Those of us who were in banking when Ronald Reagan entered the White House remember the interest rate rollercoaster ride brought about by the Federal Reserve when it aggressively tightened the money supply to tame inflation. It was during this era of unprecedented volatility that interest rate swaps, caps and floors were introduced to help financial institutions keep their books in balance. But over the years, opaque pricing, unnecessary complexity and misuse by speculators led Richard Syron, former chairman of the American Stock Exchange, to observe, “Derivative. That’s the 11-letter four-letter word.”
As community banks bought into Syron’s “D-word” conclusion and resolved to avoid their use altogether, several providers fed these fears and designed programs that promise a derivative-free balance sheet. But many banks are beginning to question the effectiveness of these solutions.
Today, as commercial borrowers seek long-term, fixed-rate funding for 10 years and longer, risk-averse community banks want to know how to solve this term mismatch problem in a responsible and sustainable manner. The fact that Syron voiced his opinion on derivatives in 1995 suggests that now might be a good time to examine the roots of “derivative-phobia,” by considering what has changed in the past quarter-century and challenging four frequently heard biases against community banks using swaps.
1. None of my community bank peers use interest rate derivatives. If you are not hedging with swaps, and your total assets are between $500 million and $1 billion, then you are in good company: More than nine out of ten of your peers have also avoided their use.
But if your bank is larger, or your growth plans anticipate crossing the $1 billion asset level, more than one in four of your new peers use swaps.
Once your bank crosses the $2 billion mark, more than half of your peers manage interest rate risk with derivatives, and institutions not using swaps become a shrinking minority.
Community banks should consider their growth path and the best practices of their expected peer group before dismissing out-of-hand the use of derivatives.
2. The derivatives market is a big casino, and swaps are always a bet. While some firms (AIG in 2008, for example) have used complex derivatives to speculate, a vanilla swap designed to neutralize a bank’s natural risks operates as a hedge. Post-crisis, the Dodd-Frank Act brought more transparency to swap pricing, as swap dealers are now required to disclose the wholesale cost of the swap to their customers. In addition, most dealers are now willing to operate on a bilateral secured basis, removing most of the counterparty risk that the trading partners of Lehman Brothers experienced firsthand when that company collapsed. These changes in market practices have made it much more practical for community banks to execute simple hedging transactions at fair prices with manageable credit risk.
3. Derivatives accounting always results in unwanted surprises and volatility. Derivatives missteps led to FAS 133—regarding the measurement of derivative instruments and hedging activities—being issued in 1998, bringing the fair value of derivatives out of the footnotes and onto the balance sheet for the first time. But the standard (now ASC 815) proved difficult to apply, leading to some notable financial restatements in the early 2000s. Fast forward nearly twenty years, and the Financial Accounting Standards Board has issued an overhaul to hedge accounting (ASU 2017-12) that is a game-changer for community banks. With mandatory adoption in 2019, there are more viable ways to solve the age-old mismatch facing banks. And the addition of fallback provisions, combined with improvements to “the shortcut method,” greatly reduces the risk of unexpected earnings volatility.
4. ISDA documents should always be avoided. While admittedly lengthy, the Master Agreement published by the International Swaps and Derivatives Association was designed to protect both parties to a derivative contract and is the industry standard for properly documenting an interest rate swap. Many community banks seeking an ISDA-free solution for their customers are actually placing the borrower into a lightly-documented derivative with an unknown third-party. If a borrower is not sophisticated enough to read and sign the ISDA Master Agreement, they have no business executing a swap in the first place. A simpler solution is to make a fixed-rate loan and execute a swap behind the scenes to neutralize the interest rate risk. This keeps the swap and the agreement between two banks, and removes the borrower from the derivative altogether.
For community banks that have been trying to solve their mismatch problem in a manner that is derivative-free, it is worth re-examining the factors that have led to pursuing a derivatives-avoidance strategy, and counting the costs and hidden exposures involved in doing so.
