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To Move Forward, You Have to Get Out of Neutral

By: Dale Stover

The twists and turns of the interest rate environment, the housing market and other historic measures used in understanding the future have made for a challenging couple of years. As directors and managers, it is important to understand why the road has changed and how these changes impact the map into the future.

To help financial institutions better manage the future, we must first clarify where we started and where we are today. In this regard, we analyzed the early 2006 earnings-at-risk position of the average institution. Rising rate expectations left many institutions following a map that invested in short/adjustable loans and investments, while lengthening funding. Our analysis revealed that 67 percent were asset sensitive, 22 percent neutral and 11 percent liability sensitive. In many cases the asset sensitivity was sufficient to trigger policy concerns over EAR. The average institution experienced a 16.6 percent loss in net-interest income with a 200-basis-points rate decline. Why the lack of concern for this exposure? At the time, consensus and reality were for a Fed tightening.

In an effort to bolster a compressed margin, directors and managers looked to rapidly capitalize on this change by adding shorter repricing assets and by locking in longer term funding. The focus was less on the cost of being wrong and more on the profit in being right. In other words, a 16.6 percent NII loss for falling rates was de minimis when compared to projected NII increases of 5 percent as rates rose.

During the last 18 months, rate consensus has shifted to neutral and now toward an ease. As market sentiment has moved, institutions have adjusted their balance sheets. These adjustments, whether made through assets or liabilities, have essentially neutralized the EAR position of many institutions. By June 2007, our average institution displayed a NII decline of 8.1 percent with a 200 bps rate drop. The potential gain to NII from rising rates had also neutralized. Both positions represented about one-half of the risk we observed 18 months prior. But is being neutral the best position for an institution attempting to increase margins?

While there is no easy answer, the long-term solution may lie in short-term balance sheet management. Historically, banks have been reactionary in their approach to EAR and balance sheet management. Reactionary management leaves directors and managers with no choice but that of bending to the will of the option holder: bond issuers, borrowers, depositors and the Federal Home Loan Bank. In other words, the earning assets will either be called or refinanced as rates fall, while funding sources will insist on higher rates. This scenario simply continues to squeeze margin. Actively managing the balance sheet during periods of low margin can lead to making the turn ahead of the competition.

As directors and managers consider the impact of being neutral, many will opt for a “wait and see,” or reactionary, approach. While a neutral EAR profile could result in better margins in the short term, a neutral approach to balance sheet management does not allow institutions to take advantage of opportunities in the marketplace.

While each balance sheet has its own intricacies, we consistently see four opportunities for directors and mangers to proactively address:

1. Invest the fed funds position — The neutral balance sheet has increased the reliance on fed funds. While the current yield curve might seem to advocate this approach, changes to the curve can be quite significant. Consider the impact of not being invested as the 10-year has trended down since June 30. Should the Fed ease, this cost becomes realized as the ability to invest at the top of the market diminishes.

2. Review portfolio runoff — Do you want to reinvest when rates are down? The investment portfolio has seen an increase in short-term roll-off. Should rates trend lower through 2007 and into 2008, these portfolios are set up for continued poor performance. This reactionary approach can be avoided by considering two options:

a) Portfolio restructuring — At current market levels many losses can be recouped within 12 months. The resulting yield increase allows the investment portfolio to serve as a source of liquidity and NIM.

b) Investment pre-funding – Reactionary management would wait until an investment matures/called to reinvest funds. Pre-funding allows one to take advantage of today’s investment rates without incurring a restructuring loss. This works by matching FHLB borrowing to the expected maturity/call date of the target investment. Funds from the borrowing can be used to invest in the current market. When the target investment matures/called, the funds are used to retire the simultaneously maturing borrowing.

3. Review deposit offerings — Do you really want to offer a 12-month CD special with an ease projected? Locking in 12-month funding at this point makes little sense. Locked funding rates + rate ease = compressed margin. By looking to shorter CDs, institutions will be better positioned to manage margin going forward.

The key for directors and management is to look past today. Reactionary management is easy and seemingly painless. Taking losses today to improve tomorrow’s income is the more difficult decision to make. Quite simply either will cost money; however, staying ahead of the curve by proactively managing can lead to less pain over a shorter time. 

Dale Stover is senior consultant, ALM advisors, for FTN Financial in Memphis, Tenn. He can be reached at 901-435-7927 or dale.stover(at)

Copyright October-November 2007 Western Banking (BankNews Publications)