Why Some Savers Don’t Pay Down Debt

In an era of rising interest rates, it would make good financial sense for consumers to pay off costly credit card debt before stashing money in a low-interest savings account. But a new paper from the Federal Reserve Bank of Boston finds many consumers acting irrationally. These so-called “borrower-savers,” as Fed economists term them, carry revolving credit card debt while simultaneously holding liquid assets in their bank accounts. Understanding their motivations for doing so could help bankers identify new opportunities to connect with their customers. 

Based on 2019 survey data, Boston Fed economists identify 42% of respondents as borrower-savers, meaning they carry $100 or more in revolving credit card debt while also holding at least $100 in liquid assets, defined as cash, money in checking and savings accounts, or prepaid cards. 

Just 40% of these consumers have liquid assets that exceed their credit card debt. The average borrower-saver carries around $5,400 in liquid assets and nearly $6,400 in revolving credit card debt, according to the researchers. On the whole, borrower-savers are financially worse off than savers, who pay down revolving credit card debt every month. 

“On the surface it would seem like there is a paradox here. You get paid a fraction of a percent on your deposits in the bank … That’s nothing compared to the interest rate that credit cards charge,” says Joanna Stavins, a senior economist and policy advisor with the Boston Fed. “If you have money in the bank, why not pay down that credit card debt?” 

But scratch the surface, and that behavior actually starts to make a lot more sense: Researchers also find that over 80% of consumers’ monthly bills need to be paid out of a bank account and can’t be charged to a credit card. 

Still, that imbalance between savings and paying down pricier debt is one of those quirks of human behavior that has myriad implications for banks. For those banks not in the credit card business, it could mean an opportunity to sell their customers on cheaper consolidation loans. It could also represent an opportunity to build goodwill with customers by offering assistance with managing bills or automating savings. 

Ron Shevlin, managing director and chief research officer with Cornerstone Advisors, notes that younger generations could be likelier to use technology to get a handle on their finances. “I think that resonates especially with a lot of younger consumers who have had it drilled into them that they have to be better at managing their finances,” Shevlin says. “You get somebody who’s 25; those habits have not been ingrained yet. And so the technology, the tools, and I think more importantly, the philosophies and approaches to managing their finances have not been solidified yet.”  

For most banks, offering the right solutions will have them working with their digital banking provider or another third party. Fintechs such as Plinquit work with community banks to help their customers set savings goals and earn rewards for achieving them, according to Bank Director’s FinXTech Connect platform. 

The Boston Fed’s paper doesn’t delve into the effect of higher incomes on saving and borrowing behaviors. Or in other words, the researchers could not say that higher income enables consumers to start saving more and avoid carrying a credit card balance in the first place. Yet, savers tend to have higher incomes, averaging about $98,000 per year compared to less than $76,000 for borrower-savers. On average, savers hold about five times more liquid assets compared to borrower-savers, as well as higher credit limits and lower mortgages due to more equity in their homes. And just a third of borrower-savers could cover a $2,000 emergency expense using liquid assets, compared to two-thirds of savers.

The proportion of borrower-savers fell from 42% to 35% in 2020, note the Boston Fed researchers, likely due to pandemic-related federal assistance programs as well as increased saving by people who kept their jobs but cut back on spending. 

With the employment picture still relatively strong, borrower-savers are generally in decent shape at the moment. But Stavins notes that many of the borrower-savers studied in the paper also have other kinds of debt; she worries how the picture could change if economic conditions further deteriorate. 

The imbalance between savings and spending could worsen. “What I’m worried about,” she says, “is that people are going to start relying on credit card debt more as the economy gets potentially worse.”  

Liquidity Observations for Banks as 2022 Closes

Investors must recognize that banks should generate and expand their revenues through the credit cycle, which covers and includes whatever problems and losses that may occur.

The increase in spread revenue and expansion of net interest margin was a significant theme from earnings reported after June 30, and will be for the rest of 2022. Yes, some deposit outflow has started; it seems natural for liquidity to decline from record levels reached throughout the earliest wave of the coronavirus pandemic. Recall: deposits increased more than 40% at all banks regulated by the Federal Deposit Insurance Corp. between December 2019 to March 2022.

