Rates Are Lower for Longer: How Do I Find Yield for My Bank?

BOLI-11-2-16.pngAs U.S. Treasury bond yields worsen, the banking industry finds itself in a familiar position. Bank portfolio managers would like better yield, but regulations restrict banks from going down the credit stack or out the curve to reach for yield. Net interest margins are at all-time lows and regulations compel us to manage regulatory risk first—price, rate and repayment risks are now secondary. Banking as we know it has changed, and not necessarily for the better. But there is a silver lining.

In December 2015, the Federal Reserve raised the funds rate 25 basis points. Immediately, foreign purchasers starving for yield drove prices to new highs, resulting in yields that were lower than before the Fed increased the rate. In early 2016, several countries moved to negative rates. Should the Fed raise rates again soon, more foreign deposits will find Treasury bonds even more compelling again.

Long term, given that the U.S. national debt stands at $19.5 trillion, the U.S. Treasury can’t afford rates to be appreciably higher. The recession of 2007, the war on terror and expansion of social programs has greatly limited options. Most economists agree that the treasury debt market will remain in the lower-for-longer phase for quite some time. Ouch. So, what to do?

Lending is the first most obvious answer but regulations remain confounding. Many bankers feel as if they are only able to grow by stealing market share. Multiple banks chasing the same high quality loans exacerbate spread compression. Agency debt and mortgage-backed securities have yields basically stuck in the 1.70 percent to 1.75 percent range. Municipals remain relatively attractive, but the laborious process, small sizes, ongoing care and price sensitivity make them less compelling.

The judicious use of Bank Owned Life Insurance (BOLI) could be a winning answer. Hear me out—with crediting rates (yield) at nearly 4 percent the concept has merit. Most money center banks and many super regionals maintain BOLI holdings at maximum allowable percentages. Yields are compelling, counterparty risk is stable and price risk is minimal. Interestingly, large banks are more likely than small banks to use the maximum allowable BOLI. Community bankers sometimes forget this break is available to all banks regardless of asset size.

BOLI has a positive effect upon your efficiency ratio as it provides additional tax-free dollars for employee benefits. Since efficiency ratio equals expenses divided by revenue, every additional dollar of revenue results in an ever-larger denominator, hence the ratio shows an immediate positive impact. BOLI is purchased at par and is always held at par eliminating price risk. Given the current cheapness of the asset, BOLI can be surrendered within a year (net of taxes and penalties) and still provide a higher return than mortgage-backed securities.

BOLI can be viewed as outsourcing a portion of your portfolio. Choose a provider that only uses insurance carriers that are A+ rated or better and that employ seasoned, capable portfolio managers. In the event of an untimely loss of an insured employee, the insurance payments help the family and assist the institution to pay for costs related to replacement.

Recently, I met with the president of an $8 billion asset bank who commented, “I really thought I didn’t want to discuss my BOLI holdings. Then I realized it’s a $100 million asset on my books and I’d better get interested in how to optimize it!” We are currently completing a review of his policy holdings.

In the current market, the BOLI asset is extraordinarily cheap. It is a high yielding, low risk asset with a superb degree of price stability. Does it solve every answer? No. Will BOLI always be this cheap? No. But given recent advancements by insurance carriers and asset managers, it is a financial tool that really demands a hard look.

Will Higher Rates Help or Hurt Banks? The Answer Is “Yes.”

interest-rates-12-28-15.pngWill the long awaited hike in interest rates turn out to be good or bad for U.S. banks? The honest answer is probably yes to both possibilities, depending on the size of the bank in question and how the Federal Reserve manages monetary policy over the next couple of years.

In case you just got back from Mars, the Fed announced on December 16 that it was raising the interest rate on overnight borrowings between banks (known as the federal funds rate) by a quarter of a percentage point. The significance of the Fed’s action had less to do with the size of the increase than with the fact that this was the first time the central bank had raised rates in more than seven years. There was a lot of commentary after the rate hike about how this would impact the U.S. economy, although a strong case can be made that this was actually a vote of confidence in the economy’s long-term prospects. The job market has rebounded since the recession ended in June 2009 and unemployment was 5.5 percent in May, according to the Bureau of Labor Statistics. While the recovery is still a work in progress, Fed Chairman Janet Yellen expressed confidence in the economy’s future during a press conference after the rate increase was announced.

