well, focusing on people, process and infrastructure optimization. This is where the risk-reward consideration, read cost-control, comes into play. A portfolio view of operational risk is in fact available, by looking at the process view of the organization, honing in on what risks arise in pursuing the business, how and where these risks arise in the process sequence, and what mix of people, process and infrastructure could optimally address these.

The implied focus therefore is in the structuring of the end-to-end control framework. This first requires you to clearly define your business objectives, service delivery standards, and compliance requirements. Next, identify the risks that arise in meeting or delivering those objectives, categorizing them along your taxonomy of risks. You can use the Basel framework. Then systematically identify which areas of your activity and processes are directly relevant to those objectives. This allows you to relate your operational risks to the specific processes and activities that carry those risks or are relevant to those risks. Focus then on defining controls where the risks are, specific to the process, in the optimal coverage amount and configuration. Maintain a dashboard of metrics that tell you if your residual (unmitigated) risks are within your risk-appetite and if the controls continue to be designed correctly and working properly. These might include some metrics of well being, similar to vital signs, that indicate business health. A second set of metrics might be smoke-detectors, by business, product, and process, with built-in lights that flash red, yellow, green against specific escalation triggers and trends.

Bottom-line, managing operational risk has never been more important than it is today, but never apparently has it been more conflicted between cost and control. It should not, and does not, need to be so! 

A Postcard from AOBA 2013

Bank Director recently completed its 19th annual Acquired or Be Acquired (AOBA) conference in Scottsdale, Arizona, and I would describe the mood — not just about the bank mergers and acquisition market, but about banking in general — as generally upbeat. I think the dark clouds that have hung over the industry since 2008 have begun to part and the future looks a little brighter.

We drew a record crowd of 700-plus attendees to the fabled Phoenician resort (once owned, temporarily, by the Federal Deposit Insurance Corp. when the former publisher of Bank Director magazine, the late Bill Seidman, was the agency’s chairman) for four days of peer group discussions, general sessions and breakouts on a wide variety of topics relating to M&A, capital and strategy.  Most of the attendees at this conference are bank chief executive officers and outside directors, so it’s almost impossible to spend a couple of days here and not come away with a strong sense of how the industry’s leadership feels about things. 

Jack_2-6-13.jpg(Unfortunately, the weather was not particularly cooperative during our stay. It rained the first couple of days — which is quite unusual for the Sonoran Desert this time of year — and in an effort to coax out the sun our managing director and executive vice president, Al Dominick, and I opened the conference by walking on stage with opened umbrellas. Our little voodoo trick was marginally successful — the sun finally appeared to stay on the final day of the event.)

If there was general consensus among the attendees about the future of the bank M&A market, it was this: We should see more deals this year than we saw in 2012 — when there were 230 acquisitions of healthy banks totaling $13.6 billion, according to SNL Financial. And one of the primary drivers will be the Federal Reserve’s ongoing monetary policy of keeping interest rates low, which has had the unhappy effect for most banks of squeezing their net interest margins. Remember, most banks make most of their money on the spread between their cost of funds and the interest rates they charge on loans. And even though deposits are dirt cheap at the moment, weak loan demand and intense competition for whatever good loans can be found have driven down loan pricing as well. Several speakers at this year’s conference predicted that the industry’s margin pressure — one might even call it a margin crisis—could last well into 2014.

A second driver could turn out to be the pending Basel III capital requirements, which in their current form apply equally to all sizes of institutions — and would force many community banks to raise capital. More than one speaker said that institutional investors are wary of putting their money into any bank that doesn’t have a compelling growth story to tell. Unless the U.S. regulators decide to apply a less stringent version of the requirements to small banks — let’s call it “Basel III Lite” — many such institutions could find themselves in the unenviable position of needing to raise capital from an unfriendly market. For them, selling out to a more strongly capitalized competitor might be their only option.

A third factor in the M&A market’s anticipated resurgence this year is the oppressive weight of banking regulation, including (but certainly not limited to) the Dodd-Frank Act. Smaller institutions will have a harder time affording the rising cost of compliance, and I’ve even heard some people suggest that banks will need to grow to $1 billion in assets before they begin to achieve what one might call “economies of compliance scale.” Although there are exceptions (including some provisions of Dodd-Frank), most regulations apply equally to all banks regardless of their size, which means it costs small banks disproportionately more as a percentage of revenue to comply than it does bigger banks with larger revenue bases. Will a large number of banks sell out solely because of the rising compliance burden? Probably not. But for an institution that is struggling with intense margin compression and needs to raise capital to meet yet another regulatory mandate, the higher cost of regulatory compliance could be the final straw.

Next year’s AOBA — set for Jan. 26 through Jan. 28 at the Arizona Biltmore resort in Scottsdale — will be the conference’s 20th anniversary and it will be interesting to see how well these predictions held up. Until then, ciao.