If you knew anything about economics...

I know a lot of bankers that fancy themselves amateur economists.  I've been more than a little guilty of this myself.  However, clearly I am not qualified to be an economist.  I don't have the vital credentials, as explained in this masterpiece from Dilbert:

Interest Rate Swaps for Credit Unions

by Dallas Wells

Over the last couple of years, I have had several conversations with frustrated management teams of large credit unions that were looking for ways to mitigate their interest rate risk.  Their balance sheets were (and still are) in positions such that very plain vanilla interest rate swaps would greatly reduce their risk.  However, because of the stance taken by their primary regulator, the NCUA (which is, ABSOLUTELY NOT, UNDER ANY CIRCUMSTANCES!!) these tools were simply out of the question.  So, instead of easily lowering the risk profile, they either decided to accept it or had to reduce the risk through some other less efficient (and more expensive) method.

That may be about to change, at least to a degree.  Due to the growing interest rate risk caused by this prolonged low rate environment, the NCUA has proposed a rule that would allow some credit unions to use a couple of specific derivative structures to manage some specific risks.  There are a TON of stipulations, but at least it is a step in the right direction.

Here is a link to the proposed rule, which includes limits on size of the institution (at least $250 million in assets), instruments (some specific swaps and caps), notional amounts, fair value losses, and even average lives per instrument and in aggregate.

Most credit unions will (and should) steer clear of all the red tape, but for a few of the larger and more sophisticated credit unions, this is welcome news.  It will be interesting to see if the final rule looks much like this proposed rule...

Exam Trends: A Focus on Market Value of Equity (MVE or EVE)

by Dallas Wells


We have mentioned this trend briefly in other posts, but since it seems to be becoming ever more prevalent, I thought it deserved its own post.  The "it" in this case is the extra attention that market value of equity (MVE) or economic value of equity (EVE) has been getting from field examiners.  Of course, as with all things exam related, the questions and issues cited are rarely the real problem.

Regulators, from Ben Bernanke all the way down to your local field office, are becoming increasingly wary of the growing interest rate risk on bank balance sheets.  The reasons have been discussed here many times, but the basic issue is duration drift on the asset side.  From a recent article at Bank Director (Is Banking’s Business Model Broken?):

...banking’s business model is significantly challenged in today’s interest rate environment. With deposit costs near zero and fierce competition for loans driving down yields, many banks are running on fumes.

As higher yielding loans mature, banks are replacing them with lower yielding assets, resulting in significant net interest margin (NIM) compression across the industry. Regardless of whether the Federal Reserve’s accommodative monetary policy has helped or hurt the economy, it is wreaking havoc on banks’ profit models.

Which inevitably leads to:

To combat the NIM squeeze, some banks are taking more interest rate and credit risk. By venturing further out on the yield curve and underwriting riskier assets, banks can generate more revenue; however, the risks may not justify the returns. In the short-term, the strategy could increase profits. In the long-term, it could create less stable institutions and the conditions for another credit crisis.  

The concern is more for community banks than with larger banks, mostly because some small banks are still reluctant to consider risk mitigation tools like interest rate swaps.  Regulators know that we are moving further out on the curve in a reach for yield.  Moreover, the kind of risk being taken will not easily be found in the 12 or even 24 month income simulations.  This is long term interest rate risk, specifically in the form of price risk, that will show up in the MVE shocks.  For this reason, examiners are taking a hard look at this often ignored (and misunderstood) metric.  In short, they are concerned that banks are too complacent about longer assets because of the huge growth in non-maturing core deposits.   But what happens when rates rise and some of these surge deposits shift back over to shorter and more rate sensitive time deposits?

Because of these concerns, we have seen a couple of important shifts in exam expectations.  Here is a short list of things your ALCO should be thinking about:

1. Does the bank (management, ALCO, and the board) really understand MVE and what it means?  Make sure everyone involved is on the same page about what it measures, and the bank's current position.
2. Do you know what parts of the balance sheet drive the results?  We have created additional reports in the BancPath model to determine which components contribute how much to the change in MVE as rates move, and you should do the same in your own model.
3. Are you measuring MVE instantaneously, or do you also look at future dates?  Examiners are now expecting that pricing betas be applied to core deposits, which requires a roll forward of the balance sheet in the MVE calculations.  Many models used by community banks cannot handle this task.
4. Do your decay rates on non-maturing deposits change as rates change?  Much like assets extend as rates rise, it is likely that these accounts will shorten as rates increase and depositors seek higher yields.  Again, this is functionality that is lacking on most models.
5. Do you have well documented support for your prepayment speed assumptions?  Extension risk is going to be a serious problem as rates rise, and those relying on outdated OTS assumptions or simple historical speeds from your own loans will not adequately capture this risk.  We have been in this low rate environment for too long, and these assumptions are just plain wrong.  After all, how can you build good models from your recent speeds when we have not seen meaningful increases in loan rates in 6+ years?

