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.

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

2022 Risk Survey: Complete Results

What’s keeping board members, CEOs, risk officers and other key executives up at night? 

With a number of evolving risks facing the industry, bank leaders have a lot on their plate. They weigh in on these key risks — from cybersecurity to rising interest rates and more — in Bank Director’s 2022 Risk Survey, sponsored by Moss Adams LLP. While it’s not surprising to find respondents almost universally more worried about cybersecurity — a perennial point of anxiety in the survey — they also reveal increased concerns in a number of areas. 

Almost three-quarters say they’re more worried about regulatory risk, with one respondent citing specific concerns about overdraft fees, fair lending and redlining, and rulemaking from the Consumer Financial Protection Bureau.  

Given expected rate hikes from the Federal Reserve, 71% say they’re worried about interest rate risk. Three-quarters hope to see a moderate rise in rates by the end of the year, though uncertainty around inflationary pressures, exacerbated by the conflict in Ukraine, could yield surprises.  

Members of the Bank Services program now have exclusive access to the full results of the survey, including breakouts by asset category. Click here to view the report.

Findings also include:

  • Most bank executives and board members report that their cybersecurity programs have matured, but respondents still identify key gaps in their programs, particularly in training bank staff (83%) and using technology to better detect and/or deter cyber threats and intrusions (64%). Respondents also reveal how the board oversees this critical threat.
  • In an indicator of how business continuity plans have evolved through the pandemic, more than 80% say at least some employees work remotely for at least a portion of their work week. When it comes to vaccinations, banks continue to take a carrot approach to vaccinations, with most encouraging rather than requiring Covid-19 vaccinations and boosters. Thirty-nine percent require, and 31% encourage, employees to disclose their vaccination status.
  • Environmental, social and governance disclosures may be getting a lot of buzz, but more than half of the survey participants don’t yet focus on environmental, social and governance issues in a comprehensive manner, but the majority set goals in several discrete areas related to ESG.
  • Sixteen percent say their board discusses climate change annually — a subtle increase compared to last year’s survey. 

Bank Director’s 2022 Risk Survey, sponsored by Moss Adams, surveyed 222 independent directors, chief executive officers, chief risk officers and other senior executives of U.S. banks below $100 billion in assets to gauge their concerns and explore several key risk areas, including credit risk, cybersecurity and emerging issues such as ESG. The survey was conducted in January 2022.

2022 Risk Survey Results: Walking a Tightrope

Despite geopolitical turmoil following Russia’s invasion of Ukraine, the Federal Reserve opted to raise interest rates 25 basis points in March — its first increase in more than three years — in an attempt to fight off a high rate of inflation that saw consumer prices rising by 7.9% over the preceding year, according to the Bureau of Labor Statistics.

“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures,” the central bank said in a statement. The Federal Open Market Committee (FOMC) is the policymaking body within the Fed that sets rates, and Fed Chairman Jerome Powell remarked further that the FOMC will continue to act to restore price stability.

“We are attentive to the risks of further upward pressure on inflation and inflation expectations,” Powell said, adding that the FOMC anticipates a median inflation rate of 4.3% for 2022. He believes a recession is unlikely, however. “The U.S. economy is very strong and well-positioned to handle tighter monetary policy.”

Six more rate hikes are expected in 2022, which overshoots the aspirations of the directors, CEOs, chief risk officers and other senior executives responding to Bank Director’s 2022 Risk Survey, conducted in January. Respondents reveal a high level of anxiety about interest rate risk, with 71% indicating increased concern. When asked about the ideal scenario for their institution, almost three-quarters say they’d like to see a moderate rise in rates in 2022, by no more than one point — significantly less than the 1.9% anticipated by the end of the year.

Moss Adams LLP sponsors Bank Director’s annual Risk Survey, which also focuses on cybersecurity, credit risk, business continuity and emerging issues, including banks’ progress on environmental, social and governance (ESG) programs. More than half of the respondents say their bank doesn’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.

Developments in this area could be important to watch: The term ESG covers a number of key risks, including climate change, cybersecurity, regulatory compliance with laws such as the Community Reinvestment Act and operational risks like talent.

“Finding employees is becoming much harder and has us [looking] at outsourcing (increased risk) or remote workers (increased risk),” writes one survey respondent. Workers want to work for ethical companies that care about their employees and communities, according to research from Gallup. Could a focus on ESG become a competitive strength in such an environment?

