The elephant in the room: What happens to earnings, funding costs and liquidity if the Fed aggressively tightens? It’s time to acknowledge the need for contingent hedging plans and evaluate how to manage risk while remaining profitable in a flat or rising rate environment.
For the past several years, the banking industry has faced significant earnings challenges. Profitability has been under pressure due to increases in nonaccruals, credit losses, new regulatory costs and the low rate environment. Some banks have responded by cost cutting, but community banks do not have as much flexibility in this regard, especially if they are committed to a level of service that distinguishes community banks from larger banking institutions. Among the risks community banks face today are:
Margin compression from falling asset yields and funding costs that are at their lowest.
Interest rate risk. Borrowers are seeking fixed rates at longer and longer terms. The fixed term necessary to win the loan often may create unacceptable interest rate risk to the bank.
Irregular loan growth has often lead to increased competition for available borrowers with good credit.
To meet the challenge of generating positive earnings at more desirable levels, most community banks lengthened asset maturities while shortening liabilities. This resulted in some temporary margin stabilization, provided short term rates stay where they are, in exchange for higher risk profile if rates rise. The strategy has generally worked for approximately the last five years, but the question is for how much longer can we expect this to continue to work? In my opinion, community banks need more robust risk management programs to manage these risks and, in response, many have increasingly turned to swaps and other hedging solutions.
One competitive solution commercial lenders are employing is loan level hedging. This is a program where the bank will use an interest rate swap to hedge on a loan by loan basis. An interest rate swap is a hedging instrument that is used to convert a fixed rate to floating or vice versa. Loan level hedging allows the borrower to pay a fixed rate, and the bank to receive a floating rate. There are two simple models:
Offer a fixed rate loan to the borrower and immediately swap the fixed rate to floating with a dealer. The loan coupon would be set at a rate that would swap to a spread over LIBOR that would meet the bank’s return target.
Offer a floating rate loan and an interest rate swap to the borrower. The borrower’s swap would convert the floating rate on the loan to fixed. Simultaneously, the bank would enter into an offsetting rate swap with a dealer. This model is usually referred to as a “back to back” or “matched book.”
In my view, these solutions help the community bank compete with dealers, regional banks, and rival community banks. These models have been around for decades and their acceptance and use among community banks has increased dramatically over the last several years. Their benefits include:
They protect margins by improving asset/liability position through floating rates on commercial assets. They may enhance borrower credit quality by reducing borrower sensitivity to rising rates.
They diversify product lines and level the playing field versus larger commercial lenders and community banks in your market who offer hedging alternatives.
They are accounting friendly. Banks should always be aware of accounting treatment before entering any hedging strategy. The accounting treatment for loan level hedges is normally friendly and often does not create any income statement ineffectiveness.
They create fee income. When properly administered, a swap program may provide the bank a good opportunity to generate fee income with no additional personnel or systems costs.
Swaps and other derivatives may provide an immediate solution without the need for restructuring the balance sheet or changing your lending and funding programs. If you haven’t considered interest rate hedging before, you should consider contacting a dealer you trust for a discussion.
Many banks operate under the false pretense that because they are deemed a “conservative bank,” there isn’t a lot of risk in their business model. I often remind boards of directors that they sit on a highly leveraged, regulated hedge fund. Would they lend money to a finance company leveraged 10 times or more, while trying to manage a 3.5 percent spread? That’s your average bank. So it might be a good idea to consider an opportunity to reduce risk, even by an incremental amount.
The first thing to do is identify the area with the greatest risk. Most banks view it as credit risk, and vigorously address this with underwriting, loan committee, loan reviews, regulatory exams, reserves, limits and diversification. Banks do a great job of this. However, in our experience, the greatest area of risk, receiving the least amount of attention, is a bank’s “bond-like risk,” which shows up in the structure of securities, loans and deposits.
This risk is basically interest rate risk, and the devil is in such details as yield curves, repricing risk and maturities. While asset/liability management strategies may help, they don’t reduce the problem banks have with their dependence on duration (which is the measurement of the sensitivity of a bond to interest rate fluctuations) in exchange for a decent return. Over 80 percent of risk factor contribution to the price volatility on a bank’s balance sheet is caused by nominal duration. What this means is loans, securities and deposits all have the same structured risk which is caused by maturities and cash flows. In light of this enormous risk concentration, pension funds, endowments, foundations and other institutions diversify this risk via stock and private equity allocations. For example, private equity allocations can reduce risk and increase returns through:
Lower volatility of returns over time compared to duration-based assets like loans and bonds. Yes, private equity has a lower volatility risk than a two-year Treasury note.
