In 2019, banks nationally were 87% dependent on net interest income. With the lions’ share of earnings coming from Net Interest Margin (NIM), implementing a disciplined approach around NIM management to capitalize on opportunities and avoid mistakes will make the difference between underperforming and outperforming institutions.
As Financial institutions across the nation cope with market and economic
challenges impacted by COVID-19, anticipating next steps to improving or protecting profitability will become increasingly difficult AND managing balance sheet “risks”.
Stress testing your institution’s balance sheet is no longer an academic exercise! COVID-19 shocked the financial system, and the fallout continues to spread through Wall Street and Main Street. Capital and Liquidity have quickly moved to the top of concerns for most financial institutions, but it is important to stay focused on four major balance sheet positions we discuss below to stay ahead of your peers.
Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses, and providing resources for seizing opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown. As we navigate this period of uncertainty over the next 12 to 24 months, capital will be tested. Rapid changes occurring within the economy are not entirely cyclical in nature; rather, structural changes will develop as consumer behavior evolves and business operations adjust to a ‘new normal’. The following are key considerations for assessing the current and future adequacy of your capital base:
• Credit Quality Deterioration – The depth and severity of cash flow interruption could lead to an expansion in nonperforming assets, ultimately increasing provision expense. Given the volume of deferrals and modifications in the immediate wake of the pandemic, realization of problem assets may not materialize until late 2020 or early 2021.
• Asset Growth – Increased loan funding, customer draws on credit lines,
and slower loan amortization may lead to larger balance sheets. Knowing the ‘breaking points’ for your capital base in terms of growth, credit deterioration, and a combination of these factors will serve your institution well for the board and regulators. If your capital stress testing results project risks to your ‘well capitalized’ status, it is critical to understand the ramifications this can have on your liquidity and access to various funding sources.
At Taylor Advisors, we have a saying, “Asset quality deterioration leads to capital erosion which leads to liquidity evaporation”. Beyond the potential for heightened credit risk, the COVID-19 pandemic has also created additional stressors for your institution’s assessment of liquidity:
• Cash Flow Interruption – Borrower deferral and modification requests will reduce expected cash inflows to your institution.
• Accelerated Loan Funding – Some financial institutions are seeing significant draws on unfunded lines of credit as businesses and consumers look to hoard any additional liquidity to ‘weather the storm’.
• Reduced Borrowing Capacity – Borrower cash flow interruption and potential for intermediate-term asset quality deterioration could lead to lower borrowing capacity with your correspondent bank, Federal Home Loan Bank and Federal Reserve Bank.
• Deposit Outflows – As cash flow interruption persists and credit availability tightens, customers’ next source of liquidity will come from their liquid assets, i.e. stocks, bonds, and deposits.
Interest Rate Risk Assessment/Position
Many financial institutions are beginning to feel pressure on interest income and earning asset yields, frequently compounded by funding costs already at historically low levels. Key considerations in managing interest rate risk from a whole balance sheet perspective include:
• Asset mix – Excess cash is expensive,and many institutions are seeing liquidity build from growing deposits, loan amortization, prepayments, and calls. Re-adjust your mix, not only to improve your earnings today, but to sustain it with higher, stable earning asset yields over time.
• Loan and Deposit Assumptions – Revisit your loan reinvestment rate
floors within the interest rate risk model and ensure that your institution’s expected pricing is reflected in your assumptions. Review rates down deposit beta assumptions. Based on earlier rate cycles, they may be too high for some deposit categories.
• Changes in Risk Profile – As rates have come down, your institution’s risk posture looks different today than in 2019. Be sure to compare base-case projections for net interest income quarter over quarter to observe any changes or adjust assumptions to reflect the new normal.
Strategies for investment portfolios and cash usually make a meaningful contribution to your institution’s overall interest income. Below are some key considerations to help guide the investment process in today’s challenging environment:
• Cost of carrying excess cash just increased – Most institutions are now earning just 0.10% on their overnight funds. There are alternatives available in the market to increase income on short-term liquidity.
• Consider pre-investing – Many institutions have been very busy with PPP loans, and investments have taken a back seat. However, we anticipate this program having a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market.
• Don’t compete with the Fed – With several asset purchase and lending programs currently in effect, prices on various types of investments are distorted. For example, many plain-vanilla agency MBS are trading at elevated prices with very low yields.
Looking Beyond 2020
Looking beyond 2020, liquidity and capital are taking center stage in most community bank ALCO discussions. Moving away from regulatory appeasement and towards pro-active planning and decision making will be of paramount importance. This can start with upgrading your tools and policies, improving your ability to interpret and communicate the results, and helping implement actionable strategies.
Changing interest rate environments require changes in strategies. Overnight rates are expected to stay low for the foreseeable future. While interest rate risk models generally project exposure based on a static balance sheet, optimizing your asset mix and margin for tomorrow is a dynamic process that can help out-earn today’s projections. For investments, be aware of the Fed’s impact on certain market sectors and look to take advantage of this phenomenon. Relative value is changing frequently in the market and staying abreast of spreads and risks will be key to generating superior returns.
Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. Why? You must know where you are to know where you want to go. Balance sheet management is about driving unique strategies and risk management practices tailored for your institution to outperform. Doing anything less will lead to sub-optimal results.
Taylor Advisors helps executives by providing strategies and expertise to effectively manage the balance sheet. Please visit our website for additional resources including success stories or to ask us a question about your balance sheet process and how we can help.