The rising rate cycle has been challenging for financial institutions for a number of reasons, with Net Interest Margin and profit volatility being top of list for many bankers. Challenging waters lie ahead for institutions as the yield curve remains deeply inverted and the Federal Reserve signaling potential for monetary policy adjustments. The industry has experienced significant Net Interest Margin volatility over the past 5 years, mainly due to a rapidly shifting interest rate environment. With rate cuts penciled in for 2024 and potential yield curve volatility, a fresh approach to ALCO can help provide stability for NIM and profit going forward.
Why must we reprioritize the NIM?
Most institutions are heavily net interest income dependent so net interest income drives the lion’s share of profitability. The median community institution’s net interest income dependency is 88%, meaning net interest income represents 88% of aggregate revenue. Since 2018, we have observed significant NIM volatility related to asset/liability mix changes, interest rate cycles and optionality. Those institutions with higher net interest income dependency have felt more profit volatility.
Reimagining the ALCO Process
The ALCO process has evolved over time as interest rate risk modeling has become more complex and regulatory expectations continue to rachet up. All too often though, we find that ALCO is simply an exercise in regulatory appeasement: reviewing reports, regurgitating ratios, checking the minimum regulatory boxes. Many times, ALCOs get caught overweighting certain areas: the economy, loan and deposit pricing, interest rate risk reports, or investments. While regulatory appeasement and these items merit inclusion in ALCO, what is often missed is utilizing ALCO as a profit center. What if decisions and strategies at your ALCO improve and or stabilize profitability? Can effective strategies move the NIM by 10bps? What could that equate to in dollars? For a $500MM institution, NIM improvement of 10bps can translate to $500,000 in pre-tax income.
Net Interest Margin is the ultimate scorecard for your ALCO and we have found strong correlations between highly effective ALCO processes and higher, stable NIMs over time. When you think about your ALCO membership…the ALCO meeting may very well be the most expensive meeting for your institution. Not just from the human capital expense, but also from the strategies that can make or lose money for your institution. We at HUB|Taylor Advisors focus on Balance Sheet Management, which varies greatly from other approaches to ALCO. Interest Rate Risk Management, Asset Liability Management are terms often used interchangeably with Balance Sheet Management, but in reality these approaches produce very different outcomes over time. Balance Sheet Management is the most comprehensive of the three and is where position assessment and strategy execution meet. Assessing risks and opportunities through the lens of the entire balance sheet helps to craft unique strategies to protect and to expand the NIM. For example:
- Are we growing market share with our loan pricing strategy? Do we have a loan strategy?
- How do loan structure and pricing decisions impact interest rate risk and liquidity?
- What effect do deposit pricing strategies have on marginal cost of funds?
- How can you utilize your investment portfolio to manage liquidity, interest rate risk, and expand income?
- How does robust capital stress testing impact contingency funding planning?
These are all examples of topics often missed at average ALCOs that cost your institution basis points at a time when institutions desperately need more basis points for earnings. Your peers with highly effective ALCOs are leveraging their meetings, having these discussions and executing strategies that come from each session.
HUB | Taylor Advisors’ Take: Interest rate volatility in 2024 will lead to more Net Interest Margin volatility. As such, your ALCO approach and process will be critical for ensuring budget and stretch goals are achieved. Many institutions may have the talent internally to run reports and aggregate an ALCO packet; however, an independent facilitator can bring powerful perspectives, best practices, and strategies to squeeze basis points out of your balance sheet. The ALCO packet is not just a document that gets approved by the Board, but rather a unique word problem that deserves custom crafted strategies for risk management and profitability to optimize your balance sheet!
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Headquartered in Louisville, HUB | Taylor Advisors provides consulting and advisory services in the areas of ALCO, capital, liquidity, interest rate risk and investments to community-based financial institutions throughout the country. To learn more, visit www.tayloradvisor.com or contact Todd Taylor at todd.taylor@hubinternational.com and Omar Hinojosa at omar.hinojosa@hubinternational.com.
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