"Skijoring" & Community Banking
Banking in the current environment is akin to getting dragged on skis by a runaway horse!
The current environment has created tremendous uncertainty and, in some instances, has made many bankers feel out of the control. While all bankers like to have full control over every aspect of their balance sheet, there are clearly some risks that are out there that bankers simply cannot control. Much like those who love skijoring, bankers have always been in the business of taking and managing risk, and the competitor who prepares the most and fully understands all the potential consequences of their actions will ultimately navigate their way down the course in the most efficient manner possible.
From the Editor
“Skijoring”…yes you read that correctly, is a sport in which a skier is pulled by a horse or mechanized vehicle via a tow line. Its roots are traced to Scandinavian countries where it transformed from a practical mode of transportation over vast snowy expanses (“Skijoring” translates to “ski driving”) to eventually becoming an exhibition sport at the 1928 Olympics in St. Moritz, Switzerland.
Subsequently, it has become wildly popular in the ski towns of the Rocky Mountains. The sport is a combination of water skiing, downhill racing, and horsemanship.
In what is likely the first article ever to compare banking to “skijoring,” DCG resident ski expert Steve Boselli examines the tremendous uncertainty community financial institutions are facing as the pandemic winds down.
The article focuses on the variability presented within deposit bases, the uncertainty of prepayment on both loans and investments and the influence the Federal Reserve may have on the shape of the yield curve (and therefore margins).
Given all the challenges currently presented in the current environment, it truly does feel as if we are strapped to a runaway horse with little ability to control the variables at play. So click into your skis, buckle up your helmet, and enjoy this month's Bulletin on balance sheet management!
Vin Clevenger, Managing Director
3 Key Risks in 2021 That Could Materially Impact the Way You Think About Strategy
1. Depositor Behavior
Often when asking management teams for their forecast for deposit growth or contraction in 2021, the response is, “I have absolutely no idea! Just too much uncertainty in too many areas, with too many moving parts.”
Clearly, the surge in funding since the start of the pandemic (whether it is added stimulus, PPP-related deposit growth, the country simply being shut down, or just an overall flight to quality), has created vast uncertainty with respect to both liquidity and interest rate risk profiles.
The interest rate risk profile of many institutions has become notably more asset sensitive (or “less” liability sensitive) since the onset of the pandemic. This is the byproduct of what most think is potentially “parked” deposit growth, commensurately elevated cash balances and an acceleration of asset cash flows in both the bond and loan portfolios.
Could this structural change in the interest rate risk profiles of institutions across the country be short lived? Will this funding stick around longer than some may think?
Do you think there is a chance you have a temporary balance sheet within your larger balance sheet?
What is the optimal way to address this uncertainty from a risk management perspective? Go to the extremes! What if every penny ultimately leaves? What if we lost it in three months? What if we lost it over 12-18 months? What if we kept 100% of the deposit balance surge?
ALL “SURGE” DEPOSITS LEAVE vs. NO “SURGE” DEPOSITS LEAVE
The reality is that most institutions fall somewhere in between. However, modeling the extremes can help management teams create some clarity on their true interest rate risk profile. If we believe the funding sticks around, should we consider putting some cash to work in the bond market? If we think the funding could run out, would we think about layering in rising rate protection now via term funding extension or the use of interest rate swaps or caps? The answers to these questions can vary greatly, depending upon if we are the institution on the right of the above graph, or the institution on the left. Much like the skijoring competitor who visualizes all the gates and jumps prior to taking the course, it is imperative to ensure that your risk management process goes to the extremes in these uncertain times, to create more clarity on what strategy makes the most sense for your balance sheet.
2. Borrower Behavior:
Whether it is embedded in various loan pools in your bond portfolio or within single credits in your own loan portfolio, this historically low rate environment has created some unprecedented trends with respect to refinance activity. We have always looked at a commercial loan without a reasonable prepayment penalty, to be a borrower’s dream. How many borrowers out there would love a loan that was fixed as rates rise and was floating as rates came down? Do those even exist? It seems to me like that is not materially different than a loan without a stiff prepayment penalty.
In the bond portfolio, many institutions got caught “off guard” with higher premiums on mortgage- related security pools paying off and amortizing that premium over a shorter window than expected. In some cases, creating negative yields.
Learn from this and be cognizant of the premium you pay on future purchases. While some contend that rates cannot go any lower, if this past decade has taught us anything, it is that rates can always go lower!
Creating a disciplined culture on prepayment penalties within your organization, regardless of where interest rates are is critical. The downtrend in the run rate of net interest income for many institutions will only be exacerbated if these two key items are not properly managed, monitored, and implemented.
3. Yield Curve Risk:
The FOMC seems committed to supporting the economy via accommodative monetary policy and continued asset purchases. Will the FOMC remain dovish? Could they change course? Will they “let” the curve get even steeper than it already has?
The anticipated margin pressure for most institutions in the next twelve months and beyond continues to be significant, driven in part by funding costs that have almost reached their implied floor levels, but mainly due to the meaningfully lower expected reinvestment rates on asset cash flow.
Despite the significant bond market sell-off which occurred since the beginning of the year, there does not (yet) appear to be a meaningful impact on loan pricing, and margin pressure is anticipated to continue.
The projected trend of your net interest income in the next 12 months should drive decision making! Do you think differently about putting cash to work in the bond market or getting more aggressive on loan pricing if you have a decline in the projected level of your net interest income? Conversely, if you do nothing and sit on the excess cash, will you maintain your balance sheet spread? Does the anticipated benefit of your budgeted growth offset a decent portion of that downward trend?
Understanding the slope of market yield curves and the potential impact to your balance sheet and earnings in the future is crucial. Doing nothing today could make some sense for most, however, it is important to strategically choose to do nothing and understand the potential risks if you choose to go down that path.
Although many bankers and skijorers are at the mercy of the “horse at the other end of the tow line” (with respect to the shape of the yield curve), those who truly understand what their profile looks like if market yield curves flattened back out and/or continued steepening will be in a better place to make the most informed strategic decisions.
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ABOUT THE AUTHOR
Steve Boselli is a Managing Director at Darling Consulting Group, 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.
© 2021 Darling Consulting Group, Inc.