Strengthening Financial Performance in a Rising Rate Environment

Interest rate volatility has been a dominant theme this year and inflation worries have begun morphing into recession fears.

For banks, rising rates are generally a positive trend; they tend to result in higher deposit franchise values and higher net interest margins. While unrealized losses in the available for sale bond portfolio also typically increase during rising rate environments, adhering to a disciplined investment framework can help bank leaders avoid knee-jerk reactions and put unrealized losses into the right context (discussed previously here).

As rates continue to rise, it’s time to check the pulse on your institution’s pricing model. In addition to pricing assets accurately, a successful bank also focuses on funding cheaply, using a number of models to identify relative value and hedging interest rate risk when necessary. Here, we’ll dive deeper into three principles that can help institutions strengthen their financial performance.

Principle 1: Disciplined Asset Pricing
Capital requirements mean that a bank has a finite capacity to add assets to its balance sheet. Each asset going on the balance sheet must be critically evaluated to ensure it meets your institution’s specific performance goals and risk mandates.

Using a risk-adjusted return on capital (RAROC) framework for asset pricing and relative value assessment helps establish a consistent, sustainable decision-making framework for capital allocation. Clearly, different assets have different risks and returns. An effective financial manager ensures that the bank is meeting its hurdle rates, or return on capital, and that the model and assumptions are as accurate as possible.

A mispriced asset isn’t just a risk to margin. It also represents liquidation risk, as assets priced incorrectly to market perceptions of risk have a higher likelihood of poor sale performance, such as losses on sale or failure to sell. The value of the institution can also be impacted if the bank consistently — even marginally — misprices assets. Overall, if an asset is not appropriately priced for the risks and costs associated with it, then a bank should critically evaluate its role on the balance sheet.

Principle 2: The Value of Deposit Funding
Banks benefit from low-cost, sticky funding. Core deposits typically comprise the largest and cheapest funding source, followed by term and wholesale funding and all other, generally short-term, funding sources.

Understanding your funding’s beta is a key first step to unlocking better financial performance.

In this application, beta is a measurement of the relationship between a funding source’s interest rate and an observable market rate; it is the sensitivity of funding cost relative to a change in interest rates.

As rates rise, low beta funding results in greater growth in franchise value compared to high beta funding. As assets reprice to the higher rate environment, balance sheets with low beta funding will see margins steadily widen. Banks with high beta funding tend to exhibit margin compression and declining valuations. Conversely, low beta funding results in more stable valuation as rates rise.

Principle 3: Risk Management in an ALM and RAROC Framework
Borrowers and depositors maximize their own utility, which often presents a dilemma for the financial institutions that serve them. When interest rates are low, borrowers typically want long-term, fixed-rate loans and depositors keep their deposits shorter term.  When interest rates are higher, we typically see the opposite behavior: depositors begin to consider term deposits and borrowers demand more floating rate loans. This dynamic can cause mismatches in asset and liability duration, resulting in interest rate risk exposure. Banks must regularly measure and monitor their risk exposure, especially when rates are on the move.

Significant divergence from neutral rate risk — a closely aligned repricing profile of a bank’s assets and liabilities — exposes a bank’s return on equity and valuation to potential volatility and underperformance when rates move. That’s where hedging comes in. Hedging can assist a bank by reducing asset-liability mismatches, enhancing its competitiveness by locking in spread through disciplined asset pricing and stabilizing financial performance. After all, banks are in the business of lending and safekeeping funds, but must take on risk to generate return. Hedging can reduce discomfort with a bank’s existing or projected balance sheet risks and improve balance sheet strategy agility to better meet customers’ needs.

There are opportunities for banks all along the yield curve. But institutions that don’t hedge compete for assets in the crowded short duration space — often with significant opportunity costs.

Rising rates generally result in stronger margins and valuations for well-funded depositories; disciplined asset pricing in a risk-adjusted framework is critical for financial performance. As a financial professional, it’s important that the board has a firm understanding of what drives deposit franchise value. Take the time to ensure that the entire leadership team understands potential risk in your bank’s ALM composition and be prepared to hedge, if needed.

How High Inflation, High Rates Will Impact Banking

In the latest episode of The Slant Podcast, former Comptroller of the Currency Gene Ludwig believes the combination of high inflation and rising interest rates present unique risks to the banking industry. Ludwig expects that higher interest rates will lead to more expensive borrowing for many businesses while also increasing their operating costs. This could ultimately result in “real credit risk problems that we haven’t seen for some time.”

While the banking industry is well capitalized and asset quality levels are still high, Ludwig says the combination of high inflation and rising interest rates will be a challenge for younger bankers who have never experienced an environment like this before.

