Wednesday, December 21, 2016

Setting Risk Limits for your Interest Rate Risk Earnings Simulation

Have you been in this situation before?  The examiners recently came in for a review and left you with some recommendation that says that you should set reasonable policy limits on your income simulation results calculated by your interest rate risk model.  However, when you ask them for guidance on what is reasonable, they say that it is for the Board to decide on what is reasonable.  They also mention that you need a limit on the percent change of net income in addition to net interest income.  So, now where do you start?
The way most banks have been setting their policy parameters has been using a 5 or 10 percent change for every 100 bps change in rates.  This parameter, for most, has been based on an industry norm or rule of thumb.  Examiners are now coming in and asking if the Board is aware of what impact that level of change in net interest income has on pre-tax net income.  This is when most bankers start to scramble.  Here is an example of how an examiner now views your 10 percent policy parameter on the percent change in net interest income.
                                                                Current                                                        100 bps change
Net Interest Income (NII)            $4,000,000           $4,000,000(-10%)     =      $3,600,000

Net Non-Interest Expense          $3,000,000                                                         $3,000,000
Pretax Net Income                       $1,000,000                                                          $600,000

Regardless of your current position of your interest rate risk, your policy parameter tells examiners that you are willing to let the position change a certain amount before making any changes in your strategy.  In this example, if you have the national average efficiency ratio of 69 percent for all banks, then your 10 percent NII policy parameter in a 100 bps rate change creates the situation that your pretax net income will change by 40 percent.  When examiners make the recommendation for setting reasonable policy limits, it is because they may see something like this with your current limit or they think the Board isn’t aware of this exposure to pretax net income.
The best way to set your limits (and easiest in my opinion) is to back into the net interest income parameter by starting with the net income position.  If you figure out the amount of change in net income the Board is willing to accept given a certain amount of change in interest rates, then you can easily calculate the percent change in net interest income.  Here is an example to illustrate this thought process.
                                                                Current                                                         100 bps change
Pretax Net Income                          $1,000,000           $1,000,000(-15%)     =      $850,000

Net Non-Interest Expense          $3,000,000                                                           $3,000,000
Net Interest Income (NII)            $4,000,000                                                           $3,850,000

If the Board is comfortable with a 15% change in net income when rates move 100 bps, then the corresponding NII dollars would be net income plus the net non-interest expense, or $850,000 + $3,000,000 = $3,850,000.  The resulting percent change in NII is 3.75%.  So, if the Board is comfortable with a 15% change in pre-tax net income, then a policy limit on the percent change of NII at 3.75% makes sense and is reasonable.  In this example, a 25% change in NII would result in pre-tax net income to be $0, or a 100% change. 
A few things to keep in mind as it relates to the policy limits in your reports. 

1.       Unless pre-tax net income is already negative or very close to being negative, a policy limit on the change of NII that causes net income to become negative is generally frowned upon, unless it takes an extreme change in interest rates to make net income negative.
2.       The policy limits should be re-assessed annually and updated, especially if there have been some material changes to ROA.

3.       When setting policy limits on both NII and Net income, they should be linked.  If your policy limit on NII is 10%, but your policy limit on net income is 20%, then in the above example, you will violate your net income parameter well before you are in range of your NII parameter.

4.       The higher the efficiency ratio of the bank, the bigger the impact a change in NII will have on net income.
Knowing what the ultimate impact of changing interest rates have on the bottom line makes the policy parameters used within your reports more meaningful.

Friday, December 2, 2016

Liquidity Funding Alternatives

The word of the day is “Liquidity.”  The definition of liquidity as examiners would see it is the ability of an institution to accommodate expected and unexpected withdrawals in deposits and other liabilities and to fund increases in assets at a reasonable cost.  Over the past few years, banks have been flush with on-balance sheet liquidity in the form of cash, securities, and core deposits.  However, loan demand has been increasing and we are starting to see liquidity tightening and the loan-to-deposit ratio increasing.  This tightening is causing banks to look and depend on funding alternatives outside of core deposits, since core deposits aren’t growing as fast as the loan demand.  So, when you are searching for additional liquidity, which option(s) are best for your situation?  As long as the bank maintains appropriate capital levels, the following options are available to you.