Higher Sharpe Ratios than bonds or loans, which means higher returns per unit of risk. (William F. Sharpe first introduced returns-based style analysis in the late 1980s, hence the name “Sharpe Ratio.”)
Very low correlation coefficients to bonds and loans, meaning the returns don’t track those of bonds or loans which will help your bank diversify its earnings stream. Banks currently try to do this through non-interest income.
Economic cycle diversification benefits for banks that can only lend money even when pressed by market forces on pricing and structure. Private equity mitigates this by investing in different parts of the capital structure than loans, and by less stringent investing periods than banks. Banks need to lend or invest their depositors’ funds immediately. Private equity funds can be more patient because they typically have a three- to five-year window in which to put their investors’ money to work.
Banks aren’t allowed to invest in private equity funds, so why am I telling you this? While banks are prohibited from investing in private equity funds, there is an exception in the Dodd-Frank Act’s Volcker Rule for Small Business Investment Companies (SBICs), which are funds that invest in small businesses and private companies. Hundreds of banks have taken advantage of this program since 1958. There are several benefits to these investment vehicles. Banks can:
Help create jobs and expand the economy.
Get Community Reinvestment Act (CRA) credit.
Get CRA service credit by serving on an advisory board.
Create opportunities for senior C&I loans.
Create opportunities for commercial deposits.
Offer solutions to customers who need a liquidity event, more equity in their business or support for a senior loan.
Earn a nice return.
SBICs, like private equity, also help reduce the aforementioned risks of volatility, duration, correlations, Sharpe Ratios, economic cycle timing and diversification, which theoretically should increase portfolio returns. SBICs can make a bank safer and more profitable. Top quartile returns (returns in the top 25 percent) for SBICs from 1998 to 2010 were higher than 15 percent, while even the bottom quartile was 6.3 percent. So even a poor performing SBIC has produced higher returns than most any other asset opportunity available to a bank during this time frame. To reduce the risk of investing in a poor performing SBIC, a bank can do the following:
Develop underwriting practices, like a bank does on loans, tailored to SBICs, targeting top quartile returns.
Create a portfolio of multiple SBICs based on the 5 percent capital limit for bank investments to diversify company and fund manager exposure.
Seek the advice of financial advisory firm.
Being conservative doesn’t mean not doing anything new, it means constantly trying to find ways to decrease risk. Any time one can reduce risk and increase profitability, it should be strongly evaluated.
The story in the iconic movie, “It’s a Wonderful Life,” is one that a lot of bankers can relate to.
The obvious connection: The protagonist, George Bailey, is a banker. But bankers can also see themselves in the tough choices George faces throughout the movie. Over and over again George must decide between taking the easy way out or doing something that’s more difficult, but which he knows in his heart is right. The banking industry currently finds itself in a similar tricky situation.
After years of new regulations and low interest rates, growth and earnings are hard to come by. To cope, banks have looked inward, focusing on cost-cutting and regulatory compliance, often at the expense of their customers. This frequently manifests itself in the most important discussion there is between a bank and their commercial customers: the negotiation of loan pricing.
Focusing on better pricing means shifting priorities at banks and doing some very difficult work in the immediate future. It’s a hard path to follow, but it’s the right choice; the one George Bailey would make. Banks that elect to take this route must learn to avoid three common mistakes when it comes to pricing loans.
1: Focusing on the Math, But Not the Execution Truly successful pricing has two dimensions: Price setting and price getting.
Price setting is the math of determining what price is appropriate given the structure and risk profile of any particular deal. Most banks do fairly well with this dimension.
Price setting covers everything from the communication of the math from the back of the bank to the front, to the negotiation between borrower and lender. Many banks continue to struggle with this dimension. To make matters worse, when their pricing isn’t working, they always turn to the math to find a solution. The bottom line is that you can’t “out-math” the competition. You have to be better at the price getting aspect, which is all about how you interact with and serve your customers.
2: Opting for “Let Me Check With My Boss” To that end, the first issue banks should focus on is moving the pricing decision closer to the customer. In most loan negotiations, the lender knows the starting point (i.e. the desired outcome) of the deal. However, once the customer pushes back on the pricing, the lender does not know how to reach the target profitability without losing the deal, and has to resort to the classic car salesman line of “Let me check with my boss to see if we can do that.”
Generally, the lender and borrower will discuss a price and structure, and then an analyst will input the deal into a pricing model. The deal is being measured on a pass or fail basis. If the deal fails, the bank must either go back and re-trade everything with the customer, or, more likely, just decide to take less on this deal, and “try to do better next time.” The only fix for this issue is to move the decision closer to the customer. The lender should be measuring against targets, and have the ability to negotiate on the fly while the customer is sitting in front of them.