Key Findings

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 respondent, the CRO of a Southeastern bank between $1 billion and $5 billion in assets, 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.

To view the high-level findings, click here.

Bank Services members can access a deeper exploration of the survey results. Members can click here to view the complete results, broken out by asset category and other relevant attributes. If you want to find out how your bank can gain access to this exclusive report, contact bankservices@bankdirector.com.

Why Community Banks Should Use Derivatives to Manage Rate Risk

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

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

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

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

Why do banks use derivatives to hedge their balance sheet?

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

Why are some banks hesitant to use swaps?

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

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

Are Fixed-Rate Loans the Quick Fix?

Commercial fixed-rate loans can be an alluring quick fix for the net interest margin pressure that many banks face today, but could expose banks to several risks while providing tepid returns.

Future earnings are largely out of the bank’s control. While the current yield of a fixed-rate loan can look attractive relative to the historic lows of short-term funding costs, its long-term return is highly dependent on the future path of short-term interest rates. When interest rates increase, the spread between the yield earned on a fixed-rate loan and the ongoing funding cost for a bank decreases — and could even go negative.

While banks have some control over funding costs, the largest factors that influence short-term funding rates are external: central bank monetary policy, inflation expectations and the overall business cycle. None of these factors are controlled by any individual bank, which means the ongoing net yield of a fixed-rate loan depends on factors outside your bank’s control.

Prepayment penalties often do not protect banks. Bank executives should temper expectations that prepayment penalties protect bank income or influence borrower behavior for fixed-rate loans. Many borrowers negotiate limited prepayment provisions in advance, or ask that prepayment penalties be fully or partially waived when refinancing. Additionally, fixed-rate borrowers are most likely to prepay when refinancing lowers their borrowing cost. These realities mean borrower prepayments often result in the loss of higher-yielding loans with little or no compensation to banks.

Interest rates and prepayments have a unique relationship that can reduce returns. Higher interest rates generally mean higher funding costs and lower prepayments, while lower interest rates result in lower funding costs and higher loan prepayments. In other words, a fixed-rate loan is most likely to remain on-balance sheet when interest rates are high and a bank would prefer it go away, but pay off quickly when interest rates are low and a bank would prefer it stay. This inverse relationship between interest rates and prepayments can significantly reduce the lifetime earnings of a fixed-rate loan.

There are tools to help. Below are some strategies that banks can use to reduce the risks of fixed-rate loans:

  • Consider a customer swap program. Banks can offer borrowers a pay-fixed interest rate swap paired with a floating-rate loan instead of originating a traditional fixed-rate loan. The borrower ends up with a fixed rate; the bank books a floating rate asset that is less sensitive to future interest rate movements. These programs can also be a significant source of non-interest fee income. Modern capital markets technology and advisory companies enable banks of all sizes to offer loan-level hedging programs to qualifying commercial clients.
  • Hedge large deals on a one-off basis. Banks can use an interest rate swap to transform the return of an individual loan from fixed to floating. The borrower maintains a conventional fixed-rate borrowing structure. Separately, the bank executes a pay-fixed swap that effectively converts the loan interest to a variable rate that aligns more closely with its funding costs. While this strategy can be used on any fixed-rate loan, it can be particularly prudent for larger and longer-term transactions.
  • Use longer-duration funding. Banks can borrow for longer terms to match fixed-rate loan maturities, or “match fund,” to reduce interest rate risk. Banks can either issue new longer-term funding vehicles or use interest rate swaps to synthetically convert the maturity of existing short-term funding instruments to longer-duration liabilities. While match funding does not address fixed-rate loan prepayment risks, it does help mitigate some of the earnings risk associated with fixed-rate loans.

How does your bank evaluate fixed-rate loans? Fixed-rate loans are not inherently bad. A well-diversified balance sheet will include a mix of fixed- and floating-rate loans. But originating an outsized portfolio of commercial fixed-rate loans comes with risks that banks should properly evaluate. How is your bank managing the risks associated with fixed-rate loans? Are you booking deals as a quick fix to get through this quarter, or building a safe balance sheet with steady earnings for the future?

The Three C’s of Indirect Swaps

Twenty years ago, there were 8,000+ banks; today there are less than 5,000, but competition hasn’t slowed.

