Try this four-step remedy
By Raymond E. Chandonnet, principal, Sandler O’Neill & Partners, New York
Try this four-step remedy. It could calm the regulators and set you up nicely for the recovery
Over a very short period of time since November 2009, banks of all sizes have intensified their focus on measuring, understanding, and mitigating exposure to rising rate risk. A recent symposium on the topic hosted by the FDIC attracted several hundred bankers. A conference call on the topic hosted by Sandler O’Neill in January attracted over 450 registrations.
Why the sudden interest? As is most often the case, the bank regulators focused their attention on the issue, and bankers then followed suit. In light of this, the timing is right for us to outline the reasons for the scrutiny, and explore the symptoms, sources, and remedies for exposure to rising interest rates.
Why all the hullabaloo?
As early as spring of 2008, regulators at the OCC began raising the alarm in various public settings that exposure to rising interest rates was the “next big thing” in terms of systemic risk in the banking system. During the current rate cycle, the Federal Reserve has reduced the Fed Funds “target” rate by 525 basis points and held it there. Here early in 2010 we find ourselves with historically low short-term rates and an extremely steep yield curve despite longer-term interest rates being near historic lows. Concerned that this rate environment encourages banks to take excessive risk to rising rates by “playing the curve,” the FDIC published an article on the topic in their Winter 2009 issue of Regulatory Insights. In this article, the FDIC made the following points:
• Rising rate risk has increased sharply particularly at “small” banks, defined as banks with less than $10 billion in assets;
• A meaningful percentage of regulatory orders implemented in 2009 contained specific provisions requiring the bank to reduce exposure to rising rates;
• Regulators consider it a best practice for banks to model interest rate risk changes at least +400 basis points, instantaneously, with a “zero growth” (static balance sheet) assumption;
• It is also considered a best practice to increase loan default assumptions on floating-rate loans in a sharply rising rate environment;
• Banks are encouraged to actively manage their interest rate-risk position through IRR mitigation strategies;
• Banks are encouraged to make use of hedging strategies involving interest rate derivatives to help reduce interest rate risk.
This was followed up by a joint directive on the topic issued by all the bank and credit union regulators on January 7th which reinforced the points made by the FDIC, focused particularly on market-value deterioration due to rising rates, and encouraged banks to increase their capital position as a buffer (as if they needed one more source of pressure to increase capital!)
How should banks respond?
Banks typically first try to rebalance their risk position by trying to influence customer behavior and product selection (more long-term CDs, more floating-rate loans). This is historically difficult to do. Once this is exhausted, banks must use the markets to change their rate-risk position. This likely involves the securities portfolio, wholesale funding, brokered CDs, and/or interest rate derivatives such as caps and swaps. There are 13 different strategies banks can employ using these products—five using cash-market instruments like securities, borrowings, and brokered CD’s, eight using derivatives. Each has its own unique impact on current and future earnings, economic value of equity, capital ratios, and each with its own particular accounting and other considerations.
A basic, important function of the asset liability committee is to have a good understanding of all of these products. While certain strategies or instruments may not fit within the culture or level of sophistication of every bank, it is imperative that management and directors are educated on, and thoughtfully consider, all interest rate risk and earnings management tools before adopting them or declining to do so. It is beyond the scope of a short article to review all 13 different strategies—but we can establish a framework for narrowing the options.
A “visit to the doctor”
The best way for banks to address the rising rate-risk issue is to follow a “visit to the doctor” analogy, an approach we have used with banks for more than 20 years. This involves, first, pinpointing the symptoms of rising rate exposure. Second, diagnosing the root cause(s) of that exposure. The third step is to examine a bank’s “vital signs” to determine the general health of the bank. The final step is to determine what “allergies” a bank has to certain medications that might cure the problem. The result? A prescription (one of the 13 solutions) customized to a bank’s symptoms, diagnosis, vital signs and allergies. Here’s more detail on the four steps:
1. Identifying the symptoms: Exposure to rising rates can manifest itself in three key ways.
a. Net interest margin can compress as rates rise due to any number of causes, all triggered by rising rates. This is generally exposed in income simulations in the bank’s IRR model.
b. Economic value of equity (EVE) can decline as rates rise due to longer term exposure to rising rates not captured in net interest income (NII) simulations. This is generally exposed in the market value of equity test the regulators require as part of interest rate risk modeling (e.g. EVE/MVPE/TB13-a tests).
c. Tangible capital ratios can come under pressure. Since unrealized gains/losses on available-for-sale (AFS) securities and held-for-sale (HFS) loans are included in tangible capital, rising rates can further pressure this ratio at a time when investors and regulators are both intensely focused on it.
