Danger Ahead! Margins Decline while Interest Rate Risk is on the Rise!

Transcription

1 Danger Ahead! Margins Decline while Interest Rate Risk is on the Rise! by: Frank L. Farone, Managing Director As the old saying goes, The best time to plant a tree was long ago, and the second best time to plant a tree is today. The same can be said for interest-rate and liquidity risk planning. As falling rates and robust liquidity continue to wreak havoc on nearly all financial institutions, there is no better time than now to put policies and other tools in place to address their potential impact on future earnings. This is the time to look in the mirror and ask yourself: Do we have tools in place to measure and monitor our risk to earnings if rates stay low for an extended period of time? What if rates drop even lower? What if rates rise? How should we manage our excess liquidity currently? How will we react to the pressures that rising rates may have on our liquidity position? What are reasonable expectations for deposit migration and disintermediation when rates do rise? How will my institution react if liquidity tightens perhaps as a result of rising rates or hopefully, increased economic activity? The outlook for many financial institutions for 2013 and into 2015 is already less than rosy, with net interest margins under significant pressure from the expected sustained low-rate environment. The recent blip in the longer-term trend of declining net interest margins is just that, a blip. The major impetus for recent margin increases has been due to a decline in funding costs, something that should have occurred long ago. Nonetheless, many financial institutions were slow to lower deposit rates as quickly as market rates declined. Other recent, non-recurring contributors to higher margins have included resets of high-cost CDs and maturing higher rate borrowings initiated in 2006 and Depositors, meanwhile, have migrated from longer-term CDs to parking their funds in low-cost, short-term accounts until more favorable rates are available. For some, reduced provisions, recoveries, and lower costs associated with problem assets have Page 1

2 helped to improve margins, but the profitability from the core business of community financial institutions (<$10 billion of assets) is, for the most part, declining. Lacking any meaningful capacity to lower deposit costs or maintain investment portfolio yields (two common margin preservation / improvement strategies that did help in the last recession), institutions will, by necessity, place greater emphasis on growing loans to buffer margin erosion. Biggest Challenge: Generating Earnings in the Current Low-Rate Environment Generating earnings in the current low-rate environment is the most significant challenge facing financial institutions today, for several reasons. First, the historically low interest-rate environment appears likely to continue, particularly given the Federal Reserve s ongoing support of monetary accommodation. This low-rate scenario is probably the greatest risk currently facing financial institutions (aside from credit risk) and will present ongoing challenges for every institution. We ll consider some strategies aimed at mitigating interest rate risk later in this article. Net interest income (interest earned on assets less interest paid on liabilities) accounts for approximately 80-85% of total revenues for most financial institutions under $1 billion in assets. Generating net new loans is becoming increasingly difficult, and those new loans are made at excruciatingly low rates due to competitive pressures and a flat yield curve that incentivizes borrowers to extend their loan terms and demand fixed rates. Meanwhile, the ability to incrementally reduce liability costs is becoming near impossible, as rates cannot go below zero. Fee income, for most community financial institutions, is declining, with the exception of those with large mortgage banking activities that are temporarily enjoying the fees from the ongoing refinance wave. Modeling Interest-Rate Risk to Facilitate Decision Making The old adage garbage in, garbage out is alive and well in interest-rate risk modeling. We continue to be surprised as to how much garbage we still see. It is not that difficult to validate the accuracy of your model. Here are a few thoughts on modeling your interest rate risk: 1. Back-test the results of your ALCO model by comparing to actual results and documenting an analysis of meaningful variances. Technically, every financial institution is required by regulation to validate its model and process by an independent party (either internal or external) on an annual basis. 2. A rigorous approach to assumption development is critical, and it should be documented. Those who control the assumptions, control the results. 3. The need to stress test your interest-rate risk position has been embedded in interagency guidance. Make sure your interest-rate risk management activities address this important area of regulatory focus. 4. Running too many different scenarios might reduce ALCO and board focus. Page 2