Not only are banks competing with other banks for loans, they are also competing for investor dollars. There’s pressure to grow and to do so profitably. It is more important than ever that banks compete for, and win, loans.

Competing for the most profitable relationships requires banks to meet borrower demand for long-term, fixed-rate debt. But that structure and term invites interest rate risk. What can banks do? What are their competitors doing?

Banks commonly use derivatives to meet customer demand for fixed-rate loans, but opt for different approaches. The majority of banks choose a traditional solution of offering swaps directly to borrowers; however, some community banks choose to work with correspondent banks that offer indirect swaps to their borrowers.

With indirect swaps, the correspondent bank enters an interest rate swap with the borrower — sometimes called a rate protection agreement. The borrower is party to a derivative transaction with the correspondent bank; the community bank is not a direct party to the swap.

Indirect swaps are presented as a simple solution for meeting customer demand for long-term fixed-rates, but community bankers should consider the three C’s of indirect swaps before using this type of product: credit, cost and customer.

Credit
A swap is a credit instrument that can be an asset or liability to the borrower, which means the correspondent bank requires security. The correspondent bank accomplishes this by requiring a senior position in the loan credit. In a borrower default, the correspondent bank has the first lien on the loan collateral.

In practice, the community bank makes the correspondent bank whole for the borrower’s swap liability. This means the community bank has an unrecognized contingent liability for each indirect swap.

Additionally, due to the credit nature of swaps, the correspondent bank must agree to the amount of proceeds, or the loan-to-value at which the bank lends. This has real-world implications for banks as they compete for loans.

Cost
While there are no out-of-pocket costs associated with putting the borrower into a swap with a correspondent bank, there are costs embedded in the swap rate that drives up the cost for the borrower and could potentially make the bank uncompetitive. These costs are often opaque — and can be significant.

Customer
A colleague of mine refers to indirect swaps as “swaps on a blind date.” It’s a funny but apt way of putting it. The borrower enters into a derivative with a correspondent bank that they have no relationship. And the borrower is accepting unsecured exposure as well: if the correspondent bank defaults and owes the borrower on the swap, they have no recourse except as an unsecured creditor.

A common theme of the three C’s is control. With indirect swaps, the community bank cedes control of the credit, they cede control of the cost of the swap and they cede control of the relationship with their customer. That’s why the majority of banks choose to offer swaps directly to their customers. Doing so allows them to manage the credit, including loan proceeds, and doesn’t subordinate the bank’s credit to a third party in the case of a workout. It allows the bank to own the pricing decision and control the cost of the swap to the borrower, making the bank’s loan pricing more competitive. It allows the bank to keep all aspects of the customer relationship within the institution.

Offering swaps to borrowers also opens the door for banks to use swaps as a balance sheet risk management tool. In this context, derivatives are an additional tool for the bank to manage interest rate risk holistically.

But what about the complexity of derivatives? How does an executive with little or no experience in derivatives educate the board and equip his/her team? How will swaps be managed? The majority of banks choose to partner with an independent third party to do the heavy lifting of educating, equipping, and managing a customer swaps program. A good partner will serve as an advisor and advocate, ensuring that the bank is fully compliant and utilizing best practices.

Indirect swaps may be simple — but a traditional solution of offering swaps directly to borrowers is a better way to meet customer demand for long-term fixed-rate loans.

Balance Sheet Opportunities Create Path to Outperformance

How important is net interest margin (NIM) to your institution?

In 2019, banks nationally were 87% dependent on net interest income. With the lion’s share of earnings coming from NIM, implementing a disciplined approach around margin management will mean the difference between underperforming institutions and outperforming ones. (To see how your institution ranks versus national and in-state peers, click here.)

Anticipating the next steps a bank should take to protect or improve its profitability will become increasingly difficult as they manage balance sheet risks and margin pressure. Cash positions are growing with record deposit inflows, pricing on meager loan demand is ultra-competitive and many institutions are experiencing accelerated cash flows from investment portfolios.

It is also important to remember that stress testing the balance sheet is no longer an academic exercise. Beyond the risk management, stressing the durability of capital and resiliency of liquidity can give your institution the confidence necessary to execute on strategies to improve performance and to stay ahead of peers. It is of heightened importance to maintain focus on the four major balance sheet position discussed below.

