Liquidity Observations for Banks as 2022 Closes

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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?”

Are Fixed-Rate Loans the Quick Fix?

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Commercial fixed-rate loans can be an alluring quick fix for the net interest margin pressure that many banks face today, but could expose banks to several risks while providing tepid returns.

Future earnings are largely out of the bank’s control. While the current yield of a fixed-rate loan can look attractive relative to the historic lows of short-term funding costs, its long-term return is highly dependent on the future path of short-term interest rates. When interest rates increase, the spread between the yield earned on a fixed-rate loan and the ongoing funding cost for a bank decreases — and could even go negative.

While banks have some control over funding costs, the largest factors that influence short-term funding rates are external: central bank monetary policy, inflation expectations and the overall business cycle. None of these factors are controlled by any individual bank, which means the ongoing net yield of a fixed-rate loan depends on factors outside your bank’s control.

Prepayment penalties often do not protect banks. Bank executives should temper expectations that prepayment penalties protect bank income or influence borrower behavior for fixed-rate loans. Many borrowers negotiate limited prepayment provisions in advance, or ask that prepayment penalties be fully or partially waived when refinancing. Additionally, fixed-rate borrowers are most likely to prepay when refinancing lowers their borrowing cost. These realities mean borrower prepayments often result in the loss of higher-yielding loans with little or no compensation to banks.

Interest rates and prepayments have a unique relationship that can reduce returns. Higher interest rates generally mean higher funding costs and lower prepayments, while lower interest rates result in lower funding costs and higher loan prepayments. In other words, a fixed-rate loan is most likely to remain on-balance sheet when interest rates are high and a bank would prefer it go away, but pay off quickly when interest rates are low and a bank would prefer it stay. This inverse relationship between interest rates and prepayments can significantly reduce the lifetime earnings of a fixed-rate loan.

There are tools to help. Below are some strategies that banks can use to reduce the risks of fixed-rate loans:

  • Consider a customer swap program. Banks can offer borrowers a pay-fixed interest rate swap paired with a floating-rate loan instead of originating a traditional fixed-rate loan. The borrower ends up with a fixed rate; the bank books a floating rate asset that is less sensitive to future interest rate movements. These programs can also be a significant source of non-interest fee income. Modern capital markets technology and advisory companies enable banks of all sizes to offer loan-level hedging programs to qualifying commercial clients.
  • Hedge large deals on a one-off basis. Banks can use an interest rate swap to transform the return of an individual loan from fixed to floating. The borrower maintains a conventional fixed-rate borrowing structure. Separately, the bank executes a pay-fixed swap that effectively converts the loan interest to a variable rate that aligns more closely with its funding costs. While this strategy can be used on any fixed-rate loan, it can be particularly prudent for larger and longer-term transactions.
  • Use longer-duration funding. Banks can borrow for longer terms to match fixed-rate loan maturities, or “match fund,” to reduce interest rate risk. Banks can either issue new longer-term funding vehicles or use interest rate swaps to synthetically convert the maturity of existing short-term funding instruments to longer-duration liabilities. While match funding does not address fixed-rate loan prepayment risks, it does help mitigate some of the earnings risk associated with fixed-rate loans.

How does your bank evaluate fixed-rate loans? Fixed-rate loans are not inherently bad. A well-diversified balance sheet will include a mix of fixed- and floating-rate loans. But originating an outsized portfolio of commercial fixed-rate loans comes with risks that banks should properly evaluate. How is your bank managing the risks associated with fixed-rate loans? Are you booking deals as a quick fix to get through this quarter, or building a safe balance sheet with steady earnings for the future?

The Issue Plaguing Banks These Days

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Net interest margin lies at the very core of banking and is under substantial and unusual pressures that threaten to erode profitability and interest income for quarters to come. Community banks that can’t grow loans or defend their margins will face a number of complicated and difficult choices as they decide how to respond.

I chatted recently with Curtis Carpenter, senior managing director at the investment bank Hovde Group, ahead of his main stage session at Bank Director’s in-person Bank Board Training Forum today at the JW Marriott Nashville. He struck a concerned tone for the industry in our call. He says he has numerous questions about the long-term outlook of the industry, but most of them boil down to one fundamental one: How can banks defend their margins in this low rate, low loan growth environment?