Although the Fed’s central mission is to fight inflation, deflation—which is a persistent decline in asset values and consumer prices—has actually been a much greater risk in recent years. Having cut the fed funds rate to nearly zero, and embarking upon a controversial strategy of massive bond purchases to pump money into the economy—known as quantitative easing—there was little more the Fed could do other than wait for the economy to heal itself, which it largely has. Yellen and the Federal Open Market Committee, the 12-member group at the Fed that actually sets monetary policy, has been waiting for an opportunity to begin pushing rates back up. Clearly the time was right.

How will this affect the nation’s banks? The impact of a quarter-point increase in the fed funds rate should be manageable, at least for now. Comptroller of the Currency Thomas Curry has expressed publicly his concern that some banks might be exposed to interest rate risk as the Fed tightens its monetary policy. Large banks, which tend to use variable rate pricing on their commercial and industrial loans, permitting lenders to reprice them if rates go up, will probably experience less economic impact than smaller banks. Many small banks don’t have the same flexibility to reprice their business loans. So as rates go up, smaller banks could actually see their net interest margins tighten even more as their deposit costs rise.

Still, the rate increase had been anticipated, predicted and over analyzed for so long that no bank should have been taken by surprise. Managing interest rate risk is an important task for management and the board, and the industry has been given ample time to prepare.

Ultimately, the impact of higher rates on the banking industry might be determined by how quickly the Fed tightens its policy. The Fed has said that it wants to continue raising rates gradually over the next few years—the exact term it used was to “normalize” rates but how gradually? Hike rates too quickly and some smaller banks could be stressed if they can’t reprice their loan portfolios fast enough to keep pace. But if banks are impacted disproportionately depending on whether they are asset or liability sensitive (being asset sensitive means your loans reprice faster than your deposits, while being liability sensitive means the reverse is true), one thing that would hurt everyone is a slow-down in the economy. Here, I would expect the Fed to be very careful. Having nursed the economy back to health, I think the last thing it wants to do is tip the economy back into a recession by acting too aggressively.

At the very least, banks should know what to expect, and the Fed—which has been very transparent under Yellen—will no doubt let them know when to expect it.

Janet Yellen Will Mean Low Interest Rates, Stability in Fed Policy

Janet Yellen may be the first woman nominated to head the Federal Reserve. But her candidacy is hardly a game-changer in other ways. With Yellen at the helm, the Fed is expected to continue its policies of quantitative easing, meaning interest rates could stay low for some time to come. Yellen is thought to be heavily concerned with keeping unemployment low. Our panel of bank attorneys weighs in on what to expect out of the Federal Reserve under Yellen’s leadership.

Do you think Janet Yellen will be good for banking?

Blanchard-Gerald.jpgJanet Yellen has been involved in one way or another with the Fed since 1994. She brings a wealth of knowledge about the interworkings between the Fed, the banking sector and the economy. She played a large role in the development of Fed response to the financial meltdown and the post-Dodd Frank rules. I would not anticipate any major mid-course changes by the Fed with her at the helm which means that the Fed will continue to focus on bringing the unemployment rate down as opposed to being fixated on the inflation rate. She will continue the focus on banks having sufficient capital to withstand the shocks of an economic downturn. At the end of the day the answer to our current doldrums is getting the economy moving to the point where the unemployment rate has dropped to the point that people feel comfortable spending and borrowing again. All boats, including the banking sector, will rise when we get to that point and she understands that.

