How to Prepare for an Unprecedented Year

Could anyone have prepared for a year like 2020?

Better-performing community banks, over the long run, generally anchor their balance sheet management in a set of principles — not divination. They organize their principles into a coherent decision-making methodology, which requires them to constantly study the relative risk-reward profiles of various options, across multiple rate scenarios and industry conditions over time.

But far too many community bankers look through the wrong end of the kaleidoscope. Rather than anchoring themselves with principles, they drift among the currents of economic and interest rate forecasts. Where that drift takes them at any given moment dictates their narrowly focused reactions and strategies. If they are in a reward mindset, they’ll focus on near-term accounting income; if the mood of the day is risk-centered, their framework will be liquidity. At Performance Trust, we have long argued that following this approach accumulates less reward, and more risk, than its practitioners ever expect.

Against this backdrop, we offer five decision-making principles that have helped many banks prepare for the hectic year that just closed, and can ensure that they are prepared for any hectic or challenging ones ahead.

  • Know where you are before deciding where to go. Net Interest Income and Economic Value of Equity simulations, when viewed in isolation, can present incomplete and often conflicting portrayals of a bank’s financial risk and reward profile. To know where you are, hold yourself accountable to all cash flows across multiple rate scenarios over time, incorporating both net income to a horizon and overall economic value at that horizon. Multiple-scenario total return analysis isn’t about predicting the future. Rather, it allows you to see how your institution would perform in multiple possible futures.
  • Don’t decide based on interest rate expectations — in fact, don’t even have expectations. Plenty of wealth has been lost by reacting to predictions. Running an asset-sensitive balance sheet is nothing more than making a levered bet on rising rates. So, too, is sitting on excess liquidity waiting for higher rates. The massive erosion in net interest margin in 2020 supports our view that most community banks have been, intentionally or not, speculatively asset sensitive. Banks that take a principle-based approach currently hold sufficient call-protected, long-duration earning assets — not because they knew rates would fall, but because they knew they would need them if rates did fall. As a result, they are in a potentially better position to withstand a “low and flat” rate environment.
  • Maintaining sufficient liquidity is job No. 1. Job No. 2 is profitably deploying the very next penny after that. In this environment, cash is a nonaccrual asset. Banks with a principle-oriented approach have not treated every bit of unexpected “excess liquidity” inflow as a new “floor” to their idea of “required liquidity.” One approach is to “goal post” liquidity needs by running sensitivity cases on both net loan growth and deposit outflows, and tailoring deployment to non-cash assets with this in mind — for instance by tracking FHLB pledgeability and haircutting — and allowing for a mark-to-market collateral devaluation cushion. Liquidity is by no means limited to near-zero returns.
  • Don’t sell underpriced options. Banks sell options all day long, seldom considering their compensation. Far too often, banks offer loans without prepayment penalties because “everyone is doing it.” Less forgivably, they sell options too cheaply in their securities portfolio, in taking on putable advances or when pricing their servicing rates. The last two years were an era of very low option compensation, even by historical measures. Principle-based decision-makers are always mindful of the economics of selling an option; those who passed on underpriced opportunities leading into 2021 find their NIMs generally have more staying power as a result.
  • Evaluate all capital allocation decisions on a level playing field. Community banks, like all competitive enterprises, can allocate capital in just four ways: organic growth, acquisitions, dividends or share repurchases. Management teams strike the optimal balance between risk and reward of any capital allocation opportunity by examining each strategy alongside the others across multiple rate scenarios and over time. This approach also allows managers to harness the power of combinations — say, simultaneously executing a growth strategy and repurchasing stock — to seek to enhance the institution’s overall risk/return profile.

So what about 2021 and beyond? This same discipline, these same principles, are timeless. Those who have woven them into their organizational fabric will continue to benefit whatever comes their way. Those encountering them for the first time and commit to them in earnest can enjoy the same.

AMERIBOR Benchmark Offers Options for Bank Capital Raises

Banks that belong to the American Financial Exchange (AFX) are not waiting until 2021 to make the switch away from the troubled London Interbank Offered Rate, or LIBOR, interest rate benchmark for pricing their offerings in the capital markets.

These institutions, which represent $3 trillion in assets and more than 20% of the U.S. banking sector, are using AMERIBOR® to price debt offerings now. They say AMERIBOR®, an unsecured benchmark, better reflects the cost of funds as represented by real transactions in a centralized, regulated and transparent marketplace. The benchmark has been used to price loans, deposits, futures and now debt — a critical step in a new benchmark’s development and financial innovation.

In October, New York-based Signature Bank announced the closing of $375 million aggregate principal amount of fixed-to-floating rate subordinated notes due in 2030 — the first use of AMERIBOR® in a debt deal. The notes will bear interest at 4% per annum, payable semi-annually. For the floating component, interest on the notes will accrue at three-month AMERIBOR® plus 389 basis points. The offering was handled by Keefe Bruyette & Woods and Piper Sandler. The transaction was finalized the first week of October 2020.

Signature Bank Chairman Scott Shay highlighted the $63 billion bank’s involvement as a “founder and supporter” of AFX.
“We are pleased to be the first institution to use AMERIBOR® on a debt issuance. … AMERIBOR is transparent, self-regulated and transaction-based, and we believe that it is already a suitable alternative as banks and other financial institutions transition away from LIBOR,” Shay said.