Defending the margin will dominate boardroom and C-suite discussions for at least eight quarters, he predicts, and may drive a number of banks to consider deals to offset the decline. That fundamental challenge to bank profitability joins a number of persistent challenges that boards face, including attracting and retaining talent, finding the right fintech partners, defending customers from competitors and increasing shareholder value.

The trend of compressing margins has been a concern for banks even before the Federal Open Market Committee dropped rates to near zero in March 2020 as a response to the coronavirus pandemic, but it has become an increasingly urgent issue, Carpenter says. That’s because for more than a year, bank profitability was buffeted by mitigating factors like the rapid build-up in loan loss provisions and the subsequent drawdowns, noise from the Paycheck Protection Program, high demand for mortgages and refinancing, stimulus funds and enhanced unemployment benefits. Those have slowly ebbed away, leaving banks to face the reality: interest rates are at historic lows, their balance sheets are swollen with deposits and loan demand is tepid at best.

Complicating that further is that the Covid-19 pandemic, aided by the delta variant, stubbornly persists and could make a future economic rebound considerably lumpier. The Sept. 8 Beige Book from the Federal Reserve Board found that economic growth “downshifted slightly to a moderate pace” between early July and August. Growth slowed because of supply chain disruption, labor shortages and consumers pulling back on “dining out, travel, and tourism…  reflecting safety concerns due to the rise of the Delta variant.”

“It’s true that the net interest margin is always a focus, but this is an unusual interest rate environment,” Carpenter says. “For banks that are in rural areas that have lower loan demand, it’s an especially big threat. They have fewer options compared to banks in a more robust growth area.”

The cracks are already starting to form, according to the Quarterly Banking Profile of the second quarter from the Federal Deposit Insurance Corp. The average net interest margin for the nearly 5,000 insured banks shrank to 2.5% — the lowest level on record, according to the regulator, and down 31 basis points from a year ago. At community banks, as defined by the FDIC, net interest margin fell 26 basis points, to 3.25%. Net interest income fell by 1.7%, which totaled $2.2 billion in the second quarter, driven by the largest banks; three-fifths of all banks reported higher net interest income compared to a year ago. Carpenter believes that when it comes to net interest margin compression, the worst is yet to come.

“The full effect of the net interest margin squeeze is going to be seen in coming quarters,” he says, calling the pressure “profound.”

On the asset side, intense competition for scarce loan demand is driving down yields. Total loans grew only 0.3% from the first quarter, due to an increase in credit card balances and auto loans. Community banks saw a 0.5% decrease in loan balances from the first quarter, driven by PPP loan forgiveness and payoffs in commercial and industrial loans.

On the funding side, banks are hitting the floors on their cost of funds, no longer able to keep pace with the decline on earning assets. The continued pace of earning asset yield declines means that net interest margin compression may actually accelerate, Carpenter says.

Directors know that margin compression will define strategic planning and bank profitability over the next eight quarters, he says. They also know that without a rate increase, they have only a few options to combat those pressures outside of finding and growing loans organically.

Perhaps it’s not surprising that Carpenter, a long-time investment banker, sees mergers and acquisitions as an answer to the fundamental question of how to handle net interest margin compression. Of course, the choice to engage in M&A or decide to sell an institution is a major decision for boards, but some may find it the only way to meaningfully combat the forces facing their bank.

Banks in growth markets or that have built niche lending or fee business lines enjoy “real premiums” when it comes to potential partners, he adds. And conversations around mergers-of-equals, or MOEs, at larger banks are especially fluid and active — even more so than traditional buyer-seller discussions. So far, there have been 132 deals announced year-to-date through August, compared to 103 for all of 2020, according to a new analysis by S&P Global Market Intelligence.

For the time being, Carpenter recommends directors keep abreast of trends that could impact bank profitability and watch the value of their bank, especially if their prospects are dimmed over the next eight quarters.

“It seems like everybody’s talking to everybody these days,” he says.

Going Up? Elevating Loan Yields With Swaps

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What a difference a year makes. Spring 2020 was like nothing we had ever seen: scheduled gatherings were cancelled and economic activity came to a screeching halt.

