Bank boards can prepare for potentially tough economic times by becoming well versed in the balance sheet and cultivating a culture of credible challenge, said speakers throughout the first day of Bank Director’s Bank Board Training Forum, held in Nashville on Sept. 11-12.
In the wake of the spring regional bank failures of Silicon Valley Bank, Signature Bank and First Republic Bank, the industry has revisited whether or not directors can really govern risk. While they have redoubled their efforts on liquidity, they now need to contemplate what might happen to their institution’s balance sheet over the next four quarters and beyond.
“2023 is a lost year for banks,” said Dan Flaherty, a managing director at the investment bank Janney Montgomery Scott. “If you have to make an investment or strategic decision that can accelerate getting to greener pastures, this is the time to do it.”
Balance sheet management and interest rate risk are urgent areas of focus for many banks. High interest rates have finally appeared in deposit costs. The spring banking crisis accelerated a deposit exodus and ignited greater competition. This is on top of the “huge” unrealized losses that banks are carrying on securities and fixed-rate loans, some of which may resolve themselves during the next two to five years depending on the direction of the federal funds rate, Flaherty said.
Boards should be asking management about the outlook for the underlying cost of funding and asset yield that go into the projected 12-month return on assets, said Brian Leibfried, partner and managing director at the investment bank Performance Trust Capital Partners. He gave the example of a bank that had projected a 70 basis point cost of funds; the actual cost of funds was 1.2%. This skewed metrics like the bank’s net interest margin, earnings and return on assets.
“The balance sheet could produce different returns,” he said. “Can the bank weather those different returns?”
Given that, boards and management teams should have a sense of how fast the assets and deposits on their balance sheet could reprice, and how long it could take unrealized losses to accrete back. Some banks may need to take dramatic action, said Eve Rogers, an audit partner at the public accounting, consulting and technology firm Crowe LLP.
“Now is the time to clean house,” she said. “There’s no reward in being more profitable [this year] versus building profitability for future years.”
Rogers added that banks may want to launch market expansion efforts in order to compete for deposits or grow a customer base. Some banks may decide to consider limited balance sheet restructuring that monetizes their unrealized loss but gives them cash and flexibility to reinvest those funds into higher-yielding opportunities or preservation of capital. Flaherty said he expects the fourth quarter may be peppered with announcements of banks selling loans or securities and booking their loss.
Forward-looking banks should also think about mitigating losses and making their balance sheet “recession-proof,” said Sydney Menefee, a former regulator at the Office of the Comptroller of the Currency and a partner at Crowe. Bank boards may expect to record losses in a recession, but losses flow through other line items on the balance sheet. Have they explored what might happen to the balance sheet if the economy enters a long period of slow growth?
The way for boards to get at those answers is by asking questions, said Leslie Schreiner, the director of diversity and inclusion at Federal Home Loan Bank of Atlanta.
“Questions are the tools of the board,” she says. To that end, it will be crucial for directors to press management on the assumptions and processes they used to model returns or come up with strategic decisions going into 2024.