Three Important Things Jerome Powell Said To Congress


strategy-8-9-18.pngJerome Powell’s semi-annual appearance before Congress was perhaps a bit more newsworthy than it has been for past chairmen of the Federal Reserve, and his core message signals a few key moves that will certainly impact how banks manage themselves over the next several months.

Powell’s appearance was overshadowed with questions about trade policy and what was happening further down Pennsylvania Avenue, but the core message from Powell, who has been on the job for less than a year, was that the central bank is continuing on a path toward normalization of interest rates, a place the U.S. economy hasn’t seen in a decade or longer.

Despite the tangents that media-savvy politicians tried to take Powell down, his core messages as it applies to bankers is important and provides signals as to how the Fed will manage the economy over the next several months.

Here’s some takeaways:

Bank profitability likely to remain high. Powell’s comments about the overall tax climate and overall business environment point to good things on the horizon for banks, which have reported strong earnings since the end of last year when tax reforms were passed.

Said Powell: “Our financial system is much stronger than before the crisis and is in a good position to meet the credit needs of households and businesses … Federal tax and spending policies likely will continue to support the expansion.”
Second-quarter results have illustrated that, with some banks reporting quarterly earnings per share around 40 percent above last year.

Fed getting back to “normal.” For several years since the crisis, the Fed bought large quantities of U.S. Treasury bonds—known as quantitative easing—to pump cash into the market and boost the economy. With plenty of indicators that the economy is now humming, Powell said the Fed has begun allowing those securities to mature, bringing that practice to an end.

“Our policies reflect the strong performance of the economy and are intended to help make sure that this trend continues,” Powell said.

“The payment of interest on balances held by banks in their accounts at the Federal Reserve has played a key role in carrying out these policies … Payment of interest on these balances is our principal tool for keeping the federal funds rate in the FOMC’s target range. This tool has made it possible for us to gradually return interest rates to a more normal level without disrupting financial markets and the economy.”

Cybersecurity tops list of risks. In his appearance before the House Financial Services Committee, Powell said cybersecurity, and the unexpected threats therein, is what keeps him up at night, aside from what he called “elevated” asset prices that would fall under more traditional concerns, like commercial real estate.

Preparing for the worst-case cybersecurity scenario is top-of-mind, he said, even more than traditional risks. Preventing and preparing should be the focus, he said.

“(Do) as much as possible, and then double it,” he said, a signal of how serious the Fed views the issue.
He then tamped that statement down, and said the Fed “does a great deal” with its supervision of banks, and advised them to continually maintain “basic cyber hygiene” by keeping up to date on emerging trends and threats.

“We do everything we can to prevent failure, but then we have to ask what would we do if there were a successful cyberattack,” he said. “We have to have a plan for that too.”

Four Ways to Effectively Deploy Excess Capital


capital-7-23-18 (1).pngFavorable economic conditions for banks, which include a healthy business sector, a rising interest rate environment, and the impact of tax and regulatory reforms, have resulted in strong earnings for many community banks. While this confluence of positive market developments has led many growing banks to tap public and private markets for additional capital to fund growth opportunities, many other institutions are facing an opposing challenge.

These institutions, many of which are located in non-metropolitan markets, are experiencing record earnings yet do not have existing loan demand to effectively deploy the capital into higher yielding assets. As a result, these institutions must evaluate how best to deploy excess capital in the absence of organic growth opportunities in existing markets to avoid the impact on shareholder returns of reinvestment into the securities portfolio during a period that continues to be characterized by historically low interest rates.

Dividends. Returning excess capital to shareholders through enhanced dividend payouts increases the current income stream provided to shareholders and is often a well-received option. However, in evaluating the appropriate level of dividends, including whether to commence paying or increase dividends, banks should be aware of two potential issues. First, an increase in dividends is often difficult to reverse, as shareholders generally begin to plan for the income stream associated with the enhanced dividend payout. Second, the payment of dividends does not provide liquidity to those shareholders looking for an exit. Accordingly, dividends, while representing an efficient option for deploying excess capital, presents other considerations that should be evaluated in the context of a bank’s strategic planning.