At Janney, we’re focused on measuring how banks can tap funding sources beyond traditional deposit gathering. One important measure of a bank’s ability to borrow are “pledged” securities, which are pledged as collateral to another entity, such as the Federal Reserve or Federal Home Loan Banks. These securities are well below pre-pandemic levels, and slightly above their totals in the first quarter of 2022. By region, banks in the Mid-Atlantic have the highest percentage of securities already pledged; as a group, banks over $50 billion in assets had the lowest percentage of pledged securities. We also performed a distribution analysis that showed most banks have between 0% and 50% of securities pledged.

Banks of all asset sizes rely on the Federal Home Loan Bank system for contingent liquidity via credit lines and borrowings called “advances,” which effectively serve as wholesale funding and are an alternative to brokered deposits. To borrow from the FHLB, banks must post collateral in the form of certain types of securities, such as Treasurys, agency-backed securities and certain private label and municipal securities, or loans, generally first-lien mortgages, home equity lines of credit, certain commercial real estate loans and some farm loans. The banks are then subjected to internal risk-ratings that determine an ultimate borrowing capacity amount. The risk-ratings and limits differ among the 11 individual FHLBs, but we know from FHLB guidance that most banks are subjected to a 25% maximum borrowing limit.

Our analysis used FDIC call report data to pull all the individual security and loan categories eligible as collateral. We then applied the FHLBs’ haircuts to the collateral values in these various categories to determine total potential collateral. Finally, we subtracted already pledged securities and existing FHLB borrowings, which banks disclose in their call reports, to the typical maximum 25% borrowing limit to determine the remaining availability.

The bottom line? Median net FHLB borrowing capacity has incrementally declined in the second quarter of 2022 by a miniscule 0.2%, and still stands at a strong 23% — only 2 percentage points below the 25% maximum and 2 percentage points above pre-pandemic levels of 20.9% in the fourth quarter of 2019. Regionally, banks in West tended to have the highest capacity, while their neighbors in the Southwest had the lowest; by asset size, banks below $1 billion in assets tended to have the most capacity and the largest banks had the lowest remaining capacity, primarily due to existing borrowings. Finally, another distribution analysis shows most banks currently have full capacity at 25%.

We combined the two concepts of pledged securities and estimated FHLB borrowing capacity to reinforce that numerous banks still enjoy high borrowing capacity, with low levels of pledged securities. We are confident that financial institutions nationwide have superb “dry powder” to fund near-term growth opportunities for new loans and franchise expansion.

We also observed that brokered funding is quite low. The average use of brokered CDs to total deposits has dropped over the past decade, to currently about 4% to 5% of total deposits. This is another available tool for banks today to fund balance sheet growth, as interest rates and underlying spread revenues are much improved. Investors should keep in mind that brokered deposits are less expensive than FHLB funding currently. In fact, about 67% of banks reported no brokered funds at the end of June. If deposits decline as banks deploy excess liquidity, brokered deposits could be a key incremental tool to generating higher revenues that allow financial institutions to “earn through the credit cycle” — a critical concept all investors should be able to grasp. Fortunately for banks, plenty of liquidity capacity exists. The critical question is, “How will banks access and deploy their available liquidity?”

Banks Inherited a Wholesale Balance Sheet During the Pandemic. Here’s What to Do.

Bank managements and directors must recognize how cash has changed significantly over the past seven quarters, from the fourth quarter of 2019 to the third quarter of 2021. The median cash-to-earning assets for all publicly traded banks has grown to 10% in recent quarters, up from 4% pre-pandemic. This is a direct impact of the Covid-19 pandemic on deposit flows from government stimulus and the reluctance to deploy cash in a time of historically low interest rates.

The result is a healthy “wholesale” balance sheet that is separate and distinct from banks’ normal operations. This must be factored into growth plans for 2022 and 2023. We think it may take several quarters to properly deploy the excess liquidity. Investors already demand faster loan growth and their tolerance towards low purchases of securities may wane. The pressure to take action on cash is real, and it should be seen as an opportunity and certainly not a curse. We see excess cash as a high-class problem that can be met with a successful response at all banks.