3: Making It “All About the Rate” Part of that negotiation will, of course, be about interest rate. It is the most visible and contested part of the deal. It is also the “sticker price” from your competitors when borrowers start shopping.
However, the great thing about commercial loans is that all aspects are negotiable, and they all move the needle in terms of risk and profit. Why not make that 60-month balloon a 55-month balloon to remove interest rate risk? Why not add collateral to reduce expected loss and provisions? If the lender can easily see what all of those terms are worth, they can trade any of them for rate.
In today’s world, customer expectations have changed. They are used to being able to get what they want, when they want it. They expect the same from their bank, and this is the best way to provide that. Give your lenders the ability to custom build financing for their customers in a responsive way, and you will earn the higher returns that you seek.
Just like in the movie, “It’s a Wonderful Life,” your tough choice will lead to a happy ending for everyone involved.
Most of the news coverage about the potential for rising interest rates has assumed rising rates will help banks. But will it help your bank? It turns out, that’s not an automatic yes. This article will help board members understand how interest rates impact a bank’s profitability, and offers questions that you should be asking your management team.
Many of the biggest banks in the country, which are the subject of so much news and analyst coverage, are deliberately managed to be asset sensitive. That means that they benefit from a rising interest rate environment, because their “assets,” mainly loans, will generate higher income as rates rise. Many big banks have more variable-rate loans on their books, such as commercial and industrial loans, than community banks do, and those loans tend to reprice more quickly up or down when rates rise or fall.
However, community banks can’t make the assumption that they will benefit when rates rise. A careful analysis of their own particular situation is necessary.
“There does seem to be a general perception that rising rates are good for all banks. That’s simply not true,’’ says Matthew D. Pieniazek, president of Darling Consulting Group, in Newburyport, Massachusetts, which advises banks on asset liability management. Many community banks that manage as if they are asset sensitive will actually experience earnings pressures when interest rates rise, he says. (This is known as liability sensitivity, when funding costs increase faster than asset yields.) The biggest risk could come from deposits, but there are also impacts on loans and investment portfolios to consider.
Regulators have made it clear that oversight of interest rate risk, or IRR, rests squarely on the shoulders of the board. The Office of the Comptroller of the Currency issued a joint “advisory on interest rate risk management in 2010” that emphasizes this point:
“Existing interagency and international guidance identifies the board of directors as having the ultimate responsibility for the risks undertaken by an institution, including IRR. As a result, the regulators remind boards of directors that they should understand and be regularly informed about the level and trend of their institutions’ IRR exposure. The board of directors or its delegated committee of board members should oversee the establishment, approval, implementation, and annual review of IRR management strategies, policies, procedures, and limits (or risk tolerances). Institutions should understand the implications of the IRR strategies they pursue, including their potential impact on market, liquidity, credit, and operating risks.”
How do rising interest rates impact deposits? Since late 2008, the Federal Reserve has kept interest rates near zero, resulting in all kinds of interest bearing deposits and investment products also hitting near zero yields. Alternatives to noninterest bearing deposits such as CDs and other term investments carry premiums that are hardly worth the trouble. There is almost no rate differential between a CD or even a government bond and an FDIC-insured nonmaturity account, such as a savings or checking account at a bank. As a result, the banking industry has experienced a substantial increase in non-maturity deposits. Pieniazek estimates that industry-wide, nonmaturity bank deposits are as much as 20 to 25 percent above normalized levels.
So it’s hard to know as rates rise, how much money will leave the bank. Some customers may do nothing. Others may move money into higher interest-bearing accounts or CDs at the bank. Still, others will put their money in investment accounts or move it to other banks and credit unions that are offering higher rates than your bank.
Pieniazek thinks there is a lot of pent-up demand for higher rates, as baby boomers are getting ready to retire and retirees have been sitting on low-earning deposits for many years. He says that a bank can look historically at its own deposit levels, and take appropriate actions to gauge how much of their non-maturity deposit base might be at risk.
It’s important as a board member to know what your bank’s plan is. “One hundred percent of financial institutions will see deposits leave,’’ Pieniazek says. Deciding how much the bank is willing to lose and the impact of rising rates on its deposit strategy is important for any board.
Questions to ask: When the Fed raises rates the first, second or third time, how are we going to react? Are we going to hold our rates and not chase money? Are we going to let deposits leave us? What are the ramifications and why is that our plan? What could occur that will cause us to change our plan?