Tender Offers and Other Stock Repurchases. Stock repurchases, whether through a tender offer, stock repurchase plan or other discretionary stock repurchase, enhance liquidity of investment for selling shareholders, while creating value for non-selling shareholders by increasing their stake in the bank. Following a stock repurchase, bank earnings are spread over a smaller shareholder base, which increases earnings per share and the value of each share. Stock purchases can be a highly effective use of excess capital, particularly where the bank believes its stock is undervalued. Because repurchases can be conducted through a number of vehicles, a bank may balance its desire to effectively deploy a targeted amount of excess capital against its need to maintain operational flexibility.

De Novo Expansion into Vibrant Markets. Banks can also reinvest excess capital through organic expansion into new markets through de novo branching and the acquisition of key deposit or loan officers. For example, a rural bank with a high concentration of stable, inexpensive deposits but weak loan demand could expand into a larger market where loan demand is strong but deposit pricing is elevated. By doing so, the bank can leverage excess capital and inexpensive deposits through quality loan growth and, optimize its net interest margin and earnings potential. With advances in technology, overhead costs associated with de novo entry into a new market have substantially decreased, although competition for deposit and loan officers is intense. Startup costs may be further diminished through a loan production office, rather than a branch in a new market.

Mergers and Acquisitions. Banks can deploy excess capital to jumpstart growth through merger and acquisition opportunities. In general, size and scale boost profitability metrics and enhance earnings growth, and mergers and acquisitions can be an efficient mechanism to generate size and scale. Any successful acquisition must be complementary from a strategic standpoint, as well as from a culture perspective. For example, a bank’s acquisition strategy could involve joining forces with, or eliminating, a competitor with a complementary business and corporate culture. Alternatively, it could be driven by corporate objectives to enhance earnings by expanding into a larger market with stronger demand for high-quality loans. On the other hand, an institution based in a metropolitan market may be inclined to target a lower growth market with a high concentration of lower cost, core deposits. In either case, the acquisitions are complementary to the institutions.

All banks with excess capital have strategic decisions to make to maximize shareholder value. In many cases, these decisions result in returning capital to shareholders, while others seek to leverage excess capital in support of future growth. The strategy for deploying excess capital should be a material component of a bank’s strategic planning process. There is no universal, or right, answer for all banks. Each bank must consider its options against its risk tolerance, long-term strategic goals and objectives, shorter term capital needs, management and board capacity.

A New View for Deposit Strategies



As rates continue to rise, now is the time for bank boards and management teams to consider deposit strategies for the future. In this video, Barbara Rehm of Promontory Interfinancial Network sits down with H.D. Barkett, senior managing director at Promontory Interfinancial Network, who shares his thoughts on what banks should consider in today’s environment.

Barkett discusses:

  • Balance Sheet Advice for Today’s Banks
  • Impact of Regulatory Relief on Reciprocal Deposits

For more information about the reciprocal deposits provision in the Economic Growth, Regulatory Relief and Consumer Protection Act, please visit Promontory Interfinancial Network by clicking here.

Feeling the Flat Yield Curve Squeeze?


interest-rate-6-26-18.pngInvestors 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.

Four Drivers of Banking M&A in 2018


merger-5-28-18.pngAfter several years of false starts, 2018 may be the year that banking merger and acquisition (M&A) truly gets in gear. Financial stocks have rallied and stabilized and boosted the value of companies’ capital war chest.

Add to that new favorable policy developments easing regulatory constraints, interest rates steadily rising, the tax reform bill’s potential boost to bottom lines, loan growth projected to increase, and abundant capital is available to invest. Still, positive developments are sometimes accompanied by challenges. Deloitte’s 2018 banking and securities M&A outlook identifies four trends and drivers that are worth watching for their potential catalyzing or hindering effect on industry M&A activity.