Ludwig knows a lot about banking, but his journey after leaving the Comptroller of the Currency’s office has been an interesting one. After completing his five-year term as comptroller in 1998, Ludwig could have returned to his old law firm of Covington & Burling LLP and resumed his legal practice. Looking back on it, he says he was motivated by two things. One was to put “food on the table” for his family because he left the comptroller’s office “with negative net worth – [and] it was negative by a lot.”

His other motivation was to find ways of fixing people’s problems from a broader perspective than the law sometimes allows. “I love the practice of law,’’ he says. “It’s intellectually satisfying.” But from his perspective, the law is just one way to solve a problem. Ludwig says he was looking for a way to “solve problems more broadly and bring in lawyers when they’re needed.” This led to a prolonged burst of entrepreneurial activity in which Ludwig established several firms in the financial services space. His best known venture is probably the Promontory Financial Group, a regulatory consulting firm that he eventually sold to IBM.

Ludwig’s most recent initiative is the Ludwig Institute for Shared Economic Prosperity, which he started in 2019. Ludwig believes the American dream has vanished for many median- and low-income families, and the institute has developed a new metric which makes a more accurate assessment of how inflation is hurting those families than traditional measurements such as the Consumer Price Index — which he says drastically understates the impact.

Ludwig hopes the Institute’s work gives policymakers in Washington, D.C., a clearer sense of how desperate the situation is for millions of American families and leads to positive action.

This episode, and all past episodes of The Slant Podcast, are available on Bank DirectorSpotify and Apple Music.

Tips for Banks to Navigate Top Risks in 2022

Banks continue to meet unprecedented challenges of the Covid-19 pandemic, geopolitical cyberthreats and increasing public awareness of environment, social and governance (ESG) issues.

With the current landscape posing ever-evolving risks for banks, Moss Adams collaborated with Bank Director to conduct the 2022 Risk Survey and explore what areas are front of mind for bank industry leaders. Top insights from Bank Director’s 2022 Risk Survey include that the vast majority of survey respondents reported that cybersecurity and interest rate risks pose increasing concerns, and they expect these challenges to persist in the second half of the year, due to turbulent economic and geopolitical conditions. The survey also identified that banks increasingly focus on issues related to compliance and regulatory risks.

Cybersecurity Oversight
Concerns about cybersecurity topped the survey responses: 93% of respondents stated that a need for increased cybersecurity grew significantly or somewhat. Bank executives and board members submitted survey responses in January, prior to heightened federal government warnings of increased Russian cyberattacks. Banks’ concerns will likely continue to increase as a result.

Data Breach Rates and Precautions
While only 5% of respondents reported experiencing a data breach or ransomware attack at their own institution in the years 2020 and 2021, 65% reported data breaches at their bank’s vendors. In response, 60% stated they updated their institution’s third-party vendor management policies, processes, or risk oversight.

As a critical U.S. industry, banks follow stringent regulatory requirements for data security. The Federal Financial Institutions Examination Council (FFIEC) cybersecurity assessment tool provides a maturity model for banks to assess their cybersecurity maturity as baseline, evolving, intermediate, advanced or innovative. Ninety percent of respondents completed a cybersecurity assessment over the past 12 months; 61% used the FFIEC’s tool in combination with other methodologies, and another 19% only used the FFIEC’s tool. And 83% of respondents said that the maturity of their bank’s cybersecurity program increased in 2021, compared to previous assessments.

Room for Improvement
Banks noted several areas of improvement for their cybersecurity programs, including training for bank staff (83%), technology to better detect and deter cyberthreats and intrusions (64%) and internal controls (43%). Thirty-nine percent believe they need to better attract and retain quality cybersecurity personnel. Banks’ investments in cybersecurity programs remained flat compared to the 2021 survey, with a median budget of $200,000.

As cybersecurity risks increase, banks should focus on researching and making appropriate investments, as well as implementing comprehensive planning for staff training, technology and governance. At the board level, respondents noted several activities as part of that body’s oversight of the cybersecurity risk management program. Key among these is board-level training (79%), ensuring continual improvements by management of their cybersecurity programs (75%) and being aware of any deficiencies in the bank’s cybersecurity program (71%).

Interest Rate Risk Concerns
The prospect of rising interest rates fueled anxiety for our respondents: 71% noted increased concern. As the Federal Open Market Committee combats higher inflation by hiking interest rates, 74% reported hoping that they wouldn’t raise rates by more than one percentage point by the end of 2022 — which is currently below what’s projected.

Faced with likely rate hikes, banks are looking to their own business models to navigate a potential decrease in overall lending volume and potential pressure on profit margins. Respondents also noted that they were increased their focus in sectors such as commercial and industrial, commercial real estate and construction, or with the Small Business Administration or obtaining other small business loans.