Determining to what extent you will lose deposits when rates rise is somewhat of a guessing game, which makes it the hardest part of the balance sheet to assess. Your bank management team can look at particular characteristics of their deposit base to make assumptions about how “sticky” those deposits are, meaning how likely they are to stay with your bank, says Rick Childs, a partner with consulting and accounting firm Crowe Horwath LLP. How long has each customer had a deposit account with the bank? Do they have other accounts or products with the bank, such as loans? Do they direct deposit every month and pay bills out of the account? Or is it a stand-alone money market account where the customer has no other relationship with the bank? Those are the depositors most likely to leave when interest rates rise.
We haven’t seen a lull this long in interest rates so it’s hard to know what will happen, Childs says. If funds leave and you have to replace those funds at higher rates, how will margins be impacted?
Net interest margins are net interest expenses subtracted from net interest income, divided by earning assets, such as loans and investments. So the higher your interest expense, the lower your income. The cost of funds is what it takes to generate the funds your bank needs to operate and lend at the level it desires. While interest expense on deposits is a large part of that, funding costs will also be impacted by borrowings and deposit surrogates such as customer sweep accounts. Bank analysts such as Fig Partners are already looking at the cost of funds for various banks to determine which banks will do better when rates rise. The theory is that the lower the cost of funds, the better the bank will do because it won’t be forced to raise rates on deposits to compete for funds.
Your management team should have well developed assumptions about how deposit rates will be impacted and what the plan is for reacting to rising rates. In general, Childs says the board should be asking management: “Explain to me what those assumptions are and how you derive those.”
What are your bank’s assumptions about what will happen to interest rates and how are those derived? How will your bank react? Your management team should have assumptions about the lag time before your bank raises rates in its different products. For example, if the Federal Reserve raises the federal funds target rate by 100 basis points over time, how much will your NOW accounts (checking accounts that earn interest) go up?
Most banks use vendors to provide interest rate risk modeling tools, and those models will have default assumptions of their own. It’s important to note that the board is responsible for making sure the bank is assessing the appropriateness and reasonableness of those assumptions. It’s not enough to outsource decision-making about interest rate risk and assume you are taking care of your oversight responsibilities.
The good news is that most banks do some kind of stress testing to see what happens to the bank under a variety of interest rate “shock” scenarios. For example, what happens if short-term rates rise 50 basis points? What about 100 basis points? How will that impact earnings? You might read or hear about a phenomenon known as the “flattening of the yield curve.” The yield curve refers to the difference between short and long-term rates or, for example, the fed funds rate versus a 10-year Treasury yield. If short-term rates increase while long-term rates don’t, that lessens the difference between those rates. A more ideal yield curve would have an upward slope, with short-term rates significantly lower than long-term rates. Flatter yield curves are generally bad for banks, because the cost of funds are driven by short-term rates.
How will rising rates impact loans? Your bank has a particular mix of terms on its loans that will impact what happens to your bank when rates rise.
You probably have a number of floating rate loans that are at a floor, meaning your bank won’t make loans or enable loans to reprice below that level despite prevailing market rates. How much will interest rates need to rise before prevailing rates go above the floor? How long will it take?
Obviously, variable rate loans in a rising rate environment are good for the bank. The bank will see increased interest income as a result. If interest income rises faster than the cost of funds, that means the bank is asset sensitive and earnings will improve in that scenario.
How will rising rates impact our investment portfolio? There are questions to ask about the bank’s securities portfolio as well. Does the bank own any securities with material extension risk? What is the concentration? Material extension risk is when the life of the security extends in a rising rate environment. Mortgage-backed securities are a good example, and plenty of banks have these. In a rising rate environment, borrowers are less likely to pay off their mortgages. Does the bank have callable bonds? These are bonds where the lender can call the bond early if rates drop, or extend the life of the bond if rates rise, Pieniazek says. Is the bank monitoring opportunities to sell bonds with undue extension risk?
Another factor to consider is what happens if rates don’t rise. Or, they rise much less and more slowly than the Fed portends. For many banks, this could be very harmful, especially if the bank is already experiencing continued declines in net interest margin… For most banks, the sustained low-rate environment is the most problematic issue, Pieniazek says. It’s important to consider this alternative scenario, as well.
In the end, all banks will be impacted by the rate environment. Understanding how your bank is affected by interest rates and the assumptions going into those estimations is a crucial ingredient to providing good oversight both today and in the years ahead.
“I know what many of you are thinking. You’re thinking, ‘This man is duplicitous. You’re thinking that he has held things close to his chest. You’re thinking that he did not respond fully to the desires and wishes of the American people. And I want to tell you ‘you’re wrong.’” –Robert S. McNamara in “The Fog of War,” a documentary.