—Gerald Blanchard, Bryan Cave LLP

fisher_keith.png“Steady as she goes” is likely to be Janet Yellen’s approach as Fed chair[man]. She will continue the push for greater transparency, reducing credit risk and the risk of runs on financial firms. Like Bernanke, she is a former academic with excellent credentials, and, based on her speeches, she hopes that keeping short-term rates low will spillover to long-term rates, raise asset values, and stimulate demand. Good for banking? Yes. But then there’s our financial mess: out-of-control tax and spending policies, elected officials who don’t understand balance, balance sheets, or balancing a checkbook, and our inability to afford even the interest on our national debt. The Fed is printing money, buying $85 billion in Treasuries and mortgage-backed bonds every month, and keeping interest rates low to stimulate our economy. The time to pay the piper is coming. Yellen’s challenge: Can she steer monetary policy back towards normalcy without precipitating another crisis? This is an unenviable task.

—Keith R. Fisher, Ballard Spahr LLP

Mark-Nuccio.jpgShattering another glass ceiling, when she becomes the first woman to chair the Federal Reserve Board, Janet Yellen, many hope, will become the economic recovery’s Rosie the Financial Riveter. Her nomination by President Obama was greeted with industry support (and relief, considering some of the alternatives). She is a pragmatic and steady economist, highly experienced in statecraft and focused on the importance of job creation. Yellen is expected to continue the easy money policies of her predecessor until unemployment rates normalize and the recession is in the rearview mirror. Her stewardship over monetary policy and bank regulation will provide the industry with a stable post-Bernanke environment and the time to gain further strength while girding against the challenges of Basel III and the implementation of the Dodd Frank Act.

—Mark V. Nuccio, Ropes & Gray LLP

Peter-Weinstock.jpgThe nomination of Janet Yellen to chair the Federal Reserve Board is a triumph for economics over politics. The wide perception was that [the other candidate] Larry Summers was too driven by political winds, and therefore, was less likely to adhere to a consistent philosophy. In the short term, however, Yellen’s adherence to qualitative easing is likely to mean that the Fed will be slow to wean itself from asset purchases with the result that market interest rates will remain slack. Consequently, banks can be expected to continue to suffer deteriorating net interest margins. Moreover, Daniel Tarullo is expected to continue his primacy over banking regulation and supervision. Thus, for bankers, the change at the top of the Fed might feel like Groundhog Day.

—Peter Weinstock, Hunton & Williams LLP

Geiringer-John.pngShe certainly has the requisite experience to be the next chair[man] of the Federal Reserve Board, and her role as president of the San Francisco Fed during the height of the economic crisis undoubtedly gave her extensive experience in the nuances of banking supervision. Many of our clients are hoping that she continues the Federal Reserve’s heightened sensitivity to the impact of overregulation on our nation’s community banking organizations. The establishment of the Fed’s Community Depository Institutions Advisory Council and its recent Community Banking Research Conference are positive steps in that direction. A continuing client concern, however, is the extent to which the Fed will give banking organizations the flexibility to navigate out of the difficult financial positions in which many find themselves, through rightsizing enforcement actions and otherwise allowing these organizations to develop creative capital raising options to improve their condition.

—John M. Geiringer, Barack Ferrazzano Financial Institutions Group

Desperately Seeking Loan Growth

2-22-13_ARS.pngWith no sign of relief anticipated from the Federal Reserve, low interest rates—and their effects on net interest margins—were top of mind for the audience at Bank Director’s 19th annual Acquire or Be Acquired conference in Scottsdale, Arizona, recently. During the audience response survey, conducted by Grant Thornton LLP and Bank Director at the end of the January, 35 percent of the 273 bank executives and directors who answered the survey said continued net interest margin compression was their top concern, while 25 percent cited loan demand. 

According to Jack Barrett, president and CEO of $216-million asset First Citrus Bank, headquartered in Tampa, Florida, concerns with the net interest margin and loan demand are connected. “Because of the dearth of organic loan demand, that engenders the margin compression,” says Barrett.  John Paisley, region president with Adams Bank & Trust, a $550 million commercial bank based in Ogallala, Nebraska, says that while the bank is seeing strong loan demand due to a strong agricultural economy and increased real estate pricing, the bank must offer below market rates to compete, forcing his bank to “learn how to operate with less margin.” 