As you can see, the concern is about the long term interest rate risk, but the questions are all about the assumptions that drive the MVE calculations.  At AMG, we have been making adjustments to our methodology in the BancPath model, and spending a lot of time making sure our clients are prepared for this discussion in their exams.  Make sure you don't get caught by surprise, and as always, let us know if we can help. 

Bank of America's Branch Fire Sale

by Dallas Wells

As a follow up to yesterday's post on The Future of Bank Branches, here is an article from Bloomberg on Bank of America putting more branches on the market (BofA Said to Seek Buyers for N.Y., Pennsylvania Branches).  Bank of America has been selling branches hand over fist for the last couple of years now.  Having to talked to several bankers involved with these transactions (some have bought branches with customers, others just the real estate), they are in many cases giving these branches away.  So what do they know that don't?  From Bloomberg:

Chief Executive Officer Brian T. Moynihan has been closing or selling outlets since 2011 to lower costs and focus on more populous markets. The CEO has said the Charlotte, North Carolina-based firm needs fewer branches as people do more banking online.

“They’re pulling out of markets they don’t have much growth in, places that aren’t meaningful to the big banks,” said Bert Ely, an independent banking consultant in Alexandria, Virginia. “There aren’t a lot of buyers for them right now, and so you’re not seeing them sell for huge premiums.”

Most of the buyers lately have been smaller banks that see these branches as an inexpensive way to gain access to markets that make sense for them.  It will be interesting to see how many customers they retain, as the typical Bank of America customer is looking for different things from their bank than the new community bank offers.  They were not necessarily looking for the friendly neighborhood banker, but for the internet and mobile solutions (both quite good by the way) or for the thousands of branches and ATMs all over the country.

So far, at least anecdotally, some of the biggest winners in these deals seem to be the remaining banks in markets that Bank of America is abandoning.  These customers see this as the last straw, and many of the local banks are picking up the leftovers.  Whichever side of the table you are on (buyer, seller, bystander), the branch network is most definitely an evolving concept for all involved.  

The Future of Bank Branches

by Dallas Wells

One of the inevitable consequences of industry wide margin compression is that all overhead costs will come under more scrutiny.  With their ever declining foot traffic and transaction volumes (not to mention high costs per unit), branch networks have been among the first items on the chopping block.  However, the banking industry faces a conundrum familiar to many other industries.  Costs must be reduced, but failure to invest in customer facing infrastructure could lead to a Sears/Blockbuster type downward spiral.

These reasons combined with shifting demographics and exciting new technology mean that the basic design and function of bank branches will change dramatically in the coming years.  Those massive, free standing behemoths sitting at every major intersection will become crippling legacy costs for many institutions as they compete with smaller, more efficient branches of the future.  In short, many banks formed their cost structures in a 4% net interest margin world, and are now hoping they can hold onto 3% net interest margins.  A vast network of dinosaur branches simply won't work.

This is an issue all community banks should be thinking about as a part of their long term planning.  One of the pioneers in this regard is Umpqua Bank.  Some of their thoughts on the future of the ranch can be found here (this link is worth the click).  Many of you have read about Umpqua and seen the pictures before, and mostly dismissed the trend.  After all, that may work in urban markets on the west coast.  What about in rural markets in the Midwest?  Maybe you don't need as much Nordstrom's and Starbucks style, but how welcoming are those cavernous branches that now have half the staff for which they were designed?  Are there empty desks?  Teller windows that are never opened?  Does it echo?  I have been inside a ton of banks over the last couple of years, and I know the answer is yes.  Even if the design is more conservative, a smaller and more cozy footprint is not only more efficient, it is more customer friendly. 

For more food for thought, I point you to this article at banktech.com (The Evolving Branch Environment).  It has specifics on how some relatively low cost technology can make these smaller branches more functional.