Defense Secretary Robert McNamara made a lot of unfortunate decisions during the Vietnam War, depicted in the 2003 documentary, “The Fog of War.” Some of the battles that banks face are obviously not as horrifying as an actual war. But they do involve a great deal of money. And any decisions involving a great deal of money require a great deal of care. Banks and their customers are under increasing attack by highly sophisticated cyber criminals successfully stealing confidential information and hundreds of millions or even billions of dollars. (There is no comprehensive official number or record keeping.) Bank boards are trying to figure out how to respond and what to do to provide proper oversight of their security apparatus.
“In terms of cyber crime, a lot of us think it’s going to get worse before it gets better,” said Ken Jones, director of fraud risk management at the consulting firm KPMG, speaking to an audience of about 300 people at Bank Director’s Bank Audit & Risk Committees Conference in Chicago recently. “The (community banks) here are absolutely a focus of the international cyber criminals.”
While some vendors may have a personal interest in terrifying you, it was clear to me that many bank directors in the audience are very concerned about cyber attacks and whether their banks are adequately addressing the problem. Is your bank staff staying abreast of threats, using security software the way it was intended and keeping a keen eye on your IT vendors? Other threats that could prove to be very costly in the years ahead include:
Interest rate risk. Many banks are extending credit at a fixed rate of interest for longer terms in an effort to compete and generate much-needed returns. This will be a problem for some of them when interest rates rise and low cost deposits start fleeing for higher rates elsewhere. You could assume the asset/liability equation will equal out, but will it? Steve Hovde, president and CEO of the investment bank Hovde Group in Chicago, is worried about financial institutions taking on too much interest rate risk, as he has seen credit unions offer 10- or 15-year fixed-rate loans at 3.25 percent interest. “I’m seeing borrowers get better deals with good credit quality than they have ever gotten in history,” he said at the conference.
Reputation risk. In the age of social media, anyone can and does publicize to hundreds of friends any complaint against a bank. Cyber attacks, such as the one that befell Target Corp., can be devastating and cost the CEO his or her job. Rhonda Barnat, managing director of The Abernathy MacGregor Group Inc., says it’s important not to give TV news an incentive to do a story, such as telling a reporter that your employee’s laptop was stolen at a McDonald’s with sensitive customer information, prompting a visit by the camera crew to the McDonald’s. As of now, there is no requirement to publicly disclose the number of records stolen, so public relations firms such as The Abernathy MacGregor Group urge circumspection. Disclosing a theft, but not disclosing how many customer records were stolen, could keep you off the front page of the local newspaper. Focus on the people who matter most: your customers, investors and possibly, your regulators. They want to know how you are going to fix the problem.
Compliance risk. Regulators are increasingly breathing down the necks of bank directors, wanting evidence that the board is actively engaged and challenging management. The official minutes need to reflect this demand, without necessarily going overboard with 25 pages of detailed discussion, for example. Local regulators are increasingly deferring questions to Washington, D.C., where they can get stuck in limbo. When regulators do give guidance, it is often only verbal rather than written and can cross the line into making business decisions for the bank, said Robert Fleetwood, a partner at Barack Ferrazzano in Chicago. In such an environment, it’s important to have good relations with your regulators and to keep them informed.
*Thanks to Wintrust Financial Corp.’s audit committee Chairman Ingrid Stafford for giving me an idea for the title of this article, if not the actual article.
Despite continued regulatory challenges and a sluggish economic environment, most financial institutions have seen their situations improve in recent months. How will banks keep the momentum going? We outline three areas to focus on.
Priority #1: Increasing Capital Capital drives so much right now from the regulators’ perspective. Excluding statutory requirements, capital is the regulators’ be-all and end-all.
So how much is enough? In recent stress tests of the banking system, the results show that all but one of the top 30 banks—Salt Lake City, Utah-based Zions Bancorp.—would have ample capital to survive the exceptionally poor economic conditions and continue to lend. However, regulators failed four other banks based on qualitative concerns about their capital plans. The latest Comprehensive Capital Analysis and Review took some industry observers by surprise, as the Federal Reserve objected to five of the 30 participants’ capital plans, and approved another two banks only after they resubmitted.
The regulatory scrutiny clearly remains intense, and banks should not expect this level of oversight to ease anytime soon. To stay ahead of the curve, banks should examine their capital levels and ask a number of questions, including:
How will my capital ratios be impacted by changes in risk weights?
How will I respond to those changes?
Do I need to change my product mix or my underwriting? Should I even consider a strategy where the bank’s assets shrink in the short term?
Do I need to adjust my risk tolerance in lending?
Should I consider outsourcing certain functions or decrease operating expenses?
