And some basic strategies for 2018!
By Lonnie Harris
Many market participants believe rates are headed higher, and as we all expect, higher rates generally lead to greater net interest income as community banks add higher-yielding assets while slowly increasing their cost of funds. Spreads and net interest margins should increase, making bankers happy. There are, however, a few fundamental asset/liability concepts to keep in mind.
First, in terms of a basic strategy, is it necessary to increase your bank’s deposit rates as the Federal Reserve moves the overnight target rate higher? Most deposit rates are not directly tied to the overnight target rate, so what is the case for increasing rates? Unless you expect material deposit run-off or there are other funding issues, try not to increase your COF prematurely. Most community banks have maintained their current COF even after the Fed has raised overnight rates five times.
Some banks however have seen their COF ratchet up because they have been borrowed “short,” thereby increasing their interest expense with each rate increase. If wholesale funding is appropriate for your balance sheet, consider extending term borrowings “out on the curve.” Yes, you will increase your cost today, but you will avoid the projected three increases in 2018 should they materialize. Also, keep in mind that brokered CDs are a viable alternative (or supplement) to term borrowings. In fact, it is possible to issue brokered CDs that allow you to retain a call. The call will cost a few extra basis points initially, but consider the advantages of a five-year CD that you can call if rates stall or decline.
Don’t forget to review the tiers (if any) in the transaction accounts (money market, savings and NOW). Some bankers have successfully raised deposits with large-balance tiers in MM accounts with fairly reasonable, but higher, rates. So far, these deposits have proven to be very sticky. The key to raising funds at the retail level is to do it in a way that rewards high balances and new customers, without repricing a large percentage of your existing accounts.
ALCO Check List #1:
Review the current “betas” in your ALM model. If rates (Treasury rates as well as overnight funds rates) continue to increase, are your betas accurate? Betas define the rate sensitivity of interest bearing deposits. Keep in mind that most betas have been calculated in a historically low rate environment. Understand the current betas and how they are calculated. Do they pass the smell test? For example, if offering rates rise 100 basis points on loans, how many basis points will it cost to maintain the current balance? Also, increase the current betas by 25 percent to stress the current assumptions. This stress will create a more conservative, less-controllable scenario of rising interest expense.
ALCO Check List #2:
Review the “retention” or “decay” rate currently being used to determine the duration or average life of the non-maturing deposits. The duration expectation of non-maturing deposits is a critical component when determining market value of equity. The longer the expectation, the greater the MVE. As with the betas, stress the “retention factors” being used to shorten expectations and decrease MVE. The stressed expectations might paint a more realistic vision created by rising rates.
An expanded version of this of this exercise would include running a “what-if” that moves some of the non-maturing deposits to time deposits. The new balance sheet would theoretically reflect a more historically correct COF assuming the migration to less-expensive, non-maturing deposits was temporary and prompted by abnormally low rates.
A few thoughts on the asset side:
Start with an assessment of the current balance sheet and add volume to compliment what currently exists. More easily said than done, of course! Theoretically, lower-yielding assets (bonds) should be replaced by new, higher-yielding loans. At first glance these loans should be locked in as long as possible, but, be careful. Don’t forget liquidity needs and repricing schedules, just in case.
The thoughts presented here are extremely basic, and that is exactly how every community bank should conduct its ALM strategy: Keep it simple!
Lonnie Harris is executive vice president in the Capital Markets Group at Country Club Bank in Kansas City.