What will loan demand look like in 2013? Fifty-seven percent of respondents expect to see an increase in loan demand in 2013, with 10 percent expecting to see a decline and one-third expecting no change. David H. Dunn, president and CEO of Wolverine Bancorp, Inc., a $284-million, publicly-traded bank holding company headquartered in Midland, Michigan, plans to fuel growth via organic loan origination, but also sees a challenge. “Everybody is looking for organic growth, and they’re doing it in an economy that’s not growing,” he says. Nichole Jordan, national banking and securities industry leader at Grant Thornton, agrees. “Growth will be hard to come by in 2013 without significant strides made in overall economic recovery,” says Jordan.  Barrett sees a market that is “erratic”, but expects to see more loan demand in 2013. “I think it’s going to be more stable in terms of loan demand. I think there’s more certainty,” he says. 

Bankers plan to address the challenges presented by loan demand in a variety of ways. Jeff Brotherson, chief financial officer of Two Rivers Financial Group, a $679-million bank holding company based in Burlington, Iowa, says that his bank focuses on hiring experienced loan producers. Data can help banks grow loans as well. Barrett supports using data analytics to better understand the market. Jordan agrees, adding that by investing in technology that allows for effective analysis and use of data, bank management teams can better monitor customer trends and be more proactive.  

While 60 percent of bankers surveyed chose loan origination as their top plan for growth, 28 percent plan a traditional merger. Not everyone who wants to buy a bank will. In fact, 83 percent of bankers surveyed at the conference want to buy a bank in 2013, although the conference itself tends to attract people interested in acquisitions. For smaller banks looking to grow quickly, this could be a wise choice. Adams Bank & Trust plans to eventually double in size, likely via acquisition. “Through organic growth, I just don’t think we’re going to get there fast enough,” says Paisley. 

Barrett is actively seeking a merger of equals in order to achieve some economies of scale, but the deal has to be right, in part due to capital concerns. ”In order to garner regulatory approval, you have to overcapitalize the transaction so high that our existing ROE [return on equity] would go down,” he says.  “We are not about reducing our returns [to] shareholders.” Many of those surveyed don’t plan to raise capital, with 66 percent giving a flat “no” to raising capital over the next year, compared to 25 percent that plan to raise capital, and 9 percent that would like to raise capital, but aren’t certain of their ability to do so. Even with Basel III looming, Brotherson does not foresee a need to raise capital at his bank, and confirms that his bank is prepared for the proposed Basel III rules that increase minimum capital ratios and make other changes to regulatory capital. Dunn characterizes his bank as extremely well-capitalized. So are banks ready—or at least preparing—for Basel III?

Perhaps banks are as prepared as they can be. Only 18 percent of bankers surveyed expressed a feeling of certainty about the political landscape, with 71 percent deeply concerned about the future of their bank and their customers. Barrett feels that the regulatory burden is unfairly placed in the laps of community banks. But as banks seek to grow, Paisley says, the regulatory burden grows right along with it. 

The survey was conducted on January 28, 2013, at Bank Director’s annual Acquire or Be Acquired conference, using an electronic survey of the audience. The 273 participants are mostly CEOs or directors of banks across the United States.

Download the full survey results in PDF format.

Losing Good Loans to Larger Banks? Try an Interest Rate Swap

Many community banks are reluctant to consider interest rate swaps due to perceived complexity as well as accounting and regulatory burdens. But, in a record low interest rate environment, the most desirable customers almost universally demand something that is hard for community banks to deliver:  a long-term, fixed interest rate. Large banks are eager to accommodate this demand and usually do so by offering such a borrower an interest rate swap that, together with the loan facility, delivers the borrower a net long-term, fixed rate obligation and the lending bank a loan with an effective variable rate.  

The alternatives to using swaps are not appealing. A community bank can limit its product offerings to only variable rate loans or short-term, fixed rate loans and thereby lose many good customers to larger competitors. The bank can offer a long-term fixed rate on the loan and then (a) sell the loan and lose ongoing earnings and the customer relationship, or (b) borrow long-term funds from the Federal Home Loan Bank to match that asset with appropriate liabilities, a choice that significantly erodes profit on the loan and uses up precious wholesale liquidity.