Capital Assessment, Position
Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses and providing resources to seize opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown.

The rapid changes occurring within the economy are not wholly cyclical in nature; rather, structural shifts will develop as consumer behavior evolves and business operations adjust to the ‘next normal.’ Knowing the breaking points for your capital base — in terms of growth, credit deterioration and a combination of these factors — will serve your institution well.

Liquidity Assessment, Position
Asset quality deterioration leads to capital erosion, which leads to liquidity evaporation. With institutions reporting record deposit growth and swelling cash balances, understanding how access to a variety of funding sources can change, given asset quality deterioration or capital pressure, is critical to evaluating the adequacy of your comprehensive liquidity position.

Interest Rate Risk Assessment, Position
In today’s ultra-low rate environment, pressure on earning asset yields is compounded by funding costs already nearing historically low levels. Excess cash is expensive; significant asset sensitivity represents an opportunity cost as the central bank forecasts a low-rate environment for the foreseeable future. Focus on adjusting your asset mix — not only to improve your earnings today, but to sustain it with higher, stable-earning asset yields over time.

Additionally, revisit critical model assumptions to ensure that your assumptions are reflective of actual pricing behaviors, including new volume rate floors and deposit betas, as they may be too high for certain categories.

Investment Assessment, Position
Strategies for investment portfolios including cash can make a meaningful contribution to your institution’s overall interest income. Some key considerations to help guide the investment process in today’s challenging environment include:

  • Cost of carrying excess cash has increased: Most institutions are now earning 0.1% or less on their overnight funds, but there are alternatives to increasing income on short-term liquidity.
  • Consider pre-investing: Many institutions have been very busy with Paycheck Protection Program loans, and we anticipate this will have a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market.

Taylor Advisors’ Take:
Moving into 2021, liquidity and capital are taking center stage in most community banks’ asset-liability committee discussions. Moving away from regulatory appeasement and towards proactive planning and decision-making are of paramount importance. This can start with upgrading your bank’s tools and policies, improving your ability to interpret and communicate the results and implementing actionable strategies.

Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. You must know where you are to know where you want to go. Start by studying your latest quarterly data. Dissect your NIM and understand why your earning asset yields are above or below peer. Balance sheet management is about driving unique strategies and tailored risk management practices to outperform; anything less will lead to sub-optimal results.

An Effective Way to Combat Cyber Breaches

Banks have always been in the business of risk management, but the risks they face aren’t stagnant; they migrate with time.

Traditionally, banks have faced two types of risk: interest rate and credit risk. Today, however, given the growth of digital banking and transactions, these two risks have been supplanted by another: cybersecurity.

The biggest challenge when it comes to cybersecurity risk is that it constantly evolves, as the threats, actors and attacks increase in sophistication. Banks that prepare for one method of intrusion may find themselves the victim of a different strategy.

Earlier this year, H. Rodgin Cohen, a partner at Sullivan & Cromwell and one of the industry’s most trusted advisors, commented on this change.

“I think the biggest risk in the [financial] system today is a successful cyberattack,” Cohen said. “That is a very serious risk, but I think the more likely [danger] is that a single bank — or a group of banks — are hit with a massive denial of service for a period of time, or a massive scrambling of records.”

Banks of all sizes feel pressure to keep their systems secure from intruders, according to Bank Director’s 2019 Risk Survey, which found that cybersecurity concerns among bankers have increased over the previous year.

Twenty percent of survey respondents say they address cybersecurity as a full board rather than delegating it to a committee, and slightly more than a third say at least one director is a cybersecurity expert.

The concern is ever present, and for some banks, very real: 18% of respondents, excluding chief lending officers and chief credit officers, reported that their bank experienced a data breach or other cyberattack within the last two years.

Concerns like these are why Bank Director created the “Best Solution for Protecting the Bank” category for its 2019 Best of FinXTech Awards. Judges selected winners from the most innovative solutions found in the FinXTech Connect platform.

The finalists for this year’s award were Rippleshot, which helps banks to identify credit and debit card fraud; IDEMIA, which  works to prevent card-not-present fraud; and Illusive Networks, which helps banks detect when their networks have been infiltrated.

This year’s winner was Illusive Networks, based in part on its work to secure the network of Israel Discount Bank, the third biggest bank in Israel.

