Strong ALCOs Breed Strong Banks: Balance Sheet Strategies for the Current Environment
Building Stronger Banks: Tools, Tactics, and Teamwork. This theme for
the upcoming 2005 Seattle Bank Management Conference sets the tone for
an important message that I look forward to sharing with all of you during
my presentation on May 19: Strong Banks Have a Strong ALCO (Asset/Liability
Committee).
I will speak to a number of challenges all banks, thrifts, and credit
unions face in the current economic/rate environment. More importantly,
I will concentrate on a variety of strategies
that have emanated from well-functioning ALCO processes. These strategies
will touch upon a wide range of balance-sheet management issues, including
investment portfolio management, deposit pricing and products, loan pricing
and products, and wholesale funding.
This article provides an overview of some of the issues and strategy
considerations that will be at the core of my presentation. As you read
it, I encourage you to make notes regarding specific questions
you have and would like me to address in my session. Please send them
to me at mpieniazek@darlingconsulting.com,
and I will tailor my comments to the issues most important to all of
you attending the Seattle Bank’s program.
The Current Environment
Last year at this time, it
seemed like everyone was anticipating the Fed to begin tightening with
expected sustained increases in short-term interest rates. However, there
were few, if any, who expected the longer end of the curve to behave
as it has. The result: a conundrum for
the banking industry as a severe unexpected flattening of the yield curve
continues to pull average funding costs higher, while asset yields struggle
to gain hoped for (and necessary) momentum. For many, margins continue
to decline. The two primary exceptions have been banks with substantial
floating-rate loan portfolios with yields that have risen above their
floors, and/or those who have been able to absorb security cash flows
into higher-yielding loan growth.
The capital markets have taken notice as well. Bank stock valuation
declines of 15 to 20% in 2005 have been quite common.
So, what is a banker to do? One thing is for sure: don’t hit the
panic button. This is not the time to unduly relax
underwriting standards, give away loans at “fire sale” prices,
reach for too much yield in the investment portfolio, or let fair-weather
depositors who bring little value dictate your deposit strategies.
Rather, this is the time for discipline. There is a premium to be realized
for focused, well thought out strategies based upon a solid understanding
of your institution’s risk/return dynamics.
It is also a time for being creative, for thinking differently about
how you manage your business: (1) your employees (expectations, incentives,
and accountabilities), and (2) your current and prospective customers
(pursuing, winning, and keeping targeted customers).
In this same vein, financial institutions must think differently about
how they create the core, net interest income component of their earnings.
This will require different approaches to asset allocation and funds
management decision-making at financial institutions of all sizes.
Investment Strategy
In today’s environment, financial institutions that are
able to absorb ongoing investment cash flow into loan growth can
count their blessings. Those faced with excess cash flow looking for a
home are faced with a dilemma.
Today there's little incentive to extend out on the
yield curve, especially for institutions already exposed to rising interest
rates. On the other hand, shortening durations increase the likelihood
that short-term funding costs (whether deposits or borrowings) will exceed
new security yields in the not too distant future. Paying down borrowings
with cash flow puts earnings back on the table, which is not very appetizing
for banks faced with the challenge of meeting internal/external earnings
expectations that appear difficult to attain.
Unfortunately, there is no silver-bullet strategy. A barbell approach
continues to work well for many. In this regard, municipal bonds would
be a good addition to a number of portfolios, especially those
purchasing intermediate- to longer-term MBS product. Callable bonds with
long maturity and short calls continue to warrant extreme caution.
Money market preferred (also known as auction rate preferred) securities
are a good alternative to fed funds sold, as they can readily provide
40 to 50 basis points over fed funds for 49-day instruments. They are
100% risk-weighted with a dividend-received deduction for a security
that qualifies as a short-term money market investment. Many banks have
found the return for the related credit risk to be attractive given the
strong historical performance of these high quality instruments. As a
result, they have been used in conjunction with barbell strategies, thereby
requiring less extension on the fixed-rate side to produce a targeted
average yield.
Loan Strategy
Anyone involved in commercial real estate
lending has an appreciation for the term “irrational pricing.” How
and why is it that lenders who would never make a floating-rate
loan at prime minus 75 basis points to a prime credit, do it so
readily when
it is disguised as a fixed-rate loan?
At the Management Conference, I will provide some easily understood
tools for benchmarking your fixed-rate loan pricing. In this regard,
I will also demystify what “enables” some of your competition
to price so aggressively.