2. Diagnosing the condition: There are five primary “diseases” that can cause deterioration in financial results as rates rise. Each source of risk has different impact on future earnings-at-risk (EAR), value-at-risk (VAR), and capital ratios:
a. Structural mismatch between duration of assets and duration of liabilities. This will cause future earnings compression, which may or may not be “caught” in the bank’s NII simulation depending on how far in the future the exposure is. This will dramatically impact tangible capital since any AFS assets will deteriorate in value, which is a deduction to capital via Other Comprehensive Income. (OCI is deducted from capital for regulatory ratios but not for tangible capital calculation—a key distinction which drives interest rate risk strategy.)
b. Call/put/prepayment options that ex-tend asset duration and shorten liability duration. This is a “second derivative” issue, meaning it makes the duration mismatch in condition a. worse.
c. Floors in floating-rate loans. Most banks have been very successful at adding floors to floating rate commercial and commercial real estate loans which have protected margins as short-term rate indexes like Prime and Libor have hit historic lows. However, these “in-the-money” floors cause those loans to act like fixed-rate assets until rates rise beyond the floor strike rate, creating a sometimes “hidden” source of rate risk. This is a very common, and often badly modeled (or ignored) risk today. This risk will impact earnings and should impact VAR (though most banks have no idea how to value the embedded floor in different rate environments).
d. Increase in fixed rate commercial/CRE lending (both new and refinanced loans). As commercial borrowers seek to control financing costs, an increase in fixed-rate lending shifts the balance sheet to a more mismatched position. This creates more earnings in the short-run (thank you, steep yield curve). However, if left unhedged, these fixed-rate loans will crimp net interest margin later as rates rise.
e. Shift in deposit mix. In a rising-rate environment, depositors shift out of low-cost, low-beta nonmaturity deposits (MMDA, savings, etc.) and into higher-cost, higher-beta time deposits. (Deposit repricing “beta” refers to the correlation between deposit pricing and market rates.) This risk is rarely modeled, despite the fact that this was one of the most significant drivers of margin compression in 2004-5 when the Fed began rapidly tightening to undo their policy accommodation during the 2001-2 recession.
3. Examining vital signs: Before determining what types of solutions the bank could implement to reduce its rising-rate exposure, a thorough review of the bank’s financial condition (“vital signs”) must be undertaken. This is done to ensure that any strategy doesn’t unintentionally stress the bank in another area. This should include the following:
a. What is the bank’s regulatory and tangible capital position? Is it under pressure?
b. What is the bank’s liquidity position? Is the bank trying to increase or decrease it?
c. What does the bank’s investment portfolio look like? Wholesale funding? Brokered CDs?
d. Does the bank have MMDA/savings accounts? Are they pegged to a rate index? If so, what?
e. Does the bank have unpledged securities collateral?
f. Any important regulatory factors?
4. Identifying allergies to medication: In most situations, there is more than one tactic the bank can employ to mitigate the identified interest rate risk. However, management may be “allergic” to some solutions, for various reasons. The most common allergies we see are:
a. Management cannot/will not incur one-time charges to restructure securities portfolio or funding;
b. Management cannot/will not give up earnings in order to reduce rate risk;
c. Management is not willing to use interest rate derivatives.
It is important to point out that in some cases, you have to live with undesired side-effects because there is only one cure. For example, we recently advised a bank that was forced under a regulatory order to reduce its rising rate exposure. For various reasons, there was no “on-balance sheet” strategy that worked, and the bank could not get credit approval for swaps. As a result, the only strategy the bank could (and did) execute involved purchasing interest rate caps.
Write the prescription
In the end, the “visit the doctor” approach will result in only one or two of the 13 possible tactics being appropriate for a specific bank’s situation. Here are some observations that may be useful to generate dialogue:
• Most strategies involving restructuring the bond portfolio will likely involve taking one-time gains and forfeiting earnings (yield) going forward. Realizing gains improves current regulatory capital ratios but not tangible capital. Conversely, the shorter duration of the restructured portfolio will benefit tangible capital (lower unrealized losses as rates rise) but not regulatory capital. Thus, bond portfolio transactions are most appropriate for banks whose regulatory capital ratios are under pressure today, are concerned about tangible capital going forward, and are willing to give up significant earnings going forward.
• Any transaction involving swapping floating rate liabilities to fixed, or swapping fixed rate assets to floating, will immediately decrease earnings due to the steepness of the yield curve. The exception to this is if the swap is “forward-starting” and qualifies for hedge accounting.
• It is sometimes possible to restructure wholesale funding (FHLB advances and repos) without taking a one-time prepayment penalty through earnings.
• It is possible to embed rising rate protection (via caps) into investments or funding without having to account for the instrument as a derivative.
• It is possible to lock in today the cost of brokered CDs that will be rolled over in the future.
• If the bank does not want to hurt current earnings or take one-time charges, the only possible transactions that will work involve either restructuring wholesale liabilities, using interest rate caps, or using rate locks against borrowings.
Putting it all together
Managing for a higher-rate environment is equal parts science and art. The bank regulators have appropriately eliminated “do nothing” and “ignore the problem” as alternatives. There is a finite list of sources of rising rate risk, and an equally finite list of potential mitigation strategies. Some of those strategies, such as extending the maturity of brokered CDs, may actually be at odds with other demands from regulators. Others may require the bank’s ALCO to come up the curve on product knowledge and integrate new strategies into their risk policy.
Is it worth it? We suppose it depends—on the risk to earnings, and therefore to franchise value, on how much pressure the regulators place on us, and on how quickly rates begin to rise. In the end, however, we can make one bold prediction: When the economy turns and we all start measuring franchise value based on earnings again, those banks that have done the best job at protecting their margins will outperform their peers, attracting investors and customers in the process. BJ
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj0210/index.php?startid=28