ESG Initiatives
Banks are under increasing pressure to adopt ESG initiatives. More than half of respondents don’t yet focus on ESG issues in a comprehensive manner, and regulators have yet to impose ESG requirements for banks. However, more than half of survey respondents say they have set goals and objectives in a variety of ESG-related areas, primarily in the social and governance verticals — employee development and community needs in particular topped the list.

Only 6% said that investors or other company stakeholders currently look for more disclosure around ESG initiatives, with diversity, equity and inclusion topping the list at 88%. Banks that haven’t established ESG strategies could first identify their top priority areas. These priorities may vary for each organization and will need to consider the values of investors, customers and local community.

Navigating the Turbulence of Rising Rates, Inflation and Volatility

Financial markets have been rocked by significant volatility in 2022.

Over the first six months of 2022, the 10-year U.S. Treasury rate jumped from 1.52% to 3.2%. A confluence of events is driving that volatility: increased inflation expectations led to more significant and sooner-than-expected increases in the Federal Funds rate, uncertainty of the first military conflict in Europe since World War II, and the economy. Financial institutions are finding themselves in very turbulent waters.

Banks that prepared for this possibility are navigating across these choppy waters with greater ease. They’re using prudent risk management tools, like interest rate swaps, to smooth earnings and protect against continued increases in long-term rates. Swaps create more flexibility for banks: they can be quickly and easily implemented and allow institutions to bifurcate the rate risk from traditional assets and liabilities.

Most banks use hedging strategies that aim to smooth earnings. For example, banks use an interest rate swap to convert a portion of their floating-rate assets to fixed. They lock in the market’s expectations for rates and bring forward future expected income.

The benefits of this strategy:

  • Synthetically converting pools of floating-rate assets via a swap extends the duration of assets, reduces asset sensitivity and increases current earnings.
  • This helps banks monetize the shape of the yield curve by bringing forward future interest income and producing smoother net income.

When it comes to hedging floating rate loans, we see a mix of Fed Funds (to hedge loans tied to Prime), SOFR, LIBOR, and a handful of banks using that Bloomberg Short-Term Bank Yield (BSBY) index.  Additionally, hedging floating rate loans with floors requires special considerations.

On the other side of the spectrum, those banks hedging for rising rates primarily use swap and cap strategies to reduce duration risk in the loan and bond portfolio. Notably, the Financial Accounting Standards Board recently introduced the portfolio layer method, which allows banks to swap pools of fixed-rate assets like loans or securities to floating.

The benefits of this strategy:

  • Synthetically converting fixed-rate assets via a swap shortens the duration of a bank’s balance sheet and hedges rising rates.
  • Create more capacity for a bank to do more fixed-rate lending.
  • Swaps can start today or in the future, allowing banks to customize the risk mitigation to its risk profile.

In the turbulent seas of this current moment, banks prepared to use hedging strategies enjoy the benefits of smoother income and mitigated rate volatility. They also benefit from their flexibility: Banks can quickly execute swaps, allowing it to bifurcate the rate risk from traditional assets and liabilities. Finally, derivatives have low capital requirements, resulting in minimal impact to capital ratios.

Adding hedging tools to the tool kit now allows your bank to get ready before next quarter’s volatility — and potential rate change — is best practice that can be accomplished quickly and efficiently.

Bank Compensation Survey Results: Findings Released

NASHVILLE, TENN., June 21, 2022 – Bank Director, the leading information resource for directors and officers of financial institutions nationwide, today released the results of its 2022 Compensation Survey, sponsored by Newcleus Compensation Advisors. The findings confirm that intensifying competition for talent is forcing banks to pay up for both new hires and existing employees.

The 2022 Compensation Survey finds that 78% of responding directors, human resources officers, CEOs and other senior executives of U.S. banks say that it was harder in 2021 to attract and keep talent compared to past years. In response to this increased pressure, 98% say their organization raised non-executive pay in 2021, and 85% increased executive compensation. Overall, compensation increased by a median 5%, according to participants.

“Banks are challenged to find specialized talent like commercial lenders and technology personnel, but they’re also struggling to hire branch staff and fill entry-level roles,” says Emily McCormick, Bank Director’s vice president of research. “In this quest for talent, community banks are competing with big banks like Bank of America Corp., which recently raised its minimum wage to $22 an hour. But community banks are also competing against other industries that have been raising pay. How can financial institutions stand out as employers of choice in their markets?”

Asked about specific challenges in attracting talent, respondents cite an insufficient number of qualified applicants (76%) and unwillingness among candidates to commute for at least some of their schedule (28%), in addition to rising wages. Three-quarters indicate that remote or hybrid work options are offered to at least some staff.

