Maintaining Composure in Turbulent Waters
The ability to remain composed and to make practical decisions are the most critical factors in navigating a boat in turbulent waters. The terms of your voyage are dictated by the sea. You have to orient the vessel in the optimal direction which gives you the best opportunity to progress to your destination without placing additional stress on your vessel or crew.
The most severe stretch of weather I had ever encountered was on a 60-mile trip from Portland, ME to our home port in Newburyport, MA. It was a beautiful Sunday in the middle of August and we were returning from celebrating a friend’s wedding. Conditions are generally benign that time of year in New England, and nothing in the marine weather forecasts we examined led us to believe otherwise. Only a few miles south of Portland, we discovered we would be in for wild ride. Unlike calm weather conditions when the boat is running on “autopilot,” we had to make several adjustments to our speed and course to make it back.
The storm caused by COVID-19 and the subsequent closure of the US economy have placed balance sheet managers in the unenviable position of having to make significant business decisions during a turbulent time. There wasn’t a single economist who forecasted the effects of a global pandemic in their 2020 projections. Accordingly, balance sheet managers have been forced to react to changing conditions without having a complete understanding of the full implications of their actions. Like the imperiled sailor, they need to remain calm and quickly evaluate what is truly critical to their success.
How you address these considerations will dictate your passage through this storm.
Do you have enough liquidity to weather the storm…or…do you have too much?
In the immediate aftermath of the nationwide quarantines, both individuals and institutions reacted by “hoarding” liquidity. It has now been widely reported that draws on lines of credit have been redeposited into checking accounts (what a great way to improve margins!). Some institutions reflexively took on additional wholesale borrowings in preparation for the unknown. Nonetheless, the specter of forbearance, funding PPP loans, modifications, large deposit outflows, municipal deposit uncertainty, etc., led many bankers to retain more liquidity than they would otherwise.
But how much liquidity is actually warranted? At a minimum, institutions should take a hard look at their expected cashflows and stress test other sources and uses to quantify a more “precise” estimate of the severity of their potential cashflow deficiencies. Only then can they make an informed determination as to whether or not their liquidity position will support funding demands. Perhaps more importantly, they also need to re-evaluate their operational and contingency funding policies to ascertain the flexibility of their defined limits and remediation tactics.
On the other side of this conundrum reside those who have seen their liquidity positions increase. These institutions have not had the level of forbearance of others, have not yet experienced material deposit runoff, and may be utilizing the newly created PPP liquidity facility to fund PPP loans. Accordingly, managing the excess liquidity position becomes a challenge. Do you purchase investments at a time when yields are paltry and Treasury intervention is at a historically unprecedented level? What about the potential for unrealized losses moving forward? What is your board's comfort level with that set of circumstances? Do you drop deposit rates to “zero?” Do you risk losing deposits which you “paid up” for during the past several years?
In rough seas, some mariners will take on additional ballast. Does your ship have enough to remain steady in rough waters, or too much which could slow you down?
How much capital will you need to absorb potential losses?
Given what the large banks are doing with their reserves in their quarterly earnings releases, it could be inferred that the depth and duration of the impending recession could be much more meaningful than most are prepared for. With all the conjecture surrounding the “alphabet soup” on the shape of the anticipated recovery, is your organization adequately capitalized for a scenario which more closely aligns with a “U” or even an “L” shaped recovery?
If unemployment reaches 20%, what can you reasonably assume for potential loss exposure? Is the well-capitalized status of your institution threatened? What steps can be taken in advance to prepare? How does potential loss influence growth strategy moving forward? Should we be “socking away" capital today? What is your plan for reserves?
Now is the time to reassess your capital plans and credit stress-testing analysis. Have either incorporated a scenario as severe as what the coronavirus has presented? What economic factors are most aligned with potential loss exposure in your loan portfolios? Has the capital plan been updated to address the remedial actions necessary to keep capital levels in excess of internal policy minimums?
