If there were ever a time when institutions across this country spent countless hours to be “precisely incorrect,” it was the 2022 budgeting process! The FOMC was simply wrong in their so-called elevated transparency with the FOMC Dot Plot; their summary of economic projections turned out to be wildly inaccurate. Just about all other forecasters from the “street” suffered a similar fate.
If you rewind twelve months, many institutions were frightened in terms of what could happen to earnings during 2022. But the reality is that most institutions exceeded their budgeted levels of net interest income.
As we enter 2023, balance sheet managers are again confronted with perhaps more uncertainty than ever before. Trying to determine what the key contributing variables look like for your institution from a bottom-line earnings perspective could be considered an artform.
I think this is the year that slight variations and tweaks on a few key assumptions on both volume and rate can create clarity for your management team, board, and shareholders. If you think you have a chance of missing the mark, what are the key drivers that could cause that to happen?
It sure seemed like this year it took longer than ever for institutions to put their final “stamp of approval” on what 2023 could look like from a net income perspective.
This article will focus on the key areas (related to interest income / expense) you should be tracking in this year’s budgeted forecast to ensure you’ve properly captured the key variables impacting your net interest income/expense forecasts.
THE SHAPE OF MARKET YIELD CURVES
One thing is for sure, there is not a member of an ALCO committee at any institution across this country who can influence the shape of market yield curves. We “roll with the punches” and adjust daily to navigate through whatever environment is presented to us at any time.
Everyone (including individual FOMC voting members) has a different perspective on how far the FOMC will continue to ratchet up short-term interest rates. I have had groups ask me, “what if short rates move to 6% or 7%, then what?” Some believe the FOMC will keep rates up “here” for years, whereas others cite forecasts in which the FOMC brings rates back down in the latter half of 2023.
The good news is that history would suggest that flat / inverted yield curves do not last forever. The bad news is that it clearly proves to be a painful time for bank and credit union margins, in the near term and while it lasts. The longer this curve stays inverted, the more margin pressure that could ensue for many.
Source: Federal Reserve Bank of St. Louis
The recently released December 2022 FOMC Dot Plot has a median of the voters getting short rates to roughly 5.125%, with tremendous uncertainty when you look out past 2023.
From the Editor
I always start the year scouring the forecasts of large investment banks to get a feel for what the “street” is thinking.
And while there is some consensus amongst a few of the banks, there are also some very disparate forecasts for both the economy and the Federal Reserve. For example, the expected year end level for Fed Funds currently ranges from the mid 3s all the way up to 6%!
Even Bank of America was reluctant to give forward guidance on their January earnings call for net interest income.
Clearly, this is shaping up to be a wildly uncertain year, with the markets and the Federal Reserve locked in a tug of war.
But what about those balance sheet managers who have the herculean task of budgeting earnings over the next 12 months?
In this month’s Bulletin, DCG Managing Director Steve Boselli outlines a few concepts to think through during the budgeting process. Specifically, he considers the influence of the yield curve on margins and the realities of loan pricing and volume. He also notes that while most expect deposit costs to continue to rise, those costs should be dictated by the amount of growth necessary to satisfy your budget during 2023.
Even though budgeting can feel like an exercise in simply being “precisely incorrect,” Steve urges management teams to place context around the range of outcomes to create greater clarity for your balance sheet moving forward.
Best of luck to all in 2023!
Vin Clevenger - Editor
Source: FOMC Dot Plot, December 2022
From a budgeting perspective for 2023, I think it is both safe and conservative to assume that this occurs in the first half of 2023. As a result, it would seem prudent to show an increase in short-term market rates to that level.
The bigger wild card will be the related move on intermediate/longer-term market rates, and how loan pricing follows. Although most are hoping for an elevated slope to market yield curves in 2023, the unfortunate reality is that most should conservatively assume longer-term rates remain at or near current levels.
LOAN PRICING / REPRICINGS / VOLUME
We often hear that institutions are budgeting for another 50-75bps increase on the short end of market yield curves, but in turn, they are also elevating new volume longer-term loan rates at a similar pace. The forward implied yield curve would suggest that intermediate/longer-term market rates may have peaked and could shift lower over time. In fact, this has been happening as of late. This dynamic supports conservatively keeping loan replacement rates at current levels. Slope matters!