1. Regulatory and legislative changes. Business-friendly legislation and regulatory policy changes may act as a flywheel to concurrently control and increase the M&A machine’s momentum in 2018. Of the potential regulatory changes, raising the statutory $50 billion asset thresholds for systemically important financial institutions, or SIFIs, designation and stress tests may have the most impact on M&A, especially within the ranks of $10 billion-$50 billion and $50 billion-$250 billion institutions. Higher thresholds could bring some regulatory relief around deal-making, opening the door to merger activity by small and midsized banks.

2. U.S. tax changes. Will the 2017 tax cuts be a boon for banking M&A? The outlook is encouraging, with some caveats. Banks and other financial services organizations may have more available capital but they also have numerous ways to use it: employee bonuses or raises, stock buybacks, pay down debt, increase dividends, invest in financial technology (fintech) and other operating improvements, or engage in cash-based M&A. And as of January 2018, sellers’ net operating losses (NOLs) became less attractive as an M&A trigger because, going forward, they will be applied at the new, lower 21 percent tax rate. On a positive note, while foreign banking organizations (FBOs) still face significant regulatory headwinds and some new burdens coming out of last year’s tax laws, tax reform may make U.S. banks on the margin more attractive to foreign-owned institutions looking to offset slow in-country growth and to expand their U.S. footprint where, historically, the tax rates made those investments less desirable from a post-tax earnings perspective.

3. Rising interest rates and higher valuations. Interest rates’ influence on 2018 banking M&A could be mixed: Rising rates may spawn competition in both lending and deposits, prompting an organization to rely more on organic growth and less on inorganic levers like acquisitions or alliances. Conversely, if an organization has loan origination or liquidity challenges, an acquisition could provide more stable access to deposits. Similarly, higher financial industry valuations may both grease and clog the gears of 2018 M&A.

Some banks—especially regionals and super-regionals—that have benefitted from the “Trump Bump” and have enhanced stock currency may engage in strategic deal-making to beef up their asset base, market presence, or fintech capabilities. However, those banks should remember that all valuations have gone up—while their acquisition currency may be higher so is the cost of what they want to buy. And, sellers may be hesitant in stock deals to accept perceived inflated currency. They may, as a result, seek higher deal multiples to protect their shareholders from any post-deal downside value risk.

4. The changing face of fintech. We expect that fintechs will continue to be a strategic investment area for financial services organizations of all types and sizes. Large and regional banks may look for technology assets to help improve their efficiency ratio, while smaller banks having difficulty growing their digital presence may acquire or partner with fintechs to fill critical gaps.

Regardless of their size, banks continue to struggle with diminishing brand value and reputation among certain customer segments including attracting and serving younger demographics in a manner they desire. Embracing the rapid adoption of cutting-edge financial technology, therefore, is not just a short-term means to boost revenues or eliminate cost inefficiencies; it’s a way for banks to repair and enhance their brand and value perception.

With banks likely to ride the wave of tax gains (outside of the impact on deferred tax asset values), increasing interest rates, higher valuations, and easing regulations during the first six months of 2018, they may see less need to push the inorganic lever of M&A to grow earnings. Still, with significant momentum in the system, the second half of the year could see some strategic and financial deal-making on par with or in excess of 2016. We expect larger banks to continue to acquire fintech capabilities and evaluate which businesses are core to their strategy and divesting those that no longer fit, smaller banks continuing to consolidate and private equity firms to continue to monetize remaining crisis-era investments.

Navigating Your Bank Through Rising Rates


interest-rates-4-2-18.pngBanks have been lamenting low interest rates for almost a decade. In boardrooms and on earnings calls, low rates have been blamed for shrinking margins, tepid deposit growth and intense loan competition.

With rates now up more than 100 basis points from their lows, we’re about to find out where that was true, and where interest rates were just a convenient scapegoat. Management teams and boards now face a few strategic questions. Among them: How is lending typically impacted by higher rates, and what strategies should my institution consider as rates continue to rise?

First, as the Federal Reserve’s Federal Open Market Committee puts upward pressure on overnight rates, there is typically a follow-on effect further out on the curve. But, these effects are rarely 1:1, resulting in a flattening yield curve. Bear flatteners, in which short-term interest rates increase more quickly than long-term rates, differ in severity, but if this one is anything like the period following the last Fed tightening cycle—from June 2004 through August 2006, as shown in the chart below—banks could be in for some pain.