Yet today, after a year highlighted by social distancing, lockdowns and restrictions, there is a sense of anticipation that feels like a wave of pent-up demand ready to break-out, much like the buds on a flowering tree. Loans last year saw the prime rate plunge to 3.25% from its recent peak of 5%, as the Federal Reserve pushed its target back to zero to help keep the economy afloat. Banks and credit unions that built up significant portfolios of variable-rate loans experienced the pain of this unexpected rate shock in the form of margin compression.

But as flowers begin to bloom this spring, there is very little hope that short-term rates will follow suit. The Federal Open Market Committee signaled at its mid-March meeting that it expects to maintain a near-zero Fed Funds target all the way through 2023 with a goal of seeing inflation rise to more normal levels. For lenders holding floating-rate assets, waiting until the 2024 presidential primary season to experience any benefit from higher yields might seem unbearable. And with the sting of last year’s free fall still fresh, the prospect of slow and steady quarter-point bumps thereafter is not appealing.

Interestingly, there is a different story playing out when we examine the yields on longer-dated bonds. Because inflation erodes the future value of fixed-income coupon payments, bond market investors have grown nervous about the Fed’s increased desire and tolerance for rising prices. Consequently, while short-term rates have remained anchored, 10-year bond yields have surged by a full percentage point in less than six months, creating a sharply steeper yield curve. This is excellent news for asset-sensitive institutions that have interest rate hedging capabilities in their risk management toolkits. Rather than simply accepting their fate and holding onto low-yielding floating-rate assets in hopes the Fed will move earlier than expected, banks with access to swaps can execute a strategy that creates an immediate positive impact on net interest margin.

To illustrate, consider an asset-sensitive institution with a portfolio of prime-based loans. Using an interest rate swap, the lender can elect to pay away the prime-based interest payments currently at a 3.25% yield and receive back fixed interest payments based on the desired term of the swap. As of March 23, 2021, those fixed rates would be 3.90% for 5 years, 4.25% for 7 years, and 4.50% for 10 years. So, with no waiting and no “ramp,” the loans in question would instantly increase in yield by 0.65%, 1% or 1.25% for 5, 7 and 10 years, respectively, once the swap economics are considered.

The trade-off for receiving this immediate yield boost is that the earning rate remains locked for the term of the swap. In other words, when prime is below the swap rate (as it is on Day One) the lender accrues interest at the higher fixed rate; when prime exceeds the swap rate, the lender sacrifices what is then the higher floating-rate yield.

This strategy uses a straightforward “vanilla” interest rate swap, with a widely used hedge accounting designation. For banks that have avoided balance sheet hedging due to complexity concerns, an independent advisor can help with the set-up process that will open the door to access this simple but powerful tool.

In the days following March 2020 we often heard that “the only thing certain in uncertain times is uncertainty.” With swaps in the toolkit, financial institutions have the power to convert uncertain interest flows to certain, taking control of the margin and managing exposure to changing interest rates in a more nimble and thoughtful manner.

Fee Income at Premium as Crisis Threatens Credit

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Companies today have to work smarter and harder to survive the coronavirus crisis, said Green Dot Corp. CEO Daniel Henry in the company’s recent earnings call.

Henry joined Pasadena, California-based Green Dot as CEO on March 26, and has been working remotely to get up to speed on the $3 billion financial company’s operations, which include prepaid cards, tax processing and a banking platform. Those diversified business lines are a source of strength, he said.

“We’re in a much better position than just kind of a monoline neo-bank to weather the storm,” he says. “We’ve got positive free cash flows, strong revenues and cash in the bank.”

After a couple of years of moderately rising interest rates, the Federal Reserve began to back off mid-2019. They dramatically dropped them to zero in February as one tool to fight the economic downturn caused by the Covid-19 pandemic and have promised to keep them low until the economy shows firm signs of recovery. Now, it looks like the industry needs to strap in for another lengthy period of low interest rates.

All this puts further pressure on already-squeezed net interest margins.

While the spread between deposits and loans represents a bank’s traditional method of generating revenue, banks also focus on fee income sources to drive profitability. Business lines that expand non-interest income opportunities could be particularly valuable in the current environment.