If a community bank wants to compete using interest rate swaps, then there are three general methods for packaging an interest rate swap with a typical loan offered by a community bank. There are several regulations that apply to swaps, including changes to the Commodities Exchange Act enacted by the Dodd-Frank Act and the numerous related rules and regulations promulgated by the U.S. Commodity Futures Trading Commission (the CFTC).  If the community bank is under $10 billion in assets, then all three swap methods described below should qualify for an exemption from regulatory requirements that interest rate swaps be cleared through a derivatives exchange. Avoiding clearing requirements saves considerable costs and operational effort.

The first is a one-way swap in which a community bank simply makes a long term, fixed-rate loan to its borrower and then executes an interest rate swap with a swap dealer (such as a broker-dealer affiliate of a larger commercial bank) to hedge against rising interest rates. In a one-way swap, the community bank is subject to fair value hedge accounting, which requires the bank to mark the swap to market on its balance sheet and run changes in fair value through its income statement.

The second is a two-way swap, otherwise known as a back-to-back swap, in which the community bank makes a variable rate loan to its borrower and enters into an interest rate swap with the borrower that, together with the loan facility, delivers the borrower an effective fixed-rate obligation and the lending bank a loan with an effective variable rate. The bank then enters into an offsetting swap with a swap dealer. Even though the terms of the two swaps in a two-way swap may be identical economically, the two swaps can present quite different credit risks to the community bank and the bank may still have to, under accounting rules, track a significant variance between the two swaps.    

Both one-way and two-way swaps have some other disadvantages. Under the CFTC’s proposed margin (collateral) regulations , financial end-users of swaps such as community banks likely will have to post initial and variation collateral to secure obligations under swaps. In one-way and two-way swaps, the borrower and the community bank must maintain records that are complete, systematic, retrievable and include, among other things, all records demonstrating the bank qualified for an exception from swap clearing requirements. Also, in a two-way swap, the community bank must ensure that the swap is economically appropriate to reduce the borrower’s interest rate risk and fulfill the bank’s reporting obligations to swap clearing organizations.  

The third method is an outsourced swap product designed for community banks.  Under this model, the community bank makes a variable rate loan and the borrower signs a simplified swap-type agreement with the swap provider, which results in the bank receiving its preferred variable rate and the borrower paying a net fixed rate. This third method generally does not carry the disadvantages of the first two methods if the provider has properly designed the product.

Once your bank has decided which method or methods it wishes to use with interest rate swaps, the bank must supplement its policies and procedures (at least its interest rate risk, asset/liability and accounting policies) and train its board, management and applicable staff in several key areas. All of this requires careful study and execution, but it can be done.

Bank Earnings Trends

The Federal Reserve’s actions in response to the U.S. economy’s sluggish growth and high unemployment rate have virtually ensured depressed bank earnings for the foreseeable future.

The Federal Open Market Committee (FOMC) recently proclaimed that it will “keep the target range for the federal funds rate at zero to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” In addition to keeping interest rates “exceptionally low,” the Fed is embarking on another round of quantitative easing (QE3)—this time with no end date in sight. Indeed, the spigot is now open.


The obvious impact to bank earnings of Fed Chairman Ben Bernanke’s monetary policies is that net interest margins will continue to contract as we have seen virtually every quarter since 2010. Deposit costs are as low as possible, and loan yields will continue to decline as higher rate loans are replaced with lower yielding assets. Interestingly, as the chart [below] depicts, banks with assets less than $1 billion have been able to sustain higher net interest margins than their larger brethren, who have brought down the industry’s margins in lock-step. Banks less than $1 billion maintain a net interest margin of 3.75 percent, while those greater than $1 billion average a net interest margin of 3.42 percent through Q2 2012.  Nevertheless, the majority of banks of all sizes are seeing NIM contraction.


