For the past 30 years, we have annually updated the UMB Sample Funds Management Policy Template. After making significant additions last year to comply with Dodd-Frank 939A (municipal bond due diligence and underwriting standards), this year’s update focuses on preparing for interest rates to return to normal. By the way, when exactly will that be?
The return of “normal” interest rates has been much anticipated for several years but has simply not occurred. The Fed’s historic bond buying programs (a.k.a. quantitative easing) have clearly held interest rates down much longer than anyone predicted. I am reminded, however, of the adage that if one continues to predict something long enough, it will eventually come true.
The time is growing closer when the Fed will change its forward guidance about holding short-term rates as low as necessary for as long as needed. It is always possible that the economy could bounce back stronger than expected in the second half of 2014, and the low rate pledge could be adjusted earlier as the Fed is now shifting from quantitative guidelines to qualitative ones. It is, after all, a pledge and not a promise. Keep an eye on movement in the stock market and the 10-year Treasury note yield for clues about normalizing rates as the Fed’s exit plan is executed.
It has been very tempting to buy longer-term bonds and make longer, fixed-rate loans to maintain earnings during the historic interest rate trough. Now the regulators are sending warning signals that banks need to be modeling what happens to their earnings and capital if and when rates finally rise. They recommend shocking one’s balance sheet for both much higher rates (plus 400 basis points, for example) and also planning for a possible liquidity shock we may experience due to the loss of some of the “surge” deposits we all received from depositors seeking FDIC coverage when the economy and stocks cratered in 2009. We have a worksheet that can help you accomplish this exercise in the 2014 policy.
Also new this year in our policy is guidance on making non-parallel interest rate shocks (also known as twists) for your balance sheet and bond portfolio so that nontraditional changes in the yield curve can be modeled if and when they occur. Given that we are in new territory for interest rates, it makes sense that we model more dramatic changes that may have not occurred in the past, and that would be adverse to bank balance sheets and profitability.
The best investment policy has always been to remain flexible and there will always be minor “tweaks” needed to remain up to date, hence our 2014 version. You would never want to make your policy so restrictive that you are constantly dealing with exceptions. There is a happy medium here and the use of the word “generally,” and the practice of setting percentage ranges that are reasonable, can help avoid policy exceptions.
(If you are interested in receiving this year’s UMB Sample Policy Template in electronic form, please email me at the address at the top.)
Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.
Copyright (c) May 2014. BankNews Media.