3 At the end of the day, the real purpose of risk management software is not to build a model. Rather, it is to facilitate decision making. Do not underestimate the importance of this distinction. Are You Asset Sensitive, Liability Sensitive, or Both? Given the current rate environment and assuming no growth in their balance sheets or, worse yet, a further flattening of the yield curve, most financial institutions can expect declining net interest income in the years ahead. How an institution models its rate scenarios, including magnitudes and yield curve slopes, will have a significant impact on the resulting exposure to changes in rates. For example, using instantaneous rate shocks versus gradual ramp-up assumptions can produce meaningfully different results. What would your interest-rate risk exposure be in a rising-rate scenario accompanied by a flattening curve similar to what we experienced in 2007? What about the timing of rate changes; should you assume rates move immediately starting today? Given the Federal Reserve s commitment to keep rates low, would it be reasonable to run a delayed risingrate scenario? A delayed scenario might be more reasonable and plausible versus managing to a lower-probability instantaneous rate shock (though shocks still need to be run for regulatory purposes, among others). Give some thought to the dynamics behind a particular interest-rate scenario. For example, what about all that temporarily parked money in low-rate / no-rate accounts? How much should you assume will shift into higher yielding CDs or outside your institution? How do you justify the assumed duration of core deposits in your model? These and many other stress scenarios need to be well thought out and modeled along with a plan to mitigate any exposures to risk. Staying Ahead of Excess Liquidity: Adjust the Liability Side of the Balance Sheet The best way to take the sting out of declining asset yields during a time of excess liquidity is to reduce rates on deposits across the board. Don t look over your shoulder at what your competitors may be doing. This is not the time to worry about potentially losing rate-sensitive money you ll get it back later if you want it. In every market, there s bound to be at least one outlier an institution that will pay premium rates to lure customers, tempting others to follow. Smart managers always look beyond the present and prepare for the future. They seek out the excellent opportunities that others miss, including the current opportunity for obtaining cheap money. They understand their marginal cost of funds and continually run alternative pricing scenarios for their ALCO and board to provide some perspective and insights into obtaining the least cost of funding at the margin. They understand the nature of cycles and trends and factor these shifts into their planning. They understand, for instance, that the sudden influx of cash into financial institutions is likely temporary and due to the worldwide recession and low interest-rate environment never before witnessed in our lifetimes. They acknowledge that depositors are less interested in return on investment and just pleased with return of investment. Investors turned savers are funneling money into checking, savings, and money market accounts just as they did following the 2000 and 2001 post dot-com bubble and the 9/11 tragedy. With rates at such historic lows, depositors are less concerned with maximizing yield but rather enjoy the comfort Page 3

4 and convenience of having access to their money without risking principal. As such, managers need to understand and appreciate the psychology of this shift in their customers thinking when pricing their cost of raw materials namely money. Smart managers are taking full advantage of today s low rates to seize inexpensive funds, both retail and wholesale. Liability-sensitive institutions should be preparing now for obtaining long-term funding at the lowest possible cost, knowing that when rates rise, depositors will become more rate-sensitive and will likely seek higher returns. And remember, long rates typically rise long before the Federal Reserve initiates rate hikes. Invest Wisely You Get What You Pay For With overnight rates as low as zero-to-25 basis points, the five-year Treasury rate yielding 75 basis points, and 15-year mortgage-backed securities (MBS) yielding in the vicinity of just 1.60%, it is hardly an easy call on where to invest your excess liquidity. The essential strategy is simple: just remember that there is no such thing as a free lunch! If not making loans, then purchasing bonds may be an inevitable and necessary evil in 2013 for some. The question is, do you buy them sooner versus later to enjoy more carry earlier in the year? On the other hand, undue reliance on the bond portfolio in this environment can be a slippery slope if one is not extremely careful and calculating. Approach callable bonds and step-up bonds with extreme caution: Do your homework to understand the risks and potential rewards of these structures and then compare to other lower-yielding alternatives. You might be very surprised at the outcome. For example, compare a step-up bond with a 15-year final maturity and to a longer-term MBS, running a series of rate scenarios through your model. Guess which one is the better bond? Be prepared for sustained low rates, but manage your balance sheet according to your current risk profile so that you don t get caught when rates turn north again. In an industry where 1% is considered a good return on assets, reducing deposit rates by 15 to 25 basis points or more will immediately bring more earnings to the bottom line than most any other yield-enhancing investment strategy, with much less risk. Build Your Portfolio of Well-Underwritten Loans Given the investment yields on the alternatives outlined above and considering that most institutions need to cover overhead that averages around 3% it is imperative to hold more loans on balance sheet. In so doing, do not compromise your credit quality. Most financial institutions have the capacity to hold more fixed-rate product in portfolio. The new guarantee fees on mortgage loans make the decision even more compelling. Although you might think that loan growth can readily be funded with excess liquidity in the form of core deposits, think about taking a balanced approach toward funding. Recognize that your core deposits carry duration uncertainties. You may want to see how an incremental blend of core deposits and wholesale funding in the form of longer-term advances could offset your exposure in a rising-rate environment. Model it! Page 4