Investors have always sought better returns for greater risk. Longer investment horizons are associated with a higher amount of risk driven by uncertainty. In the fixed income markets, this translates to higher yields for longer maturities to compensate investors for the risk, thus creating what is called the yield curve. The yield curve has a positive slope in a normal market. The curve can also be flat or even inverted, which typically indicate transitionary periods in the market. That said, interest rate troughs usually do not last more than seven years, and central banks normally do not pump trillions of dollars into global markets as they have over the last several years. With protracted recovery and extreme monetary policy measures, this dreaded flat yield curve seems to be here for a while.
Banks’ primary earning power is largely driven by net interest margin, which is impacted by the shape of the yield curve and the ability to manage interest rate risk. It is prudent to perform non-parallel rate simulations on a regular basis, and regulators require this type of analysis. These simulations should be reviewed with management and saved for future use. Given the protracted flat yield curve environment, banks are feeling margin compression. If you have not done so, it may be time to retrieve these reports, understand if and where risk is impacting your balance sheet and manage your margin accordingly.
There are a number of ways a flat yield curve can negatively impact interest rate margins. Liquidity pressure is often at the top of the list in a rising rate environment. We have seen seven upward moves in the target fed funds rate since the bottom of the recovery, a total of 175 basis points. Depositors are hungrily pursuing newfound interest income. Most banks have had to follow suit and raise deposit rates. On the asset side of the balance sheet, fixed-rate loan yields have remained relatively stagnant. A typical rate on a 20-year amortizing 5-year balloon, owner-occupied commercial real estate loan in the $1-million to $5-million range was priced around 4.75 percent during the bottom of the rate trough.
As deposit rates have risen, banks have had difficulty in pricing the yields on loans of this type much above 5 percent. A third pressure point is the investment portfolio. During a normal yield curve environment, institutions with asset-sensitive balance sheets could earn income by borrowing short-term liabilities and investing at higher yields further out on the curve. Given the tightness of spreads along the curve where typical banks invest, there is minimal advantage to implementing this type of a strategy.
Since the issue of margin compression driven by the flat curve is a top concern for those who manage interest rate risk, the better question is what to do about it. Most bankers know it is present but many avoid the potential ramifications. The non-parallel simulation is an important exercise to understand the implications over the next year or so. The bank may even want to consider running a worst-case scenario simulation around an inverted curve as well. From there some strategic deposit pricing can be implemented.
One strategy may be either maintaining a short duration, and hopefully, inexpensive deposit or locking in funds for longer terms, pending balance sheet needs. Locking in longer term funding will come at a cost to the net interest margin unless the curve inverts. The interest rate risk simulation will help answer those types of questions. It is also a good time to look at a loan pricing model. This would help determine whether to continue to compete on price or pass on deals until margins improve. There is even a level that where banks should turn down business. It is important to understand the price point that becomes dilutive to earnings. Finally, there is a point that one stops taking duration risk in the investment portfolio, stays short and prepares to take advantage of future opportunities while reducing price risk.
Although a flat yield curve is not a new market phenomenon, it is currently impacting bank margins and may continue to for the next year or longer. Our Balance Sheet Strategies Group recommends banks consider the use of a detailed, non-parallel simulation to assess the current market and how to position the balance sheet moving forward. In addition to optimizing the interest rate position going forward, this will also help preserve and potentially enhance the interest margin. Every five basis points saved or earned on a $250-million balance sheet will equate to $125,000 in interest rate margin.
How can financial institutions proactively combat the risks facing the industry today? The 2018 Risk Survey—presented by Bank Director and Moss Adams LLP—compiled the insights of directors, chief executive officers and senior executives of U.S. banks with more than $250 million in assets. According to the survey, the worries keeping top executives awake at night align with the key priorities that banks commonly hear from banking regulators: cybersecurity, compliance and strategic risk.
Cybersecurity Cybersecurity was the biggest concern by far, reported by 84 percent of respondents.
The survey addressed the confidence that executive and directors have in their institutions’ cybersecurity programs, with an emphasis on staffing and overall effectiveness. Access to the proper talent—in the form of a chief information security officer (CISO) or a strategic partner with the necessary skill set—and associated costs are key to a successful program, and 71 percent of respondents revealed their bank employs a full-time CISO.
While technical skills are valuable in today’s business environment, financial institutions must overcome their dependence on skilled technicians who don’t necessarily have the ability to strategically look at the changing technological landscape. The CISO should build an appropriate plan by taking a full view of the bank’s technology and strategy. Without this perspective, a bank could provide hackers with an opening to breach the institution, regardless of size or location.
