BEST PRACTICES IN ASSET/LIABILITY MANAGEMENT. AMIfs Institute July 18, 2016 Monday Afternoon Session

Transcription

1 BEST PRACTICES IN ASSET/LIABILITY MANAGEMENT AMIfs Institute July 18, 2016 Monday Afternoon Session 1

2 Agenda - Introduction to ALM Monday, July 18 Afternoon Best Practices in ALM Structuring the ALCO Process Language of ALM Duration & Convexity Managing Capital Managing Liquidity Managing Interest Rate Risk ALM in the Current Environment 2

3 ALCO Process & Responsibility Distinguish Between Management & the Board Board s Role Establishing Policy Investment, Interest Rate Risk & Liquidity Monitoring Interest Rate Risk & Liquidity Risk Based on Policy Senior Management s Role Managing liquidity on an ongoing basis! Managing Interest Rate Risk Exposure Manage Growth & Capital Ratios Achieve an acceptable Net Interest Margin 3

4 The ALCO The Mix of Managers Managers Role CEO CFO Controller Lenders Retail Validate the importance of the committee. Chair the meeting/set the agenda/assemble a packet Represent the budget process/bring supporting data. Provide info on the loan pipeline. Discuss loan activity & pricing behavior in the current market. Provide info on deposit activity. Alert the committee to customer behavior and pricing. 4

5 Agenda & Decision Making Agenda Business Cycle Interest Rate Forecast Cash Flow Pro Forma Interest Rate Risk Exposure Overview Investments & Borrowing Loan & Deposit Activity Decision Making Deploy Cash ( ) Make loans 1 st Option Buy investments Repay maturing deposits Repay FHLB advances Funding Assets (2007 & ) Sell loans Sell investments Borrow from FHLB Attract deposits 5

6 Decisions Based on Critical Data! Where are we in the business cycle? Growth of GDP determines loan demand: as lenders banks need to be concerned with local economy? What is the interest rate forecast? We are going to make decisions regarding positioning assets and liability maturity where are rates headed? What is the bank s or credit union s liquidity position? Balance sheet liquidity plus a cash flow pro forma! What is the interest rate risk exposure? Is our balance sheet asset or liability sensitive? 6

7 Business Cycle Impact on Bank Management Peak 2007 Recession 2008 Trough Expansion 2009 to 2017??? High loan demand & strong asset quality. Weak loan demand & asset quality problems Weak loan demand credit problems continue Strengthening loan demand & higher asset quality. High interest rates flat yield curve Short-term Rates drop quickly steeper yield curve Low Rates steep yield curve Rates slowly increase Yield Curve becomes flatter Low Liquidity due to loan funding Cash increases Call & Prepayment accelerate Awash with cash in a low rate environment Slowly lose liquidity & asset funding becomes expensive High interest rate risk Liability sensitivity causes margin compression Banks benefit from Liability sensitivity Liability sensitivity pays off IRR increases liability sensitivity becomes problem

8 Interest Rate Environment 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 0.09% 0.35% 0.67% 1.00% 1.42% 1.75% 2.25% 2.04% 2.66% 2.50% 0yr 1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr 8

9 Cash Flow Pro forma Critical for ALCO Decision Making Balance Sheet Liquidity = Cash + Fed Funds + Bank Deposits +ST Securities Cash Inflow Non Discretionary Loan Amortization Loan Prepayment Maturing investments Callable investments = inflow [+] Discretionary Cash Outflow Non Discretionary Confirmed loan pipeline Maturing advances Maturing CDs [40%] = outflow [-] Discretionary + > - Deploy Cash [ ] - > + Fund Assets [ ]

10 Interest Rate Risk Exposure Asset Sensitive Where are we in rate cycle? This is an easier call in July Do you want to become less asset sensitive? [July 2016] That depends on you view of Fed action to raise rates. Has asset sensitivity ever been a serious problem [Look at 2008 for the best example]? Liability Sensitive Where are we in rate cycle? At top of cycle problem become most serious [2007]. At the current point in the cycle liability sensitivity has paid off? What about May 2015 or 2016? Why is liability sensitivity the more serious concern? 10

11 Your ALCO has reviewed Critical Data! Business Cycle Focused on loan demand Interest Rate Forecast Short-term interest rates increase in 2015 and are forecasted to moderately increase through The institution s liquidity position has been determined. A cash flow pro forma has been provided for the 3 rd Quarter of 2016! Currently the typical community financial institution is seeing liquidity shrink! Liquidity Ratios >8% The bank s interest rate risk exposure has been determined asset or liability sensitive! Now we are ready to make decisions! 11

