Three years ago, we inaugurated a new online publication, What Counts, with an article entitled, “Know Thyself: Understanding Your Institutional Profile.” In this flagship article, we developed a framework that focused on knowing where you stand (and will stand) with respect to three key variables: interest rate risk, liquidity, and capitalization.

Since then, the market trends that we highlighted 36 issues ago—margin contraction, competition, volatility, changing capital conditions, and sudden shifts in product demand and funding conditions—have only intensified. Still, the last three years have also seen significant change in the economic landscape. A steep yield curve has given way to an intransigently flat yield curve. Shrinking retail deposits have reduced the number of institutions in the “excess liquidity” category. And, as margins are increasingly pressured, the ability to optimize capital levels has become even more crucial. Today, it’s more important that ever to “know thyself” and to have a readily available playbook that you can reference when faced with inevitable downside scenarios.

Knowing thyself necessitates the acceptance of several prerequisites:

• Accurate modeling and evaluation of your institution’s operating results and market value sensitivity against multiple interest-rate, liquidity, and capitalization scenarios.
• De-emphasizing attempted forecasting of interest rate and liquidity conditions, and instead, focusing on specific actions you can take to protect your institution from adverse outcomes.
• Accepting the notion that the strategies that you develop are your own. The era of “one size fits all” has long since passed.

Now, let’s revisit the three key variables that we addressed three years ago in the context of today’s economic environment...

Know Thyself Variable #1: Interest Rate Sensitivity
To say that your institution’s market value, cash flow, and earnings are inextricably linked to interest rate fluctuations is an understatement. You need to understand your level of sensitivity to rate changes, but sometimes, it’s not all that straightforward. Over the past three years, we’ve observed numerous institutions that, after modeling their various buckets of loans, investments, deposits, and borrowings, projected immediate asset sensitivity—only to become liability sensitive within a year’s time. Additionally, many institutions have found that their operating results can vary with the shape of the yield curve; in many cases, more than they can vary due to the projected absolute level of interest rates.

To understand your institution’s level of sensitivity to interest rate changes, consider the following:

With an unexpected rise in interest rates, asset-sensitive institutions experience large cash flow and market value increases. Typically, these institutions fund with longer maturities and see their assets re-price faster than their liabilities. Conversely, liability sensitive institutions see their earnings and market values decrease as weighted average re-pricing of liabilities occurs at a faster rate than that of assets.

Know Thyself Variable #2: Liquidity Measurement
Your liquidity position represents your forecasted ability to meet future operating cash needs—both expected and unexpected—without sustaining negative impact on market value and earnings.

Typically, institutions with sufficient liquidity have a minimal balance of overnight deposits, a moderate proportion of retail deposits to overall funding, some unused credit line with the Seattle Bank and the capacity to fund new loans. Excess liquidity positions may be triggered by market events, such as accelerating prepayments in a mortgage portfolio or bond calls. Institutions with excess liquidity are characterized by large balances of overnight deposits, large proportions of retail deposits to overall funding, and large unused wholesale credit lines. In a declining rate environment, accelerating pre-payable assets may result in excessive levels of high-cost funding that can only be invested in lower-yielding assets.

The process of successfully measuring and managing liquidity should not rely solely on such static barometers as loan-to-deposit ratios, amounts of “volatile” liabilities, or cash and investments on hand. Instead, effective liquidity management should entail an internally generated forecast of your future operating cash needs. That means engaging your front-line loan and deposit personnel in estimating payoffs, originations, and prepayments for each of your balance sheet buckets to determine your institution’s liquidity-risk ratio.

Rather than serving as a static measure of liquidity, a liquidity-risk ratio provides a forward-looking, cash flow-based projection of sources and uses of funds. You could, for example, project your sources and uses at three-, six-, nine-, and 12-month intervals in the future. Mechanically, you could calculate net projected liquidity by modeling the relationship of [maturing assets, scheduled and unscheduled loan/investment payments, and unused borrowing capacity], and [deposit outflow, projected loan demand, and debt service]. Once you have generated an estimate of your sources and uses of funds, you can measure those net projected sources of cash against your available credit lines, available collateral, and other potential sources of liquidity. The regularly calibrated net projection should be closely aligned to an institution’s quantified liquidity management policy.

Remember: There can be a dark side to excess liquidity, particularly if it results from over-funding of assets that have prepaid faster than originally anticipated. This can occur when rates drop and institutions are forced to invest in lower yielding assets. You can score some protection against over-funding through the use of returnable advances, which provide the borrower the right to terminate unneeded high-cost funding.

Know Thyself Variable #3: Capital Requirements

Typically, institutions with constrained capital see their liabilities growing at a faster rate than their capital, a low proportion of investments to total assets and strong market demand for loans and deposits. Excess capital represents opportunity lost. Institutions with excess capital are characterized by constrained ROE, a high proportion of investments relative to total assets and reduced market demand for loans and deposits.

Know Thyself: Your Institutional Profile
Once you have the tools to help you measure and monitor your rate sensitivity, liquidity, and capitalization targets (and if you have not, contact your Seattle Bank relationship manager immediately!), you can put it all together to define your institutional profile. Are you an ASC, LSE, NEC, or something else? Refer to the chart below to understand where your institution fits.

Next, it’s time to re-assess your prescriptive strategies in concert with today’s flat yield curve and tight liquidity environment. Once again, it’s all about assessing (i.e., measuring and monitoring) your institutional profile and developing a set of strategies that are right for you. But, remember: it’s not your job to forecast interest rates, as tempting as it may be, but rather to know how badly your institution may fare in a less-than-favorable interest rate, liquidity, or capitalization situation. As those who have taken a computer programming class at some point in their careers would say, “spend 5% of your time on the ‘if’, and 95% on the ‘then’!”