With this in mind, Bank Director ranked publicly traded institutions based on noninterest income as a percentage of net income, using year-end 2019 data from S&P Global Market Intelligence. We focused on profitable retail banks with a return on average assets exceeding 1.3%.

Many of these banks rely on traditional sources of noninterest income — mortgages, insurance, asset management — but two differentiate themselves through unique business models.

Green Dot topped the ranking, with the bulk of its fees generated through prepaid card transactions. It also earns revenue through its Banking-as-a-Service arrangements with companies such as Uber Technologies, Apple, Intuit and long-term partner Walmart.

Meta Financial Group deploys a similar model, offering prepaid cards and tax products. The Sioux Falls, South Dakota-based bank will soon issue federal stimulus payments via prepaid cards to almost four million Americans through a partnership with the U.S. Treasury.

The remaining banks in our list take a more traditional approach.

Institutions like Dallas-based Hilltop Holdings primarily generate fee income through mortgage lending. Keefe, Bruyette & Wood’s managing director Brady Gailey believes the low-rate environment will favor similar financial institutions. “Hilltop has a very strong mortgage operation … which should do even better this year, given the lower rate backdrop that we have now,” he says.

The $15.7 billion bank announced the sale of its insurance unit, National Lloyds Corp., earlier this year; that deal is expected to close in the second quarter. Even without its insurance division, Hilltop maintains diverse fee income streams, says Gailey, through mortgage, investment banking (HilltopSecurities) and commercial banking.

Hilltop CEO Jeremy Ford said in a January earnings call that the insurance business wasn’t “core. … this will allow us to really focus more on those three businesses and grow them.”

As the fifth-largest insurance broker in the U.S., Charlotte, North Carolina-based Truist Financial Corp. enjoys operating leverage and pricing power, according to Christopher Marinac, the director of research at Janney Montgomery Scott. “[Insurance will] be a key piece of that income stream,” he says. “I think insurance is going to be something that every bank wishes they had — but Truist truly does have it, and I think you’re going to see them take advantage of that.”

In Green Dot’s earnings call, Henry said he’s still evaluating the company’s various business lines. But with Covid-19 pushing consumers to dramatically increase their use of electronic payment methods — both for online shopping and more hygienic in-person transactions — he’s bullish on payments.

“Covid is really forcing a lot of consumers [to] search out a digital solution,” Henry said. Visa recently reported that while face-to-face transactions declined significantly in April, there was an 18% uptick in digital commerce spending.

Recently, Green Dot investigated a spike in card sales in a particular area. It turned out that a local cable company’s offices were closed due to Covid-19. A sign on the company’s door instructed customers wanting to make in-person payments to go to a store across the street and buy a Green Dot card so they could make their payment electronically.

“A lot of the consumers that were hanging on to cash over the last few months really didn’t have an option and got pushed into the electronic payments world,” he said. “That will definitely benefit us at Green Dot.”

 

Top Fee Income Generators

Rank Bank Name Ticker Primary Fee Income Source Total Noninterest Income ($000s), YE 2019
#1 Green Dot Corp. GDOT Card $1,071,063
#2 Hilltop Holdings HTH Mortgage $1,206,974
#3 Waterstone Financial WSBF Mortgage $129,099
#4 HarborOne Bancorp HONE Mortgage $59,411
#5 Meta Financial Group CASH Card $221,760
#6 Truist Financial Corp. TFC Insurance $5,337,000
#7 FB Financial Corp. FBK Mortgage $135,038
#8 JPMorgan Chase & Co. JPM Asset management $58,456,000
#9 PNC Financial Services Group PNC Corporate services $7,817,138
#10 U.S. Bancorp USB Payments $9,761,000

Sources: S&P Global Market Intelligence, bank 10-Ks

Navigating Your Bank Through Rising Rates

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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.

Optimistic About Loans But Worried About Deposits

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risk-3-5-18.pngThere are a lot of reasons why Greg Steffens is confident about the economy. As the president and CEO of $1.8 billion asset Southern Missouri Bancorp, which is headquartered in the southern Missouri town of Poplar Bluff, he sees that consumers are more confident, wages are growing, most corporations and individuals just got a tax break, and the White House announced a major infrastructure funding plan.