Second, as rates start to quickly rise, nominal loan yields lag, resulting in declining credit spreads. It takes time for borrowers to adjust to the new reality, and competing banks can be expected to play a game of chicken, waiting to see which will blink first on higher loan rates and face a potential loss of market share.

Taken together, these two phenomena can put intense pressure on loan profitability. Banks are now enjoying an increase in net interest margins, but this comes on the back of rising yields on floating rate loans funded with deposits that have not yet become more expensive. Deposit costs will soon start moving, and once they do, they can move quickly.

This is a time when a rising tide no longer lifts all boats, and the banks that properly navigate the asset side of their balance sheet will start to separate themselves from everyone else. So, what does “proper navigation” look like? It’s not timing the market or outguessing the competition. Instead, winning during pivots in interest rates is all about adhering to a disciplined pricing process.

Trust the Yield Curve
The top performing banks let the yield curve guide pricing. We see evidence of this discipline in the mix between floating and fixed-rate structures. When rates were low, and the yield curve was steep, many banks were tempted to move out on the curve. They instituted arbitrary minimum starting rates on floating structures and saw their share of fixed-rate loans reach record highs. Now that rates are starting rise, these banks fear the exposure those fixed rates created, so they are desperately trying to correct the mix.

Disciplined banks ended up with the opposite scenario. With a steep curve, they found the lower floating-rate structures to be popular with borrowers. Now that the curve is flattening, borrowers are choosing more fixed-rate structures. These banks have large blocks of floating-rate loans that are now repricing higher, and that mix will naturally shift to fixed as rates move higher and the curve flattens, protecting them from dropping yields when the cycle eventually turns again. These banks let the yield curve help them manage their exposure, working in sync with borrower demand instead of against it.

Supercharge Cross-Sell Efforts
We also see top performing banks paying more attention than ever to their cross-selling efforts. In a rising rate environment, low cost deposits become much more valuable. Banks that already have deposit gathering built into their lending function are taking advantage, as their relationship managers can offer more aggressive loan pricing when the deals are accompanied by net new deposits. These banks have well-established processes for measuring the value of these deposits, tracking the delivery of promised new business and properly incentivizing their relationship managers to chase the right kind of new accounts.

When it comes to surviving—and thriving—in a rising rate environment, there is no magic bullet or secret shortcut. Instead, the answer lies in continuing to do what you should have been doing all along: Trusting the process you’ve built, staying disciplined and ignoring all the noise around you in the market.

And if you don’t have a process—a true north that you can use to guide your commercial bank’s pricing strategy—then get one right now. Rough seas may well lie ahead.

Does Your Bank Have a Deposit Strategy?


strategy-1-22-18.pngMany banks lack a clear, written deposit strategy and funding plan. For the last several years, that’s been somewhat understandable. After all, deposits flowed into banks and have now reached historic highs, even though banks on average pay little or nothing in interest on the vast majority of those deposits.

Now that’s changing. Deposits are an increasingly important topic for bank boards. We are on the front end of an environment bankers have not seen in almost a decade. The Federal Reserve raised the fed funds target rate by 75 basis points last year, and three more rate increases are expected this year.

Banks already are seeing deposit competition heat up. Close to 64 percent of bankers said that deposit competition had increased in the last year, and 77 percent expected it to increase during the subsequent 12 months, according to Promontory Interfinancial Network’s Bank Executive Business Outlook Survey in the third quarter of 2017. Although in the past banks have had to compete in rising rate environments, we’ve never seen a point in history quite like this one, and it would be wise to assume rising rates will impact deposits, as well as your bank’s funding mix and profit margins.

