Compliance Guide

Developing Rational Balance Sheet ‘Bogeys’

By Lonnie Harris

Balance sheet management has always been difficult but never more so than in today’s extended low-rate environment. Since December 2008 when the Fed dropped overnight funds to a range of 0-25 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 left with greater interest rate risk on their 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 its strategies.

First, determine the interest rate risk in the current balance sheet. Don’t assume the current position is acceptable, or unacceptable, until the risk is quantified in various rate scenarios.  This evaluation of risk should include a look at rates: 1) lower (at least 50 to 100 basis points for management purposes); 2) no change; and; 3) higher by 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 portfolios, 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); shocked market value of equity; 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 were 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 to 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.

Lonnie Harris is executive vice president of Asset Management Group Inc., a Wholly Owned Subsidiary of Country Club Bank, Kansas City.

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