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  • Writer's pictureZach Zoia

The Prediction Issue


Now Is the Time to Do Our Homework on Deposits


There is a famous story about Nobel Prize winning economist Kenneth Arrow harkening back to his time serving in the US Air Force as a weather officer during World War II. Kenneth was not an award-winning economist at that time, but he was a trained statistician with a penchant for understanding numbers and using them to solve problems. This ultimately led him to a post whereby his team was tasked with producing long-range weather forecasts for the Allied generals.


It does not take an intellectual capable of winning a Nobel Prize to understand the futility of predicting the weather thirty days in advance; nonetheless, that was what Kenneth’s group was asked to accomplish. When his team pushed back to their commanding officer that the forecasts being developed were no better than a coin flip, they received the following response:


“The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”


With the volatility the industry faced in 2022, and the uncertainty surrounding the banking environment for 2023, many risk managers are feeling like Kenneth in relation to their ability to accurately forecast a budget and manage their balance sheets amidst a sea of changing conditions. For many, 2023 budgets are already off the mark less than two months into the year.


Accordingly, being prepared for the quickly changing variables facing risk managers this year continues to get a lot of attention in the conversations we have been having nationwide.


 

From the Editor


Prior to a recent ALCO meeting, the CEO of a bank asked me the following: “Vin, how would you characterize the general demeanor of bankers thus far during 2023?”


When I glanced back at him during our short walk to the Board room, I noticed the same look of exasperation on his face that has become all too common these days. I responded, “It’s exactly how you look right now.”


The confluence of an inverted yield curve, deposit outflows, tepid loan demand, unrealized losses in the bond portfolio, and bank failures have combined to make it feel like we are navigating through the “Perfect Storm” of balance sheet management.


In this month’s Bulletin, DCG Managing Director Zach Zoia summarizes five critical discussions (based upon remarks by DCG CEO and President Matt Pieniazek at recent industry conferences) that ALCOs should have to create clarity for your organization. Zach asserts that fostering a strong risk management culture is the best way to prepare your institution for this uncertain environment.


So before you “batten down the hatches,” we hope Zach’s overview helps shape your forecast for the weather we are likely to face as an industry in 2023.


Vinny Clevenger, Managing Director


 

DCG President & CEO, Matt Pieniazek, had the honor of speaking at Bank Director’s Acquire or Be Acquired conference in late January, where his focus was on managing balance sheets in a world of great uncertainty.


He also joined DCG’s On the Balance Sheet podcast (join the conversation here) in January to lay out his predictions on the key issues and challenges facing bankers in 2023.


One thing I’ve heard him say numerous times, and he reiterated in the podcast interview, is that “2023 is going to present the banking industry with one of its most uncertain and potentially challenging environments in a very long time.”


Thinking that through, this should place a real premium on creating clarity with decision-making, as it could be very easy to let fear and uncertainty drive conversations, and ultimately outcomes.


No matter where rates and economic conditions go this year, here are five predictions Matt – and the rest of the DCG team – are confident ALCOs will need to stay concentrated on as this year unfolds.


The Funding Cost Escalator Becomes an Elevator


Deposit cost pressure is now in high gear, but it is not in the highest, yet. This has been the number one conversation around most ALCO tables, and DCG’s predicative analytics forecast via our Deposits360 platform has been showing that this issue will not be going away any time soon.


Betas initially paled vs prior cycles, ostensibly due to the quickness and shock of the rates hikes in 2022, and now the “catch-up” is becoming reality.


We believe it will be more severe and backloaded than the other two rising rate cycles this century.


Management teams need to attack this challenge in digestible and targeted segments, as deposit mixes and value propositions vary. Think operational vs discretionary balances … are these being comingled? Think stratification of large vs small vs in-between account balances … what is our strategy for these different cohorts?


While all your depositors have something in common in that they “bank” with your institution, they all have different needs and place different values on the services provided. ALCOs need to drill into this to price their deposit base more effectively and efficiently.

Additionally, as deposit attrition increases, and we expect it to continue, groups need to have real conversations about how much outflow they are willing to accept, especially as liquidity continues to tighten industry-wide. As this transpires, will we be able to understand the strategic difference between losing discretionary balances vs overall relationships?