There are a couple of reasons why the environment has changed. Historically, big banks ignored the rate wars for deposits, a game that was left to community banks. But this time, the new liquidity coverage ratio requirement that came out of the Basel III accords could encourage big banks to get more competitive on deposit rates. The ratio, finalized in the U.S. in 2014, requires banks with more than $250 billion in assets to keep a ratio of 100 percent high-quality liquid assets, such as Treasury bonds, relative to potentially volatile funds. Banks that move toward more retail deposits will have a lower expected level of volatile funds.

Also, banks have a majority of their deposits in liquid accounts while term deposits, such as CDs, are at historic lows. There’s no hard-and-fast rule to know how much of those non-term deposits will leave your bank as rates rise.

As the economy has improved, surging loan growth has put more pressure on the need to grow deposits. Loan-to-deposit ratios are rising, and as banks need to fund further growth, demand for deposits will rise. What this will do to competition for deposits and, therefore, deposit rates, is unclear. We have found that many banks aren’t raising rates on their loans, and the best borrowers can easily shop around to get the best rates. This will put pressure on margins if banks don’t raise rates on loans as interest rates rise.

Still another factor is that people have had a decade since the financial crisis to get comfortable with the benefits of online and mobile banking. Online banks, not incurring costs associated with physical branches, often offer higher interest rates on deposits than traditional banks.

One of the best ways to prepare for the changing environment is to make sure your bank has a written, well-prepared deposit strategy. We’re not talking about a 100-page document. In fact, the asset/liability committee (ALCO) of the bank may need a five- to 10-page report highlighting the rate environment, the bank’s deposit strategy, and alternative funding plans and projections. The bank’s full board may just need a three- to four-page summary of the bank’s deposit strategy, making sure that management is able to address key questions:

  1. Who are your bank’s top 10 competitors, and what are they doing with rates? What new products are they offering?
  2. How will the Federal Reserve’s expected moves in the coming year impact our rates, our margins and our annual net income?
  3. What is our bank’s strategy for contacting our largest depositors and determining their needs?
  4. What new deposit products do we plan to offer, and how will we offer them only to our best customers? Not all customers or deposits have equal value to the bank.
  5. What is our funding plan? In other words, what are our alternatives if we need deposits to grow, and what will they cost? This is perhaps the most difficult question to answer.

While it’s important not to be caught off guard in a rising-rate environment, rising rates can be a good thing for a bank with a solid deposit strategy in place. For the first time in a long time, the wind will be in the sails of bankers. They just need a plan for navigating the changing environment ahead.

BOLI Market to Remain Steady in 2018


BOLI-12-6-17.pngAs 2017 comes to a close, bank-owned life insurance (BOLI) continues to be an attractive investment alternative for banks, based on the increasing percentage of banks holding BOLI assets and the high retention rate of existing BOLI plans. Through the first half of 2017, BOLI carriers reported receiving almost $1.4 billion in new BOLI premiums, according to the market research firm IBIS Associates. Assuming an annualized production level of $2.8 billion, this is only slightly behind the actual full-year new premium results of $3.2 billion received in 2016.

In 2016, 91 percent of new premiums were invested in general account products, and through mid-year 2017, the results were very similar, with 84 percent of new BOLI premiums going to that product type. Cash surrender value of BOLI policies held by banks stood at $164.5 billion as of June 30, 2017, reflecting a 3.5 percent increase from $159 billion as of June 30, 2016, according to the Equias Alliance/Michael White Bank-Owned Life Insurance (BOLI) Holdings Report™. Further, the percentage of banks holding BOLI assets increased in that time period, from 61.3 percent to 62.8 percent. With that in mind, what can we expect of the BOLI market in 2018, given today’s economic and legislative landscape?

Impact of the Economy on BOLI in 2018
Overall, the economy generated some very positive results in 2017. Unemployment declined to just over 4 percent, the stock market hit several new highs, and wage growth increased, albeit slightly. However, banks and other financial institutions continue to operate in a low interest rate environment with no significant market change expected in 2018, based on a November 2017 informal survey that Equias conducted of major BOLI carriers.