“It is obvious from the survey results that talent is the primary focus for community banks,” says Flynt Gallagher, president of Newcleus Compensation Advisors. “Recruiting and retaining talent has become a key focus for most community banks, surpassing other concerns that occupied the top spot in prior surveys — namely tying compensation to performance. It is paramount for community banks to step up their game when it comes to understanding what their employees value and improving their reputation and presence on social media. Otherwise, financial institutions will continue to struggle finding and keeping the people they need to succeed.”

Key Findings Also Include:

Banks Pay Up
Banks almost universally report increased pay for employees and executives. Of these, almost half believe that increased compensation expense has had an overall positive effect on their company’s profitability and performance. Forty-three percent say the impact has been neutral.

Commercial Bankers in Demand
Seventy-one percent expect to add commercial bankers in 2022. Over half of respondents say their bank did not adjust its incentive plan for commercial lenders in 2022, but 34% have adjusted it in anticipation of more demand.

Additional Talent Needs
Banks also plan to add technology talent (39%), risk and compliance personnel (29%) and branch staff (25%) in 2022. Respondents also indicate that commercial lenders, branch and entry-level staff, and technology professionals were the most difficult positions to fill in 2020-21.

Strengthening Reputations as Employers
Forty percent of respondents say their organization monitors its reputation on job-posting platforms such as Indeed or Glassdoor. Further, 59% say they promote their company and brand across social media to build a reputation as an employer of choice, while just 20% use Glassdoor, Indeed or similar platforms in this manner. Banks are more likely to let dollars build their reputation: Almost three-quarters have raised starting pay for entry-level roles.

Low Concerns About CEO Turnover
Sixty-one percent of respondents indicate that they’re not worried about their CEO leaving for a competing financial institution, while a third report low to moderate levels of concern. More than half say their CEO is under the age of 60. Respondents report a median total compensation spend for the CEO at just over $600,000.

Remote Work Persists
Three quarters of respondents say they continue to offer remote work options for at least some of their staff, and the same percentage also believe that remote work options help to retain employees. Thirty-eight percent of respondents believe that remote work hasn’t changed their company’s culture, while 31% each say it has had either a positive or negative impact.

The survey includes the views of 307 independent directors, CEOs, HROs and other senior executives of U.S. banks below $100 billion in assets. Compensation data for directors, non-executive chairs and CEOs was also collected from the proxy statements of 96 publicly traded banks. Full survey results are now available online at BankDirector.com.

About Bank Director
Bank Director reaches the leaders of the institutions that comprise America’s banking industry. Since 1991, Bank Director has provided board-level research, peer-insights and in-depth executive and board services. Built for banks, Bank Director extends into and beyond the boardroom by providing timely and relevant information through Bank Director magazine, board training services and the financial industry’s premier event, Acquire or Be Acquired. For more information, please visit www.BankDirector.com.

About Newcleus
Newcleus powers organizations as the leading designer and administrator of compensation, benefit, investment and finance strategies. The personalized product selections, carrier solutions and talent retention programs are curated to optimize benefits and improve ROI. www.newcleus.com.

Source:
For more information, please contact Bank Director’s Director of Marketing, Deahna Welcher, at dwelcher@bankdirector.com.

Advice to Bank Directors: Don’t Be Reactive on Credit Quality

With credit quality metrics at generationally stellar levels, concern about credit risk in 2022 may seem unwarranted, making any deployed defensive strategies appear premature.

For decades, banking has evolved into an orientation that takes most of its risk management cues from external stakeholders, including investors, trusted vendors, market conditions — and regulators in particular. Undoubtedly, becoming defensive prematurely can add challenges for management teams at a time when loan growth is still a main strategic objective. But waiting until credit metrics pivot is sure to add risk and potential pain. Banks have four key reasons to be more vigilant in 2022 and the next couple of years. These, and the suggested steps that prudent management teams should take in their wake, are below.

1. The Covid-19 sugar high has turned sour.
All of the government largesse and regulatory respites in response to Covid-19 helped unleash 40-year-high inflation levels. In response, the Federal Reserve has begun ramping up interest rates at potential intervals not experienced in decades. These factors are proven to precede higher credit stress. Continuing supply chain disruptions further contribute and strengthen the insidious inflation psychology that weighs on the economy.

Recommendation: Bankers must be more proactive in identifying borrowers who are particularly vulnerable to growing marketplace pressures by using portfolio analytics to identify credit hotspots, increased stress testing and more robust loan reviews.