Steffens projects that a strong local economy will help Southern Missouri to grow loans by 8 to 10 percent this year. But he sees the potential for net interest margin compression as well, particularly because competition for loans and deposits has gotten so tight.

His thoughts about the future, a mixture of optimism and concern, are typical of bankers these days as shown by Promontory Interfinancial Network’s latest Bank Executive Business Outlook Survey. Although bankers report higher funding costs and increased competition for deposits, their optimism about the future has improved, and economic conditions for their banks are better now than they were a year ago.

Top-Lines-Q4-2017-long-version.pngAlong with a generally improving national economy and improvements in the banking sector, the passage of the Tax Cuts and Jobs Act shortly before the survey was taken likely influenced the increase in optimism among many bankers. The emailed survey, conducted from Jan. 16 through Jan. 30, included responses from bank CEOs, presidents and chief financial officers from more than 370 banks.

Some highlights include:

  • Sixty-three percent say economic conditions have improved compared to a year ago, while 5 percent say things have gotten worse, compared to 49 percent last quarter who said conditions improved and 9 percent who said things had gotten worse.
  • Slightly more than 58 percent report a recent increase in loan demand, up 7.5 percentage points from last quarter.
  • Bankers think the future will be even better with 64 percent projecting an increase in loan demand in 2018, compared to just 51.2 percent who projected annual loan growth in the fourth quarter 2017 survey.
  • The Bank Confidence IndexSM, which measures forward-looking projections about access to capital, loan demand, funding costs and deposit competition, improved by 2.4 percentage points from last quarter to 50.5, the highest rating for the index since the second quarter of 2016.
  • Regionally, the highest percentage of bankers expecting loan growth is from the South at 71.9 percent. But the biggest improvement in expectations for loan growth is in the Northeast, which climbed 27.1 percentage points from last quarter to 64.1 percent expecting loan growth in 2018.

Charlie Funk, the president and CEO of MidwestOne Financial Group, a $3.2 billion asset banking company in Iowa City, Iowa, says he expects the tax cuts will lead to higher commercial loan growth, although he hasn’t seen evidence of that yet.

He’s worried now about another factor on his balance sheet: deposit competition. “Deposits are going to be where the major battles are fought,’’ he says. The bank already is paying some large corporate depositors more than 1 percent APR on money market accounts, compared to 30 basis points just after the financial crisis. He expects the bank’s net interest margin to narrow somewhat this year as deposit costs increase faster than loan yields.

Other bankers report higher levels of deposit competition as well. In the Promontory Interfinancial Network survey, 80 percent of respondents expect competition for deposits to increase during the year, compared to 77.4 percent who thought so last quarter. The overwhelming majority have seen higher funding costs this year at 78.1 percent, compared to 68.4 percent last quarter who experienced higher funding costs. Nearly 89 percent of respondents expect funding costs to increase this year.

Representatives from larger community banks, with $1 billion to $10 billion in assets, were more likely to say funding costs will increase. The Northeast had the highest percentage of respondents saying funding costs will moderately or significantly increase, at 92.3 percent.

One of those Northeastern banks is Souderton, Pennsylvania-based Univest Corp. of Pennsylvania. With $4.6 billion in assets and a 100 percent loan-to-deposit ratio, the highly competitive deposit market is putting pressure on the bank to match loan growth with deposits. Univest Senior Executive Vice President and Chief Financial Officer Roger Deacon says funding costs have inched up, partly driven by competition for deposits. “The competition is almost as high on the deposit side as on the loan side,’’ he says.

The good news is that the bank is asset sensitive, meaning that when rates rise, its loans are expected to reprice faster than its deposits. “I’m cautiously optimistic about the impact of rising rates on our business,’’ Deacon says.