To understand the impact of continued low interest rates on BOLI carriers offering fixed-income products, it is important to understand the carriers’ investment philosophies and portfolio compositions. The investment objective of most carriers is to build a diversified portfolio of securities with a long-term orientation that optimizes yield within a defined set of risk parameters. The portfolio strategy often targets investment-grade securities. Corporate bonds are usually the largest holding in the portfolio, along with commercial mortgages and mortgage backed securities, private placements, government and municipal bonds, a small percentage of junk bonds, and other holdings. Some of the carriers in our informal survey stressed they will be allocating more of the portfolio to higher quality bonds in 2018 to guard against any potential downturn in the economy in 2019 or 2020.

Continued low market interest rates will somewhat affect the credited interest rates offered by carriers on both new BOLI sales as well as existing BOLI policies. Credited interest rates and net yields (defined as the credited interest rate less the cost of insurance charges) on new BOLI purchases are currently expected to remain stable in 2018. As a result, new BOLI purchases are, once again, expected to be in the $3 billion to $3.5 billion range in 2018. We also anticipate that approximately 80 to 90 percent of new premiums will be directed to general accounts with higher interest rates.

For existing general account and hybrid separate account BOLI policies, credited interest rates are likely to remain level or decrease slightly, unless market interest rates begin to rise at a faster clip than we have seen in recent years.

Impact of Federal Legislation on BOLI in 2018
One of the key proposals under the Tax Cuts and Jobs Act, passed recently by both houses of Congress, is to reduce the corporate tax rate from 35 to 20 percent. If this were to occur, the taxable equivalent yields on BOLI policies would be slightly lower. For instance, if the net yield on a new BOLI policy was 3.5 percent, then the taxable equivalent yield on that policy would be 5.38 percent at the current federal tax rate of 35 percent, due to the favorable tax treatment that life insurance policies receive.

With the lower federal corporate tax rate under the proposed legislation, the tax equivalent yield for a 3.5 percent net yield BOLI policy would be reduced to a still attractive 4.38 percent. If the corporate tax rate ends up at 25 percent, as some predict, the tax equivalent yield would be 4.67 percent.

Looking ahead to 2018, the continuation of low interest rates and a possible reduction in the corporate tax rate may have some minor impact on BOLI sales and existing BOLI policies, but neither should result in any material impact on the BOLI market.

Understanding the Attributes of Core Deposits


deposits-9-27-17.pngAs loan growth materializes, it is important to renew the focus on liquidity management, have an overall liquidity plan and a contingency funding plan. In order to create and implement such plans, it is important to understand the attributes of deposits. Even if a bank is not experiencing stronger loan growth, it is necessary to understand the elasticity of core deposits in order to make accurate modeling assumptions.

Anyone who experienced a higher interest rate environment remembers depository institutions having to compete with money market funds and other non-bank investment instruments that paid comparatively high rates. As the economy emerges from the bottom of a 10-year interest rate trough, depositors are starving for interest income. Institutions are finding that customers are willing to buy longer term CDs in exchange for yield. We simply do not know how long deposits will remain on books in a higher rate environment or how much we will have to pay to keep them.

The primary core deposit assumptions used for interest rate simulation models are beta and decay. Deposit beta is an indication of how rates correlate to the market. For example, if you use a beta of 0.25 on your savings rate, for every projected market rate move of 100 basis points, the savings account rate will move 25 basis points.

Decay is the measure of deposit attrition, or how long deposit accounts will likely remain open. If you decay a savings account over a 60-month period, you make the assumption that the savings account will have a 60-month maximum life. The normal range for decay is 24 months for sensitive deposits and 84 months for more static accounts.

Historically these numbers have been typically supplied by market averages, vendors, the Office of Thrift Supervision (which was merged with the Office of the Comptroller of the Currency in 2011) and management estimates. Various forms of deposit studies are gaining popularity but remain the least common means of obtaining core deposit assumptions. Meanwhile other modeling assumptions utilize prepayment rates, discount rates and spreads and are much more precise. The higher degree of precision for these non-deposit modeling assumptions helps reduce simulation risk. The irony here is that even though non–deposit assumptions are much more precise, they have a lesser impact on simulation results. This means that the greatest amount of simulation risk comes from assumptions with the least amount of basis!