2. Post-booking credit servicing is struggling across the industry.
From IntelliCredit’s perspective, garnered through conducting current loan reviews and merger and acquisition due diligence, the post-booking credit servicing area is where most portfolio management deficiencies occur. Reasons include borrowers who lag behind in providing current financials or — even worse — banks experiencing depletions in the credit administration staff that normally performs annual reviews. These talent shortages reflect broader recruitment and retention challenges, and are exacerbated by growing salary inflation.

Recommendation: A new storefront concept may be emerging in community banking. Customer-facing services and products are handled by the bank, and back-shop operational and risk assessment responsibilities are supported in a co-opt style by correspondent banking groups or vendors that are specifically equipped to deliver this type of administrative support.

3. Chasing needed loan growth during a credit cycle shift is risky.
Coming out of the pandemic, community banks have lagged behind larger institutions with regards to robust organic loan growth, net of Paycheck Protection Program loans. Even at the Bank Director 2022 Acquire or Be Acquired Conference, investment bankers reminded commercial bankers of the critical link between sustainable loan growth and their profitability and valuation models. However, the risk-management axiom of “Loans made late in a benign credit cycle are the most toxic” has become a valuable lesson on loan vintages — especially after the credit quality issues that banks experienced during the Great Recession.

Recommendation: Lending, not unlike banking itself, is a balancing game. This should be the time when management teams and boards rededicate themselves to concurrent growth and risk management credit strategies, ensuring that any growth initiatives the bank undertakes are complemented by appropriate risk due diligence.

4. Stakeholders may overreact to any uptick in credit stress.
Given the current risk quality metrics, banker complacency is predictable and understandable. But regulators know, and bankers should understand, that these metrics are trailing indicators, and do not reflect the future impact of emerging, post-pandemic red flags that suggest heightened economic challenges ahead. A second, unexpected consequence resulting from more than a decade of good credit quality is the potential for unwarranted overreactions to a bank’s first signs of credit degradation, no matter how incremental.

Recommendation: It would be better for investors, peers and certainly regulators to temper their instincts to overreact — particularly given the banking industry’s substantial cushion of post Dodd-Frank capital and reserves.

In summary, no one knows the extent of credit challenges to come. Still, respected industry leaders are uttering the word “recession” with increasing frequency. Regarding its two mandates to manage employment and inflation, the Fed right now is clearly biased towards the latter. In the meantime, this strategy could sacrifice banks’ credit quality. With that possibility in mind, my advice is for directors and management teams to position your bank ahead of the curve, and be prepared to write your own credit risk management scripts — before outside stakeholders do it for you.

Inflation, Interest Rates and ‘Inevitable’ Recession Complicate Risks

What is the bigger risk to banks: inflation, or the steps the Federal Reserve is taking to bring it to heel?

Community banks are buffeted by an increasingly complicated operating environment, said speakers at Bank Director’s 2022 Bank Audit and Risk Committees Conference in Chicago, held June 13 to 15. In rather fortuitous timing, the conference occurred in advance of the Federal Reserve’s Federal Open Market Committee’s June meeting, where expectations were high for another potential increase in the federal funds rate. 

On one hand, inflation remains high. On the other hand, rapidly increasing interest rates aimed at interrupting inflation are also increasing risk for banks — and could eventually put the economy into a tailspin. Accordingly, interest rates and the potential for a recession were the biggest issues that could impact banks over the next 12 to 18 months, according to a pop up poll of some 250 people attending the event.  

Brandon Koeser, a financial services senior analyst at audit and consulting firm RSM US, said that inflation is the “premier risk” to the economic outlook right now. He called the consumer price index trend line “astonishing” — and its upward path may still have some momentum, given persistently high energy prices. Just days prior, on June 10, the Bureau of Labor Statistics announced that the CPI increased 1% in May, to 8.6% over the last 12 months. 

Koeser also pointed out that inflation is morphing, broadening from goods into services. That “rotation” creates a stickiness in the market that will be harder for the Federal Reserve to fight, increasing the odds that inflation persists.

It is “paramount” that the economy regain some semblance of price stability, Koeser said. In response, central bankers are increasing the pace, and potential size, of federal fund rate increases. But jacking up rates to lower prices without causing a recession is a blunt approach akin to “trying to thread a needle wearing boxing gloves,” he said.

While higher interest rates are generally good for banks, an inflationary environment could dampen loan growth while intensifying interest rate and credit risk, according to the Federal Deposit Insurance Corp.’s 2022 Risk Review. Inflation could lead consumers to cut back on spending, leading to lower business sales, and it could make it harder for borrowers to afford their payments.