Institutions building the foundation of a robust cybersecurity program should also focus on three key areas:
Assessment tools: Is the institution leveraging the proper technologies to help maximize the detection and containment of potential issues?
Risk assessments: Has management identified current risks to the organization and implemented proper mitigation strategies?
Data classification: Has management identified all critical data and its forms, and addressed the protection of this data in the risk-assessment process?
Compliance Compliance was the second biggest area of concern, identified by 49 percent of respondents. It’s an area that continues to evolve as new regulators have been appointed to head the agencies that regulate the industry, and technological tools—dubbed regtech—have entered the marketplace.
More than half of survey respondents indicated that the introduction of regtech has increased their banks’ compliance budgets, demonstrating that the cost of solutions and staff to evaluate, deploy and support these efforts in an effective manner is a growing challenge.
Because the volume of available data and the ability to analyze that data continues to grow, respondents may have felt this technology should have effectively decreased the cost of operating a robust compliance program.
Executives looking to decrease costs may want to consider the staffing required to operate a compliance program and whether deploying technology would allow for fewer personnel. When technology is properly used and standards are developed to help guarantee efficient use of it, the dilemma of acquiring technology versus adding staff can often be more easily solved.
Strategic Risk Strategic risk was the third largest area for concern, identified by 38 percent of respondents. Many directors and executives are wrestling with what the future holds for their institutions. The debate often boils down to one question: Should they continue to build branches or invest more in technology—either on their own or by partnering with fintech companies?
Fintech companies are a growing player in lending and payments segments, areas that were historically handled exclusively by traditional institutions. That, coupled with clients who no longer value personal relationships and instead prioritize being able to immediately access services via their devices, increases the pressure to deliver services via technology channels.
Financial institutions have entered what many would call a perfect storm. Every institution will need to make hard decisions about how to address these issues in a way that facilitates growth.
Assurance, tax, and consulting offered through Moss Adams LLP. Wealth management offered through Moss Adams Wealth Advisors LLC. Investment banking offered through Moss Adams Capital LLC.
In the regular course of business, banks are exposed to market risks from movements in interest rates, foreign currencies and commodities. Many banks respond by utilizing over the counter derivative instruments to hedge against volatility. Under current accounting standards, banks must account for derivatives under the ASC 815 (formerly FAS 133) models.
There are three hedge accounting “models” under ASC 815: 1) cash flow, 2), fair value, 3) and net investment hedging. There are specific times when one model is required over the others, and the mechanics of each are different in many ways. Because of its breadth, hedge accounting could be seen as intimidating and difficult to understand. There have been instances where banks made mistakes in their adherence to hedge accounting which resulted in income statement volatility. As a result, the perception hedge accounting is difficult and fraught with potential danger has discouraged many banks from entertaining derivative solutions
On September 8, 2016, the Financial Accounting Standards Board (FASB) submitted a proposed draft to update hedge accounting. Specifically, the draft seeks to better align a bank’s economic results with its financial reporting and simplify hedge accounting.
The proposed changes appear to better align the accounting rules with a bank’s risk management objectives and simplifies some important items of ASC 815. Many of the existing rules remain unchanged, but the proposed changes should produce greater interest in the use of derivative solutions among community banks.
Specifically, the proposal for improving how economic results are portrayed on financial statements includes:
Expanding the use of component hedging for both nonfinancial and financial risks.
Adding the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate as an eligible benchmark interest rate for fair value accounting in the United States.
Eliminating the separate measurement and reporting of hedge “ineffectiveness,” a concept that has been difficult for companies to explain and for readers of financial statements to understand.
Requiring for cash flow and net investment hedges that all changes in fair value of the hedging instrument included in the hedging relationship be deferred in other comprehensive income and released to the income statement in the period(s) when the hedged item affects earnings.
Requiring that changes in the fair value of hedging instruments be recorded in the same income statement line item as the earnings effect of the hedged item.
Requiring enhanced disclosures to highlight the effect of hedge accounting on individual income statement line items.
Highlights of the Proposed Changes Most Likely to Affect Financial Institutions
The proposal also includes some ways to simplify hedge accounting, including the following:
Providing more time for the completion of initial quantitative assessments of hedge effectiveness.