12 Theoretical Decision Making Short-term Interest Rates This is the average Fed Funds rate over the last ten years. When rates are low and declining Shift to a more asset sensitive position. 12

13 Theoretical Decision Making Are rates going up or down? Let s look at probability 95% chance rates increase! Rates will Increase Rates will Decrease Reversion to the Mean Current Rate > Historical Average Rates will fall! Decrease asset duration Key strategy in 2016 Increase asset duration Current Rate < Historical Average Rates will rise! But when? This is why we need to modify theory! Increase liability duration Key strategy to consider in 2016 Decrease liability duration 13

14 The Language of ALCO Duration Tells us the volatility of an asset or liability. For example, Five Year T-Note has a Modified Duration of 4.52% What does this mean? Convexity [Option Risk] Tells us the symmetry of the volatility. What distorts symmetry? Embedded options! Difficult for the non-financial manager, but critical to ALM decisions & risk management. Think about the convexity in your balance sheet callable, caps, floors, prepayment! 14

15 Let s Explore the Convexity in a Bank or Credit Union Balance Sheet Assets Callable Investments Liabilities FHLB Advances Callable ARM Loans Caps DDA Sweeps Fixed Rate Loans Prepayment CDs - Redemption Commercial Loans Floors HELOC prepayment & floors 15

16 Liquidity Management One of the Key functions of ALCO Defined: Ability to fund loan commitments and deposit outflows. Ability to obtain cash at a reasonably price July, Liquidity should be managed on both sides of the balance sheet. Assets Cash + Short-term Investments + Loans AFS Liabilities Borrowing + Brokered CDs + Retail CDs Factors that make liquidity management a challenge: Interest rate volatility Regulatory policies Basel III Accounting Rules FAS 115 Complexity of FHLB advances 16

17 Review the Liquidity Cycle Peak 2007 Recession Expansion High loan demand Funding loan commitments High interest rates flat yield curve Low Liquidity due to loan funding & asset duration extension Need to consider liability sensitivity causes margin compression Weak loan demand Short-term Rates drop quickly steeper yield curve Cash increases Call & loan prepayment accelerate Banks benefit from Liability sensitivity Strengthening loan demand Need to fund loan commitments Rates slowly increase Yield Curve becomes flatter 2015 or 2016? Slowly lose liquidity & asset funding becomes expensive [2007 & 2016] IRR increases liability sensitivity becomes problem 17

18 Accurate Cash Flow Pro forma is One Key to Effective Liquidity Management Cash Inflow Non Discretionary Loan Amortization Loan Prepayment Maturing investments Callable investments = inflow [+] Cash Outflow Non Discretionary Confirmed loan pipeline Maturing advances Maturing CDs (40%) = outflow [-] Discretionary Discretionary + > - Deploy Cash [2014] - > + Fund Assets [ ] 18

19 Federal Home Loan Bank Advances Level of complexity have increased over the last twenty years as the Federal Home Loan Banks have tried to provided sophisticated products to cope with more volatile interest rate environments. As we examine the FHLB offerings it is important to remember that this is wholesale funding. The FHLB buys money at a small premium to the Treasury yield curve and resells the money to community banks. Also note advances can be used to management liquidity and interest rate risk. Type Overnight Advance Term Advance Fixed Term Advance - Floating Convertible Advance Embedded Call Embedded Put Amortizing Advance Short-term Comment 6mo - 10 years 1 10 years Fixed term [1 to 3 yrs.] then convert to Libor FHLB option rising rate Bank s option falling rate Matching RML portfolio Forward Advances Hedging

20 Interest Rate Risk Driven by Volatility of Market Interest Rates: a good reference 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% High (3/13/00) Today (8/31/09) PrevLow (6/13/03) Mean 20

21 Interest Rate Risk Define: The impact on the Bank s financial statements from a change in market interest rates: Income Statement Impact on Net Interest Income or the Net Interest Margin Balance Sheet Impact on Market Value Capital or Economic Value of Equity (EVE) Risk is volatility of financial statements above are key metrics! 21

22 Types of Interest Rate Risk 1. Re-pricing Risk This refers to the timing of the re-pricing of assets and liabilities. The concept is measured using a Gap Analysis. 2. Basis Risk The risk results from the weak correlation between the rate changes on assets and liabilities. Assets and liabilities may have similar re-pricing time frames, but may respond differently to changes in open market rates. For example, Libor & Prime are both short-term rates, but do not perfectly correlate. 3. Yield Curve Risk When we model changes in interest rates we often speak of instantaneous parallel shifting of the yield curve, but that is not the way rates change. Yield curves change incrementally, and often in a non parallel fashion. 4. Option Risk The risk arises from embedded options included in financial contracts. An embedded option creates non linear behavior in asset pricing as interest rates change. The most common imbedded options are call features on bonds and prepayment options on mortgages. 5. Price Risk The price of a fixed income security is inversely related to the direction of change in market interest rates. Price risk is the effect on the value of asset and liabilities and ultimately capital as interest rates change. 22