At a minimum, banks will need to integrate into their capital planning and strategic planning processes an analysis of where they stand relative to Basel III requirements. This will ensure they are well-positioned to address any capital needs.
Priority #2: Managing Credit Quality The continued low-rate environment has compressed the net interest margin for most institutions. As a result, bank executives are turning to new, expanded or modified product offerings and service lines to improve performance.
As with any new opportunity, it’s critical to make sure that the risks are appropriately assessed and priced. New products and services may have a totally different risk profile than the bank’s traditional fare—and the bank may be ill-equipped to manage the risks of the new products and services. Banks may lack the necessary controls, risk-management processes, expertise and appropriate information systems needed to effectively monitor and manage these new products and services.
As banks look for new sources of income, it is imperative that they demonstrate the ability to manage the associated risks. Banks should not only be extremely diligent about following their underwriting standards, but also should be looking for new ways to shore them up.
A well-managed plan for expansion into new products, services or markets will include the following:
Clearly communicate the growth strategy to regulators and the board.
Develop risk plans that address risks particular to any new areas.
Ensure sustained board and senior management oversight.
Manage and monitor credit risk.
Clearly document lending policies and procedures.
Confirm that diversification/concentration management and controls align with established risk tolerances.
Undertake stress testing and risk monitoring.
Strengthen underwriting and documentation standards.
Confirm that adequate loan review programs are separate from credit extending units/personnel.
Priority #3: Managing Interest Rate Risk Interest rates remain low, compressing net interest margins and creating fierce competition among banks for higher yielding assets. Many banks are now turning to aggressive interest-rate strategies, such as extending asset or loan maturities or increasing holdings of riskier investments. However the OCC cautions that when interest rates increase, “banks that reached for yield could face significant earnings pressure, possibly to the point of capital erosion.”
While managing interest rate risk is highly complex, doing the following will help ensure a well-managed program:
Be prepared to demonstrate to regulators your interest-rate-risk management plans and to support key assumptions used in modeling.
Maintain documentation of how the bank considered the results of the models.
Establish risk controls and limits.
Monitor and report risk.
Ensure adequacy of internal controls and audit.
Consider whether to add certain expertise to your board or management team.
Banks that are not already stress testing should begin to do so.
For public banks, evaluate whether your interest rate risk disclosures appropriately tell your story.
Model assumptions have gained a great deal of importance in the banking industry. Financial institutions are using them more and more to generate output that summarizes the risks embedded in their balance sheet. But are these models always accurate? The answer, at least from banking regulators, is increasingly no.
For example, many interest rate risk (IRR) models continue to show that earnings will improve as a result of an increase in interest rates. However, a December 2012 presentation by the San Francisco Federal Reserve indicates that deposit assumptions, such as decay rates, beta-adjusted gaps (the relative repricing rate assumed for deposits versus a benchmark rate), account balances and deposit mix have a significant impact on IRR measurements. As a result, the Fed contends that the current IRR environment may cause model results to provide misleading data. In particular, the Fed cited an increase in non-maturity deposits as a percentage of total deposits.
The Fed noted that one of the main reasons for the increase in non-maturity deposits since midway through the recession is the drop in the federal funds rate. It believes that customers have parked funds over the past several years in non-maturity deposits since there’s been little difference in earnings between non-maturity and time deposits. This shift has caused non-maturity deposits to increase to 83 percent of total deposits as of December 31, 2012, from an average of 62 percent from 1985 to 2008—an increase of 33 percent.
So, for example, if your institution’s IRR model deposit mix assumption is based on current or recent historical deposit characteristics, there could be a surprise waiting for you, since it isn’t likely that interest margins on your deposit base will remain the same as interest rates rise. More likely, most institutions’ deposit mix will return to average pre-recession levels.
Changes to basic deposit assumptions can have a significant impact on earnings. For example, if interest rates rise by 200 basis points (bps), reallocation of the deposits mix to pre-recession levels may negatively impact earnings at risk (EAR) by up to 400 bps. EAR is a measure of the change in earnings based on changes in interest rates. Let’s say you’re currently reporting a positive exposure to EAR of 5.8 percent using today’s deposit mix. By adjusting the deposit mix to pre-recession levels, using the same 200 bps increase in interest rates, you’d see your EAR drop to a positive exposure of 1.8 percent.
Similarly, changing account balance assumptions to assume a decline in non–interest bearing deposits or changing deposit decay and beta-adjusted gap assumptions could easily take a positive EAR result and make it negative.
So what can you do to help your institution address these risks and regulators’ concerns?
Reexamine key IRR assumptions. Don’t focus only on deposit assumptions, but regularly evaluate all assumptions feeding your IRR. This exercise most likely will result in an adjustment of your model assumptions and drive a deeper understanding of the true risks embedded in your balance sheet.