The inaugural incorporation of AMERIBOR® in a debt offering paves the way for more debt deals and other types of financial products linked to the benchmark. The issuance adds to the list of U.S. banks that have already pegged new loans to the rate, including Birmingham, Alabama-based ServicFirst Bancshares, Boston-based Brookline Bancorp and San Antonio-based Cullen/Frost Bankers. As AFX adds to deposits, loans and fixed income linked to AMERIBOR, the next risk transfer instrument up for issuance will be a swap deal.

Banks of all sizes have options to choose from when it comes to an interest rate benchmark best suited to their specific requirements. AMERIBOR® was developed for member banks and others that borrow and lend on an unsecured basis. Currently, AFX membership across the U.S. includes 162 banks, 1,000 correspondent banks and 43 non-banks, including insurance companies, broker-dealers, private equity firms, hedge funds, futures commission merchants and asset managers.

This article does not constitute an offer to sell or a solicitation of an offer to buy the notes, nor shall there be any offer, solicitation or sale of any notes in any jurisdiction in which such offer, solicitation or sale would be unlawful.

When Rates are Zero, Derivatives Make Every Basis Point Count

It’s been one quarter after another of surprises from the Federal Reserve Board.

After shocking many forecasters in 2019 by making three quarter-point cuts to its benchmark interest rate target, the data-dependent Fed was widely thought to be on hold entering 2020. But the quick onset of the coronavirus pandemic hitting the United States in March 2020 quickly rendered banks’ forecasts for stable rates useless. The Fed has acted aggressively to provide liquidity, sending its benchmark back to the zero-bound range, where rates last languished from 2008 to 2015.

During those seven years of zero percent interest rates, banks learned two important lessons:

  1. The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
  2. Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.

The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about  funding/liquidity and realize meaningful savings in the process.

To illustrate: A bank looking to access the wholesale funding market might typically start with fixed-rate advances from their Federal Home Loan Bank. These instruments are essentially a bundled product consisting of liquidity and interest rate protection benefits; the cost of each component is rolled into the quoted advance rate. By choosing to access short-term funding instead, a bank can then execute an interest rate swap or cap to hedge the re-pricing risk that occurs each time the funding rolls over. Separating funding from rate protection enables the bank to save the liquidity premium built into the fixed-rate advance.

Some potential benefits of utilizing derivatives in the funding process include:

  • Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
  • In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
  • Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
  • In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
  • Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.

Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs. 

While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking 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 a board and management team separate facts from fears and make the best decision for their institution.

With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.

Making Interest Checking More Interesting


Retail-banking-6-26-15.pngFor consumers, having an interest checking account these days is, well, uninteresting.

Financial institutions only pay a few basis points of an interest rate at most, which requires a significant balance to generate meaningful interest income to customers. Even high-yield checking accounts average just 1-2 percent, but with qualifying balances capped around $10,000, customers annually make barely enough to go out for a nice dinner for two.

What can your financial institution do to make interest checking more interesting? In most cases, you can’t afford to pay a lot more interest than you’re paying today. And while you understand that, many customers don’t (just ask them).

So you have to think differently about what a checking account that pays interest delivers to customers. 

The essence of interest checking is that it lets your customers experience “making money on their money.” When this happens, it increases personal net worth. With increased net worth, customers now have more effective purchasing power (in terms of reinvesting and spending capacity).

When you think of interest checking as just “making money,” here’s a typical case of what your customer experiences today: The average balance of an interest checking account from StrategyCorps’ CheckingScore database tracking nearly four million checking accounts is almost $12,546. Earning two basis points of annual interest, the account makes the customer a whopping income of about $2.50. Not a great financial or emotional experience for your customer.

However, when you think of extending the essence of an interest checking account to include providing money-saving benefits, the financial and emotional experience a $12,546  average  balance checking customer has is much more relevant and meaningful.

So what are these money-saving benefits that can be offered in a checking account and how much can they typically save? Our experience in providing in-store local merchant discounts easily generates at least $10 per month for places everyone spends money—the dry cleaners, auto maintenance shops, restaurants and grocery stores. Offer travel-related discounts on hotels, rental cars and theme parks for an annual trip, and at least $100 can be saved. Add discounts for prescriptions and vision care, and saving another $50 is not difficult. And providing in-demand services like cell phone insurance ($120), roadside assistance ($70) and identity theft protection ($120) to replace what nearly one in three consumers already pay directly to companies providing these services, and that’s another $310 in total savings.

Now let’s compare customer experiences. A traditional interest checking account rewards a $12,546 DDA customer $2.50 in interest income. A modernized interest checking rewards the same customer with $2.50 in interest income and $580 in easily realized savings on things that a customer spends his/her hard-earned money on every day, resulting in $582.50 of effective yield or about 4.6 percent instead of .02 percent.

Said another way, to earn $582.50 with a .02 percent interest rate would require an average balance of just over $2.9 million, which isn’t realistic except for very few customers per financial institution. But wouldn’t it be a positive experience if many more of your customers could feel like they were being offered a product that provided the potential reward to be treated like a multi-million dollar relationship customer.

Granted, a customer has to use these benefits to earn the savings yield, but all of these benefits have mass market appeal with spending situations that are frequent and common. They also are delivered via a mobile app or a website, which are the preferred channels that your customers want to bank with you anyway.

If you’re wondering how to improve the user experience of your interest checking customer, pay them as much interest as you can afford so they’re able to make as much money as possible, but also provide the tools to let them save as much money as possible on things they have to buy. Until interest rates recover to levels to generate material amounts of interest income, the money-saving ability of these kinds of benefits will make interest checking more interesting.

Smart, top performing financial institutions are already successfully employing this to retain and grow interest checking customers. If you want to keep your interest checking uninteresting, then keep paying your $12,546 checking balance customer $2.50 in interest.