23 Impact on Financial Statements Income Statement NIM [Margin] = II/AA IE/AA Balance Sheet PV of Asset PV of Liabilities = PV of Capital or EVE 23

24 Income Statement Impact Asset Sensitivity Assets respond more to a change in rates than liabilities. Asset Sensitive Rates Increase Margin increases Rates Decrease Margin decreases Liability Sensitivity Liabilities respond more to a change in rates than assets. Liability Sensitive Margin decreases Margin increases 24

25 Balance Sheet Impact Asset Sensitivity Assets duration is shorter than liability duration. EVE will increase with rising rates. Liability Sensitivity Liability duration is shorter than asset duration. EVE will decline with rising rates. Asset Sensitive Liability Sensitive Rates Increase NPV of Equity (EVE) Increases NPV of Equity (EVE) decreases Rates Decrease NPV of Equity (EVE) decreases NPV of Equity (EVE) increases 25

26 How can we measure IRR? Re-pricing Gap The Re-pricing Gap is determined from the balance sheet and measures the impact on the income statement. This is a traditional measure many banks use to measure IRR. Duration Gap Duration of Assets minus Duration of Liabilities is derived from balance sheet and applies to the balance sheet. Simulation Analysis Models each asset & liability as to the impact from a change in interest rates. Allows for a simulation of both the balance and income statement from a rise and fall in rates. 26

27 Simulation Models All banks have turned to simulation models to meet regulatory requirements. 1 st step is to determine trigger rates on all earning assets and interest bearing liabilities. 2 nd step is to set the elasticity or sensitivity of each asset and liability to the trigger: For example: HELOC Trigger is Prime Sensitivity is 100% in up and down environments 27

28 Managing the Balance Sheet Use Current Environment for a Case Study What does theory tells us? Opportunity costs. What modifications should we make? Asset decision Investment & Loans. What are the risks Duration, Extension or reinvestment? Liability decisions borrowing versus deposits. What are the risks? 28

29 ALCO Meeting Agenda Let s hold an ALCO meeting 7/18/16 National/State/Local Business Cycle Interest Rate Forecast Cash Flow Pro forma Liquidity Risk! Interest rate risk report know your sensitivity! Decision making What Theory tells us? Modifying Theory Bank specific factors or macro economy factors! Managing Assets in the 3 rd quarter 2015 Managing Liabilities in the 3 rd quarter

30 Economic Forecast This is national, but we lend locally so check your local area Real GDP 1.8% 2.6% 2.4% 2.1% 2.2% 2.4% Consumer Price Index 1.2% 1.5% 1.9% 2.4% 2.3% 2.2% Core CPI 2.2% 2.3% 2.2% 2.1% 2.1% 2.1% Unemp. Rate 4.8% 4.7% 4.6% 4.5% 4.5% 4.4% Residential Const. 9.0% 9.0% 8.5% 8.5% 8.5% 8.0% 30 Crude Oil ($)

31 Interest Rate Forecast Fed Funds 0.50% 0.50% 0.75% 1.00% 1.25% 1.50% Prime Rate 3.50% 3.50% 3.75% 4.00% 4.25% 4.50% Conventional Mort. 3.89% 3.95% 4.06% 4.12% 4.26% 4.33% 2 Year Note 0.84% 0.97% 1.16% 1.38% 1.54% 1.77% 5 year Note 1.39% 1.47% 1.74% 1.84% 1.94% 2.05% 10 Year Note 1.87% 1.98% 2.13% 2.22% 2.38% 2.47% 2-10 Year Spread 1.03% 1.01% 0.97% 0.84% 0.84% 0.70% 31

32 Decision Making Start with a theoretical framework! This is the average Fed Funds rate over the last ten years. When rates are low and declining Shift to a more asset sensitive position. 32

33 Managing the Balance Sheet 3 rd Quarter 2016 Expectation S-T Rates will rise in bps Yield Curve will flatten in 2016 & 2017 What is your July 1 Liquidity & Cash Flow Proforma IRR Exposure Is your Institution Asset or Liability Sensitive? ALCO Bias given forecast Shorten asset duration ALCO Bias given forecast Lengthen liability duration Managing Assets Investments & Loans Managing Liabilities Borrowing & Deposits Off Balance Sheet Hedging Caps or Swaps 33

