Strengthening Financial Performance in a Rising Rate Environment

Interest rate volatility has been a dominant theme this year and inflation worries have begun morphing into recession fears.

For banks, rising rates are generally a positive trend; they tend to result in higher deposit franchise values and higher net interest margins. While unrealized losses in the available for sale bond portfolio also typically increase during rising rate environments, adhering to a disciplined investment framework can help bank leaders avoid knee-jerk reactions and put unrealized losses into the right context (discussed previously here).

As rates continue to rise, it’s time to check the pulse on your institution’s pricing model. In addition to pricing assets accurately, a successful bank also focuses on funding cheaply, using a number of models to identify relative value and hedging interest rate risk when necessary. Here, we’ll dive deeper into three principles that can help institutions strengthen their financial performance.

Principle 1: Disciplined Asset Pricing
Capital requirements mean that a bank has a finite capacity to add assets to its balance sheet. Each asset going on the balance sheet must be critically evaluated to ensure it meets your institution’s specific performance goals and risk mandates.

Using a risk-adjusted return on capital (RAROC) framework for asset pricing and relative value assessment helps establish a consistent, sustainable decision-making framework for capital allocation. Clearly, different assets have different risks and returns. An effective financial manager ensures that the bank is meeting its hurdle rates, or return on capital, and that the model and assumptions are as accurate as possible.

A mispriced asset isn’t just a risk to margin. It also represents liquidation risk, as assets priced incorrectly to market perceptions of risk have a higher likelihood of poor sale performance, such as losses on sale or failure to sell. The value of the institution can also be impacted if the bank consistently — even marginally — misprices assets. Overall, if an asset is not appropriately priced for the risks and costs associated with it, then a bank should critically evaluate its role on the balance sheet.

Principle 2: The Value of Deposit Funding
Banks benefit from low-cost, sticky funding. Core deposits typically comprise the largest and cheapest funding source, followed by term and wholesale funding and all other, generally short-term, funding sources.

Understanding your funding’s beta is a key first step to unlocking better financial performance.

In this application, beta is a measurement of the relationship between a funding source’s interest rate and an observable market rate; it is the sensitivity of funding cost relative to a change in interest rates.

As rates rise, low beta funding results in greater growth in franchise value compared to high beta funding. As assets reprice to the higher rate environment, balance sheets with low beta funding will see margins steadily widen. Banks with high beta funding tend to exhibit margin compression and declining valuations. Conversely, low beta funding results in more stable valuation as rates rise.

Principle 3: Risk Management in an ALM and RAROC Framework
Borrowers and depositors maximize their own utility, which often presents a dilemma for the financial institutions that serve them. When interest rates are low, borrowers typically want long-term, fixed-rate loans and depositors keep their deposits shorter term.  When interest rates are higher, we typically see the opposite behavior: depositors begin to consider term deposits and borrowers demand more floating rate loans. This dynamic can cause mismatches in asset and liability duration, resulting in interest rate risk exposure. Banks must regularly measure and monitor their risk exposure, especially when rates are on the move.

Significant divergence from neutral rate risk — a closely aligned repricing profile of a bank’s assets and liabilities — exposes a bank’s return on equity and valuation to potential volatility and underperformance when rates move. That’s where hedging comes in. Hedging can assist a bank by reducing asset-liability mismatches, enhancing its competitiveness by locking in spread through disciplined asset pricing and stabilizing financial performance. After all, banks are in the business of lending and safekeeping funds, but must take on risk to generate return. Hedging can reduce discomfort with a bank’s existing or projected balance sheet risks and improve balance sheet strategy agility to better meet customers’ needs.

There are opportunities for banks all along the yield curve. But institutions that don’t hedge compete for assets in the crowded short duration space — often with significant opportunity costs.

Rising rates generally result in stronger margins and valuations for well-funded depositories; disciplined asset pricing in a risk-adjusted framework is critical for financial performance. As a financial professional, it’s important that the board has a firm understanding of what drives deposit franchise value. Take the time to ensure that the entire leadership team understands potential risk in your bank’s ALM composition and be prepared to hedge, if needed.

Saving Money as Part of Due Diligence

due-diligence-8-18-15.pngAs acquisitions continue to play a major role in financial institutions’ strategic growth plans, management teams and boards are under increasing pressure to deliver results—with minimal surprises. Though due diligence often is seen as a necessary evil to completing a transaction, it can help identify opportunities to drive profitability and assess integration hurdles so an acquirer effectively can plan for and mitigate the risk of an unsuccessful integration.

Cost savings often are touted as a primary driver of acquisitions in banking. Many public filings show that estimated cost savings of a target’s expense structure run north of 25 percent. Preliminary cost estimates that are provided by management or investment advisers often are based on high level analysis prior to a letter of intent (LOI) being signed. Once an LOI is signed, due diligence should be performed to verify the extent, timing, and operational effects of the proposed cost savings as these are critical to recognizing the value in many acquisitions. Cost saving estimates should be continually adjusted throughout the due diligence process as new facts come to light.

Following are three areas of significant cost saving estimates and examples of how thinking through integration objectives throughout the due diligence process will help eliminate surprises.

  1. Back Office Consolidation
    Significant cost savings can be realized through back office consolidation. Consolidating back office operations can get delayed, however, due to vendor backlogs for conversion or de-conversion of data. Product mapping issues also might delay moving from one core processor to another. Such delays can have significant impact on the returns analysis as the savings are delayed and two operating structures remain for extended periods of time. While it might not be possible to fully address all factors that can potentially affect the integration, reviewing product mapping and starting the system conversion timeline discussions during due diligence will provide insights into timing and possible roadblocks.
  2. Branch Rationalization
    Eliminating branch overlap or consolidating unprofitable locations can be a source of cost savings. A branch profitability analysis can identify the product usage, transaction activity, and relationship value and should be performed during due diligence. However, the costs associated with exiting facilities as well as operational drag must be considered. Acquisition accounting requires recognizing the assets and liabilities at fair value upon the change in control, and operational costs to exit or restructure a bank generally are represented through the acquirer’s income statement post-combination.
  3. Vendor Management
    While combining core processing systems are a given for cost savings, comprehensive vendor management cost savings often are overlooked in the initial transaction value proposition. Again, considering integration while performing due diligence can help executive teams concentrate vendors across the combined organization. Thinking in terms of pricing power, service level expectations, integration support, and breadth of service, acquisitions often set the stage for new conversations with vendors. Taking the time during due diligence to analyze the future stable of vendors to eliminate overlap or consolidate platforms can be a significant value driver. Analyzing vendors early on allows acquirers to execute formal vendor selection processes shortly after the transaction announcement and realize cost savings soon after legal closing.

Best Practices to Follow
Here are best practice recommendations for achieving targeted cost savings:

  • Each cost savings assumption should be championed or assigned to a cost savings owner.
  • The cost savings owner should help establish the initial savings estimate and timeline to recognize cost savings during due diligence.
  • The cost savings owner should be able to affect the integration plan to achieve the cost savings objective.
  • The integration vision should be defined during due diligence to accomplish the cost savings.
  • Cost savings estimates should be revisited throughout the due diligence process to adjust for one time costs identified and for revisions to the plan.

This article originally appeared in Bank Director digital magazine’s Growth issue. Download the digital magazine app here.