We expect financial institutions will become far more open about their two balance sheet positions in the near future. First, let’s talk about the “normal” operation with stated goals and objectives on growth (e.g. loans, earnings per share and returns on tangible equity). Next, segment the “wholesale” balance sheet, which contains the cash position and any extra liquidity in short-term securities. Using our industry data above (10% cash in earning assets, up from 4% pre-pandemic), a $3 billion community bank has $300 million in cash instead of the usual $120 million it carried two years earlier — this establishes a $180 million wholesale position. Company management should directly communicate how this separate liquidity will be used to enhance earnings and returns in future quarters. Likewise, boards should stay engaged on how this cash gets utilized within their risk tolerance.

Late in the fourth quarter of 2021, certain company acquisitions disclosed the use of excess cash as a key rationale of the deal. An example is Ameris Bancorp, whose executive team stated in its December 2021 purchase of Balboa Capital that the transaction was funded by excess cash. Back in May 2021, Regions Financial (which is neutral-rated by Janney) acquired EnerBank with a home improvement finance strategy that would deploy its liquidity into new loans. Regions has since completed additional M&A deals with the same explanation. Many more small M&A transactions seem likely in 2022 using cash deployment as an underlying theme.

It has been my experience for three decades as an equity analyst that banks miss chances to explain their strategy in a succinct yet powerful manner. Remaining shy under the pretense of conservatism does not generally reward a higher stock valuation. Instead, banks who are direct and loud about their strategy (and then execute) tend to be rewarded with a stronger stock price. Hence, it is a far better idea to express a game plan for cash and a bank’s distinct “wholesale” balance sheet.

The current cash positions (which produced little to no earnings return in prior quarters) are now a superb opportunity to make a difference with investors. We encourage banks to be direct on how they will utilize excess cash and liquidity separate from their existing operations. The Janney Research team estimates banks can generate nearly a 10% boost to EPS by 2023 from managing excess cash alone. This is separate from any benefit from higher interest rates and Federal Reserve policy shifts that may occur.

Outlining a cash strategy in 2022 and 2023 is a critical way to differentiate the bank’s story with investors. Bank executives and directors must take advantage of this opportunity with a direct game plan and communicate it accordingly.

Banks Face a New Regulatory Environment: From Overdrafts to Fair Lending

Regulatory risk for banks is evolving as they emerge from the darkest days of the pandemic and the economy normalizes.

Banks must stay on top of regulatory updates and potential risks, even as they contend with a challenging operating environment of low loan growth and high liquidity. President Joseph Biden continues to make progress in filling in regulatory and agency heads, and financial regulators have begun unveiling their priorities and thoughts in releases and speeches.

Presenters during the first day of Bank Director’s Audit & Risk Committees Conference, held on Oct. 25 to 27 in Chicago, provided insights on crucial regulatory priorities that bank directors and executives must keep in mind. Below are three of the most pressing and controversial issues they discussed at the event.

IRS Reporting Requirement
While politicos in Washington are watching the negotiations around Biden’s proposed budget, bank trade groups have been sounding the alarm around one way to pay for some of it.

The proposal would require financial institutions to report how much money was deposited and withdrawn from a customer’s bank account over the course of the year to the IRS in order to help the agency identify individuals evading taxes or underreporting their income. Initially, the budget proposal would require reporting on total inflows and outflows greater than $600; in subsequent iterations, it was later pushed to $10,000 and would exclude wage income and payments to federal program beneficiaries. It has the support of the U.S. Department of the Treasury but has yet to make its way into any bills.

Like all aspects of the spending bill, the budget proposal is in flux and up for negotiation, said Charles Yi, a partner at the law firm Arnold & Porter, who spoke via video. Already, trade groups have mounted a defense against the proposal, urging Biden to drop it from considerations. And a critical senator needed for passage of a bill, Sen. Joe Manchin (D-W.V.), came out against the proposal; his lack of support may mean Congressional Democrats would be more apt to drop it.

But if adopted, the informational reporting requirement would impact all banks. Banks would have to report a much greater volume of data and contend with potential data security concerns.

