Bracing Your Balance Sheet

From loans to deposits to investment portfolios, it’s time to prepare for rising interest rates

By Wade Oliver

The FDIC defines interest rate risk as the potential for changes in interest rates to reduce a bank’s earnings or economic value. Too much interest rate risk can leave capital and earnings vulnerable, subjecting a bank to competitive disadvantages and a weakened financial condition.

In December 2009 the FDIC published a Supervisory Insight for its field examiners that included a section titled “Nowhere to Go but Up: Managing Interest Rate Risk in a Low-Rate Environment.” Although the FDIC’s assertion that interest rates could not fall from the levels of December 2009 proved misguided for every interest rate—except perhaps for the prime and Fed Funds rates—its observations and warnings were excellent. They are even more applicable today than when they were published nearly four years ago.

Community bankers have added long assets and option risks to their balance sheets to help replace earnings lost from low loan volumes and margins, and this position could pose significant risk of margin compression when interest rates eventually rise. Treasury rates and the interest rates associated with them will rise as market forces take effect; the prime rate will rise as the Federal Reserve transitions from an accommodating stance to a more restrictive posture. The interest rate cycle will continue, and as it does, community banks’ net interest income and underlying economic value will change.

The charge for managers of banks’ balance sheets is not to predict when interest rates will rise, nor to predict how far interest rates may go or place bets that the markets will behave in a specific manner. Interest rates are driven by market and economic conditions that are inherently unpredictable. Prudent risk management requires you to ensure that your bank’s financial performance remains acceptable, not only in likely environments but also during “black swan” events that now appear to be unlikely.

In essence, your responsibility is to optimize how your community bank’s balance sheet performs in interest rate environments that you believe are both likely and unlikely to occur. No one knows when interest rates will rise, but recent action and statements by the Federal Reserve, coupled with current economic projections, indicate an increased likelihood that interest rates will begin to increase in coming quarters.

As your community bank considers how it will prepare for rising interest rates, whether they come next month, next year, or in the next decade, it should look at the risk profile of each area of your bank’s balance sheet—its loan portfolio, its deposit base, and its institutional investment portfolio. That interest rate risk review should be done in light of today’s uniquely uncertain environment.

On the loan side

When evaluating the interest rate risk in your community bank’s loan portfolio, consider three major factors.

First, while prepayment activity in your community bank’s loan portfolio is influenced by many factors, including the health of the local economy and the language of your bank’s loan documents, the level of interest rates relative to a loan note rate is certainly a driving force. You understand that if interest rates rise significantly, your bank’s customers lose incentive to prepay their loans.

Second, the benefits of “in the money” floors embedded in your community bank’s current loan portfolio could transform into a relative drag on its overall balance sheet performance. At the beginning of the recession, many banks enjoyed strong pricing power and generated more floating-rate loans with floors that kept the accrual rate of their notes much higher than an adjustable rate would demand. Under many rising interest rate conditions much of your bank’s loan portfolio could reprice only slightly or not at all, even while its funding rates become much more volatile.

These risks are normally captured fairly well in today’s simulation models. However, the extension risk of loan portfolios originated during an extremely low interest rate environment may be very different than your previous experience. Assumptions used for expected prepayments may need to be more aggressive than those used in the past.

The third major interest rate risk that may not be captured well in a loan portfolio review is the likelihood that customer behavior could change. The depressed economic environment over the last five years has generated bank balance sheets with strong liquidity and capital along with lackluster loan demand. These dynamics have intensified competition for new loan originations, which in turn has compressed loan spreads to levels below historic trends.

Rising interest rates resulting from increased economic activity may generate increased loan volumes and increased spreads, but rising interest rates during a tepid economic recovery may continue to compress the spreads on new loans. These scenarios, which may not be captured in income simulation models, need to be considered.

Continue to monitor your community bank’s actual rate of new loan originations in relation to its funding costs, as well as your bank’s loan pricing trends. Using a current loan-pricing assumption in a simulation may produce very different projected earnings, and perhaps prevent an overly optimistic forecast of increased revenues.

On the deposit side

As with loan portfolios, deposit structures also embed interest risk into community banks’ balance sheets, and perhaps more risk now than ever. While most community bankers understand how deposit-rate sensitivity can affect their bank’s interest rate risk profiles, recent events unique to today’s banking environment have added a new degree of complexity and difficulty in assessing the risks of rising interest rates.

Since the Great Recession, community bankers have seen a dramatic increase in the percentage of their balance sheets funded by NOW, savings and other demand deposit accounts. This increase, averaging more than 20 percent of overall bank deposits, stems in part from customers leaving the uncertainty of brokerage accounts and money center banks and returning to the comfort of their community bank relationships. These funds have been deposited with flexibility and safety in mind, with the rate of return paid on their deposits proving to be a secondary concern. The result is a funding base of potentially transitional customers ambivalent about current low deposit returns.

