DCG Bulletin. Is Your Balance Sheet Ready for a Flatter Yield Curve? April From the Editor Keith Reagan

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1 Is Your Balance Sheet Ready for a Flatter Yield Curve? Written by Vincent A. Clevenger, Managing Director Certain things, they should stay the way they are. J.D. Salinger, The Catcher in the Rye Fortunately for those of us who call New England home, change is on the way! The record setting snowfall totals are a distant memory and spring is in the air. Likewise, the Federal Open Market Committee (FOMC) may be moving closer to increasing interest rates. It s hard to believe the last time the FOMC increased interest rates was in June of 2006! No matter your opinion on a potential rate increase by the Fed, it certainly appears that the prolonged near-zero rate environment is coming to an end. Considering all the rhetoric from FOMC members in combination with improving economic fundamentals (vs. recent years), the Fed has spent a lot of energy trying to forewarn financial markets of an impending interest rate increase. Overtures for higher Fed funds rates started to emerge during 2014, yet the bond market has rallied. The 10 -year Treasury currently resides in the 1.90% % range whereas that same bond would have fetched a yield nearly 100bps higher just 12 months ago! Although the initial rate increase will be headline news, I have yet to encounter a community banker who has designs on dramatically changing their current strategy for 25bps- 50bps of higher short-term rates. However, what concerns most bankers are both the timing of rate increases, the terminal level the Fed funds rate ultimately reaches, as well as the eventual shape of the yield curve. Recent comments by Chairwoman Yellen suggest that the Committee will proceed cautiously in moving rates higher. However, the cap for Fed funds in this next cycle (assuming it actually comes to fruition) presents a murkier picture. The highly publicized Dot Blot has rates moving back to historical norms (3.50% %) over the long term whereas the markets are projecting a lower terminal level (2%ish). What actually happens is anyone s guess. Given that the FOMC is approaching liftoff while the long end of the yield curve continues to trade well below 2014 levels, the banking industry should be preparing for a flatter yield curve. In This Issue Vol. 17, No. 4 Is Your Balance Sheet Ready for a Flatter Yield Curve? Bullet Point From the Editor Keith Reagan Is your balance sheet ready for a potential change of Fed policy? Whether or not traditional economic numbers support Fed tightening, the market is beginning to believe it will happen in the next few quarters. In this month s DCG Bulletin, Vinny Clevenger discusses preparing your balance sheet for rising rates with a flat yield curve, while in the Bullet Point Matt Doggett looks at the risk/reward of a potential strategy to protect against rising rates. Please continue to provide feedback and suggested topics for future articles. - Keith Reagan Questions or Feedback? Contact Keith ext. 161 kreagan@darlingconsulting.com

2 Accordingly, most executives want to know how their balance sheet will behave if rates move up in a flattening fashion and what they can do to prepare themselves for this environment. The following are a few items for consideration as the potential for rising rates approaches: 1) Earnings at Simulation Banks should be acutely aware of the differences between projections for Net Interest Income when rates increase in a parallel fashion versus a flattening trend. The differences between a parallel shift in rates versus a flattening increase can be substantial. For example, a flattening of market yield curves will likely increase deposit costs which are traditionally correlated to the short end of the curve. Overall asset yields are more likely to remain commensurate to current levels, as longer -term assets would not be projected to see as much increase in yields. This compression would not be reflected in a parallel shift (or shock) which would maintain the spread between Fed funds and longer dated Treasuries which currently exists. Most banks will observe intensified pressure on margin given the declining yield curve slope presented in a flattening scenario. This information can be critical to management when determining pricing and product strategies on both sides of the balance sheet. It should also give management an indication of the amount of insurance or growth necessary to alleviate earnings pressures. 2) Get Your Arms Around Depositor Behavior Given the amount of deposit growth that the industry has experienced since the recession, most bankers would acknowledge that they have a percentage of their deposit base which has sought a return of principal as opposed to a return on principal. These parked deposits are poised to leave the banking system when the FOMC starts increasing rates and better alternatives emerge. There is not a banking institution in this country that will not face this dilemma. However, the extent to which these deposits leave the system will vary significantly from institution to institution. For example, banks who have seen a material increase in transactional based accounts may be less susceptible to deposit exodus as opposed to those who have had significant growth in MMDA accounts. Now is the time to figure out who your fair-weather depositors are! Often, I hear executives mention that our institution has demonstrated stable growth over the past decade and therefore we don t believe we will experience the level of outflow others will. I m not sure that rationale is sufficient without further analysis. Banks should look closely at depositor concentrations, understand the nature of their municipal/public deposit relationships, and identify deposit products designed to potentially capture deposit outflow. Banks should also understand what their wholesale borrowing capacities are and what terms best fit their balance sheet if they are unable/unwilling to retain deposits. Ambivalence to the notion of surge deposits can be a costly mistake. Upcoming Events AMIfs 2015 Annual Profitability, Performance & Conference April 24, 2015 New Orleans, LA FHLB Des Moines Regional Member Meeting April 29-30, 2015 St. Louis, MO FMS Finance & Accounting Forum June 15-16, 2015 Scottsdale, AZ AICPA National Conference on Banks & Savings Institutions September 18, 2015 Washington, DC FMS NY/NJ Chapter 2015 East Coast Regional Conference September 21, 2015 Atlantic City, NJ Connecticut Bankers Association 2015 Annual Meeting November 14, 2015 Palm Beach, FL DCG s consultants are frequent speakers for programs around the U.S. To arrange a speaking engagement or educational program with DCG, please contact Kelly Coletti, Director - Marketing Communications, at ext. 173 or kcoletti@darlingconsulting.com for more information.