Fed Funds Purchased

·         Used for short-term funding needs – generally overnight.
·         Readily available at a reasonable cost.
·         Can be expensive in a volatile market when funding needs are more long term.
·         Adds to the Net Non-Core Funding Dependence ratio, also known as the Dependency Ratio, for regulatory purposes.

Internet and Listing Service Deposits

·         Generally, counted as core deposits for the Dependency ratio calculation.
·         Can be accessible even when capital is under pressure.
·         Customers can opt out and take the penalty if rates change enough to prompt the move.
·         Using internet deposits may not increase the funds available, but could increase the cost of the core funds.
·         Listing service deposits can have limited audience due to being a paid subscription service.  Only those that subscribe can get or provide funds.
·         With listing service deposits, may not be able to get all the funding needed or wanted at a certain duration and need to be at the higher end of rate scale to get noticed.

Term Borrowings

·         Can get funding out to 30 years.
·         Can have fixed or floating rate advances.
·         Can be accessible when capital is under pressure. (May have to deliver collateral)
·         Generally required to purchase stock to be able to borrow.  Dividends from the stock purchase can help to reduce the overall borrowing cost.
·         Will generally need to post collateral to be able to borrow.
·         Borrowing costs can be significant.
·         Adds to the calculation for the Dependency Ratio for regulatory purposes.
·         Many times has a pre-payment penalty if you want to get out of the position.

Bank-Issued Brokered CDs or DTC Brokered Deposits

·         Can get funding out to 30 years.
·         No collateral posting requirements.
·         Issued CDs are protected from prepayment from market rate changes as they don’t have a provision for early withdrawal.
·         Can be issued as callable by the issuer, giving more control over exiting the position.
·         Open to a broader audience as there is not a subscription required.  Any depositor that has a brokerage account has access to a brokered deposit.
·         Will not interfere with your local footprint deposit pricing.  This is an additive funding source and doesn’t cannibalize a local funding program.  Banks can black-out certain markets, if desired.
·         Provides additional liquidity sources by keeping your borrowing lines available.
·         May be more cost effective than other long-term funding options.
·         Adds to the calculation for the Dependency Ratio for regulatory purposes.
·         Generally unavailable when capital is under pressure.

As you can see when going through the pros and cons of each of the above funding alternatives, banks have options when it comes to alternative liquidity funding.  While cash on hand, a high quality securities portfolio, and core deposits are the preferred funding sources for bankers and regulators alike, knowing what is available when those options aren’t gives you, the banker, the ability to make the best decision when it comes to profitability. 

Part of our service to our customers is to understand all of your needs.  We have the tools and knowledge to understand your overall asset liability strategies.  Through our asset liability management division, Asset Management Group, we provide our clients with detailed liquidity reports to track current liquidity and project future liquidity needs.  We also consult with our clients on various liquidity strategies depending their needs.  Our Capital Markets Group helps our clients with managing the securities portfolio to provide liquidity or yield depending on the situation.  The Capital Markets Group can also assist with helping clients issue brokered deposits should that need or want make sense.

If you have questions or just want to learn more, reach out to your Country Club Bank representative, or you can call or email 800-226-1923 or

Monday, October 3, 2016

Testing Critical ALM Assumptions

Fear is a great motivator. Even though most bankers are always interested in the ALCO process and the degree of IRR (Interest Rate Risk) contained in the current balance sheet and pricing strategy, at times they seem almost obsessed. This obsession usually comes shortly after receiving notice of the next exam date!

Keep a few things in mind. Most bankers are more prepared than they initially think because most have been participating in meaningful ALCO meetings for years now, and they understand the reporting and risk guidelines they are using.

But, also keep this in mind; regulators are not only interested in reviewing the critical assumptions used in your reporting system, they are also becoming more and more “obsessed” with “stressing” these assumptions, perhaps looking for a “breaking point” along the way. In fact, the lengthy low-rate environment we still “enjoy” has generated heightened “scrutiny” related to a couple of these “key” assumptions.

The first is the rate sensitivity of deposits (these measures of rate sensitivity are called Betas) and the second is the ability to maintain current balances of non-maturing accounts (referred to as “decay” or “retention” rates).

