“The good seaman weathers the storm he cannot avoid, and avoids the storm he cannot weather”
ALM Strategy | Deposits | Loans | ALCO
During the boating season, I find myself constantly checking weather reports. I have several applications on my phone that I scroll through every hour before departure to determine the best course for the day. In New England, it’s rare to get a full day of calm seas and light winds. Inevitably, conditions change. And it’s usually when you are already out on the water that all of those marine forecasts prove inaccurate.
That’s when I remind myself of the above quote and prepare our vessel for safe passage to port.
I can’t think of a better quote to sum up the first two months of the year for bankers. While we all spend a lot of time and effort following reputable economists to determine the best possible strategy, the “forecasts” always change and unexpected “storm clouds” gather.
Clearly a lot has changed in a relatively short period of time. Balance sheet managers are dealing with a number of issues that haven’t occupied our foremost attention for the past several years.
Let’s look at what has changed and the key considerations for navigating in this new paradigm.
Below are five ALCO initiatives to shift the silver bullet quest toward a forward-looking and strategically-focused ALCO meeting.
Geopolitical Uncertainty
Unfortunately, nothing more concisely encapsulates a raging storm than the military aggression in Ukraine. The world changed on February 24th. Surely, we are all keeping the citizens of Ukraine close in our thoughts.
The uncertainty has obviously gyrated financial markets. Given some of the capital requirements in place emanating from the Great Recession, the US banking system is thought to be in good condition to weather whatever may be the fallout of sanctions on Russian entities.
How this conflict ends remains to be seen, but the ripple effects are already being felt within the global banking system. There is no doubt that community financial institutions will be managing through a volatile period. So “batten down the hatches;” the ride might be bumpy.
The Federal Reserve
Say goodbye to “inflation is transitory” and hello to the “inflation is persistent” narrative. You don’t have to look too hard to find a reputable economist or even FOMC member predicting the FOMC will increase rates several times this year. As of late February, Goldman Sachs was predicting seven, and others, like JPMorgan predicted increases at NINE consecutive meetings.
It has been quite some time since the FOMC moved rates to that degree. In fact, during the most recent rising rate cycle which commenced in 2015, it took 28 months in total for the FOMC to raise the Fed Funds rate by 125bps. During the 2004 tightening cycle, it took only 11 months for rates to increase by 125bps. This time, if we believe any of the referenced forecasts, it might only take 5-6 months. What does this mean for your balance sheet?
Do we need to increase deposit rates?
The most obvious question financial institutions are asking is what will happen to those excess deposits laying around on the balance sheet? Deposit rates typically lag market rate increases, but how will that materialize if the period during which we usually lag is significantly truncated versus prior cycles?
Some have mentioned that “this time is different” in reference to the surplus of liquidity that institutions currently have on their balance sheet. They maintain that lags should be more pronounced versus prior cycles because of this phenomenon.
Ultimately that may be true, but is your team prepared for when a competitor in your local marketplace “misbehaves” and introduces deposit promotions? Are you comfortable with potential runoff? Are we afraid of losing market share? Are the folks on the front lines versed on how to respond? Is there a strategy in place to address these issues? Do we understand what our pricing may look like if the FOMC keeps going?
How far can we stretch the rubber band before it snaps?
The good news is that you still have some time to develop a response as odds are the FOMC only increases rates by 25bps in March and they are not scheduled to meet in April. Your institution's response to this escalation will significantly influence what your bottom line looks like by year-end.
The Yield Curve
The 10 year US Treasury closed out 2021 at 1.52%. Since then, we have seen that yield occasionally move north of 2% (with a sojourn back down to 1.70%). And while that is certainly noteworthy, the real action has been at the 2 year tenor. That rate has moved from 73bps up to 1.58% during that same time frame. Accordingly, the spread between the 2 year and 10 year has narrowed to approximately 30bps.
While none of us is rooting for a bear flattening because of what historically occurs shortly thereafter (each gray shaded period on the above chart indicates recession), there are some considerations given the newly established level of rates in the belly of the curve.
Has your loan pricing inched up?
Should we be asking for higher rates? Or, conversely, are we committed to “moving out” some of our excess liquidity and are therefore relatively indifferent to offering rates?