Community banks have become accustomed to customers, even traditionally rate-sensitive customers, who have become used to receiving a low rate of return on their deposits. When interest rates begin to rise, however, more customers may become dramatically more sensitive to the rates they receive for their deposits, and in many cases many deposits may migrate regardless of the rate banks offer their customers. This potential drain of deposit funding would create noticeable stress on both earnings and liquidity, and this possibility may not be captured by your bank’s simulation models. In short, you may have “core” customers with funds in “core” accounts, but those funds may still be quite transient.

These deposit market risks are significant, but behind the scenes a potentially more significant risk may be lurking. The final repeal of Regulation Q in 2011 may have simplified some deposit operations, but it also opened the door for even more competition for commercial deposits. You may discover that the movement from business sweep accounts and other creative ways of attracting corporate deposits toward direct interest paid has little affect on the net cost of these deposits and on your bank’s ability to retain these funding sources. However, you may also discover that your bank’s business accounts are extremely sensitive to rate competition and subject to being “purchased” by other banks willing to offer higher deposit rates.

Remember that Regulation Q was enacted in 1933 after the Great Depression in part to protect the banking industry, specifically smaller banks. Congress believed the Depression had been caused in part by excessive bank competition for deposit funds that drove down the margin between lending rates and borrowing rates and encouraged overly speculative investment behavior by the large banks.

Today’s regulatory reporting requirements and oversight may prevent such speculation in the future, at least in part—or it may not. But the interest rate risk embedded in the loan and deposit components of your community bank’s balance sheet are largely the result of customer preference. All customers, particularly businesses operating in a competitive marketplace, tend to act in their own best interest, which is often the opposite of their bank’s best interest.

To balance these deposit risks, community banks must use tools that do not require their customers to accept products outside their own preferential structures. These tools (primarily wholesale funding, the investment portfolio and interest rate caps and floors) allow banks to balance the interest rate risk embedded in their retail products.

On the investment side

Using term Federal Home Loan Bank advances and brokered deposits can allow community banks to add stable, long-term funding to their balance sheets at reasonable rates, offsetting some of the extension or liquidity risks in their loan portfolios. Similarly, the investment portfolio allows banks to structure their cash flow and re-pricing characteristics to complement the structure of their loan portfolios.

For most community banks, the investment portfolio is their primary tool for changing their interest rate risk profile, and increasingly banks are using derivative products such as interest rate swaps and caps to manage these risks. Currently, more than 1,000 community banks use derivative products to effectively reduce their interest rate risk. This allows those banks to take advantage of a very efficient marketplace to convert long-term fixed-rate assets to adjustable rates, or to convert adjustable rate funding to fixed rates.

While these wholesale investment products have their own interest rate risk, the amount and direction of that risk can be controlled. To manage the investment risks of rising interest rates, community banks today must be even more diligent about assessing the effects of their stress-test scenarios, particularly for unexpected events that could occur.

Today’s combination of regulatory, interest rate, and economic conditions require unique analysis. These five risk management steps should be part of your community bank’s analysis: Run stress-test simulations or calculations to assess the effects of compressed spreads on your loan portfolios.

Assess the long-term effects of a rise in interest rates that would be sufficient to increase your bank’s funding costs (generally about 100 basis points or so) without breaking through the floors already in place in your bank’s loan products.

Evaluate the income effects of replacing large percentages of your bank’s non-maturity deposit bases with alternative funding sources, including the possibility of adding significantly more wholesale funding and the limits of your bank’s capacity to do so.

Run simulations that change the base assumptions for your bank’s loan and deposit sensitivity, then test other alternative scenarios.

Determine the effects on capital, liquidity and flexibility from unrealized losses in your bank’s securities portfolio due to an increase in interest rates.

Your community bank’s asset-liability committee should focus on managing the risks embedded in your bank’s balance sheet, including preparing for unlikely events that would cause stress on your bank’s operations if they occurred. Such stress scenarios are a regulatory focus and central to effective risk management. If their results reflect a risk that is unacceptable to your bank, be proactive. Evaluate your bank’s ability to change the structure of its investment portfolio and wholesale funding to offset the risk, either by restructuring current positions through future cash flows or adding new funding and securities to reduce the exposure.

The recession of 2007 created an unusually uncertain environment for community banks’ balance sheets. Virtually every aspect of banking is much different today than it was before the recession. Effectively managing your community bank’s risks from rising rates in this environment may require new analysis to adjust for new risks not yet unaccounted for.