In retrospect, the regulators have been keenly interested in the above two phenomena for quite a long time. In fact, referring back to the last Supervisory Insights issued by the FDIC (Winter 2014), here is how they framed the process:

"The objective of sensitivity analysis is to isolate the impact a single assumption may have on the results of the IRR measurement system. This is accomplished by changing one assumption (e.g., increasing the decay rate or the beta factor by X percent) and re-running the analysis to compare results.)" 

Rates have been so low for so long the conjecture is that it might be difficult to predict how depositors will react if, and when, rates increase. So, the calculated Betas (in the last five years) may turn out to be somewhat inaccurate because it is difficult to predict how aggressive depositors might react if they see higher rates offered down the street. And, the migration to Non Maturing deposits might suddenly reverse and head for the exit, or at least back to Time Deposits.

Please keep in mind that BancPath has included a series of reports in the addendum titled "Assumption Stress Tests". In these reports, we use six separate tests to gauge the impact of assumption changes (stresses).

In relation to the two assumptions discussed above we “stress” the betas and retentions assumptions to  see what impact the changes have on Interest Expense (and thus Net Interest Income) and the Market Value of Equity

Currently Betas are calculated using the last 60 periods. But, as discussed above, these may be too low (who knows for sure) if rates zoom up. So, the Betas are stressed by increasing them to 125% (or to what extent desired by bank management) and a report is run to show the increased rate sensitivity (increased cost associated with the higher Betas) and the new risk profile. The impact of the increased betas varies across the board depending on current Betas, current balances, and the current liability mix.

The second test “stresses” the current “retention factor” of non-maturing deposits, including NIB DDA’s; Money Markets (MM); Savings, and NOW accounts in relation to Market Value of Equity (MVE). The test is simple because it reduces current retention factor expectations by 25% (25% is a default but the reduction is determined by the bank for each report run). So, for example, if MM accounts have a determined duration of four years, the “stressed” duration would become three years (4 X .75 = 3). This is critical because the duration used determines how far you move along the wholesale funding curve to determine the difference between current cost (retail) and replacement cost (wholesale). So, if rates increase and MM account balances disappear this test prepares management and the board for less value in these deposits, and ultimately less MVE.

If you spend the time to understand the key assumptions used in your reporting system, and then understand the results produced by stressing these assumptions, you will have a great start toward your exam preparation.

Call us at AMG (800.226.1923) if you want help sorting out the critical assumptions in your ALM reporting system.

Thursday, August 18, 2016

Wednesday, June 29, 2016

Data Aggregation - The impact on your results

Does your model provide you with the most accurate picture of your balance sheet?  All asset liability models have to aggregate data at some point in the process.  The timing of that data aggregation can have an impact on the results you receive.  Most models in the market place today use instrument-level data from your core provider as a starting point for analysis.  However, what your model does with that information after it is received makes all the difference in the results.  Many models look for homogenous groups within the instrument-level data with which to perform the analysis.  The more categories that are used for analysis, the better.  However, the best solution and what is more unusual in the market place is a model that analyzes each instrument individually then aggregates the results for an easy to read report.

The charts above show the impact on income of a grouping of 10 commercial loans that re-price within 12 months.  Because timing is important of when each loan re-prices, being able to analyze each loan individually has a big impact in the results we have seen, even in the most simple balance sheet structures.  Models that are capable of this type of instrument level analysis are generally more expensive than models that aren’t capable of this analysis.  The above sample shows an income difference of 6.63% on just $3MM in loans, how big would the impact be on your portfolio? If you are making decisions on results that do not accurately portray your interest rate risk position, the cost could certainly be far greater with a “cheaper” model.

Thursday, June 23, 2016

Developing rational balance sheet “Bogeys”; understanding the Interest Rate Risk associated with your Targets!

Balance sheet management has always been difficult but never more so than in today’s extended low rate environment. Since December of 2008 when the Fed dropped overnight funds to a range of 25 basis points many of the “routine” decisions were replaced with uncertainty and downright confusion. In retrospect, it is apparent that most managers were initially too conservative, as they expected rates to increase almost immediately. This period was followed by “impatience” and more accurately, “market pressure”, which has resulted in duration extension in both the loan and investment portfolios, at historically low rates. These phases were not necessarily “knee jerks”, but it is questionable how much planning and modeling actually preceded those decisions.   