In 2021, long rates surged in the first quarter of the year only to settle lower for much of the calendar year. Despite the oscillation in rates, most lenders would contend that pricing on commercial deals really didn’t budge at all. Is now the time the market will accept higher pricing?
In some markets on selected deals, you are seeing commercial real estate loans at levels below conforming 30-year mortgage rates.
Could this simply be attributed to the market “lagging” on loan pricing as the procurement process simply hasn’t caught up yet? Or, will pricing remain hyper-competitive?
For those pricing off the 5-year point of the FHLB curve plus a spread, those rates are flirting with 5%. In some markets, pricing has increased to an extent; however, in others you might not see a penny in your pipeline. Now is the time to reassess loan pricing and determine what is the best strategy given all the factors that impact lending.
Is this a “buying” opportunity?
Some institutions have intentionally allowed their cash position to grow. Maybe it’s the notion that their COVID-related deposit surge is heading back out the door. Maybe it’s the fear of unrealized losses in the bond portfolio. Or maybe it's simply a bias towards a higher rate forecast driven by inflation.
Whatever the case, it can be argued that the opportunity cost associated with maintaining a large cash position versus purchasing bonds is undeniably high. If rates don’t move commensurate to a preferred economic forecast, is your institution comfortable foregoing yet another year of income?
For those who have been sitting on the sidelines, is it time to finally take the plunge?
Given the move in market interest rates, most are engaged in replenishing their existing cashflow but also adding to their overall portfolios. While the best structures for your portfolio are dependent upon the risk profile of your institution, now is the time to educate your ALCO Committees / Board so that they clearly understand the role of the investment portfolio during 2022 and beyond.
Do I extend wholesale funding?
It seems like an eternity since the last time someone asked whether they should extend their wholesale borrowing position. For those institutions who did not experience the surge in deposit balances over the past two years, it's once again time to evaluate what terms are optimal for the overall funding mix of the balance sheet. As always, the answer depends on several variables and the inherent balance sheet posture.
For those whose net interest income levels increase as rates rise, they are likely to roll their funding short.
However, for those who manage a liability-sensitive balance sheet, the answer to this question becomes more complicated. What is my expectation for deposit growth? What do our pipelines look like on the other side of the balance sheet? Would we consider utilizing hedges or the options market to alleviate some of that pressure?
Dating back to 1994 (utilizing FHLB Boston advance rates), when evaluating “rolling” funding short versus extending to a five-year term borrowing, the overall cost of the short-term borrowing was “cheaper” than the term borrowing in excess of 95% of the time. The odds are still strongly in favor (> 90%) of overnight when comparing to 2- & 3-year borrowings as well. (Huge thanks to DCG colleague Zach Zoia who sourced this information).
One thing to keep in mind is that interest rates have been in gradual decline for the past 40 years. Could this time be different? Will current levels of inflation cause the FOMC to move to a greater degree than anticipated to stem the tide? Maybe, but maybe not. Nonetheless, balance sheet managers should understand the variables that influence their decision on whether to extend liabilities.
Summary
Before pulling up the anchor and heading back to port, I think through all the potential variables that may influence our journey through the turbulent waters en route to the dock.
The most important thing when crossing rough waters is to simply listen to what the boat is trying to tell you. If you are going too fast, you’ll know (i.e., your teeth start rattling from the hull slamming into the waves). If your crew is looking nauseated, then maybe it’s time for a less direct tack! Paying attention to the attitude of the boat and putting the vessel in the best position to succeed is critical.
And for bankers, it’s really no different. Doing what you do best and deferring to what your balance sheet is trying to tell you is the easiest way to avoid mistakes during this uncertain time. Understanding your model and formulating strategies that take advantage of your strengths will ensure continued success.
We here at DCG wish you all a safe passage in 2022.
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ABOUT THE AUTHOR
Vinny Clevenger is a Managing Director at DCG. In this position, he currently advises financial institutions on balance sheet management strategies. He takes a practical approach to the demands that the economic and regulatory environment place on his clients. Since joining the firm in 2003, he has worked in a number of capacities within DCG assisting clients in all aspects of ALM including process reviews, model validations, policy reviews, capital management, and contingency liquidity planning.
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