34 Issues to Consider Work with the current environment Slope of yield curve [opportunity cost] A positive yield curve rewards extension, but is the reward worth the risk. If you study the yield curve you can see the inflection point is approximately 2-3 years The 3-10 year segment has increase considerably since 2 nd quarter, Be careful the steeper the YC the more likely ST rates will increase. Shorten duration don t lengthen! Magnitude of Change in Interest Rates The average increase in the Fed Funds rate over the last twenty-five years is 273 basis points, but be careful of the starting point [0.25% in 2014 is the lowest rate FF rate in history]. Once the Fed starts to increase rates the change could be large: we are probably not going to replicate 2004 to 2006 [25 basis points every six weeks]. This encourages us to stay relatively short. Timing the Change in Interest Rates This is the key issue in decision making especially given FOMC comments over the last six months: an extended period of low rates to 2016: benchmarking change to unemployment rate and inflation. Do you want to be in cash for 6 months - two years? What would lead the Fed to postpone increasing rates this Fall? 34

35 Managing Investments Pick a Duration Beyond 2 years to achieve significant risk/reward tradeoff July 2013 I recommended extending out from 5 to 7 years. July 2014 I was more cautious 4 to 6 years on the curve. July 2015 I would not go beyond 4 years: this also depends on the average duration of your current portfolio if average is > 4.5 years be careful. This is all predicated on the assumption that the Fed will move FF 4 th Q 2016 and the slope of the curve 3 to 5 years remains at current levels of.70% to 0.80%. This is a tough investment environment and it is likely to get even more difficult as Fed increase ST rates what path is Yellen going to take? Gradual or large jumps this will determine investment behavior going forward. 35

36 How far are you willing to go in July 2016? 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 0.09% 0.35% 0.67% 1.00% 1.42% 1.75% 2.25% 2.04% 2.66% 2.50% Best point on the curve: 5-year point for coupon bonds 7 to10 year sector for MBS ( yr avg. life) 0yr 1yr 2yr 3yr 4yr 5yr 6yr 7yr 8yr 9yr 10yr 36

37 Pick a Sector Credit Spreads 7/3/16 Average 2 Year Treasury to Fed Funds 40 bps 48 bps 2 Year Treasury to 10 Year Treasury 161bps 151 bps Agency to Treasury 2 Year 1 bps 21 bps Agency to Treasury 5 Year 12 bps 25 bps 10 Year Treasury to 30 year MBS 72 bps 120 bps Investment Grade Corporates (10 year) 139 bps 152 bps AA Corporates (10 Year) 94 bps 101 bps BBB Corporates (10 year) 193 bps 180 bps Municipals Similar to Corporates 37

38 Community Bank Loan Portfolio Trends Data in the table represents the median and therefore there is dispersion around this number. Some banks have substantially lower numbers. Loan to asset ratios was down among all peer groups lowering the yield on assets and compressing the margin, but this is beginning to reverse. This was becoming a serious issue most cost structure requires a loan portfolio of 65% to 75% of assets. Commercial $ m % 65.9% 64.7% $500-1B 68.3% 66.9% 65.1% $1B-3B 66.5% 64.7% 62.8% Thrift $ m 69.3% 67.7% 65.9% $300-1B 68.2% 66.1% 63.9% $1B % 64.1% 61.9% 38

39 Trends in Loan Market decrease in modifications should stabilize portfolio yields this would slow down even more if the curve steepens. Rise in rates in last two months has increased residential mortgage rates and slowed refinancing and should soon impact commercial loan pricing. Maturity10 year plus maturities are becoming more common driven by the competition from larger banks, but these banks are swapping fixed rate to floating rate. Pricing pressure from competition there are loans you need to walk away from we are not getting paid for risk. Large bank are chasing small loan size forcing regional banks down eventually adding new competition for community banks. Competitors are searching for any opportunity to originate loans Non Owner Occupied & SBA are gaining in popularity. 39

40 Loan Portfolio Management Sectors & Strategies Residential Mortgage Lending 10 year loans Hold in portfolio great cash flow & acceptable duration. 15 year: (4% duration) Maybe if you are experiencing loan to asset ratio near 60% 30 year: (8% duration) at 4.1% in 2015 more banks will rationalize holding in portfolio: the key is, how liability sensitive is your balance sheet? Also remember average rate is 5.75%. Refinancing: Up until April, 2013 originations were booming, but the refinancing boom is over. We are in a purchase market. Home Equity Loans I would continue to push HELOC in 2016, but you will need to aggressively price Prime or lower forget teaser rates, but go for good credit quality. Commercial Loans Don t be desperate hold for a rate that reflects credit risk and watch duration. Compromise rate rather than duration. 40

