• Joe Kennerson

Searching for the Silver Bullet


Searching for the Silver Bullet

ALCO | Deposits | Loans




“Any silver bullet strategies?”


This is a question we have received more this year than in any past year. The silver bullet quest is to fend off earnings pressure emanating from lower expected fee income (PPP and mortgage gain-on-sale), limited funding cost relief, and new loans originating at coupons lower than the portfolio level.

The answer, of course, is that there is no silver bullet. If there were then we wouldn’t be stressing about 2022 earnings pressure. It comes back to changing the conversation at ALCO. We are in a basis point game over the next two years, and if your ALCO is backward-looking then you run the risk of leaving basis points on the table.


Below are five ALCO initiatives to shift the silver bullet quest toward a forward-looking and strategically-focused ALCO meeting.

1. Quantify Margin Pressure


By now, you should have a good idea of what 2021 net interest income (NII) levels will look like. Utilize your interest rate risk (IRR) model to project out base case NII levels for 2022. Most of you will see a downward trend. From there we can start to peel back the layers and talk about how we attack that pressure starting with filling this “gap.” Consider the following:


How much loan growth and at what spread? How does that growth number compare to budget expectations? How much can we squeeze from the deposit side? How much cash would we have to put to work? How far out on the curve should we go, and does our risk position support extension? These are all strategies you are discussing today but bringing that NII pressure into context with ALCO will change the conversation.


2. Tell Your Deposit Story


There are two key areas of focus here. First, what are the expectations for deposit surge stability? Our industry has experienced epic post-COVID deposit growth. The big challenge today is trying to figure out how much of that surge is going to stick around for the long term. Dive into the data. Identify what you consider to be “surge” and the origin of that growth: consumer vs. business and changes in balance concentrations among existing vs. new customers. Through September, our Deposits360°® data analytics show no signs of deposit behavior patterns that would suggest a deposit surge run-off.


Second, start planning for the Fed tightening cycle. What does a 50 bp increase mean to your funding costs? 100 bps? What did you learn from the last cycle in terms of sensitivity and product positioning? Your core deposit stability and rate sensitivity are by far the biggest factors impacting your IRR profile – and therefore influencing strategy decisions.


3. Develop a Plan for Excess Cash


Your deposit analysis should give you confidence to decide how much of your cash you are willing to put to work. The recent sell-off in the intermediate part of the treasury yield curve has provided 125-175 bps of spread opportunities depending on the bond package. If the loan pipeline and budget expectations are not enough to cover margin pressure, then it may be worth exploring investment opportunities.

Examine the impact of a shorter-duration strategy that provides more near-term cash flow against a barbell strategy. Run these strategies as pro-formas in your IRR models. It is critical that you analyze the impact of the strategy with the entire balance sheet and not just in isolation of the transaction. In one recent client meeting, we discovered that we only had to invest 60% of the cash in a barbell strategy to yield the same base case earnings from a shorter-duration investment strategy. The barbell also resulted in less NII at risk as rates rise.


4. Identify the Capacity to Extend Assets


We are not speculating on the future of rates when we discuss asset extension initiatives. No one knows where rates are going. The good news is that as risk managers we are not expected to predict the future of rates. Our job is to manage risk. And the worst-case earnings scenario for almost every institution is a sustained low-rate environment and the pressure that puts on asset yields. Protecting against this worst case generally comes from the asset side.

The solution is that every bank can extend assets – it just depends on whether you should be adding protection as you extend or if your existing balance sheet supports fixed-rate assets. Many banks have proven through our Deposits360°® solution that they have a very strong, stable, and non-rate-sensitive core funding base that supports longer-term assets.


5. Change the Loan Conversation


The antidote for earnings pressure starts with loans. The challenge is that there are 10,000 other banks and credit unions facing the same challenges with the same hopeful loan solution. Expect this competitive pressure to have an impact on loan underwriting and rate/term structures. Many cannot afford to walk away from the best credits based strictly on rate or term, within reason of course. On the mortgage side, should you be holding more fixed-rate mortgages? For commercial real estate, are you losing deals based on rate/term? Have this discussion at ALCO, and if you are saying no then do you fully understand what you are saying yes to?


Today’s silver bullet is a more strategic and forward-thinking ALCO. The basis points are going to be hard to come by and we cannot afford to leave anything on the table. Now is the time to change the conversation at ALCO.


 

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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 call at 978-499-8150 to to work collectively to transform ALCO into a profit center.


 

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