Although you may have set a course before you left port, is it now time to adjust your sails?
Is there a credit in the United States more “bankable’ today than there was 2 months ago?
In the weeks leading up to the shutdowns, financial institutions had tremendous refinancing volumes, and commercial pipelines were relatively healthy. Today, pipelines have skidded to a halt. With very few exceptions, all sectors of the economy have been ravaged. Considering over 22 million workers have lost their jobs in the initial month of the quarantine, the likelihood of pipelines reversing course next quarter seems low. And while the government has interceded with unparalleled levels of stimulus for most corners of the economy, not every individual and/or business will endure after the dust settles.
Given this backdrop, how do you underwrite new credits in this environment? On the residential front, how can you be sure the borrower is safe in their job moving forward given business uncertainty? For commercial borrowers, what additional considerations should be made given the potential for property value declines, reduced consumer activity, prolonged unemployment, etc., if the anticipated economic recovery takes longer to materialize than some expect?
What about credit spreads? Falling rates should cause spreads to increase for the obvious reason that economic activity has declined and, therefore, the extension of credit has become an inherently riskier proposition. In fact, the large banks have already increased down payments and FICO scores as prerequisites for extending residential loans. Others have curtailed or eliminated any home equity originations.
But are your lenders prepared for those conversations? It was only a few months ago in many markets where spreads were extraordinarily tight, and what’s the response when your competition resumes “business as usual?”
When the seas are raging, an overabundance of caution is not a sign of weakness, it’s a sign of experience, for you know it may get worse before the seas relent.
Will you ever have a better opportunity to “win back" customers from large banks again?
The $350 billion Payroll Protection Program has presented a golden opportunity for community institutions to recapture “Big Bank” customers. It’s no secret that the prioritization of PPP loan requests was correlated to the size of the relationship. The ability to actually speak with a representative in an expeditious fashion is a “luxury” only afforded to the most profitable relationships at the large banks.
I had the “pleasure” of helping a family member go through the process with two separate large banks (both within the top 10 in total assets) who unfortunately had the same fruitless results at both. Consequently, they have vowed to move their business relationships to a community bank.
With the next round of PPP loans, community institutions can continue to position themselves as more responsive to the needs of their communities and the businesses which inhabit them.
So, how do you plan to capitalize on that? When “business as usual” returns, how are you positioned to re-insert your institution into business needs of these large bank customers? What systems may need to be in place to accommodate that potential business? What should the marketing message look like? What education internally should be prioritized to lenders, CSRs etc., to “re-” garner market share lost to the mega banks?
It truly is time to adopt the “all hands on deck” mentality.
Hold steady and that distant shore will come into focus.
I have two distinct memories of that trip in August of 2018. Re-entry from the Atlantic Ocean into the Merrimack River was absolutely treacherous. The narrow and shallow river mouth creates large waves. After five hours of slugging it out with the open ocean, the last 300 yards were going to be the roughest. Fortunately, we powered up and glided down the 12-foot swells without incident and breathed a collective sigh of relief upon entry into the river!
My other memory of that trip was the incredible smile on the face of our young daughter after the trip was completed. She simply thought she was on a sleigh ride through the ocean. Among a group of adults, she was easily the calmest!
While no one in the industry was forecasting the current state of affairs, your ability to remain calm, ask the right questions, and act prudently will dictate your institution's success. And if you properly position the organization, maybe you can lure a few customers away from your larger brethren and create long-term relationships (just like we added a one year old to our crew that August day!).
Learn more about our Asset/Liability Management services.
ABOUT THE AUTHOR
Vinny Clevenger is a Managing Director at DCG. In this position, he currently advises financial institutions on balance sheet management strategies. He takes a practical approach to the demands that the economic and regulatory environment place on his clients. Since joining the firm in 2003, he has worked in a number of capacities within DCG assisting clients in all aspects of ALM including process reviews, model validations, policy reviews, capital management, and contingency liquidity planning.
© 2021 Darling Consulting Group, Inc.