41 Product Liability Strategies FHLB Borrowing Rate 1 mo. 0.30% Overnight 0.54% 3 mo. 0.37% 3 Month 0.68% 6 mo. 0.52% 6 Month 0.71% 1 Yr. 0.55% 1 year 2 Yr. 0.75% 0.82% 3 Yr. 0.96% 2 year 0.91% 4 Yr. 1.23% 3 Year 1.04% 5 Yr. 1.49% 4 Year 1.23% 6 Yr. 1.80% 5 Year 1.34% 7 Yr. 2.05% 7 Year 1.64% 8 Yr. 2.36% 10 Year 2.07% 9 Yr. 2.59% 10 Yr. 2.79% 30 Year 3.15% Prepayment fees have decreased in last three months as yield curve steepened. Banks with advances maturing in 2015 or even 2015 are in a great position to restructure balance sheet lengthen liability duration. Look at the cost of advances and consider the flexibility you have in lengthening liability duration. Think about a ladder! Think of the options if you are making loansdo I need to match maturity if rates will not change until 2015 or later? Borrowing is good option in lengthening liability duration, but it may be more expense in 2017 than 2016, and will be very expensive the day before Yellen raises rates! 41

42 Liability Management Trends in Bank Deposits Look at the trends in the last seven years: 1. Most community banks & credit unions have experienced an increase in deposits how much may partially depend on your pricing total is $2-3 Trillion. Why household seeking safety of FDIC insurance/outflow from investment companies/money Market Mutual Funds are paying very low rates/large banks have pulled back on rates. 2. Many community banks & credit unions are experiencing an increase in core deposits [checking, MMDA and savings accounts] and a decline in certificates. Why partly due to pricing CD pricing has not been aggressive, but also because households desire liquidity. 3. Have we accepted a lot of HOT MONEY? That is the important question arising from these trends. Where is the HOT MONEY? 42

43 Let s Rethink Core Deposits FDIC Definition of Core Deposits : DDA + NOW + MMDA + SA + CD < $250,000 Note Core Deposits are one of the best correlators to success in Community Banking; therefore an accurate definition is critical. What is a core deposit? Practical Considerations: Low cost over the rate cycle; relatively insensitivity to a change in market rates, and offers cross sell opportunities. My Definition of Core Deposits : DDA + NOW + MMDA + SA But let s talk about MMDA and maybe savings accounts 43

44 Customer Behavior & Core Deposits What are assumptions for core deposits? Customer is not rate sensitive. Deposit cost remain relatively low regardless of rate environment. What if these assumption are wrong? Look at your pricing on your savings accounts: 22 basis points. Look at pricing on CDs: 96 basis points What would the cost be if there is a surge back to CDs? 44

45 2006: Customer Profile: 2016 vs Millenniums (+Y): 14 to 28 years [most were not customers] Gen X: 29 to 41 years Baby Boomers: 42 to 60 years [nobody was retirement age] Senior: 61+ [our best legacy customers] 2016 Millenniums (+Y): 24 to 38 years [rapidly becoming customers] Gen X: 39 to 51 years Baby Boomers: 52 to 70 years [Rapidly retiring] Senior: 71+ [our legacy customer are declining] 45

46 Industry Profile: 2006 versus : Last time rates increased! Branch activity is declining, but remains an important channel for many customers. On line banking is beginning to approach a inflection point [probably ] Few banks had a virtual branch 2016: Welcome to a new world! Digital Banking is surpassing traditional channels Mobile banking growth is at an inflection point Customers are very tech savvy [Millenniums, Gen X and Baby boomers, but even senior citizens are more aware] Internet banks (Allay) are poise to lead competition Many banks have a e-branch or virtual branch 46

47 Deposit Strategies in the Current Environment Understand customer behavior Know your customers. Customers have few options critical as you determine rates. Many banks are awash with liquidity some have chosen to shrink this could be a good option. Asset yield are falling we need to try to decrease deposit costs. STEP 1: Evaluate the path of the inflows over the last three years where has it been going product and tier. STEP 2: Get more aggressive with all deposit pricing test the market until you see some outflow. STEP 3: Pay a lot of attention to the HOT MONEY likely high tiered savings and MMDA these are Fidelity customers. Step 4: Reduce checking account rates before rate rise. 47