5 Adjusting Investment and Funding Strategies to Manage Risk: A Case Study The charts below illustrate a typical interest-rate profile. The simulation shows declining net interest income in all rate scenarios using a static balance sheet approach. The charts demonstrate how one thrift institution, whose major business line is mortgage origination, made a few minor changes to its investment portfolio mix, while adding some term wholesale funding to leverage and balance its risk. Note that the institution profiled had high levels of overnight funds and was selling all loans in the current environment. Meanwhile, earnings were declining and loan levels were shrinking. After carefully reviewing ALCO reports, it was recommended that overnight funds be extended into a blend of 15- and 20-year MBS with steady cash flows and very low premiums. An additional recommendation was to leverage $25 million of Federal Home Loan Bank (FHLBank) borrowings to fund these investments using a barbell approach. The combined net incremental results illustrate higher levels of income in all scenarios, reduced exposure to flat, falling, and even rising rates, better utilization of capital, and less risk to capital under a sustained flat or falling rate environment. The base case scenario shows a net pickup of an additional $2.4 million to $2.6 million in net interest income over the first 24 months in the base case and falling rate scenarios. If rates were to start rising now, all rising rate scenarios would still produce a positive net increase to net interest income. Which profile presents more risk now? The reality is that many institutions cannot afford to sit on cash and pay up for funds or wait for growth to materialize. You can imagine what the impact would be if the institution were to hold mortgages at twice the yield of the MBS strategy or intelligently and aggressively priced fixed-rate commercial loans! And we haven t even discussed deposit pricing strategies. A New Normal in Balance Sheet Risk Management There is a new normal in balance sheet risk management. The good old days, when financial institutions took interest-rate risk and liquidity-risk management for granted and did only what was deemed sufficient to keep the regulatory monkey off their backs, are undoubtedly over. As with any balance sheet decision, you must trust your ALCO process and perform your due diligence to determine the right mix and balance of assets and liabilities, including wholesale funding. For many, shrinking the balance sheet is not a viable option. Ultimately, only growth Page 5

6 can offset shrinking margins and income. There are no silver bullets or one-size-fits-all strategies. However, the few simple observations and action steps outlined in this article are nearly universal. 1. Understand your risk position and impact to your net interest income and net income and take appropriate action. For many, lowering deposit rates is the simplest and lowest-risk strategy. Use the wholesale markets (e.g., your FHLBank) as your benchmark for pricing, and don t be afraid to be aggressive in lowering deposit rates. You may be surprised how many deposits (that you feared would flee) actually stick around. 2. If possible, generate and hold more loans and determine the right mix of funding required. Run sensitivities on different blends of wholesale and core funding. Remember that the former source is duration-certain, while the latter is not, in a rising-rate environment. What you view as your core funding today could either re-price upward or exit in a rising-rate environment tomorrow. 3. Determine how much growth is required to offset shrinking margins and income. 4. Measure and quantify the cost of staying short with investments versus extending out the curve in longer-term, well-structured investments or loans. These few simple steps can make a huge difference in your earnings over the next few years when margins will most likely be under the greatest pressure in our careers. Unfortunately, the challenges ahead are significant. Preparing to manage through those challenges requires an honest assessment of your institution s present performance and the outlook for the future. Taking no action and hoping to wait out the storm may just be the greatest risk of all! Adaptation to changing times is the key to 2013 and beyond! Frank L. Farone Managing Director, Inc. ffarone@darlingconsulting.com Tel: Frank is a managing director of (DCG), working nationwide with CEOs and CFOs of financial institutions to increase earnings through the proactive management of capital, liquidity/funding risk and interest rate risk. He assists clients in understanding and anticipating the effects of changing market conditions on their balance sheets, and develops and implements effective strategies based upon a clear understanding of risk/reward tradeoffs. He is a frequent author and speaker in the banking industry and is on the faculty of numerous educational and banking organizations. Frank graduated magna cum laude from Siena College in Albany, N.Y., and holds an accounting degree from Albany Business College. This article first appeared in the Q issue of What Counts, a quarterly online publication of FHLB Seattle. This article may not be reproduced or distributed without written permission from DCG. Page 6