I will also describe how lenders can readily quantify the value of interest-rate
caps that many are feeling pressured to incorporate into floating-rate
loans, and how this can be incorporated into loan pricing strategy.
An understanding of these concepts is invaluable when you’re looking
to grow loans in an environment of intense competition, tightening spreads,
and a flat yield curve.
Deposit Strategy
Are you prepared for the potential
impact of continued higher interest rates on the behavior of your deposit
base?
If cost of funds management is important to your institution, then it
is imperative that you identify and segment your non-relationship, high
probability rate-sensitive deposits from your core base. Investing a
little time today to do some fairly basic analysis can go a long way
to enjoying lower average funding costs tomorrow. For example, for each
of your larger products, create a matrix that stratifies the account
by dollar range and identifies user propensity by balance size to have
a primary checking account, other deposits, and/or a loan. This information
can provide meaningful insights for current deposit product and pricing
strategy. It can help you design new stand-alone and relationship products
and pricing strategy. It can also enable you to compete for new money,
while minimizing potential cannibalization costs on existing balances
and the probability of losing valuable customer relationships.
I will discuss some of these strategies at the Management Conference.
Additionally, I will explore successful efforts by a number of institutions
to make the most of their commercial/business lending relationships to
drive meaningful deposit growth. I will also address whether CDs, as
we know them today, are a dying breed.
Wholesale Funding Strategy
For many banks, the continued
flattening of the various market yield curves has increased the attractiveness
of extending the maturities of their wholesale funding book. We support
this strategy for those of you who have a fairly high degree of exposure
to rising rates. We caution others.
Darling Consulting Group has been seeing a growing number of institutions
with a near-term (e.g., two-year) exposure to rising rates, coupled with
a similar or even worse longer-term exposure to falling rates. For these
institutions, a term floating-rate borrowing with an interest-rate cap
is probably a better alternative. (Only time will tell). This provides
insurance against rising rates at a lower current cost than fixed-rate
funding, while preserving the ability to reduce funding costs if interest
rates were to reverse trend over the life of the borrowing.
The important thing with funding strategies in general is to make sure
that management clearly understands whether its actions constitute hedging
or speculation when it comes to managing the structure of its wholesale
funding base. For example, most asset-sensitive banks we see continue
to manage their funding maturities/repricings on the shorter end of the
curve in order to better match up with the higher repricing sensitivity
of their asset base (notwithstanding the flatness of the curve). To extend
maturities would constitute speculation on higher rates since they are
already positioned to benefit in that direction. A reduction in rates
would be problematic, and funding extensions would serve to increase
this risk. This doesn’t mean that funding extensions aren’t
warranted; it simply means that doing so is increasing a bet as opposed
to reducing a risk.
The reality for the banking industry is that the use of wholesale funding
will only increase. The FDIC also acknowledges this fact in many of its
internal and external publications.
In this regard, financial institutions will require a well coordinated,
dual funding strategy that includes both retail/commercial and wholesale
elements. Management of the type and mix of these sources must be
coordinated with the overall management of liquidity and interest-rate
risk.
Additionally, this requires that all institutions revisit their policy
statements to ensure that their liquidity measures and processes support
the likely increased role of wholesale funding sources, such as Seattle
Bank advances and brokered deposits.
Conclusion
Being a strong bank will require
disciplined management processes. And for the vast majority of the high-performing
institutions, a strong ALCO will be at the core.
Financial institutions that make the necessary and appropriate commitments
to their balance sheet management activities will see measurable returns
in the level and sustainability of their earnings. They will experience
greater discipline and creativity and, therefore, success when it comes
to investment portfolio management, deposit pricing and product strategy,
lending strategy, and wholesale funding decisions.
I look forward to exploring these challenges and strategies with all
of you in more detail at the Seattle Bank’s 2005 Management Conference.
President of Darling Consulting Group, Inc., Matthew D. Pieniazek works
with financial institutions nationwide in the areas of asset/liability
management, capital management, strategic planning, and mergers and acquisitions.
The topic of his presentation at the Seattle Bank’s 2005 Management
Conference is “Solving Today’s Asset Allocation and Funding
Dilemmas.”
President of Darling Consulting
Group, Inc., Matthew D. Pieniazek works
with financial institutions nationwide in the areas of asset/liability
management, capital management, strategic planning, and mergers and acquisitions.
The topic of his presentation at the Seattle Bank’s 2005 Management
Conference is “Solving Today’s Asset Allocation and Funding
Dilemmas.”
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