“Essentially, you’re turning on a data feed from your bank to the government for these funds and flows,” said Arnold & Porter Partner Michael Mancusi, who also spoke via video.

Overdrafts Under Pressure
Consumer advocates have long criticized overdraft fees, and regulators have brought enforcement actions against banks connected to the marketing or charging of these fees. Most recently, the Consumer Financial Protection Bureau settled with TD Bank, the domestic unit of Canada-based Toronto-Dominion Bank, for $122 million over illegal overdrafts in 2020. And in May, Bank of America’s bank unit settled a class lawsuit brought by customers that had accused it of charging multiple insufficient fund fees on a single transaction for $75 million.

Pressure to lower or eliminate these fees and other account fees is coming not just from regulators but from big banks, as well as fintech and neobank competitors, said David Konrad, managing director and an equity analyst at the investment bank Keefe, Bruyette & Woods. Banks have rolled out features like early direct deposit that can help consumers avoid overdrafts or have started overdraft-free accounts. These institutions have been able to move away from overdraft fees because of technology investments in the retail channel and mobile apps that give consumers greater control.

But insufficient funds fees may be a significant contributor of noninterest income at community banks without diverse business lines, and they may be reticent to give it up. Those banks may still want to consider ways they can make it easier for consumers to avoid the fee — or choose when to incur it — through modifications of their app.

Fair Lending Scrutiny Continues
Many regulatory priorities reflect the administration in the White House and their agency picks. But Rob Azarow, head of the financial services transactions practice at Arnold & Porter, said that regulators have heightened interest in fair lending laws — and some have committed to using powerful tools to impact banks.

Regulators and government agencies, including the Consumer Financial Protection Bureau and the U.S. Department of Housing and Urban Development, have stated that they will restore disparate impact analysis in their considerations when bringing potential enforcement actions. Disparate impact analysis is a legal approach by which institutions engaged in lending can be held liable for practices that have an adverse impact on members of a particular racial, religious or other statutorily protected class, regardless of intent.

Azarow says this approach to ascertain whether a company’s actions are discriminatory wasn’t established in regulation, but instead crafted and adopted by regulators. The result for banks is “regulation by enforcement action,” he said.

Directors should be responsive to this shift in enforcement and encourage their banks to conduct their own analysis before an examiner does. Azarow recommends directors ask their management teams to analyze their deposit and lending footprints, especially in zip codes where ethnic or racial minorities make up a majority of residents. These questions include:

  • What assessments of our banking activities are we doing?
  • How do we evaluate ourselves?
  • How are we reaching out and serving minority and low-to-moderate income communities?
  • What are our peers doing?
  • What is the impact of our branch strategy on these communities?

The Coming Buyback Frenzy

Capital planning is examined as part of Bank Director’s Inspired By Acquire or Be Acquired. Click here to access the content on BankDirector.com.

The banking industry hasn’t been this well capitalized in a long time. In fact, you have to go back to the 1940s — almost 80 years ago — before you find a time in history when the tangible common equity ratio was this high, says Tom Michaud, president and CEO of investment bank Keefe, Bruyette & Woods, during a presentation for Bank Director’s Inspired By Acquire or Be Acquired platform.

That ratio for FDIC-insured banks has nearly doubled since 2008, he says, reaching 8.5% as of Sept. 30, 2020, says Michaud.

A big part of the industry’s high levels of capital goes back to the passage of the Dodd-Frank Act in 2010, the Congressional response to the financial crisis of 2008-09. Because of that law, banks must maintain new regulatory capital and liquidity ratios that vary based on their size and complexity.

During the pandemic, banks were in much better shape. You can see the impact by looking at the capital ratios of just a handful of big banks. Citigroup, for example, had a tangible common equity ratio in the third quarter of 2020 that was nearly four times what it was in 2008, Michaud says.

With a deluge of government aid and loans such as the Paycheck Protection Program, the industry’s losses during the pandemic have been minimal so far. The Federal Deposit Insurance Corp. has closed just four banks, far fewer than the deluge of failures that took place during the financial crisis. So far, financial institutions have maintained their profitability. Almost no banks that pay a dividend cut theirs last year.