At the same time, banks awash in pandemic liquidity added longer-term assets in 2021 in an attempt to capture some yield. Assets with maturities that were longer than three years made up 39% of assets at banks in 2021, compared with 36% in 2019, according to the FDIC. Community banks were even more vulnerable. Longer-term assets made up 52% of total assets at community banks at the end of 2021.

Managing this interest rate risk could be a challenge for banks that lack institutional knowledge of this unique environment. Kyle Manny, a partner at audit and consulting firm Plante Moran, pointed out that many banks are staffed with individuals who weren’t working in the industry in the 1980s or prior. He shared an anecdote of a seasoned banker who admitted he was “caught flat footed” by taking too much risk on the yield curve in the securities portfolio, and was now paying the price after the fair value of those assets fell. 

And high enough rates may ultimately send the economy into a recession. In Koeser’s poll of the audience, about 34% of audience members believe a recession will occur within the next six months; another 36% saw one as likely occurring in the next six to 12 months. Koeser said he doesn’t think it’s “impossible” for the central bank to avert a recession with a soft landing — but the margin for error is getting so small that a downturn may be “inevitable.”

Banks have limited options in the face of such macroeconomic trends, but they can still manage their own credit risk. David Ruffin, principal at credit risk analytics firm IntelliCredit, a division of Qwickrate, said that credit metrics today are the most “pristine” he had seen in his nearly 50 years in the industry. Still, the impact of the coronavirus pandemic and inflation could hide emerging credit risk on community bank portfolios. Kamal Mustafa, chairman of the strategic advisory firm Invictus Group, advised bankers to dig into their loan categories, industry by industry, to analyze how different borrowers will be impacted by these countervailing forces. Not all businesses in a specific industry will be impacted equally, he said.

So while banks can’t control the environment, they can at least understand their own loan books. 

The Future-Proof Response to Rising Interest Rates

After years of low interest rates, they are on the rise — potentially increasing at a faster rate than the industry has seen in a decade. What can banks do about it?

This environment is in sharp contrast to the situation financial institutions faced as recently as 2019, when banks faced difficulties in raising core deposits. The pandemic changed all that. Almost overnight, loan applications declined precipitously, and businesses drew down their credit lines. At the same time, state and federal stimulus programs boosted deposit and savings rates, causing a severe whipsaw in loan-to-deposit ratios. The personal savings rate — that is, the household share of unspent personal income — peaked at 34% in April 2020, according to research conducted by the Federal Reserve Bank of Dallas. To put that in context, the peak savings rate in the 50 years preceding the pandemic was 17.7%.

These trends became even more pronounced with each new round of stimulus payments. The Dallas Fed reports that the share of stimulus recipients saving their payments doubled from 12.5% in the first round to 25% in the third round. The rise in consumers using funds to pay down debt was even more drastic, increasing from 14.6% in round one to 52.3% in round three. Meanwhile, as stock prices remained volatile, the relative safety of bank deposits became more attractive for many consumers — boosting community bank deposit rates.

Now, of course, it’s changing all over again.

“Consumer spending is on the rise, and we’ve seen a decrease in federal stimulus. There’s less cash coming into banks than before,” observes MANTL CRO Mike Bosserman. “We also expect to see an increase in lending activities, which means that banks will need more deposits to fund those loans. And with interest rates going up, other asset classes will become more interesting. Rising interest rates also tend to have an inverse impact on the value of stocks, which increases the expected return on those investments. In the next few months, I would expect to see a shift from cash to higher-earning asset classes — and that will significantly impact growth.

These trends are unfolding in a truly unprecedented competitive landscape. Community banks are have a serious technology disadvantage in comparison to money-center banks, challenger banks and fintechs, says Bosserman. The result is that the number of checking accounts opened by community institutions has been declining for years.

Over the past 25 years, money-center banks have increased their market share at the expense of community financial institutions. The top 15 banks control 56.2% of the overall marketshare, up from 40% roughly 25 years ago. And the rise of new players such as fintechs and neobanks has driven competition to never-before-seen levels.

For many community banks, this is an existential threat. Community banks are critical to maintaining competition and equity in the U.S. financial system. But their role is often overlooked in an industry that is constantly evolving and focused on bigger, faster and shinier features. The average American adult prefers to open their accounts digitally. Institutions that lack the tools to power that experience will have a difficult future — regardless of where interest rates are. For institutions that have fallen behind the digital transformation curve, the opportunity cost of not modernizing is now a matter of survival.

The key to survival will be changing how these institutions think about technology investments.

“Technology isn’t a cost center,” insists Christian Ruppe, vice president of digital banking at the $1.2 billion Horicon Bank. “It’s a profit center. As soon as you start thinking of your digital investments like that — as soon as you change that conversation — then investing a little more in better technology makes a ton of sense.”

