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  • Writer's pictureEric Poulin

Balance Sheet Paralysis


Now Is the Time to Do Our Homework on Deposits


Many financial institutions over the past 24-36 months have either lost confidence in their interest rate risk models or, at the very least, struggled to develop a deeper and more intimate understanding of their risk profiles. The reasons for this are as intuitive as they are challenging.


Government stimulus spurred by the COVID-19 pandemic resulted in, on average, +25% “surge” deposit growth on community FI balance sheets (a bit less than 20% remains today). Among a sample of DCG clients, this drove a transformative shift from 60/40 liability-/asset-sensitive in Q1 2020 (1) to 70/30 asset-/liability-sensitive in Q1 2021 (2).


Shortly thereafter, the Fed ventured down an aggressive path to raise rates to tame inflation and many FIs discovered that the untested “surge” balances were much more rate-sensitive than initially anticipated, resulting in another transformative shift Q2 2022 and beyond (3).


Source: Darling Consulting Group


These wide shifts are primarily due to market dynamics that are out of any individual’s control. Even in a more “normal” environment, DCG often hears feedback from both clients and non-clients about the relative density of this process: too many numbers, too many scenarios, too much information to disseminate in a timely manner.


What can institutions do?


The good news is that understanding your risk profile and using this information to make strategic decisions is not only manageable but can also be easy, provided you start with a high level of confidence in the foundation of your model.


Let’s assume that this foundation is established by using a clean data set. From there:

  • Incorporate appropriate assumptions (more on this below)

  • Build your models

  • Analyze the output in the form of graphs over an appropriate timeframe

  • Illustrate the output over a five-year horizon to identify key trends and inflection points as loans and deposits cycle


Sounds straightforward. Why is there so much confusion?


Based on regulatory guidance, the number of “required” scenarios can be staggering. Whether a bank running varying Shocked and Ramped rate environments of -400bps to +400bps, a Value-at-Risk calculation, gap reports, stress tests, etc. or a Credit Union that runs all of these scenarios plus the NCUA’s Supervisory Test, there are plenty of opportunities for “paralysis by analysis.”


The key focus here is scenarios that matter. For scenarios that matter to your institution, pay special attention to environments where risks begin to materialize. For example, an asset-sensitive institution may have exposure to a falling rate environment. A scenario that matters for this FI could be -200bps.


What about assumptions?


Assumption development is an instrumental but sometimes difficult part of this process. Consider the need to assume how deposit balances and rates may fluctuate under different rate environments. By definition, non-maturity deposits are under no contractual obligation to behave a certain way, which is where the challenge begins. One potential solution to develop confidence in these numbers is through a core deposit analysis. However, sometimes these dense calculations can be difficult to interpret. So, how can one feel comfortable with these model inputs, whether from a study or otherwise?


A common approach is to develop pro forma or “what-if?” analyses. Adding a bit of humility to the mix, layer in assumptions that answer the question, “What if our projected assumptions are wrong?”


The ultimate takeaway should be twofold:

  1. Stressing model assumptions to understand the impact to the risk profile if they are too high/too low

  2. Providing important context to the potential range of outcomes if, for example, deposit betas need to be elevated in a rising rate environment

In addition to adding context to critical model assumptions, institutions may use these alternative simulations to add color to current strategic conversations. As you craft the scenarios, consider questions like:

  • What if my assumptions are wrong and they are too high/too low?

  • What if deposit attrition continues? Increases?

  • Does my risk profile change materially if we meet our strategic goals of XX% loan growth and XX% deposit growth?

  • How do alternative liquidity sources (FHLB, Fed, Brokered/non-member CDs) impact my earnings outlook?

  • What is the change to my risk profile if I extend wholesale funding?

  • Can derivatives mitigate potential exposures on my balance sheet?


Where do we go from here?


With a strong understanding of your risk profile, focusing on scenarios that matter, and utilizing pro-forma scenarios to understand your model assumptions more completely, you will be armed with a powerful strategic tool.


For those eager to take the next step and leverage this strategic tool to inform and direct strategy discussions, our recommendation is to begin to incorporate the use of data analytics to further illuminate areas of opportunity and/or stressors (e.g., potential deposit cannibalization).


ALCOs are evolving to focus on more than just regulatory appeasement. Sunsetting are the days when an ALCO would build a model, compare results to policy, check the box, and adjourn. Today’s top institutions leverage this valuable time with resources from all lines of the business (including retail and lending teams) to drive strategic vision across the organization. As you consider your next ALCO meeting, ask yourself if you’re leveraging your models to drive strategic value. If not, it may be time to evolve your process.

 

If you are interested in evolving your ALCO process but aren't sure where to begin, Contact DCG to discuss actions you can implement now.

 

ABOUT THE AUTHOR


Eric Poulin is a Senior Consultant at Darling Consulting Group, where he assists community financial institutions with the delicate balance of optimizing earnings while prudently managing risk. In this role, he works collaboratively with ALCOs to develop comprehensive strategies for all aspects of Asset Liability Management. Eric strives to distill complex concepts into actionable intelligence and delights in bringing education to the industry.


Eric began his career at DCG in 2014 as a financial analyst and works closely with the implementation, development, and education of DCG’s decision-support tools (Deposits360°® and Prepayments360°™). He lives in the Seacoast area of NH with his wife and is a graduate of the University of New Hampshire with a degree in economics.

Contact Eric Poulin: email epoulin@darlingconsulting.com or call 978-499-8010 to set up a time to meet.

 

© 2023 Darling Consulting Group, Inc.

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