Meanwhile, regulators required many of the large banks, which face extra scrutiny and stress testing compared to smaller banks, to halt share repurchases and cap dividends last year, further pumping up capital levels.

That means that banks have a lot of capital on their books. Analysts predict a wave of share repurchases in the months ahead as banks return capital to shareholders.

“The banking industry continues to make money,” said Al Laufenberg, a managing director at KBW, during another Bank Director session. “The large, publicly traded companies are coming out with statements saying, ‘We have too much capital.’”

Investors have begun to ask more questions about what banks are doing with their capital. “We see investors getting a little bit more aggressive in terms of questions,” he says. “‘What are you going to do for me?”

Bank of America Corp. already has announced a $2.9 billion share repurchase in the first quarter of 2021. In fact, KBW expects all of the nation’s universal and large regional banks to repurchase shares this year, according to research by analysts Christopher McGratty and Kelly Motta. They estimate the universal banks will buy back 7.3% of shares in 2021, while large regionals will buy back 3.5% of shares on average. On Dec. 18, 2020, the Federal Reserve announced those banks would again be allowed to buy back shares after easing earlier restrictions.

Regulators didn’t place as many restrictions during the pandemic on small- and medium-sized banks, so about one-third of them already bought their own stock in the fourth quarter of 2020, according to McGratty.

In terms of planning, banks that announce share repurchases don’t have to do them all at once, Laufenberg says. They can announce a program and then buy back stock when they determine the pricing is right.

Shareholders can benefit when banks buy back stock because that can reduce outstanding shares, increasing the value of individual shares, as long as banks don’t buy back stock when the stock is overvalued. Although bank stock prices compared to tangible book value and earnings have returned to pre-Covid levels, the KBW Regional Banking Index (KRX) has underperformed broader market indices during the past year, making an argument in favor of more repurchases.

Robert Fleetwood, a partner and co-chair of the financial institutions group at the law firm Barack Ferrazzano Kirschbaum & Nagelberg LLP, who spoke on the Bank Director session with Laufenberg, cautions bank executives to find out if their regulators require pre-approval. Every Federal Reserve region is different. Regulators want banks to have as much capital as possible, but Fleetwood says they understand that banks may be overcapitalized at the moment.

High levels of capital will help banks grow in the future, invest in technology, add loans and consolidate. For the short term, though, investors in bank stocks may be the immediate winners.

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.

Balance Sheet Opportunities Create Path to Outperformance

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

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

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

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

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

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

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

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

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

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

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

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

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

New Pandemic Safety and Soundness Standards for Banks

In June, financial regulators jointly issued “Interagency Examiner Guidance for Assessing Safety and Soundness Considering the Effect of the COVID-19 Pandemic on Institutions.” In addition to existing rating systems such as CAMELS, examiners will also assess management’s responsiveness to Covid-19 stresses. With this in mind, CLA is offering financial institutions our interpretation of, and key takeaways from, the guidance.

Asset quality
Asset quality will be a primary focus for all examiners. Safety and soundness exam standards have not changed despite the impacts of Covid-19. Assess and document the changing risk in your loan portfolio and appropriately respond with necessary changes to policies, procedures and programs that help customers, borrowers and communities.

Credit classification and credit risk review
The rise in credit risk due to the pandemic is widespread; no community or financial institution is untouched. As such, the June guidance emphasizes that you should reevaluate assigned credit ratings on the regulatory credit risk rating scale to assess if a change is necessary due to coronavirus-related challenges.

An objective credit risk review will help validate assigned ratings and eliminate “surprises” that could occur during your regulatory examination. In May, regulators released the “Interagency Guidance on Credit Risk Review Systems” and re-emphasized the fundamental concept of an independent credit risk review, which echoes the significance of the process at a critical time.

Credit modifications
Regulators continue to emphasize their support for banks working prudently with borrowers through the pandemic. In August, the Federal Financial Institutions Examination Council explored the need for additional accommodations for certain borrowers via loan modifications. While working with borrowers, banks should obtain current financial information to assess the viability of additional accommodations. Establishing and documenting a systematic approach to loan modifications is prudent and shows what, if any, considerations are being made to the credit risk rating as multiple modifications continue.