In order to demonstrate the impact of these core deposit assumptions, we can take a typical Bank asset/liability management simulation and compare the results of the Economic Value of Equity (EVE shock/stress both with and without these beta and decay assumptions.) This serves as a stress test of the deposit assumptions. To stress the assumptions, we will simply set all betas to one and all maturities to one month. Then we can compare the results. To keep it simple, we will look at it graphically:

EVE-chart.png

Note how the EVE variance is between +7 percent and -14 percent when the betas and decays are utilized in the simulation. Once they are removed, this variance is between +10 percent and -30 percent, showing that it almost doubles in a rising rate scenario. In this case, removing the assumptions or making material changes to them can cause a financial institution to approach or exceed prudent risk limits. Additionally, this will also impact the net interest income shock as well, but a complete simulation will need to be performed to assess the impact.

The graph shows that core deposit assumptions are an important variable in the modelling results, especially if used as a management tool. As mentioned, this can be also used as a regulatory stress test. Stress tests are good but they do not serve the purpose of creating valid assumptions for management purposes. This can be accomplished by a core deposit study. A detailed core deposit study is a fairly involved and costly project but it will produce the most accurate assumptions. An abbreviated core deposit study can be used to understand the correlation of deposit line items to market rates and back into decay rates. There are a number of companies offering such services for institutions without in house expertise. It is worth exploring such options as the regulators are most likely to focus on core deposits as interest rates rise.

The Window of Opportunity to Sell Is Now


acquisition-5-22-17.pngDespite the recent pullback in bank stocks, valuations are still trading near a 10-year high (up 18.3 percent post-election). The drastic run up in both bank prices and trading multiples has had a direct impact on mergers and acquisitions (M&A) activity. The average price to tangible book value (P/TBV) for transactions is up 27 percent to 1.68 P/TBV since the presidential election. As multiples have expanded, buyers have a currency to pay higher values for targets in transactions. With bank valuations at a high level, both for publicly traded companies and their targets in an acquisition, management teams must evaluate two questions: Will the current optimism among bankers become reality? And, are we currently in a window of opportunity to sell?

To determine answers to these two questions we must first look into what is stoking investor optimism for bank stocks. There are three main drivers: rising interest rates and increased yields on loans, potential regulatory reform reducing associated noninterest expenses, and comprehensive tax reform reducing the overall tax burden on banks.

It would be overly optimistic to assume that all three of these factors would occur. Indeed, there are three main headwinds that should impede banks from increasing earnings to the most optimistic values: historical lessons, the current macroeconomic environment and government execution. These headwinds will not only have an impact on the trading of public bank stocks, but will have a direct impact on M&A pricing.

  1. Historical lessons from a rising rate environment: From 2004 to 2006, rates increased from 100 basis points to 525 basis points. The thought has been that a rising rate environment will allow banks to increase earnings through higher yields on loans. However, from 2004 to 2006, we saw the exact opposite. As rates increased, deposits migrated to higher yielding products, offsetting the benefit from the increased yield on loans, ultimately leading to a decrease in net interest margin. As banks felt the pinch, they began to expand their balance sheets by increasing loan to deposit ratios. The years to come proved challenging as nonperforming assets increased drastically.
    Interest-rate-chart.png
  2. Macroeconomic environment: Bull markets have historically lasted approximately seven years. We are more than eight years into the current bull-market run. How much longer can this bull-run last?
  3. Government execution: As the current trading multiples include regulatory and tax reforms that must be implemented by the government, we must ask ourselves if we can truly count on the government to deliver. Given the challenges the Republicans face passing healthcare reform, it is hard to believe that the Trump administration will be able to push through both comprehensive tax and regulatory reform without significant push back and concessions.

The headwinds facing the current optimism will have a direct impact on M&A pricing. If you are a potential seller and believe that the stars will align and all factors surrounding the current optimism will come to fruition, then enjoy the ride. If you are questioning any of these factors, it is likely that you have realized we are in a window of opportunity to sell.