FASB Update Removes Roadblock to Hedging With Derivatives

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derivatives-11-13-17.pngComplex hedge accounting rules are high on the list of reasons that community banks have chosen to avoid derivatives as risk management tools. But the Financial Accounting Standards Board (FASB) created a stir a little over a year ago, when it promised to improve accounting for hedging activities. That stir turned into a wave of fanfare from community banks in August 2017, when the final Accounting Standards Update (ASU 2017-12) was issued for ASC 815 – Derivatives and Hedging, the standard formerly known as FAS 133. In order to appreciate the excitement surrounding the new hedging guidance from FASB, it helps to take a quick look at the history behind the accounting standard that is widely considered to be the most complex the accounting organization has ever issued.

When derivatives were introduced in the mid-1980s, they were known as “off-balance sheet” instruments because there was not a neat way to fit them onto a firm’s financial statements. Derivatives were instead relegated to the footnotes. As derivative structures became more complex and began to be used more aggressively by treasurers who often viewed derivatives as profit centers, a sharp unexpected rate hike in 1994 led to large derivative losses at Procter & Gamble and others. With speculative trades buried deep in the footnotes, demands for transparency from the investor community led to FAS 133 which, starting in 2000, required for the first time that derivatives be carried at fair value on the balance sheet.

In order to prevent having on-balance sheet derivative values lead to wild swings in earnings, hedge accounting rules were created as a shock absorber. But while the original intent of hedge accounting was to be helpful, in practice it was difficult to apply and unforgiving when applied incorrectly. It also lacked viable solutions for some of the most common challenges facing community banks.

With that as a backdrop, here are three changes included in ASU 2017-12 that will make hedging with derivatives much more practical and worry-free for community banks.

1. Portfolio Hedging of Fixed-Rate Assets
What made hedging a portfolio of fixed-rate mortgages impractical under the original standard was the caveat that almost every loan in the pool needed to be homogeneous with regard to origination date, maturity date and prepayment characteristics. Some banks would occasionally hedge larger commercial loans one at a time, but this very common source of interest rate risk was either hedged in a different manner or ignored in the past. The newly introduced “last-of-layer” designation eliminates this unattainable caveat and will enable liability-sensitive banks to hedge a portion of an identified closed portfolio of prepayable assets. As a result of this new strategy, banks will have a one-time opportunity to reclassify held-to-maturity securities as available for sale if they are eligible for the last-of-layer designation. Mitigating interest rate risk in both the loan and securities portfolios will now be squarely on the table for community banks’ consideration.

2. Impact of Hedging on NIM
Most banks undertaking a derivative strategy are looking to protect or enhance the bank’s net interest margin (NIM). The original standard required that hedge ineffectiveness be measured, which sometimes created unwanted accounting surprises. By eliminating the concept of ineffectiveness from the hedging framework, FASB will reduce complexity associated with interpreting hedging results. Hedge mismatches will no longer need to be separately measured and reported in financial statements. The economic impact from mismatches between the hedge and the hedged item will be reported in the same income statement line item when the hedged item affects earnings. For banks, this will enable typical hedging activities to impact NIM as intended.

3. Reduced Restatement Risk
In the past, some banks attempted to reduce the burden of hedging through the use of the “shortcut method,” where the assumption of a perfectly effective hedge was permitted by FASB when specific conditions were met. But the breach of any shortcut criterion, due to a minor missed detail or an unexpected change in business conditions, led to a loss of hedge accounting privileges and sometimes an embarrassing accounting restatement. The new ASU introduces an improvement to the shortcut method of assessing effectiveness by allowing for a fallback, long-haul method to be documented at the time of designation. This change will significantly reduce the risk of a restatement, and banks will be able to pursue prudent hedging activities with less fear of an accounting misstep.

By reducing complexity and making more hedging strategies viable, the new guidance is expected to be adopted prior to the mandatory 2019 deadline by most banks who actively hedge. In addition, more community banks are likely to consider installing hedging capabilities for the first time thanks to FASB clearing this long-time roadblock.

Why Every Basis Point Matters Now

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derivatives-2-17-17.pngAfter eight years of waiting for interest rates to make a meaningful move higher, the fed funds rate is making a slow creep towards 2 percent. With a more volatile yield curve expected in the upcoming years and continued competition for loans, net interest margins (NIM) may continue to compress for many financial institutions. The key to achieve NIM expansion will involve strong loan pricing discipline and the full toolkit of financial products to harvest every available basis point.