Earnings
Despite strong earnings in recent years, the guidance clearly communicates a distinct possibility that bank core earnings could be reduced by the pandemic. Analyze the pandemic’s impact on your current year earnings, how it will detract or enhance your earnings potential, and document accordingly.

Capital
Strong capital and a well-developed plan lead to enhanced viability. Loan growth, deposit growth, and inflows from government stimulus have happened quickly, without an opportunity to fully assess the capital impact. Regulators have even encouraged the use of capital buffers to promote lending activities. Given the pandemic-related changes, updating your capital plan and previously established limits and triggers is essential. Additionally, a current assessment of your overall risk profile and forecasted risks allows you to develop relevant strategies that address risk in your capital.

Liquidity
Most financial institutions have been liquid since the last recession, with less dependency on third parties for funding. Also, as happened during the last recession, there has been an inflow of funds from consumer savings due to economic uncertainty. The guidance readily admits liquidity profiles for financial institutions remain uncertain due to the coronavirus; yet, amid the uncertainty, expectations to employ smart strategies remain — which only places greater emphasis on your overall funding strategy and contingency plans.

Sensitivity to market risk
Earnings and capital evaluations require an assessment of sensitivity to market risk, primarily in the form of interest rate risk. Reassess your asset liability management (ALM) policies and related models to address changes that have occurred to your interest rate risk profile. Decipher between risks that are temporary and risks that will have longer-term effects.

These points will impact assumptions and data incorporated in ALM models, including the impact of loan modifications, payment timing and deposit growth. Additionally, stress testing models are important tools during the pandemic. Incorporate stress scenarios such as fluctuations in unemployment and the impact of possible future shutdowns to manage your risk. Like credit review, banks should strongly consider engaging independent verification of these models to confirm integrity, accuracy and reasonableness.

Management
Management should serve as the driving navigational force during this time of uncertainty. The guidance specifically states examiners will evaluate management’s actions in response to the pandemic. Management can demonstrate responsiveness by fostering open lines of internal communication on a day-to-day basis, and by engaging with the board of directors to obtain a different perspective that could enhance your risk assessment process. Prioritize documentation, which includes an assessment of what policies, procedures and risk assessments need to be revised based on decisions made in response to the pandemic.

The CARES Act: What Banks Need to Know

Banks will play a critical role in providing capital and liquidity to American businesses and consumers, and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) includes several provisions that benefit depository institutions. The implications for bank directors and officers are significant; they may need to make major decisions quickly.

Expanded SBA Lending
The CARES Act appropriates $349 billion for “paycheck protection loans” to be made primarily by banks that will be 100% guaranteed by the Small Business Administration (SBA) through its 7(a) Loan Guaranty Program. The SBA issued an interim final rule on the program on April 2 and has issued additional formal and informal guidance since that date. Application submissions began on April 3. Banks and borrowers will want to move quickly, due to the limited funds available for the program.

Provisions Benefitting Depository Institutions Directly

Troubled Debt Restructuring Relief. A financial institution may elect to suspend the requirements under generally accepted accounting principles and federal banking regulations to treat loan modifications related to the COVID-19 pandemic as troubled debt restructurings. The relief runs through the earlier of Dec. 31 or 60 days after the termination date of the national emergency, and does not apply to any adverse impact on the credit of a borrower that is not related to the COVID-19 pandemic.

CECL Delay. Financial institutions are not required to comply with the current expected credit losses methodology (CECL) until the earlier of the end of the national emergency or Dec. 31.

Reduction of the Community Bank Leverage Ratio. Currently, a qualifying community banking organization that opts into the community bank leverage ratio framework and maintains a leverage ratio of greater than 9% will be considered to have met all regulatory capital requirements. The CARES Act reduces the community bank leverage ratio from 9% to 8% until the earlier of the end of the national emergency or Dec. 31. In response to the CARES Act, federal banking regulators set the community bank leverage ratio at 8% for the remainder of 2020, 8.5% for 2021 and 9% thereafter.