The right technology in place allows banks to regain their competitive advantage, says Bosserman. Banks can pivot as a response to events in the macro environment, turning on the tap during a liquidity crunch, then turn it down when deposits become a lower priority. The bottom line for community institutions is that in a rapidly changing landscape, technology is key to fostering the resilience that allows them to embrace the future with confidence.

“That kind of agility will be critical to future-proofing your institution,” he says.

Revisiting Funds Transfer Pricing Post-LIBOR

The end of 2021 also brought with it the planned discontinuation of the London Interbank Offered Rate, or LIBOR, the long-running and globally popular benchmark rate.

Banks in a post-LIBOR world that have been using the LIBOR/interest rate swap curve as the basis for their funds transfer pricing (FTP) will have to replace the benchmark as it is phases out. This also may be a good time for banks using other indices, like FHLB advances and brokered deposits, and evaluate the effectiveness of their methodologies for serving their intended purpose. In both situations, newly available interest rate index curves can contribute to a better option for FTP.

The interest rate curve derived from the LIBOR/swap curve is the interest rate component of FTP at most large banks. It usually is combined with a liquidity transfer price curve to form a composite FTP curve. Mid-sized and smaller banks often use the FHLB advance curve, which is sometimes combined with brokered deposit rates to produce their composite FTP curve. These alternative approaches for calculating FTP do not result in identical curves. As such, having different FTP curves among banks has clear go-to-market implications.

Most large banks are adopting SOFR (secured overnight funding rate) as their replacement benchmark rate for LIBOR to use when indexing floating rate loans and for hedging. SOFR is based on actual borrowing transactions secured by Treasury securities. It is reflective of a risk-free rate and not bank cost of funds, so financial institutions must add a compensating spread to SOFR to align with LIBOR.

Many mid-tier banks are gravitating to Ameribor and the Bloomberg short-term bank yield (BSBY) index, which provide rates based on an aggregation of unsecured bank funding transactions. These indices create a combined interest sensitivity and liquidity interest rate curve; the interest rate and liquidity implications cannot be decomposed for, say, differentiating a 3-month loan from a 5-year loan that reprices every three months.

An effective FTP measure must at least:

  • Accurately reflect the interest rate environment.
  • Appropriately reflect a bank’s market cost of funding in varying economic markets.
  • Be able to separate interest rate and liquidity components for floating rate and indeterminant maturity instruments.

These three principles alone set a high bar for a replacement rate for LIBOR and for how it is applied. They also highlight the challenges of using a single index for both interest rate and liquidity FTP. None of the new indices — SOFR, Ameribor or BSBY — meets these basic FTP principles by themselves; neither can FHLB advances or brokered deposits.

How should a bank proceed? If we take a building block approach to this problem, then we want to consider what the potential building blocks are that can contribute to meeting these principles.

SOFR is intended to accurately reflect the interest rate environment, and using Treasury-secured transactions seems to meet that objective. The addition of a fixed risk-neutral premium to SOFR provides an interest rate index like the LIBOR/swap curve.

Conversely, FHLB advances and brokered deposits are composite curves that represent bank collateralized or insured wholesale funding costs. They capture composite interest sensitivity and liquidity but lack any form of credit risk for term funding. This works fine under some conditions, but may put these banks at a pricing disadvantage for gathering core deposits relative to banks that value liquidity more highly.

Both Ameribor and BSBY are designed to provide a term structure of bank credit sensitive interest rates representative of bank unsecured financing costs. Effectively, these indices provide a composite FTP curve capturing interest sensitivity, liquidity and credit sensitivity. However, because they are composite indices, interest sensitivity and liquidity cannot be decomposed and measured separately. Floating rate and indeterminant-maturity transactions will be difficult to correctly value, since term structure and interest sensitivity are independent.

Using some of these elements as building blocks, a fully-specified FTP curve that separately captures interest sensitivity, liquidity and credit sensitivity can be built which meets the three criteria set above. As shown in the graphic, banks can create a robust FTP curve by combining SOFR, a risk-neutral premium and Ameribor or BSBY. An FTP measure generated from these elements sends appropriate signals on valuation, pricing and performance in all interest rate and economic environments.

The phasing out of LIBOR and the introduction of alternative indices for FTP is forcing banks to review the fundamental components of FTP. As described, banks are not using one approach to calculate FTP; the results of these different approaches have significant go-to-market implications that need to be evaluated at the most senior levels of management.

Bank Director Releases 2022 Risk Survey Results

BRENTWOOD, TENN., Mar. 29, 2022 – Bank Director, the leading information resource for directors and officers of financial institutions nationwide, today released its 2022 Risk Survey, sponsored by Moss Adams LLP. The findings reveal a high level of anxiety about interest rate risk as well as a lack of awareness in the environmental, social and governance (ESG) space.

