Diversifying to Narrow Extension Risk

By Nicole Burczyk

Over the past several decades, the fixed income market has been predominately a bull market.  Investors have consistently seen the same investment decisions rewarded purely because each meaningful rise in interest rates was followed by an even more significant correction.  Over this period of time, as yields lowered, prepayments increased as investors refinanced mortgages at even lower interest rates.  Within this framework of lowering interest rates, bank investors have been able to invest in longer fixed rate pass through securities without much concern for the extension risk imbedded in these pools. However, given the current outlook for higher rates, it may be time to consider evaluating the risk within your current portfolio and diversifying into additional mortgage back structures when appropriate.


Asset Liability Management — Alternative Rate Scenarios

Respect the shocks but manage to the more likely!

By Dennis Zimmerman

This asset/liability management theme is one that our ALM team has been challenging community bank asset/liability committees to embrace over the last several years.

While regulatory expectations mandate that bank management understand the financial impact to earnings and capital in extreme rate scenarios traditionally defined as shocks, it needs to remember that these instantaneous and significant shifts in rates have a very low probability of happening. Using the typical +/-400bps shock scenario as an example, when was the last time all points on the yield curve instantaneously increased 4 percent? Never. Because it makes sense to establish policy limits to help protect earnings from extreme changes in rates, management should respect the shock outcomes. After all, limits are designed to aid management in 1) identifying IRR exposures, 2) initiating discussions regarding risk and 3) taking action to mitigate extreme risk, when necessary.


It’s Déjà Vu All Over Again

By Chris Thompson

The late, great New York Yankee, Yogi Berra, proved to be an accidental humorist. With mangled language and misplaced modifiers, the professional ball player and amateur commentator on the human condition oddly articulated the essence of the matter with quips that inadvertently made sense. No one could argue with the fun fact, “You can observe a lot by watching,” and everybody smiles at the one-liners, “Nobody goes there anymore, it’s too crowded” and “When you come to a fork in the road, take it!” These are simple truths expressed with a strange clarity that resonate with anyone living in the real world and unimpressed by frothy eloquence. You tell ‘em, Yogi!


Stay Curious: Learning New Things Makes Us Better

By Matthew Maggi

“The noblest pleasure is the joy of understanding.” — Leonardo da Vinci

Inspiration comes from various sources. Lately, mine comes from a book I’m reading. Walter Isaacson has written several biographies about “geniuses,” including Benjamin Franklin, Albert Einstein and Steve Jobs. I’m reading his latest biography on Leonardo da Vinci. This tome, weighing in at 5.2 pounds, is full of exquisite language and enlightening photos detailing techniques, thoughts and interpretations of his works. The theme that stays with me is curiosity. Da Vinci had a voracious appetite for learning and often made lists of things to learn each day. I can relate to this because if I am not learning, a feeling of ennui overtakes me.


A Short ALCO Check List

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. 

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