Our “Normal” Loan Pricing Definition Will Require Recalibration


It is true that absolute loan yields increased over the course of 2022, but for most, relative loan spreads did not move higher. In fact, loan spreads compressed in a number of sectors. With copious amounts of liquidity, many accepting lower spreads to maintain or restore margin, as the yields were still higher than additional investing in the bond portfolio.


As 2022 progressed, we were challenging ALCOs to engage in harder conversations about the spreads being accepted to achieve their growth targets. Now, with liquidity tighter, the marginal cost to fund the loans much higher, and credit concerns on the horizon (think inverted curves, possible recession, etc.), loan pricing warrants a hard look to ensure the growth captured is actually profitable. Perhaps growth needs to slow? It’s becoming a much more frequent discussion item.


Notwithstanding, the examination of loan pricing does not end with the yield and spread discussion. Banks and credit unions need to truly understand the value of the options that are a part of every deal, from forward commitments to prepayment penalties to caps and floors. These options are often “given away” and can be very costly if not underappreciated by your lending team.


Your Liquidity Story Will Matter Greatly


Liquidity dynamics in the industry have changed considerably over the past year. Banks and credit unions went from having too much to too little.


Has your philosophy on liquidity changed in the wake of these trends?


The biggest concern we have been hearing seems to stem from bonds purchased over the past few years. Yes, they may be at unrealized losses. But in most cases, those larger bond portfolios are still able to be converted into cash at a market cost via the pledging mechanism (e.g., FHLB, Fed, etc.).


Your view on the composition of your liquid assets (i.e., cash vs bonds), and how you can still fund the balance sheet even if cash is low and bond market values are not in your favor for a sale, will be vital in defending the flexibility of your liquidity profile.

Moreover, situations like the industry just experienced elevate the importance of robust contingency funding planning and stress testing.


Management teams need to clearly define how liquidity is maintained and manage those conversations both internally and externally.


There Is a Hidden NII Risk That Needs to Be Addressed


Most models I have analyzed over the past year show upward trending base case net interest income (NII) levels, which was a welcomed reversal of the downward margin pressure most felt during the lower yield years of 2020 and 2021. One of the key contributors was the ability of most financial institutions to lag their deposit costs over the course of 2022, while asset replacement yields were increasing.


Now, the deposit rate lag elastic band is “snapping,” and more groups are either becoming, or “feeling” more liability sensitive. Is your ALCO talking about the potential “catch-up” costs developing that may not be fully captured in your NII models?


The best ALCOs are addressing this in conversations and running scenarios to help quantify what the cost impact could be, and how that may change their income simulation trajectories.


Inverted Yield Curve Environments Remain Dangerous


Yield curve inversions are not our normal operating environment, but they do occur from time to time, usually as rate cycles transition from rising rates to falling rates. The fact that financial institutions can invest in 3-month Treasury bills at a higher yield than 5-year treasury notes or borrow money cheaper for 5 years than 3 months, can be confounding.


Listening to the needs of your balance sheet is the best counsel during these times, albeit often hard to execute. Some will extend funding too long in pursuit of current income, while others will shorten duration with the same goal in mind.


Please do not forget about what happens to your balance sheet if rates fall again, which is generally a banker’s worst-case scenario, even if the speculator in you thinks we will never go back down again.


History shows these cycles come and go, and the best management teams are elevating the conversation of the value of current income today versus protecting the future income of tomorrow’s rate landscape.


How’s the Weather Looking, Kenneth?


No one can predict the weather months in advance, nor the rate and economic environment. Yet, we can make sure we have strong risk management cultures and frameworks in place. Ones that will encourage the right and often difficult conversations that need to occur at ALCO, to best prepare us for the uncertain conditions ahead.

 

To tap into the latest bank and credit union insights from across the Darling Consulting Group team, visit our article archives.


 

ABOUT THE AUTHOR


Zach Zoia is a Managing Director at Darling Consulting Group. He helps management teams throughout the country develop strategies to improve financial performance and more efficiently and effectively manage liquidity, capital, and interest rate risks.


Zach began his career with DCG in 2008 as a financial analyst. He earned a BS in finance from Boston College and his MBA from Babson College.

 

© 2022 Darling Consulting Group, Inc.

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