Contrary to what is being said on Twitter and in bank technology blogs, the branch is not dead, and you cannot ignore new investments in this channel.  But, our approach to branches must change.  Is your management team ready?

Moody's Agrees: Low Rates are Adding Risk to Banks

by Dallas Wells

Last week Chairman Bernanke used the phrase "reaching for yield" in a speech.  To some this might be welcome, as it at least means that the Fed is aware of the building risk in the financial system.  However, bankers are also aware that the Federal Reserve is a regulator, so a focus on who is reaching how far for yield could lead to some uncomfortable exams.

American Banker also has an article up (Low Yields, Loosening Terms Raise Risk for Banks: Moody's) that summarizes Moody's opinion that banks are stretching on both terms and credit standards:

A combination of low yields and loosening terms may be setting banks up for trouble in the event of an economic downturn, one of the nation's top credit ratings agencies said Monday.

Nearly two-thirds of banks with assets of more than $20 billion say they have lowered pricing on loans to large and middle-market businesses in recent months, while nearly half of lenders reported relaxing loan conditions, up from 30% in January, according to the Federal Reserve's latest survey of senior loan officers.

The combination, which comes amid an uptick in commercial and industrial lending, increases risk for banks, says Moody's Investors Service in a report published Monday.

Be careful out there - your choices are generally between paltry yields or too much risk.  Let us know if we can help.

Should community banks get back to consumer lending?

By Dallas Wells

As community banks battle each other to the death on loan pricing, many are actively looking for new products to help grow higher yielding assets.  A couple of years ago that meant more banks jumping into SBA and C&I lending, which has contributed to much of the added price pressure in those markets.  Now many are turning back to consumer lending, hoping they can somehow regain turf that has largely been ceded to the megabanks in recent years.  After all, these loans have high yields, short durations, and great cross sell opportunities.  But is the regulation/compliance problem and competing with the big guys worth the revenue?

I will point you to two articles for more information.  First is a post from Cornerstone Advisors on their Gonzo Banker blog about community and regional banks getting into the credit card business.  The returns they highlight will look very tempting to those out there slugging it out for fixed rate loans that translate to sub 200 spreads over LIBOR.  Banks that do credit cards well have historically been high performers, but make sure you do your homework.  There are lots of ways to tackle this business that can generate revenue and allow you to keep your relationship with your customer - just make sure you match your program with your operational capacity and skill set, or you could be biting off more than you can chew.

Second is an article from Banking Strategies on small dollar loans.  Again, I would suggest caution, as we don't want to get too cute raise the payday lending and overdraft ire of customers and regulators.  However, some of these pilot programs have shown promise, and it is impossible to deny that there is a market to be served.  After all, how many payday loan/check cashing businesses are there in your community?

Community banks are struggling with margin compression, which in the past has caused many of them to make decisions they later regretted.  So, tread lightly, but times like these certainly dictate that we need to keep looking under every rock for potential revenue.  Consumer lending is a business many small banks abandoned as too costly, but with new technology, you just might be able to make it work.

5 Performance Keys

by Dallas Wells

Bank Director posted an article last week (Taking a Cue from World-Class Athletes—Five Keys to Top Performance in 2013) that summarizes the results from a Fiserv study on banks between $1 billion and $10 billion in assets.  While most of this list falls under "easier said than done," there is one item that I found intriguing:

It’s all about the volume.

Top performing banks are simply lending more than their peers. For leading growth banks, total loans as a percentage of average earning assets was nearly 75 percent, compared to an average of 65 percent for all banks studied. But, while top performers lead with higher loan volume, it’s often done with some sacrifice to loan yield. This can be attributed to two factors: aggressive pricing and higher quality of loans.
 

This is a tricky balance, but the banks that are thriving in this zero rate world are those that are doing a better job of choosing their battles.  They are deciding which deals they really want, and aggressively going after them.  On all other deals they are holding the line on disciplined pricing.  As always, loan pricing comes down to a rate/volume trade off.  We suggest that your pay extra attention to variance reports on interest income, and analyze the rate/volume trends.  How much volume do you need to add to cover the inevitable drop in loan yields?

 

The Loan Market as a Nash Equilibrium

by Dallas Wells


There is a common saying in banking that you are only as smart as your dumbest competitor.  Some of you probably hear that and cringe, but unfortunately it seems all too true today, especially in the market for loans.  As a follow up to yesterday's post, why is it that so many bankers are so willing to give in to borrowers right now?