Perform stress testing or scenario testing of your assumptions periodically. Determine which have the greatest potential impact on your institution, and spend more time ensuring those assumptions are valid.
Perform detailed, comprehensive back testing. The best way to determine whether the assumptions used in your IRR model are reasonable is to test actual results based on prior assumptions. Analysis will help you identify the impact of shifts in transactional patterns and the resulting impact on the balance sheet. Although you may not be able to predict these types of shifts, by completing this testing you’ll be able to modify assumptions and update your model, resulting in more accurate, meaningful reporting.
Revisit scenario testing. What changes are occurring in the market that could affect your institution negatively? What’s the likelihood they’ll occur and the degree of impact on your institution? Is your institution willing to assume that level of risk?
Document your evaluation. Your regulator conducts analysis in these areas to evaluate your management of IRR. Thoroughly documenting the basis of your assumptions will aid them in understanding how you mitigate risk as an organization.
Over the past 30 years, bank-owned life insurance (BOLI) has proven to be a powerful asset for banks, providing strong yields that help offset the ever-rising cost of benefits. Over 3,840 banks reported BOLI holdings of almost $144 billion in the third quarter of 2013, and the pace of BOLI purchases remains robust.
BOLI Holdings Reported by Banks
# of Banks
# and % Reporting BOLI
Tier 1 Capital
Reported BOLI CSV
% of BOLI to Assets
% of BOLI to Capital
* Source: Call Reports as of 9/30/2013. Values reported in (000,000s).
BOLI is an investment tool and insurance product on the lives of bank officers which allows for enhanced tax-preferred earnings for the bank.
Interagency guidance on BOLI requires thorough pre-purchase analysis and ongoing risk management of BOLI. While regulators have identified eight risks inherent in BOLI, two of them warrant greater attention, credit risk and interest rate risk.
Credit risk arises from a carrier’s obligation to pay benefits upon death, or cash surrender value (CSV) upon surrender. In loan terms, will the carrier repay when the “loan” becomes due? A life carrier default, where payment of life insurance is truly in question, can only occur after “busting through” a safeguard framework with multiple layers of policy owner protection.
The potential 30- to 40-year holding period for a BOLI policy is one of the primary reasons why the carriers that actively offer BOLI are rated in the top 10 percent of their industry—discerning bank purchasers wouldn’t have it any other way. Because of the long-standing framework and history for policy owner protection, we believe there is nominal difference in credit risk among most BOLI carriers.
At a minimum, banks have reviewed credit ratings; some even do a cursory review of carrier financial statements. While that suffices as an initial filter, in the post-Dodd-Frank Act world, banks should no longer rely solely on credit rating agencies to assess the quality of BOLI carriers. A trusted BOLI vendor can help banks get a thorough pre-purchase and monitoring process in place.
Interest rate risk is the risk to earnings from movements in market rates. It is a function of the maturities of the assets in the carrier’s investment portfolio. Unlike a bank’s bond portfolio, general account and hybrid account BOLI does NOT expose a bank to mark-to-market risk when rates rise. That’s because the insurance company owns the assets on its books and offers a set rate of return to the bank. (Carriers offer separate account BOLI as well, where banks are able to choose the underlying investment portfolio. However, separate accounts can expose the bank to mark-to-market risk.)
Arriving at BOLI yield is fairly simple: Carriers invest banks’ premiums and retain a portion of their return as compensation for their investment management, resulting in a gross crediting rate. From the gross crediting rate, carriers subtract cost of insurance (COI) charges to compensate them for insurance risk. The end result is the policy’s net yield.
It’s important to note that the potential holding period for BOLI (30-40 years) is NOT its interest rate risk. Carrier portfolios are typically 6-10 years in average duration. While this longer duration is how BOLI provides greater yield potential, in a rising rate environment, it may create a temporary disconnect in expected return. BOLI crediting rates will lag market trends, and it’s important to review BOLI yield projections in that context.
When reviewing BOLI projections, focus on gross crediting rate and COI charges. No carrier can consistently credit more than it can earn on its assets, just as a bank can’t pay more on its deposits than its cost of funds. Ask for and review the carrier’s history of net yield on invested assets. Carriers have had relatively similar investment yields over the past five years. The question to ask is how reasonable is the gross crediting rate given the carrier’s recent actual history?
COI charges are very competitive for most carriers. However, there are clear outliers with higher COIs, suggesting that those carriers must credit a higher rate to overcome their higher COI charges. To our knowledge, no carrier has raised COI charges on existing BOLI, so it is reasonable to expect projected COIs to remain stable.