Allowing subsequent assessments of hedge effectiveness to be performed on a qualitative basis when an initial quantitative test is required.
Clarifying the use of what’s known as the critical terms match method for a group of forecasted transactions.
Allowing an institution that erred in using the shortcut method to continue hedge accounting by using a “long-haul” method.
Small business investment companies have been growing in popularity since the financial crisis, as these can help banks comply with the Community Reinvestment Act and manage interest rate risk, as Dory Wiley, CEO at Commerce Street Capital, explains in this video.
A contingent hedging plan should be unique to every bank and developed in concert with internal modeling and management’s rate expectations. Like a captain adding ballast to a ship to provide a smoother ride, hedging allows a bank to reduce volatility and limit the impact of sudden interest rate changes. (See BMO’s previous article on this topic.) The goal is not to eliminate risk, but proactively mitigate or control risk at a suitable cost.
Derivative use among community banks has increased over the last several years. The graphs below illustrate the growth in the number of banks with swap and gross balances. Interestingly, after the Dodd Frank Act was enacted in 2012, at a time when using derivatives was expected to be more onerous, the year-over-year growth in derivative use among community banks has accelerated rather than declined.
One possible explanation with the migration of bankers from larger institutions to smaller community banks is they bring with them an understanding of derivatives and their benefits. The sustained flat curve and low rate environment may have compelled banks to evaluate and use derivatives.
How To Create a Contingent Hedging Plan Regulators require banks to establish contingent funding plans. Developing a contingent hedging plan could follow the same approach. The plan can include description of roles, responsibilities and action plans where applicable. It should also allow management to act quickly when rate assumptions change. Among the items one can include:
Determine Economic Goals with Quantitative Guidance: What are the economic risks the bank is trying to mitigate? The more quantifiable the risk, the more specific you can be with your dealer and the more targeted the recommended solution.
List of Approved Transaction Types: Keep definitions broad enough to allow management to act opportunistically without waiting for approval at the monthly board meeting. Learn the basic mechanics of these trades today, so when you look to execute in a volatile market you will already have some understanding on which trades are most suitable for the risk.
Cost and Timing: There is usually a trade off or “cost” to do a hedge–nothing is for free. Get on someone’s rate sheet distribution, remain aware of current hedge levels and determine a range of acceptable cost. When one waits too long to trade, the hedge cost may become prohibitively expensive.
Understand Accounting Treatment: Derivatives are subject to FAS133 / ASC815 accounting treatment. Develop a familiarity of which accounting model is required and under which hedging circumstance.
Transaction Mechanics: Know who to call and how to execute a trade. Develop familiarity with terminology and swap nomenclature in order to accurately communicate intent.
Counterparty Selection: This may be the most important ingredient. Without access to a dealer counterparty to help provide solutions, creating a contingent hedging plan could be a moot point.
The Dodd-Frank Act provides advantages for hedgers if they transact with a registered swap dealer (RSD). The act defines swap dealers as entities who “hold themselves out as dealers in swaps; make a market in swaps; regularly enter into swaps with counterparties in the ordinary course of business for their own accounts; or engage in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.”
These entities are required to register with the Commodity Futures Trading Commission and are held to higher business conduct standards. A list of provisionally registered swap dealers can be found here.
Hedgers Can Expect the Following Benefits From RSDs Price transparency: The act requires all RSDs to quote mid + bid/offer spread on every trade. The hedger knows exactly what the dealer is making.
Liquidity / Cost: By trading directly with a market maker, the hedger crosses one bid or offer spread rather than two which normally happens when going through an intermediary.
Fair Credit Terms: You get fair credit terms with bi-lateral collateral posting for uncleared trades.
Expertise: RSDs can provide direct market color, trade recommendations and regulatory guidance. The level of expertise will be much higher given the critical mass and scale required to be a market maker in this regulatory environment.
Hedgers should consider that the regulatory burden on RSDs is significant, so dealers have responded by recalibrating business lines. While there are still RSDs willing to face small banks, many other dealers have exited the community bank space entirely. When evaluating a swap partner, you may want to ask about their commitment to your asset class.
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.