In short, it comes down to the fact that the loan market a a whole is not growing fast enough:

Banks are facing rapidly declining asset yields, and have no more room to reduce funding costs.  Margin compression is a reality for all banks, and the only solution is to outgrow the dropping asset yield.  It is a simple rate vs volume trade off.  The problem is that most banks in any given market are pursuing this same strategy, and the puny overall loan growth can't provide for everyone.  Banks are trying to grow by stealing business from each other, which has created a nasty Nash Equilibrium.

This particular Nash Equilibrium is causing the "right" decision for each bank to be to match low rates.  How so?

Consider a small market that has two banks (Red Bank and Blue Bank) that are competing for the same $2 million worth of loans ($1 million at each bank).  The loans are currently at 5%, but the borrowers want to refinance and feel that it should be a 3% loan in the current environment.  This table summarizes the choices for each bank:

Each bank has the choice to either offer 5% or 3%.  If both banks offer 5%, they can expect to retain their loans.  However, if one offers 3% and the other holds at 5%, the bank with the lower rate ends up with both loans.  Here is the revenue impact of the decision matrix above:

With this table, we can look at the expected outcome.  Red Bank can offer 5%, and they will either earn $50k or they will earn $0.  With a 50/50 probability from Blue Bank, their expected revenue is $50k + $0k = $50k, times the 50% probability = $25k.  In other words, if they offer 5%, they can expect to on average earn $25k.

But, if Red bank offers 3%, they will either earn $60k, or they will earn $30k.  Using the same process, $60k + $30k = $90k, times the 50% probability = $45k.  If they offer 3%, they expect on average to earn $45k.

This is a Nash Equilibrium because both banks face the same decision, and can know how the other will optimally behave.  If both banks were willing to stay at 5%, they would each earn $50k.  Instead, using the basic thought process above, they will actually earn $30k.  Both banks reduce their income out of fear.

So what is the answer?  Unfortunately, there is no easy answer, which is why we are all still facing this conundrum on a daily basis.  The banks that are avoiding this, though, generally fit somewhere on this list:

• They are a niche lender with expertise in a specific market.  This expertise either provides added value for the borrower or limits the competition.
• They have long term borrowers that have been with the bank through multiple rate and economic cycles.  The bank has built trust, and their borrowers know they will treat them fairly.  There is no need to shop every new and old borrowing need.
• They are proactive with their balance sheet structure, and find ways (such as with swaps) to offer terms that other banks will not bid as aggressively.  Every bank in town will chase a short or variable rate loan with a strong credit profile.  Not as many will chase a 10, 15, or 20 year fixed rate.

If you feel like you are stuck in this Nash Equilibrium with no end in sight, where can you fit on this list to end the cycle?  Let us know if we can help.

Negotiating Loan Terms

by Dallas Wells

Most of our recent posts have been about loan pricing and structure, which should come as no surprise to most of you.  This is THE topic for banks right now, from rural community banks to the Wall Street megabanks.  This means it is also the primary topic in our strategy discussions with clients.  Our Flex Loan program is certainly helping clients book longer loans without the interest rate risk, but many are still facing hurdles on prepayment language and prices that translate to spreads under 200 basis points.  I had this on my mind when I saw this post from Seth Godin's blog called "Avoiding the Custom Bully."  Here is an excerpt:

Here's the thing: no matter how much you paid for your ticket, you never bother to even try bullying the conductor or the gate agent to get your train or plane to leave a few minutes later.

It leaves when it leaves, that's the deal.

Part of the challenge of selling custom work is that it sometimes seems that everything is up for grabs. You should stay up all night for a week. You should rearrange the orchids in order of smell, because even though it's not in the spec, hey, that would be good service, and we are paying a lot...
 

Does this sound familiar to any of the lenders out there?  Especially at community banks?  Your borrowers are pushing back because they feel like they can.  This isn't 2006, and they know they have the upper hand.  They can smell the fear.  In working with many of our banks, we have found that just because a borrower asks for something does not make it a deal killer if you don't bend.  While you have to be realistic about the current market pricing, don't bend on every request.  You might lose a few here and there, but the deals you book will be cleaner and better structured.  And your clients might even respect you more for it.