Where to look on the balance sheet? Here are some suggestions.

Loan Portfolio
The loan portfolio is a great place to look for opportunities to improve the profitability. Being able to win loans and thus grow earning assets is critical to long-term success. A common problem, however, is the mismatch between market demand for long-term, fixed rate loans and the institution’s reluctance to offer the same.

Oftentimes, a financial institution’s interest rate risk position is not aligned to make long-term, fixed rate loans. A few alternatives are available to provide a win-win for the bank and the borrower:

  • Match funding long-term loans with wholesale funding sources
  • Offer long-term loans and hedge them with interest rate swaps
  • Offer a floating rate loan and an interest rate swap to the borrower and offset the interest rate swap with a swap dealer to recognize fee income upfront

With the ability to offer long-term fixed rate loans, the financial institution will open the door to greater loan volumes, improved NIM, and profitability.

How much does a financial institution leave on the table when prepayment penalties are waived? A common comment from lenders is that borrowers are rejecting prepayment language in the loan.

How much is this foregone prepayment language worth? As you can see from the table below, for a 5-year loan using a 20-year amortization, the value of not including prepayment language is 90 basis points per year.

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At a minimum, financial institutions should look to write into the loan at least a 1- to 2-year lock out on prepayment, which drops the value of that option from 90 basis points to 54 basis points for a 1-year lock out or 34 basis points for a 2-year lock out. That may be more workable while staying competitive.

Investment Portfolio
The investment portfolio typically makes up 20 percent to 25 percent of earning assets for many institutions. Given its importance to the financial institution’s earnings, bond trade execution efficiency may be a way to pick up a basis point or two in NIM.

A financial institution investing in new issue bonds should look at the prospectus and determine the underwriting fees and sales concessions for the issuance. There are many examples in which the underwriting fees and sales concessions are 50 to 100 basis points higher between two bonds from the same issuer with the same characteristics, with both issued at par. To put that in yield terms, on a 5-year bond, the yield difference can be anywhere between 10 and 20 basis points per year.

If you are purchasing agency debentures in the secondary market, you can access all the information you need from the Financial Industry Regulatory Authority’s Trade Reporting and Compliance Engine (TRACE) to determine the mark up of the bonds you purchased. Using Bloomberg’s trade history function (TDH), in many cases, it is easy to determine where you bought the bond and how much the broker marked up the bond. Similar to the new issue example above, a mark-up of 25 to 50 basis points more than you could have transacted would equate to 5 to 10 basis points in yield on a 5-year bond.

For a typical investment portfolio, executing the more efficient transactions would increase NIM by 1.5 to 5 basis points. For many institutions, simply executing bond transactions more efficiently equates to a 1 percent to 3 percent improvement in return on assets and return on equity.

Wholesale Funding
A financial institution can use short-term Federal Home Loan Bank (FHLB) advances combined with an interest rate swap to lock in the funding for the desired term. By entering into a swap coupled with borrowing short-term from the FHLB, an institution can save a significant amount of interest expense. Here is an example below:

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Derivatives
As you can see from a few of the previous examples, derivatives can be useful tools. Getting established to use derivatives takes some time, but once in place, management will have a tool that can quickly be used to take advantage of inefficient market pricing or to change the interest rate risk profile of the institution.

Number of Community Banks Using Derivatives, by Year

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Conclusion
In a low interest-rate environment and with increased volatility in rates across the yield curve, net interest margins are projected to continue to be under pressure. The above suggestions could be crucial to ensuring long-term success. Offering longer-term loans and instilling more efficient loan pricing is the start to improved financial performance.

Who Are the Top Growth Banks?

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bank-growth-5-20-16.pngTo every rule there is an exception—or in this case, 10 of them.