Additionally, with the historic increase in market rates in 2022, there is a noteworthy amount of adjustable-rate loans that are anticipated to jump to what could be a 250-300bp contractual rate increase at the next reset date. In some cases, those rates are well above the current market in some regions/states. It could make some sense to conservatively assume that at those contractual reprice dates, the loan matures and is replaced at the current market.
The idea of a loan “beta” getting built into models is arising more frequently. For most, loan betas have increased just a fraction of the full market movement. However, one could argue that if longer-term market rates jumped at this point in the cycle, loan pricing would need to follow given the fact that credit quality concerns are surfacing, the cost to fund the loans is high, and investment yields are approaching loan yields in some markets.
One thing that we have heard in our travels across this country is that on average, the expectation for net new loan growth in 2023 is less than previous years. In fact, those that had been experiencing 8%-10% loan growth over the past few years, are now looking at forecasts for 2023 in the 0%-5% range. Ultimately, loan volume could be a problem for some groups in 2023.
DEPOSIT VOLUME / MIX / PRICING “CATCH-UP”
A CEO recently told me, “I feel like I’ve lost control of my funding base and the ability to lag my cost of funds.” For some, projecting deposit costs in 2023 may feel like throwing darts blindfolded. Here are a few considerations to create some clarity in the forecasting process.
Deposit Volume / Mix
In the past few months, there has been a shift from non-maturing deposits to time deposits. Institutions have blown the dust off those legacy CD promotions to retain deposit balances.
With the expectation of this trend continuing throughout the early part of 2023, it would be prudent to assume some measure of deposit migration back to higher cost funding, whether it leaves your institution and is replaced with higher cost wholesale funding or shifts to the latest time deposit or MMDA special (a 5-10% shift at a minimum, should be built in).
Source: Darling Consulting Group Deposits360°®
Deposit Pricing “Catch-Up”
We all know that the recent increase in short-term interest rates happened faster than it has in 40 years. We’ve reached the point where those that have historically been desensitized to yield are waking up. If your institution has lagged to this point (as most have), you may have a false sense of security about how much deposit pricing pressure could be coming your way, even if market rates stabilize.
It has truly been a wakeup call for many.
Deposit betas may need to increase, and in some cases, well over 100% of market to “catch-up.” Deposit pricing will need to be looked at very closely in both the “flat” interest rate scenarios as well as the more aggressive rising rate scenarios. So even if your group thinks the FOMC is almost finished with this tightening cycle, don’t expect your deposit costs to abate because of it.
Source: Darling Consulting Group Deposits360°®
Pricing to Grow vs Pricing to Retain
Getting a better handle on your liquidity profile and liquidity needs may save you a lot on your cost of funds. All too often we see institutions that are “priced to grow” on CD products. In reality, no new balances are coming in. It’s simply their existing CD maturities rolling into that product. If the goal were to simply maintain balances, a lower rate probably could have gotten the job done. Understand if you are “pricing to grow” or “pricing to retain.”
Clearly, if you are sitting on higher cost wholesale funding or have a robust loan pipeline to fund, that is a different story, and you may want to be “priced to grow.” These are important considerations when forecasting your 2023 deposit costs.
WRAP-UP
Although it is only a few weeks old, 2023 has all the ingredients of being one of the most volatile years for bankers that we have seen. Considering the rate environment, outlook for inflation and other key economic indicators, budget expectations on both sides of the balance sheet may vary greatly for thousands of institutions across this country.
Make sure you are looking at the correct variables and how they could potentially impact your balance sheet and earnings in 2023 and beyond. If you think that there is a chance that you could be “precisely incorrect,” let’s at least understand where and why!
ABOUT THE AUTHOR
Steve Boselli is a Managing Director at DCG, where he consults with financial institutions of all sizes across the country on balance sheet management strategies. He takes a hands-on approach in developing bank/credit union-specific strategies to best fit the risk profile for each institution’s balance sheet, while also balancing the regulatory demands/pressures in the current environment.
Since joining the firm in 2005, he has held various positions within DCG, assisting clients in all aspects of ALM, including quarterly ALM modeling/consulting for advisory clients, process reviews, model validations, policy development/reviews, strategy development sessions, capital management/planning, credit stress testing/forecasting and contingency liquidity planning.
Steve holds a B.S. in both accounting and finance from Syracuse University.
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