2021 Strategy Spotlight
ALCO | Deposits | ALM Strategy
Last year was one of the most challenging years in banking, and we are all happy to say good riddance to 2020. However, while the new year is here, last year’s challenges have not gone away; in fact many are elevated. For most, margins reached all-time lows and are likely continuing lower. Thanks to PPP and mortgage-related income, earnings fared better than expected, but what about 2021 and beyond? Now include a shift in political control, the potential for additional cash build-up (deposit growth from another round of stimulus), the overhang of credit uncertainty, and waning loan activity - and the earnings outlook for the industry looks bleak. And we thought 2020 was tough…
6 Key Steps to Re-charge ALCO
The decisions you make with your balance sheet today will have long-lasting effects and, therefore, having an effective ALCO process is essential in developing optimal decisions for your balance sheet. Below are the six key steps to re-charge your ALCO meeting:
1. Quantify your net interest income (NII) pressure. The downward trend in income continues, as most have a limited capacity to reduce funding costs while asset yields are declining with no end in sight (more aggressively in some markets). This ongoing margin squeeze is inevitable if rates stay low. So, what is a banker to do? Step one in the process is to quantify NII pressure by comparing your annualized run rate of NII as of 12/31/20 versus what your ALM model is projecting through 2021. For most, the outlook is for lower NII. This NII “gap” has been the nucleus of our Q4 ALCO meetings, and sets the tone for management teams to start the very difficult discussions on how to ultimately fill that “gap” at a minimum and then incrementally grow NII.
2. Identify potential deposit outcomes. Imagine this: An unprecedented deposit surge that has changed our liquidity position, interest rate risk profile, capital ratio, and has left us with cash burning a hole in our pocket. Now envision deposit surge 2.0. Predicting the future of the deposit surge is nearly impossible, but we must start somewhere. First, answer every question possible on the origin of your deposit surge. For example, what has been the change in average balance size? By tier? How much is PPP related? How much growth is from new customers vs. the existing base? Now start to track how the spring 2020 vintage is behaving. This is a relatively simple project if equipped with the right tools, and the results will help your team envision what cash levels are on the horizon, and thus providing strategic insights that dovetail into cash deployment initiatives.
3. Forecast cash expectations. Here is the challenge…there are about 10,000 financial institutions in this country, most having more cash than they would like, yielding next to zero and with the Fed expected to be on hold for 2-3 more years. This liquidity trap is creating a greater sense of urgency to get this cash working, which is easier said than done in today’s low rate environment. To address this problem, start by providing the ALCO with a 90/180-day forecast to estimate cash levels. Let this analysis help facilitate discussion on the most effective strategies for managing excess cash (e.g. wholesale paydowns/prepayments, deposit pricing, lending initiatives, investment alternatives, derivative strategies, etc.).
4. Understand your capacity to extend assets. Let’s face it, the critical dilemma many of us have been dealing with for the last year as rates have collapsed and the demand for long-term loans has accelerated is, “Should we hold or sell?” and “How much capacity do we have to hold long- term assets?”. These are decisions many of you have never had to deal with before, at least not to the same degree. While not an easy discussion with your management team or board, it is one that we all must face. And while there is no magic number or percentage one can use as a rule of thumb, there is an effective and proven methodology that will assist your ALCO in determining your balance sheet’s capacity to add longer-duration assets. The prerequisite is having confidence in your model results, understanding the deposit story (step 2), and having the right risk reports to help you support your position. Any institution can extend assets (if we choose), but does your existing balance sheet support extension (and how much) or do we need to add protection? If adding protection, how much and how best to accomplish?
5. Simplify the interest rate risk presentation. The challenge with trying to quantity our risk position and our capacity to add duration as outlined in step 4 is that we have too many rate scenarios to run for ALCO (ramps, shocks, twists, value-at-risk, stress tests…) which adds confusion and makes it difficult to bring clarity to the ALCO audience. This overwhelming information often prevents us from our ability to listen to what our balance sheet is telling us. Parse out the scenarios that make sense today (hint, would not focus on shocks), and simplify the IRR section of your ALCO presentation.
6. Tell your story. Remember, there are no answers to your challenges in the ALCO package, only questions to be answered. Although the headwinds most of us face are the same, your balance sheet and risk profile is unique. It is going to take some difficult conversations with ALCO to manage this margin pressure – and your meetings should sound different today. Utilize ALCO as a platform to tell your story.
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ABOUT THE AUTHOR
Joe Kennerson is a Managing Director at Darling Consulting Group. In this capacity, he works directly with financial institutions by providing solutions for their asset liability management process in the areas of interest rate risk, liquidity risk management, ALM modeling, regulatory compliance and executive-level education. He is a frequent speaker and author and directly advises clients in all aspects of ALM.
Contact Joe Kennerson: jkennerson@darlingconsulting.com or 978-499-8150 to discuss strategy ideas to improve NII and ways to enhance the ALCO meeting experience.
© 2021 Darling Consulting Group, Inc.