Conventional wisdom says that revenue growth at commercial banks and thrifts in the current environment is challenged by continued downward pressure on net interest margins as the competition for loans remains fierce. But there is a group of banks that are thriving in today’s banking market despite the competitive pressures facing the industry. Working with Atlanta-based Bank Intelligence Solutions, a Fiserv subsidiary that collects and analyzes performance data on depository institutions, Bank Director identified 10 banks and thrifts that exhibited strong top line growth over a five quarter period ending March 31. Bank Intelligence Solutions CEO Kevin Tweddle admits that the industry’s growth performance over that period of time has not exactly been stellar. “These aren’t numbers that jump off the page,” says Tweddle. “It’s a really tough environment.” Still, these companies have been able to rise above the environment and post strong performances—which are all the more impressive given the economic headwinds that most banks have to deal with. The ranking includes public and private institutions over $1 billion in assets.

The issue of growth will be addressed at Bank Director’s Growing the Bank conference, which is scheduled for May 23-24 in Dallas. Included on the agenda are sessions on how to grow your business through smart branching decisions, collaboration, partnerships and acquisitions.

The conference attendees could also learn a thing or two from the 10 banks on our ranking, where the order was determined by their compound average growth rate in revenues over the five linked quarters. The top ranked bank—Sioux Falls, South Dakota-based MetaBank—led the pack with a growth rate of 19.3 percent over that period. The $3 billion asset bank is well diversified across multiple business lines, although lending still accounts for a significant part of its growth and profitability. MetaBank operates from 10 branches in Iowa and South Dakota, and reported 22 percent loan growth in its most recent fiscal year, which concluded September 30, 2015.The bank also saw 10 percent loan growth in the first two quarters of its 2016 fiscal year, which ran through March 31. Loan growth was particularly strong in commercial and agricultural sectors, although MetaBank also benefited from its December 2014 acquisition of AFS/IBEX, then the seventh largest U.S. insurance premium finance company. This unit makes loans to commercial businesses to fund their property/casualty insurance premiums, and it grew at an annualized rate of 52 percent between the date of acquisition and Meta’s fiscal year end in September of last year. MetaBank’s is also one of the country’s largest prepaid card issuers in the country, and in fiscal year 2015, that business grew its deposits by 25 percent and fees by 16 percent.

MetaBank also has a significant tax related business following its September 2015 purchase of Refund Advantage, which provides tax refund transfer software to electronic return originators (EROs) and their customers. An ERO is a tax preparer who has been authorized by Internal Revenue Service to submit tax returns to the IRS in an electronic format, and MetaBank earned significant software usage fees during its second quarter which ended March 31. Although the prepaid card and tax related operations are run as separate businesses from the retail bank, they are included in MetaBank’s overall results for reporting purposes.

The third ranked bank on our growth list, San Diego-based BofI Federal Bank, is a digital bank that operates nationwide through online and mobile platforms. The bank’s compound average growth rate through the five-quarter period was 11.93 percent. Of late, BofI has been seeing considerable growth in jumbo single family loans, small balance commercial real estate and commercial and industrial loans. It has also benefited from its August 2015 acquisition of H&R Block Bank, which provided BofI with 257,000 new deposit accounts and the opportunity to cross-sell its products to that bank’s customers.

Growing revenues in the current economic environment is a challenge even for most of the banks on this list, although their performance shows that strong growth can be achieved. One thing that MetaBank and BofI have in common is a degree of specialization—agricultural loans and prepaid debit cards for MetaBank, jumbo mortgage loans for BofI. And if there’s one secret to cracking the revenue growth code, it might be having a niche that differentiates your bank from the rest of the pack.

The Top 10 Banks for Growth
Rank Bank Headquarters Assets (millions) Growth Percentage*
1 MetaBank SD 3,071 19.3
2 Academy Bank, N.A. CO 1,034 18.13
3 BofI Federal Bank CA 7,696 11.93
4 HarborOne Bank MA 2,246 11.49
5 Sterling Bank and Trust FSB CA 1,766 11.21
6 Beverly Bank & Trust, N.A. IL 1,012 10.62
7 WashingtonFirst Bank VA 1,755 9.74
8 First Foundation Bank CA 2685 9.7
9 Franklin Synergy Bank TN 2,298 9.7
10 TD Bank USA N.A. NJ 19,675 8.6

Source: Bank Intelligence Solutions and bank call reports
* CAGR based on revenue for bank for five trailing quarters through March 31, 2016
** MetaBank’s results include significant fee income from card and tax service related activities that are reported as part of its results.