Illusive approaches cybersecurity from a hackers’ point of view in order to beat them at their own game. Its strategy isn’t to stop an intrusion per se — a feat that seems increasingly impossible with the number of entry points into a system and the scores of malicious actors.

Rather, it detects and remediates an attack once it has happened. Intruders breaking into a bank’s system must persistently monitor the network for bits of information or credentials that will help them move from machine to machine and gradually close in on the data they want. Illusive plants false information across the bank’s network so that, when attackers act on it, the bank can catch them red-handed.

Illusive calls this “endpoint-focused deception.” The deceptive information is only visible to malicious actors and triggers an alert within Illusive. The technology then captures details about the bad actor directly from the machine they were using, which the bank then uses to track and stop the attack.

One of the main selling points of Illusive’s solution is the short implementation period. In Israel Discount Bank’s case, it took a matter of weeks to implement the solution. The net result is that, not only is the solution harder to detect for potential cyber criminals, but it’s also fast and easy to implement.

Addressing the Top Three Risk Trends for Banks in 2019



As banks continue to become more reliant on technology, the risks and concerns around cybersecurity and compliance continue to grow. Bank Director’s 2019 Risk Survey, sponsored by Moss Adams LLP, compiled the views of 180 bank leaders, representing banks ranging from $250 million to $50 billion in assets, about the current risk landscape. Respondents identified cybersecurity as the greatest concern, continuing the trend from the previous five versions of this report and indicating an industry-wide struggle to fully manage this risk.

Other top trends included the use of technology to enhance compliance and the potential effect of rising interest rates. Here’s what banks need to know as they assess the risks they’ll face in the coming year.

Cybersecurity
Regulatory oversight and scrutiny around cybersecurity for banks seems to be increasing. Agencies including the Securities and Exchange Commission are focused on the cybersecurity reporting practices of publicly traded institutions, as well as their ability to detect intruders. The Colorado legislature recently passed a law requiring credit unions to report data breaches within 30 days. It’s no surprise that 83 percent of respondents said their concerns about cybersecurity had increased over the past year.

Most of the cybersecurity risk for banks comes from application security. The more banks rely on technology, the greater the chance they face of a security breach. Adding to this, hackers continue to refine their techniques and skills, so banks need to continually update and improve their cybersecurity skills. This expectation falls to the bank board, but the way boards oversee cybersecurity continues to vary: Twenty-seven percent opt for a risk committee; 25 percent, a technology committee and 19 percent, the audit committee. Only 8 percent of respondents reported their board has a board-level cybersecurity committee; 20 percent address cybersecurity as a full board rather than delegating it to a committee.

Compliance & Regtech
Utilizing technological tools to meet compliance standards—known as regtech—was another prevalent theme in this year’s survey. This is a big stress area for banks due to continually changing requirements. The previous report indicated that survey respondents saw increased expenses around regtech. This year, when asked which barriers they encountered around regtech, 47 percent responded they were unable to identify the right solutions for their organizations. Executives looking to decrease costs may want to consider whether deploying technology could allow for fewer personnel. When this technology is properly used, manual work decreases through increased automation.

Other compliance concerns for this year’s report included rules around the Bank Secrecy Act and anti-money laundering. Seventy-one percent of respondents indicated they implemented or plan to implement more innovative technology in 2019 to better comply with BSA/AML rules.

Compliance with the current expected credit loss standard was another area of concern. Forty-two percent of respondents indicated their bank was prepared to comply with the CECL standard, and 56 percent replied they would be prepared when the standard took place for their bank.

Interest Rate & Credit Risk
The potential for additional interest rate increases made this a new key issue for the 2019 report. When asked how an interest rate increase of more than 100 basis points, or 1 percent, would affect their banks’ ability to attract and retain deposits, 47 percent of respondents indicated they would lose some deposits, but their bank wouldn’t be significantly affected. Thirty percent indicated an increase would have no impact on their ability to compete for deposits.

However, 55 percent believed a severe economic downturn would have a moderate impact on their banks’ capital. In the event of such a downturn, deposits and lending would slow, and banks could incur more charge-offs, which would impact capital. This fluctuation can be easy to dismiss, but careful planning may help reduce this risk.

Assurance, tax, and consulting offered through Moss Adams LLP. Investment advisory services offered through Moss Adams Wealth Advisors LLC. Investment banking offered through Moss Adams Capital LLC.