The 2022 Risk Survey finds that the majority of responding directors, CEOs, chief risk officers and other senior bank executives are more concerned about interest rate risk compared to the previous year. Why? While interest rate increases — kicked off with a quarter-point hike announced by the Federal Reserve earlier this month — would ease pressures on bank net interest margins, they could also dampen loan demand and slow economic growth. When asked about the ideal scenario for their institution, almost three-quarters of survey respondents say they’d like to see a moderate rise in rates in 2022, by no more than one point. That’s significantly less than the 1.9% expected from the Fed by the end of the year.

“Finding the balance between an increase in rates without a decrease in the volume of lending can be an art form,” says Craig Sanders, partner at Moss Adams. “Banks with more diverse loan portfolios and those that made the right bets regarding loan terms will be better positioned to adapt to the new, ever-changing environment.”

Findings also reveal that more than half of the respondents’ banks don’t yet focus on ESG issues in a comprehensive manner, and just 6% describe their ESG program as mature enough to publish a disclosure of their progress. 

“While we see a handful of primarily larger, public banks focused on ESG, it’s a broad issue that touches on several areas important to community banking, including community and employee engagement, risk management and data privacy, and corporate governance,” says Emily McCormick, vice president of research at Bank Director. “The survey finds banks setting goals in these distinct spheres when it comes to ESG, despite a lack of formal programs or initiatives.”

Key Findings Also Include: 

Top Risks
Respondents also reveal increased anxiety about cybersecurity, with 93% saying that their concerns have increased somewhat or significantly over the past year. Along with interest rate risk, regulatory risk (72%) and compliance (65%) round out the top risks. One responding CRO expresses specific concern about “heightened regulatory expectations” around overdraft fees, fair lending and redlining, as well as rulemaking from the Consumer Financial Protection Bureau around the collection of small business lending data. 

Enhancing Cybersecurity Oversight
Most indicate that their bank conducted a cybersecurity assessment over the past year, with 61% using the Cybersecurity Assessment Tool offered by the Federal Financial Institutions Examination Council (FFIEC) in combination with other methodologies. While 83% report that their program is more mature compared to their previous assessment, there’s still room to improve, particularly in training bank staff (83%) and using technology to better detect and/or deter cyber threats and intrusions (64%). Respondents report a median budget of $200,000 for cybersecurity expenses in fiscal year 2022, matching last year’s survey.

Setting ESG Goals
While most banks lack a comprehensive ESG program, more than half say their bank set goals and objectives in several discrete areas: employee development (68%), community needs, investment and/or volunteerism (63%), risk management processes and risk governance (61%), employee engagement (59%), and data privacy and information security (56%).

Protecting Staff
More than 80% of respondents say at least some employees work remotely for at least a portion of their work week, an indicator of how business continuity plans have evolved: 44% identify formalizing remote work procedures and policies as a gap in their business continuity planning, down significantly compared to last year’s survey (77%). Further, banks continue to take a carrot approach to vaccinations and boosters, with most encouraging rather than requiring their use. Thirty-nine percent require, and 31% encourage, employees to disclose their vaccination status.

Climate Change Gaps
Sixteen percent say their board discusses climate change annually — a subtle increase compared to last year’s survey. While 60% indicate that their board and senior leadership team understand the physical risks to their bank as a result of more frequent severe weather events, less than half understand the transition risks tied to shifts in preferences or reduced demand for products and services as the economy adapts.

The survey includes the views of 222 directors, CEOs, chief risk officers and other senior executives of U.S. banks below $100 billion in assets. Full survey results are now available online at BankDirector.com.

About Bank Director
Bank Director reaches the leaders of the institutions that comprise America’s banking industry. Since 1991, Bank Director has provided board-level research, peer-insights and in-depth executive and board services. Built for banks, Bank Director extends into and beyond the boardroom by providing timely and relevant information through Bank Director magazine, board training services and the financial industry’s premier event, Acquire or Be Acquired. For more information, please visit BankDirector.com.

About Moss Adams LLP
With more than 3,800 professionals across 30-plus locations, Moss Adams provides the world’s most innovative companies with specialized accounting, tax, and consulting services to help them embrace emerging opportunity. We serve over 400 banks and other financial institutions in all stages of the growth cycle helping our clients navigate an evolving regulatory environment, maintain profitability, and manage risk throughout each phase of their business’s growth. Discover how Moss Adams is bringing more West to business. For more information visit www.mossadams.com/fs.

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For more information, please contact Bank Director’s Director of Marketing, Deahna Welcher, at dwelcher@bankdirector.com.