• Zach Zoia

Unlocking Valuable Strategic Lending Insights


Now Is the Time to Do Our Homework on Deposits

Loans | ALCO | Interest Rates



Staying ahead of the competition means asking the right questions


The lending market these days can be likened to a popular fishing hole, with dozens and dozens of boats (i.e., banks and credit unions) all casting their lines into the same prime spots, resulting in intense competition (i.e., pricing pressures). Amid this highly charged environment, there are a number of common elements impacting lending strategy discussions, including:

  • Deployment of excess liquidity

  • Relative spreads versus absolute yields

  • Capacity for duration

  • The specter of recession (credit risk)

  • Usefulness of derivative and option pricing

  • Competition for lending talent

Taking these factors into account, institutions must try to change the conversation around lending strategy if they truly want to get away from fishing with the same old crowd. This change ideally will take place at ALCO, where the focus should be on four key questions.


Rising rates: friend or foe?


There’s a reason the market generally places higher value on institutions in rising-rate environments: investors tend to see loan growth opportunities as a good thing, and the core deposit franchises funding those loans become increasingly more valuable. So why do institutions remain hesitant?


The truth is that the greatest exposure lenders face is in periods of lower/declining rates, when issues like growth opportunities, net interest margin and credit risk become heightened. Nevertheless, many are averse to adding asset duration as rates rise, when it may generally be the best strategy.


What is impeding loan growth?


When it comes to explaining obstacles that get in the way of achieving loan growth, there are two common points that tend to arise:


1) Rate v. spread

A bank’s focus on relative spread versus absolute yield is a critical determinant of future lending success. With the yield curve above 2018 peak levels, banks should aim for similar spreads today. Yes, absolute yields are increasing, but for many, spreads are nowhere near those 2018 levels. Conversely, when yields were “lower” in 2020-21, institutions achieved spreads that were actually better than those seen today. Which environment were you more comfortable lending in?


Overall, it’s important to understand that absolute rate levels can be misleading, which means it makes more sense to shift the conversation to relative spreads for context. Among the questions to consider:


As loan yields moved higher early in 2022, how did that conversation begin?

  • What’s stopping us from further increasing loan yields?

  • Is this a transition period or a “new normal?”

  • How do we respond to the notion that “lenders need to lend?”

  • Do we understand comparative investment market alternatives?

  • Will an increase in our cost of funds jumpstart loan pricing even higher?


2) Fixed-rate capacity v. appetite

In most cases, a lender’s capacity for fixed-rate loans is greater than it may think, and declining interest rates are more likely to be its greatest interest rate exposure. It’s rare, in fact, for a lender to not have capacity for additional fixed-rate loans, even if the balance sheet structure has liability-sensitive tendencies. Duration decisions should be more related to how loans are funded versus the actual length of the asset being originated.


But can you get paid for adding duration? The steepness or flatness of the yield curve often indicates the extent to which markets perceive what duration is worth. Use the shape of the curve to your advantage. Be ready to offer customers a range of deals, priced appropriately, and let them decide what fits best for their own goals. Think outside the normal construct of 5, 7, and 10-year terms!


Why should you understand derivatives?


Derivatives sometimes carry a negative connotation, yet they can be valuable tools for a community banker to understand. Even if your institution is not actively “set-up” to enter into derivatives contracts, your lenders should have a strong conceptual grasp of how they work. Every loan deal that goes out to a customer has some degree of “option” being priced in, and those options can be assessed every day in the derivatives markets (e.g., floors, caps, prepayment penalties, swaps, etc.).


An institution’s ability to properly value loan options can help protect its balance sheet no matter where rates go, so do not “just say no” to understanding how derivatives work. They can provide flexibility for your lending team and create a competitive advantage.


What’s the worst that can happen?


Finally, we always want to be mindful of, “How can the current strategy/deal/transaction/etc. go wrong?” From a lending and ALCO standpoint, the old standbys of capital planning and stress testing should be considered ongoing best practices in any institution – not just “in case of emergency” measures. The market today is pricing in the possibility of recession and the potential for higher credit risk – this is the time to fully understand what can happen so that you’re ready if and when it does.


As time and markets evolve, so too must the conversations at ALCO. Make sure you are homing in on these four key items, and you’ll be moving your institution away from the crowd and toward a better place to fish.


 

For more perspectives about lending, visit DCG Bank and Credit Union Insights.


 

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 B.S. in finance from Boston College and his M.B.A from Babson College.


 

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