3 3) Wholesale The FOMC has tacitly encouraged financial institutions to take advantage of the carry trade by funding longer duration assets with short-term funding. As a result of improving loan demand in many markets, some banks have utilized additional borrowings/brokered deposits to help fund the growth. This strategy has undoubtedly been profitable over the last several years. However, increases to borrowing rates may be on the horizon. Expectedly, many banks are questioning whether now is the time to extend liabilities. Simply put, the answer is dependent upon the level of exposure which resides on your balance sheet and how it relates to earnings targets and internal policies. For banks that have a large concentration of longer term residential loans coupled with higher rate premium deposit accounts, the solution may be to extend borrowings. This extension could lock in a degree of cost savings if rates increase. On the other side of the debate are those who would rather let it ride and deal with the margin compression accompanying an FOMC rate increase. These folks are compelled to play a game of chicken with the FOMC to see if they will actually raise rates more or less than currently projected. In theory, the cost of longer-term borrowings reflects future market expectations for interest rates. However, try telling that to those who extended their borrowings over the last several years. As with all bets, there will be winners and losers. What s important is that your institution understands the dynamics associated with different funding strategies and understands whether or not they fit your balance sheet. (For more insight, refer to the accompanying Bullet Point by Matt Doggett which analyzes the risk/return tradeoffs of funding extensions). Similar to J.D. Salinger s quote above, it would be nice if the FOMC would keep rates at current levels and let banks continue to operate in an environment where funding costs are next to zero. Unfortunately, those days appear to be numbered. With financial markets and FOMC members hinting at a rate increase during Q3/Q4 of 2015, there is no better time to develop strategies to ensure your balance sheet is prepared.

4 THE BULLET POINT Written by Matt Doggett, Manager, Financial Analytics Discussions about rising rates are heating up faster than the spring air. Is it just hot air or has the window of expected short-term rate increases finally arrived? Whether or not there is economic data to support an increase in rates over the next few months, clearly it s something all ALCOs must consider. As Vinny Clevenger discusses in the Bulletin, institutions should fully understand their interest rate risk profile in parallel and non-parallel changes in rates. It s not inconceivable to envision a flat yield curve should the FOMC tighten. Generally speaking, rising rates with a flat yield curve would be problematic for financial institutions, as funding cost increases would likely outpace pricing on long term loans and securities. Is there something that can be done today to protect earnings from this potential flat rate environment? If there is, what s the cost? One potential solution is to extend wholesale funding, but we have to ask, Are we willing to pay up for that insurance or should we keep funding short and be paid for the interest rate risk we re incurring? The graph below shows a scenario that an institution is discussing. It s an extension of short-term advances out 3 and 4 years. The base model (on the left) assumes that all borrowings will roll short upon maturity. Visibly, this alternative scenario (on the right) offers some protection as rates rise; however, understand that if rates remain constant there is a cost involved. Extension from short-term borrowings into 3 & 4 year borrowings would increase cost 115bps, therefore the premium or cost of rising rate insurance would be $115,000 per $10 million of extension, and short-term borrowing costs would need to average 1.15% higher than current rates before the insurance begins to pay dividends. It is not ALCO s job to predict market rate movements, it is to show conceivable scenarios to fully educate management and Boards to make the best decision based on their appetite for risk and to balance that with the need for earnings today. Once all of the information has been presented and ALCO fully understands the risk/reward dynamics of different strategies (remember, consciously doing nothing is also a strategy), the best decisions can be made.

5 The 31st Annual Balance Sheet Management Conference Marriott Long Wharf Boston, Massachusetts June 1-2, 2015 Online registration is open. Simply visit DarlingConsulting.com to learn more about how you can benefit from this information-packed conference. Earn up to 13 CPE credits! As always, this year s DCG Balance Sheet Management Conference will be filled with timely sessions that are sure to provide a number of strategies for improving the financial performance of your institution, as well as better preparation for your next exam. Monday will feature a general session with Steven S. Little, a much sought after expert on the subject of business growth and the future of opportunity. Leading off Tuesday s program will be a general session conducted by Dr. Chris Kuehl, a managing director of Armada Corporate Intelligence. We will also be offering our popular core sessions: /Return Trade-Offs in Balance Sheet Management Measuring and Managing Interest Rate Measuring and Managing Liquidity Developing & Documenting BSM Strategies Click here to register. Don t wait the event sells out every year! The DCG Bulletin is a regular publication produced by Darling Consulting Group (DCG). The Bulletin provides essential information, commentary and suggestions to help bankers address strategic and financial management issues and concerns. DCG specializes in education, strategic planning and management tools for financial institutions, helping managers of banks, thrifts and credit unions enhance profitability in today s dynamic banking environment. Readers may obtain permission for reprinting the contents of the Bulletin for distribution to others by contacting Stephanie Pitman, Marketing & Sales Assistant, at ext. 174 or spitman@darlingconsulting.com. Attribution must be given to DCG for all reprints.