Today, after more than eight years of lower rates, many banks are now left with greater interest rate risk on the books coupled with historically low margins and spreads.  Now is the time to develop a plan that generates an acceptable margin and spread regardless of where rates end up. Yes, it is possible, assuming management embraces reasonable expectations and is willing to model risk associated with their strategies.
First, determine the interest rate risk in the current balance sheet. Don’t assume the current positon is acceptable, or unacceptable, until the risk is quantified in various rate scenarios.  This evaluation should include a look at lower rates (at least 50 to 100 basis points for management purposes); “no change”; and up the usual increments. Of course the regulatory parameters are necessary but 200 basis points is a great guideline for current management decisions.
Examine the balance sheet and try to develop realistic cash flow projections generated by the loan and investment portfolios. Anticipating and planning for expected cash flow in various rate scenarios will pay huge dividends and lead to better spreads and margins. 

Even though most banks have extended loan and investment durations in the last eight years do not flatly assume the loan portfolio is “too long”, thereby generating excessive interest rate risk. Many banks could actually extend their fixed rate loan portfolio without creating excessive risk because they generate excellent cash flow from existing loans and investment portfolio, while funding with a large percentage of stable core deposits (backed by wholesale funding availability). That being said, keep in mind you may have to look a few years down the road to see the negative impact of too many fixed rate loans (or securities). On balance sheet liquidity (including stressed liquidity); and the shocked Market Value of Equity (MVE); and the loan to deposit ratio are necessary tools to help determine the degree of risk.

Conversely, do not assume a variable rate loan portfolio will be “bullet proof” in a rising rate environment. It is somewhat surprising, but the floor rate on many variable rate loans is considerably higher than the “Index plus the spread” used to initially price the loan. The “gap” between the index pricing and the floor may require considerable rate movement to increase current income. It is critically important to identify what rate movement is necessary for each loan to actually “pierce the floor”, thereby generating greater income. The other relevant issue is the lock-out period. Loans may not have a floor issue but may not be eligible to reprice immediately. In fact, it is not uncommon for some banks to routinely include a three or even five year (or longer) lock-out period that prevents repricing. And, in some cases the floor (which is helpful because it produces higher current income) and lock-out period may prevent repricing for the foreseeable future.

Lastly, be realistic regarding the loan “pipeline”. Be prepared for the best, but most projections are usually tainted with lender optimism and should be trimmed a bit. Have a funding plan, but try not to have excessive funds sitting in cash.
It is elementary, but question the viability and the cost of current funding sources going forward. Most banks have experienced a “rotation” of Time Deposits to transaction accounts (Money Market, Savings and NOW) as CD rates have cratered. It is a worthwhile exercise to model the increase (if any) in the cost of funds if deposits where to swing back to the more traditional CDs.  Plus, keep in mind some deposits will most likely seek greener pastures elsewhere, regardless of the rate offered.

The specifics mentioned here are just a few of the relevant issues to consider, but now is the time set targets and bogeys within the context of Interest Rate Risk going forward. “I think rates are going up” is not a strategy. In particular, beware of excessive cash. It makes the balance “look” better and it will react immediately to rising rates, but don’t expect to make up lost income with higher rates, sometime in the future! The cost of “waiting” will be nearly impossible to recoup down the road. Consider near term borrowings or alternative wholesale funding if needed. In any case, model various alternatives to determine what works best for the balance sheet within the bank’s risk guidelines.

 In summary, now is the time to manage future loan, investment, and funding strategies through a deep understanding of your current balance sheet and its behavior going forward! Good Luck!

Wednesday, April 27, 2016

Duration Trend

We have added a new report to the Executive Summary of the BancPath report.  Many of our customers have requested and we have delivered a duration trend report of the investment and loan portfolio.  You will see this new page immediately after the Repricing Drift page at the end of the Executive Summary.  The goal of this page is to point to the changing risk profile of the bank based on the duration of the investment and loan portfolios.  If you have questions about this page, please let us know. 

DURATION Trend Analysis
24 mos ago
12 mos ago
9 mos ago
6 mos ago
3 mos ago
1 mos ago
Agcy NC
Agcy Call
Muni GO
Muni REV
Total Invest
Total Comm'l
Total Comm'l RE
Total RE
Total AG
Total Cons
Gross Loans
Earning Assets