Revival of Bank Debt Guarantee Program. The CARES Act provides the Federal Deposit Insurance Corp. with the authority to guarantee bank-issued debt and noninterest-bearing transaction accounts that exceed the existing $250,000 limit through Dec. 31. The FDIC will determine whether and how to exercise this authority.

Removal of Limits on Lending to Nonbank Financial Firms. The Comptroller of the Currency is authorized to exempt transactions between a national bank or federal savings association and nonbank financial companies from limits on loans or other extensions of credit — commonly referred to as “loan-to-one borrower” limits — upon a finding by the Comptroller that such exemption is in the public interest.

Provisions Related to Mortgage Forbearance and Credit Reporting

The CARES Act codifies in part recent guidance from state and federal regulators and government-sponsored enterprises, including the 60-day suspension of foreclosures on federally-backed mortgages and requirements that servicers grant forbearance to borrowers affected by COVID-19.

Foreclosure and Forbearance on Residential Mortgages. Companies servicing loans insured or guaranteed by a federal government agency, or purchased or securitized by Fannie Mae or Freddie Mac, must grant up to 180 days of forbearance to borrowers who request and affirm financial hardship due to COVID-19 through the period ending on the later of July 25, or the end of the national emergency.

Servicers are not required to document the borrower’s hardship. The initial 180-day forbearance period must be extended up to an additional 180 days at the borrower’s request., Servicers of federally backed mortgage loans may not assess fees, penalties, or interest beyond the amounts scheduled or calculated during this forbearance period, as if the borrower made all contractual payments on time and in full under the terms of the mortgage contract. The law also imposes a foreclosure moratorium on federally backed mortgage loans of at least 60 days, beginning on March 18.

Forbearance on Multi-Family Mortgages. Multifamily borrowers with a federally backed multifamily mortgage loan that was current on its payments on Feb. 1, may request forbearance for a 30-day period with up to two 30-day extensions, during the covered period. Servicers are required to document borrower’s hardship. Borrowers must provide tenant protections, including prohibitions on evictions for non-payment and late payment fees, in order to qualify for the forbearance, and servicers are required to document the borrower’s hardship.

Moratorium on Negative Credit Reporting. Any furnisher of credit information that agrees to defer payments, forbear on any delinquent credit or account, or provide any other relief to consumers affected by the COVID-19 pandemic must report the credit obligation or account as current if the credit obligation or account was current before the accommodation.

Whipsawed by Interest Rates

One of the things that bankers hate most is uncertainty and abrupt changes in the underlying economics of their business, and the emerging global crisis caused by the COVID-19 pandemic is confronting them with the perfect storm.

You can blame it all on the Federal Reserve.

Indeed, the higher rates that the Fed gave in 2018, it is now taken away — and that is creating a big challenge for banks as they scramble to adapt to a very different interest rate scenario from what they were dealing with just 15 months ago.

On March 3, as the economic impact of the coronavirus both globally and in the United States was becoming more apparent and fears about a possible recession were mounting, the Fed made an emergency 50 basis-point cut in interest rates, to a range of 1% to 1.25%. The Fed’s action was dramatic not only because of the size of the reduction, but also because this action was taken “off cycle” — which is to say two weeks prior to the next scheduled meeting of the Federal Open Market Committee, which is the Fed’s rate-setting body.

And as this article was being posted, many market observers were expecting that the Fed would follow with another rate cut at its March 17-18 meeting, which would drive down rates to their lowest levels since the financial crisis 12 years ago. Needless to say, banks have been whipsawed by these abrupt shifts in monetary policy. The Fed increased rates four times in 2018, to a range of 2.25% to 2.50%, then lowered rates three times in 2019 when the U.S. economy seemed to be softening, to a range of 1.50% to 1.75%.    

Now, it appears that interest rates might go even lower.

What should bank management teams do to deal with this unexpected shift in interest rates? To gain some insight into that question, I reached out to Matt Pieniazek, president of the Darling Consulting Group in Newburyport, Massachusetts. I’ve known Pieniazek for several years and interviewed him on numerous occasions, and consider him to be one of the industry’s leading experts on asset/liability management. Pieniazek says he has been swamped by community banks looking for advice about how to navigate this new rate environment.