In addition to credit risk and interest rate risk, boards should thoroughly evaluate the additional risks of BOLI. The key to a positive experience with BOLI is to fully understand those risks and have reasonable expectations explained to your board by a trusted BOLI advisor. BOLI has a competitive yield, no mark-to-market risk (except for separate account BOLI), very strong credit risk, and gross crediting rates that should adjust with the general market, albeit with a lag. When presented accurately, fully understood and implemented properly, BOLI is an attractive asset for banks to own.
Scott Richardson is a registered representative of Independent Capital Company, Inc., Parma, Ohio. IZALE Financial Group is not affiliated with Independent Capital Company, Inc.
The Federal Deposit Insurance Corp. (FDIC) issued a recent letter to financial institutions saying the agency is increasingly concerned that some banks and thrifts are not sufficiently prepared for volatility or a sustained rise in interest rates. The FDIC is reemphasizing the need for oversight by the board and management, policy frameworks and prudent exposure limits, effective measurement and monitoring of interest rate risk, and risk mitigation strategies. But it also has introduced some new statements in its latest letter worth noting:
“…institutions with a decidedly liability-sensitive position could experience declines in net interest income and potential deposit run-off in a rising rate environment. Moreover, rate sensitive liabilities may re-price faster than earning assets as coupons on variable rate loans and investments remain below their floor.”
“If interest rates were to rise markedly, institutions that have concentrated bond holdings in long-duration issues could experience severe depreciation of a magnitude that could be material relative to their capital position. Institutions that rely primarily on a long-duration fixed-income portfolio for liquidity could have difficulty meeting short-term cash needs if other marketable assets or funding sources are not readily available.”
“…significant, unmitigated levels of interest rate or market risk can lead to losses and liquidity constraints when prevailing rates change significantly.”
Long duration assets, such as step-up bonds or fixed-rate mortgages, will likely be a focus of the FDIC during its next exam of your institution and should be an important concern for the asset liability committee (ALCO). Due to historically low interest rates, bankers have been forced to extend the duration of the investment and loan portfolio in an effort to increase margins; at the same time, depositors are favoring shorter term certificates of depositors or money market funds as they anticipate rising rates. Some banks have a high risk due to extending cash flow on the asset side and not matching the re-pricing on the liabilities side. This has also manifested in significant unrealized losses on securities available for sale. While these unrealized losses do not affect regulatory capital, they do affect GAAP (Generally Accepted Accounting Practices) capital, which can affect market perception and the overall health of the institution should liquidity needs emerge.
The board has the ultimate responsibility for the risks undertaken by its institution. In response to the most recent letter, it is imperative that the foundations listed below are continually and proactively addressed and revisited by the board and management.
Has the board approved the interest rate risk policy in the last twelve months and evaluated the bank’s policy limits? We often hear that the limits set within a policy are the “industry standards.” The policy limits should reflect the institution’s risk appetite that is commensurate with the institution’s strategic plan and capital position.
Have the internal controls of the model been reviewed by an independent third party? Although management may seem to understand the asset-liability committee process and the model it is working with, it is crucial that each institution have its model independently validated. Key assumptions such as prepayment speeds (the change in the behavior of long term assets due to a change in rates, and decay (the speed with which the accounts “decay” or roll off your balance sheet) can alter the model results in ways to make the institution look like it is within policy or vice versa.
Is the board receiving appropriate reporting from management? At minimum, the board should receive a quarterly interest rate risk analysis. The board should get analysis more often if it is managing risk outside policy limits. The income simulations should have a minimum horizon of two years, preferably with a static balance sheet rather than a dynamic balance sheet. The immediate interest rate shocks should include changes in rates of at least 300 and 400 basis points, nonparallel rate shocks (shocks of the yield curve using twists or changing slopes) and account for basis risk and yield curve risk. The market value equity simulation should also include changes in rates of greater magnitude and include nonparallel rate shocks.
Has the board and management considered alternative risk measurement and monitoring tools? Analyzing the bank’s interest rate risk position using alternative methods can provide varying pictures of how well the bank is postured in the current and expected interest rate cycles. In addition to the static interest rate risk and market value of equity calculations, the Asset Liability Committee should consider a variety of modeling techniques such as gap Analysis (the difference between a bank’s rate sensitive assets and rate sensitive liabilities distributed by maturity), stress testing and earnings simulations in a variety of interest rate scenarios.
Economists are still predicting rates will remain fairly flat for the near term; however, rates are unlikely to remain low forever. The time is now to evaluate the bank’s interest rate risk appetite and act if the current position puts the bank’s capital position at risk.