As Financial institutions across the nation cope with market and economic challenges created by COVID-19, anticipating next steps to manage balance sheet “risks” AND improve or protect profitability is becoming increasingly more difficult.
In Part 1 of our miniseries, we discussed the importance of robust liquidity stress testing, a comprehensive contingency funding plan, and anticipating potential changes in loan and deposit portfolios.
In Part 2, we discussed potential impact on capital from asset quality deterioration, margin compression, and other balance sheet changes.
In Part 3, we discussed investment strategies as portfolios and cash usually make a meaningful contribution to institution’s overall interest income.
In Part 4, we turn our attention to interest rate risk management and look at challenges relating to exposures to falling/low rates. 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. Call protection should be a focus within the loan and investment portfolios to minimize risk of cash flow volatility. Re-adjust your mix, not only to improve your earnings today, but to sustain it with higher, stable earning asset yields over time.
- Loan Pricing – Credit spreads have widened significantly for corporate debt across the curve. While commercial loan customers keep an eye on prime rate and may request rate modifications, keep in mind that credit risk is elevated while credit availability is shrinking. Maintaining diligence in loan pricing will be a key factor for stabilizing loan yields. 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.
- Liability Pricing –Aggressively seek reductions in funding costs with a bias towards shorter terms to retain control over future repricing. Be aware of upcoming CD maturities along with opportunities to reprice other borrowings lower. Additionally, consider 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. Focusing on asset mix will be key to reversing any compression in a safe manner.
Taylor Advisors’ Take: Changing interest rate environments require changes in strategies. 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 and can help out-earn today’s model projections. Remember to maintain discipline in loan pricing and ensure you are being adequately compensated for credit and interest rate risks. Take advantage of all opportunities to lower funding costs. Re-evaluate key model assumptions including loan reinvestment rate floors and deposit betas for rates down scenarios. Regulators still expect institutions to maintain a comprehensive interest rate risk management process, assumption documentation, stress testing, back testing, and a periodic independent review.
We hope you have found our mini-series on balance sheet management to be practical and informative as you and your team navigate through this unprecedented time.