When margins contract, banks are forced to pull other levers in order to maintain consistent net income streams:

  • As asset quality has improved across the industry, banks have been able to release reserves back into income, although at some point this strategy will end as banks are unable to continue depleting their reserves.
  • Declining interest rates have meant increases in the value of securities portfolios for many banks which, in turn, increased income from realized gains on sale; however, securities yields will continue to decline during the low interest rate environment and future gains on sales will decline.
  • Noninterest income is notoriously difficult to generate—especially for community banks—and lawmakers have cracked down on fees such as overdraft, rendering this strategy more or less futile.
  • Banks can streamline operations and become more efficient, although at some point this strategy faces diminishing returns.


All the strategies above can help maintain earnings for the short term, but eventually they will leave bankers grasping at air without any more levers to pull. Absent an increase in net interest margins, returns on assets will continue to decline; this is inevitable. At that point, banks will face a choice: increase credit risk and loan volume to generate yield, increase interest rate risk by stretching for yield, or accept diminished returns. Certainly, one unintended consequence of Chairman Bernanke’s policies is that banks will begin to take on more credit and interest rate risk, threatening the industry’s renewed strength once again.

However, another strategy exists to increase shareholder value: exploring an acquisition or merger is one of the only ways to increase returns in today’s environment. Both buyers and sellers can benefit greatly from this strategy if the right deal is struck. A buyer can increase its net interest income by combining with a partner that has higher yielding assets or a lower cost of funds. Furthermore, cost savings can result in a more efficient operation. Likewise, sellers tired of fighting for returns—particularly those small, community banks—can achieve a liquidity event and cash out or ride the buyer’s stock, resulting in returns that could take years to achieve on a standalone basis.

Banks can expect at least another three years of difficult returns. Thankfully, the industry’s balance sheets are healthier, and it is likely industry consolidation will pick up precipitously as a consequence.

The Mixed Blessing of Bank Deposits

mixed-blessing.jpgThe U.S. banking industry is drowning in deposits and that’s not necessarily a good thing. As of June 30, deposits in U.S. banks (but excluding credit unions) totaled $8.9 trillion, up nearly 8.5 percent from June 30, 2011, according to the Federal Deposit Insurance Corp. Total bank deposits have actually increased every year since 2003, although the increase from 2011 to 2012 was the sharpest jump over that time.

There’s no great mystery why this is happening. The U.S. economy’s uncertain outlook and a volatile stock market has led many consumers and businesses to park their investment funds in insured deposit accounts rather than risk losing a big chunk in another market meltdown. Normally banks would be quite happy to have a surfeit of low-cost deposit funding, but it’s actually something of a mixed blessing nowadays. Slack loan demand and low rates of return on investment securities like U.S. Treasuries, the latter a direct result of the Federal Reserve’s easy money policy in recent years that has kept interest rates low, are making it very difficult for banks to earn a decent return on all those deposits.

What makes this multi-year increase in deposits so interesting is that it has occurred at the same time banks have been closing branches and pruning their networks. As of June 30, according to the FDIC, there were 97,337 bank branches nationwide, down from a high of 99,550 in 2009, and there has been a consistent year-over-year decline since then. There’s no mystery why this is happening either. Two seminal events since 2010—new restrictions on overdraft charges and a cap on debit card fees—have taken a big bite out of the profitability of most retail banking operations and banks have responded by cutting costs, partly through layoffs but more so through branch closings. That deposit levels have continued to rise, even as the number of branches has declined, has no doubt made it easier for banks to trim their brick-and-mortar networks.

But here’s the rub. What happens if in a few years the U.S. economy makes a strong comeback and retail investors are once again confident enough to put their money into the stock market? Banks don’t have to compete with the stock market now for consumer funds, but they would in that scenario. Most banks have developed multi-channel distribution systems with the traditional branch as the hub and alternatives like automated teller machines, in-store branches, the Internet and more recently the mobile phone as spokes. And while remote channels like online and mobile have steadily grown in popularity in recent years, how effective will they be as deposit gathering tools if banks must once again compete for funds?

Here’s my best guess at what the future holds: Don’t be surprised if, say, five years from now the trend has reversed itself and banks are once again opening new branches.  It might be like a relic of days gone by, but a deposit war between Main Street and Wall Street would be just the thing to give the hoary old bank branch a new lease on life.