One of Pieniazek’s first comments was to lament that many banks didn’t act sooner when the Fed cut rates last year. “It’s just disappointing that too many banks let their own biases get in the way, rather than listen to their balance sheets,” he says. “There are a lot of things that could’ve been done. Now everyone’s in a panic, and they’re willing to talk about doing things today when the dynamics of it are not very encouraging. Risk return or the cost benefit are just nowhere near the same as what they were just six months ago, let alone a year, year and a half ago.”

So, what’s to be done?

Pieniazek’s first suggestion is to dramatically lower funding costs. “No matter how low their funding costs are, very few banks are going to be able to outrun this on the asset side,” he says. “They’ve got to be able to [be] diligent and disciplined and formalized in their approach to driving down deposit costs.”

“In doing so, they have to acknowledge that there could be some risk of loss of balances,” Pieniazek continues. “As a result, they need to really revisit their contingency liquidity planning. They have to also revisit with management and the board the extent to which they truly are willing to utilize wholesale funding. The more you’re willing to do that, the more you would be willing to test the water on lowering deposits. I think there is a correlation to comfort level and challenging yourself to lower deposits and well thought out contingency planning that incorporates the willingness and ability to prudently use the wholesale market. Aggressively attacking deposit costs has to be accompanied by a real hard, fresh look at contingency liquidity planning and the bank’s philosophy toward wholesale markets.”

This strategy of driving down funding costs might be a hard sell in a market where competitors are still paying relatively high rates on deposits. “Well, you know what?” Pieniazek says. “You’ve got two choices. You either let village idiots drive your business, or you do what makes sense for your organization.”

Most banks will also feel pressure on the asset side of their balance sheets as rates decline. Banks that have a large percentage of floating rate loans may not have enough funding to offset them. As those loans reprice in a falling rate environment, banks will feel pressure to correspondingly lower their funding costs to protect their net interest margins as much as possible. And while community banks typically don’t have a lot of floating rate loans, they do have high percentages of commercial real estate loans, which Pieniazek estimates have an average life span of two and a half years. The only alternative to lowering deposit costs to protect the margin would be to dramatically grow the loan portfolio during a time of great economic uncertainty. But as Pieniazek puts it, “There’s not enough growth out there at [attractive] yield levels to allow people to head off that margin compression.”

Pieniazek’s second suggestion is to review your loan documents. “While I’m not suggesting [interest] rates are going to go negative, most banks do not have loan docs which prevent rates from going negative,” he says. “They need to revisit their loan docs and make sure that there’s lifetime floors on all of their loans that will not enable the actual note rate to go zero. They could always negotiate lower if they want. They can’t negotiate up.”

His final suggestion is that community banks need to strongly consider the use of derivatives to hedge their interest rate exposure. “If you think in an environment like this that your customers are going to allow you to dictate the structure of your balance sheet, you better think again,” he says. “Everyone’s going to want to shorten up … What you’re going to find is retail customers are going to keep their money short. In times of uncertainty, what do people want to do? They want to keep their cash close to them, don’t they?”

Of course, while depositors are going to keep their money on a short leash, borrowers “are going to want to know what the 100-year loan rate is,” Pieniazek says. And this scenario creates the potential for disaster that has been seen time and again in banking — funding long-term assets with short-term deposits.

The only thing you can do is augment customer behavior through the use of derivatives,” Pieniazek says. “Interest rate caps are hugely invaluable here for banks to hedge against rising rates while allowing their funding costs to remain or cycle lower if rates go lower. In a world of pressure for long-term fixed rate assets, being able to do derivatives … allows banks to convert fixed-rate loans in their portfolio to floating for whatever time period they want, starting whenever they want.”

During times of uncertainty and volatility, Pieniazek says it’s crucial that bank management teams make sound judgments based on a clear understanding of their ramifications. “Don’t let panic and fear result in you changing your operating strategy,” he says. “The worst thing to do is make material changes because of fear and panic. Let common sense and a clear understanding of your balance sheet, your risk profile, drive your thought process. And don’t be afraid to take calculated risks.”