Asset-Sensitive Strategies for a Flat Yield Curve Environment
Asset-sensitive institutions have benefited from three successive years of Fed rate increases. It hasn’t been a bad time for assets to be pricing faster than liabilities. Even though you would likely not be reading this article if you knew that rates would soon decline, you may not be feeling terribly comfortable with an implied forward yield curve that, at one point this month, was projecting overnight rates at 45 basis points below the current Fed funds rate. In considering the possibilities, your first inclination may be to urge (i.e., incentivize) your loan officers to negotiate as many interest rate floors in their variable rate loan documents as possible. Barring that, you may consider purchasing interest rate floors in the capital markets for some “insurance” in the event of a significant interest rate drop. Still, it hurts to pay an upfront insurance premium to a Wall Street counterparty and subject yourself to the mark-to-market vagaries of FASB 133. One additional means that asset-sensitive institutions may consider in order to obtain protection from declining rates, is to take down variable or fixed rate advances which contain contractually negotiated floors.

Here’s another word of caution for a falling interest rate situation. Avoid the mistakes that financial institutions faced in early 2003 when interest rates declined and 30-year mortgages and other longer-term assets started prepaying far faster than originally envisaged. If rapidly accelerating prepayments would impair your projected operating metrics, fight fire with fire and look at funding longer-duration assets with returnable advances. This would give you the option to terminate high-cost funding that you may not need if these assets pay down at a faster rate than you currently expect.

Figure 1: Asset-Sensitive Strategies for a Flat Yield Curve Environment by Institutional Profile

Liability-Sensitive Strategies for a Flat Yield Curve Environment
For liability-sensitive institutions, the past three years have produced their share of challenges. For institutions with liabilities that have re-set faster than their assets, it’s been tough to preserve and protect interest margins. As an example, if you borrowed at variable rates in 2003 to fund intermediate-term assets, you’re probably counting the hours until those 2.50% agency investments work their way off your balance sheet. Although implied forward rates point to a future rate decline, you probably remember that the forward markets are really nothing more than a “point spread.” As many Monday morning quarterbacks know, point spreads are often not representative of the actual score. Indeed, as a liability-sensitive institution, you’re no doubt wary of recent remarks by Fed officials concerning the outlook for inflation and their according high reluctance to drop short-term rates.

How can you protect yourself against the downside scenario of rising rates? You might consider tactics that would increase the duration of your funding. To do this, you could induce depositors to extend maturities by positively sloping your CD rate curve. You may also consider taking out wholesale advances in the three- to five-year maturity range. Another option would be to take on advances with embedded interest rate caps to provide further protection against rising interest rates. Asset durations may be adjusted downward, perhaps through swapping longer-term mortgages for adjustable rate mortgages.

Figure 1: Liability-Sensitive Strategies for a Flat Yield Curve Environment by Institutional Profile

The Art of Knowing Thyself
Practicing the art of knowing thyself—measuring and monitoring your interest rate, liquidity, and capital position—results in the invariable conclusion that one size does not fit all. Moreover, your position on each of these three radars may very well have changed over the past three years.

As the threat of margin compression continues, the importance of effective liability management has never been so important. Your best line of defense is to minimize your cost of funding. While your competitors may be launching aggressive CD specials at marginal rates far in excess of wholesale levels, cooler heads will prevail through adhering to viable funding strategies. These funding strategies must include:

• Gaining a realistic view of the cannibalization potential of CD specials.
• Pricing deposits such that you are not paying up for the deposits that would have come in the door anyway. (Would a 6.50% CD promotion have brought in the same amount of money, as a 5.75% CD promotion?)
• Developing timely deposit promotions. Are you looking at overseas companies that may be increasing their U.S. operations? Have you joined the many international chambers of commerce to raise your institution’s visibility? In order to spur new transactional accounts, could you reimburse your top-level MMDA customers for a fixed amount of out-of-network ATM transactions, or offer complimentary wire transfer services with their stockbroker? Some institutions are now offering complimentary brokerage transactions to their better customers.
• Constructing liability policies that recognize wholesale funding as often the lowest cost of funds for an institution. Have you designed a wholesale funding policy that puts in place secured and unsecured limits (perhaps expressed as a percentage of your assets or capital)?

In the coming months, the Seattle Bank will be offering new tools that will help you manage your unique set of interest rate, liquidity, and capital requirements. Stay tuned for new seminars and new structured advance products that can further assist your institution’s ongoing process of self-assessment.

In the meantime, may the pressures against your margins remain marginalized!

IMPORTANT DISCLAIMER, PLEASE READ: The Federal Home Loan Bank of Seattle ("Seattle Bank") publishes What Counts for educational and promotional purposes only. The data and analysis presented are based upon information obtained from sources that we consider reliable. The opinions expressed represent the current opinions of our staff and are subject to change without notice. We make no warranties, express or implied, regarding the accuracy or completeness of any information, analysis, or opinions presented. No part of this newsletter may be reproduced in any manner without the written permission of the Seattle Bank. The Seattle Bank, its employees, agents, and contractors are not registered investment advisors, financial advisors, or broker dealers, and they are not acting in a fiduciary capacity. The information contained in this newsletter does not constitute a recommendation, offer to sell, or solicitation of an offer to purchase any particular investments or products, including without limitation securities of any companies discussed, and it should not be construed as such. It is the reader’s responsibility to evaluate the suitability, risks, and merits of any investment, funding strategy, or business proposal presented in this newsletter. Newsletter content is for our readers' informational purposes only. Please refer to our Terms of Use for details.