Managing With Rising Rates
By Jim Clarke
Asset/liability management is the art of structuring a bank’s balance sheet to take advantage of the current environment, and anticipated changes in the future environment.
Beginning in January 2001, expectations were for interest rates to fall, and fall they did from 2001 to 2003, reaching the lowest rates experienced in 46 years. During 2003 and 2004, bankers managed assets and liabilities in an environment of 1 percent short-term interest rates and a 3 percent spread between the Fed funds rate and the rate on the 10-year Treasury with the expectation that rates would increase. That increase began in June 2004. The Fed has increased the Fed funds rate 275 basis points in 15 months and is probably not done, as many believe we will see a 4 percent Fed funds rate by year end, and a relatively flat yield curve which makes balance sheet management even more difficult.
What is an Asset/Liability Management Committee (ALCO) to do? I would suggest we start with theory. Theory tells us that in a historically low rate environment such as was experienced in 2003, the ALCO should shorten asset duration and lengthen liability duration. In a relatively high rate environment with a flattening yield curve such as that experienced in 1999-2000, the ALCO should lengthen asset duration and shorten liability duration.
History provides additional information relevant to balance sheet management. Bank liquidity is generally plentiful in the low rate environments, but liquidity tightens as rate rise. Interest rate risk exposure comes in two varieties – asset sensitivity and liability sensitivity. We recently experienced the lowest interest rate environment in 46 years, asset sensitive banks suffered margin compression, but no banks failed. The lesson of history is that the most serious problems resulting from changing interest rates arise not from asset sensitivity, but rather from liability sensitivity in a rising rate environment. Liability-sensitive banks are beginning to suffer margin compression and, as the Fed continues to raise rates, the resulting shrinking margins and spreads may substantially reduce profitability.
At this point in the cycle, I would recommend caution on the asset side of the balance sheet, but more aggressive strategies for liabilities. Obviously in asset management, floating rate loans would be the preference. Home equity line-of-credit originations appear to be strong in many markets and represent a good asset choice, especially when tied to prime. Adjustable rate mortgages are more problematic, though preferable in the current environment, but note, seven- and 10-year adjustable rate loans do little for short-term balance sheet management. Thirty-year mortgage originations, unless sold into the secondary market, are obviously verboten. Another caution is long-term commercial real estate lending. Community banks are being force to extend commercial loan duration due to competition, particularly from the large regional banks. Be careful, those banks are likely using interest rate swaps, and if you are reluctant to use derivatives, don’t play the game until long-term rates increase – and with $64-a-barrel oil prices, they will soon.
Deposit Pricing Is Key The key to liability management is deposit pricing. With rates rising, it is critical to separate non rate-sensitive deposits or true core deposits from those deposits that are sensitive rate. My recommendations would begin with NOW accounts, and the suggestion is straightforward – don’t raise the rate. Secondly, savings accounts have historically been insensitive to changing rate environments; therefore, price them at a level to encourage retention, but not to attract new funds. In other words, ensure that these two accounts, along with DDA, remain stable core deposits. Money Market Deposit Accounts (MMDA) have become “hot money” and if you choose to retain these funds you will need to price with the competition – the large regional banks are making it a pricy game. My suggestion is to use aggressive CD pricing on selected maturities to encourage the movement of funds from MMDA to certificates.
Your ALCO is operating in a new environment. We have not experienced rising interest rates since the 1990s. Many banks need to continually re-evaluate the assumptions they are using in their ALM models. The Fed has provided 13 months of rising rates; therefore banks should be able to back-test to see if their decay assumptions and elasticity assumptions are valid. The current rate environment will place significant stress on the profitability of liability-sensitive institutions and accurate modeling is critical to managing our balance sheets. Also, the regulators anticipate problems given the increasing interest rates; therefore, carefully reassess your funds management policies, particularly the interest rate risk policy, before the next examination.
Jim Clarke is principal at Clarke Consulting, based in Villanova, Penn.