Are your lending strategies fully supported? Four tips to consider.

posted on Friday, January 13, 2017 in Strategies

John P. Biestman, CFA
Vice President and Senior Relationship Manager

“If something cannot go on forever, it will stop.”
Herbert Stein, Former Chairman, Council of Economic Advisers (CEA)

It is hard to believe that the December 2015 Federal Reserve rate hike occurred on almost exactly the seventh anniversary of the 2008 decision to establish a target range for the federal funds rate of 0 to 1/4 percent. Over the past seven years, we have seen this policy backed up by aggressive purchases of bonds, treasuries, agencies and mortgage-backed securities, and its alteration of Treasury holdings (“Operation Twist”). Indeed, across the globe, central banks such as the European Central Bank and the Bank of Japan have embarked on accommodative policies aimed at negative interest rates in order to spur economic demand.

In recent years, the Federal Home Loan Bank of Des Moines—with the generous assistance of nationally known balance sheet consultants—has sponsored and produced multiple educational seminars, articles and strategies with two recurring themes related to the Fed's actions:

  • Excessive liquidity
  • Zero interest rate policy (ZIRP), in which the central bank supports low nominal interest rates in an effort to reverse slow economic growth

Classic economists John Maynard Keynes (1883-1946) and Friedrich Hayek (1899-1992) examined both of these topics. In Keynesian theory, fiscal and monetary stimulus is designed to counter the possibility of a liquidity trap—a point at which returns are so low that investors elect to keep their savings in cash rather than what could be productive economic activity.

Keynesian economics postulates that the multiplier effect of fiscal stimulus is magnified when nominal rates are close to zero. Hayek, on the other hand, was often critical of aggressive monetary policy and the resulting excessive liquidity. Hayek believed that excessive liquidity could actually exacerbate business cycles and create an environment that is conducive to asset bubbles and unwise investments.

What Does This Mean for the Banking World?

It's tough to maintain net interest margins in a low-rate environment without increasing credit risk or interest rate risk. As many community lenders face these tight parameters, the following actions have become all the more important while navigating your way through today's labyrinth of zero interest rate policy (“ZIRP”) and excessive liquidity.

At some point, your financial institution must find a path toward growth.

The balance sheet growth objectives are all the more difficult to accomplish given today's competitive lending environment, flat yield curve and cost of compliance. There are some strategies, however, that could rejuvenate your growth prospects:

  • Hold some of the mortgages you've been originating
  • Purchase some 15-year mortgage-backed securities
  • Look at potential pockets of demand in your market (For instance, would commercial mini-perm or fixed rate agricultural loans be a good fit with your customer base?)

To mitigate the extension risk associated with these growth strategies, consider a long-term funding structures with a Symmetrical Prepayment Feature. In exchange for a modest-rate premium, fixed-rate funding can be prepaid in advance of its maturity with a monetary gain that can offset any losses that an asset might sustain in a rising-rate environment.

Diversify your funding sources.

Diversify your funding base in much the same manner as you would diversify your investment or loan portfolio. It is a mistake to interpret funding diversification as merely “secured” or “unsecured.” There are multiple variables to consider:

  • Retail vs. wholesale: particularly in a changing regulatory and rate environment, core deposits can quickly shed some of their “core” characteristics and actually exacerbate rather than mitigate interest rate risk. FHLB advances, for example, carry defined durations.
  • “Core” vs. “non-core”: Although core deposits may be abundant now, it is hard to know when and how duration and rates might change. The actual duration of core funds can be highly variable, particularly for those that have been derived from “surge” sources, such as temporarily non-rate-sensitive money that will only change its spots once rates rise. Duration uncertainty could also stem from changes in demographics, market channels, and “stickiness” of fee-based services such as online bill pay.

Blending your funding sources can help you optimize net interest margin and manage balance sheet risk.

The concept of blended funding incorporates an aggregate liability approach to funding assets. Asset-growth strategies are ideally supported by a diversified portfolio consisting of:

  1. Core funding: Focus on how certain deposit products, such as term CDs, might perform in a rising-rate environment. What is the time period you have assigned for penalties on early withdrawals? The typical answer might be six months. In a rapidly rising rate environment and in the information age, the increasingly savvy consumer could very readily conclude that migrating funds into a higher-yielding asset would cover a six-month penalty on short order.
  2. Wholesale funding, including FHLB Des Moines advances
  3. Equity

As an example, the FHLB Des Moines Blended Funding Model can help you assess different funding scenarios against varying interest rate outcomes and deposit assumptions.

Get your interest rate risk assessment methodologies in order.

We are now on the seventh anniversary of the interagency directive on interest rate risk. Although the prospect of rising rates appears to fade with time and slow economic growth, the inconvenient truth is that most financial institutions have more interest rate risk today than they did several years ago. Do you have an interest rate risk policy that describes the pre-determined actions that you would take in the event the proverbial water boils over the stove? If not, ask yourself if your institution is preparing as follows:

Are you testing your balance sheet's sensitivity to varying time horizons? Your net interest margins may react very differently to a changing rate environment one year from now, versus three years from now.

  • Are your non-maturity deposit decay rate and duration assumptions on the mark? Using a strictly historical approach may be inaccurate in today's world of heightened consumer awareness of prevailing rate levels. Are you considering including floors and ceilings in your loans?
  • Are you back-testing your modeling process and validating the results with the assistance of qualified external parties?
  • Are you testing rate sensitivities against economic value of equity (EVE) in addition to net interest income (NII)? EVE analysis considers the market value of an institution's assets and liabilities under different rate scenarios. When rates change, the net present value of all anticipated future cash flows also changes. It's a broader assessment than that of measuring changes in net interest income. EVE analysis, however, does have some drawbacks, including the precise timing of rate risk and uncertainties associated with the selection of an appropriate discount rate. Still, the two approaches of NII and EVE projections go hand-in-hand.

Contingency funding / wholesale funding plans should be more than a regulatory compliance afterthought.

Contingency and wholesale funding plans can help a management team focus on identifying potential liquidity stress sources. As an example, what potential sources of funding might exist if a financial institution were to sustain credit losses and migrate beyond a regulatory designation of CAMELS 3? Having readily available and diversified sources of asset-based liquidity (e.g., on-balance sheet, unencumbered securities) and liability-based liquidity (e.g., FHLB Des Moines advances) is essential before any stress event occurs.

Ideally, wholesale funding policies formalize the benefits of funding diversification. Such a policy would apply specific limits and targeted usage levels for each specific funding source. These limits and targets could be benchmarked to an institution's assets, liabilities or deposits, but an asset benchmark is typical. Your wholesale funding policy might also reference marginal cost analysis. Wholesale funding rates and their relationship to marginal cost are an appropriate benchmark for addressing such questions as:

  • Where should you set existing rates of existing deposit products?
  • In the event interest rates increase, should you raise your deposit pricing or stand pat?

A tool that analyzes marginal cost of funds under varying cannibalization scenarios can help you develop growth and product segmentation strategies and customer retention or deposit pricing strategies.

It is hard to believe that for more than seven years, the financial landscape has been dominated by close-to-zero interest rate policies and excess liquidity. Heeding the aforementioned pieces of advice might help us rest easier as we remember the words of Mr. Stein: “If something cannot go on forever, it will stop.”


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