Asset/Liability Management and Balance Sheet Dynamics

The Banking Environment

It is not news that community banks have struggled with sluggish net interest margin for several years. We know that funding cost hit bottom some time ago, while yields on earning assets continued to whittle lower. Older loans and bonds paid off or matured and were replaced by newer and much lower yielding assets. Now, though rates are higher, the yield curve has flattened and margin compression is again problematic, especially for smaller institutions since three-quarters of their net operating revenue comes from net interest income. Clearly, community banks have a great incentive to focus on their asset/liability management processes.

Dynamic Analysis

Bank financial performance is the result of dynamic processes. Balance sheets are constantly changing as the volumes of different assets and liabilities, the rates paid (or earned) on those balances, and the cash flows moving into and out of those accounts are fluctuating and unpredictable. What we need to know is, given the mix of assets and liabilities and the rates associated with them, how can we expect margins and earnings to perform under different rate environments as the re-pricing assets and liabilities filter through the balance sheet over time?

In order to do this analysis, we must have tools that allow us to make assumptions about rate changes, options risk, curve shifts, prepayments, and sensitivities or betas. The ultimate point of the exercise is to determine how the bank is positioned, and what changes, if any, the bank may wish to make in order to shore up exposures to interest rate risk.

Every Balance Sheet Is Different

Each community bank has unique characteristics and ways of doing business that reflect the economic landscape of the market that they serve. Some are loan-driven suburban banks that face strong competition for deposits. Others do business in agricultural communities where loan demand and deposit growth are driven by seasonal factors. The one thing they all have in common is the fact that they operate in the same interest rate environment at any given point in time. Every bank must assess its exposure to interest rate risk and the interplay of three subcategories of risk: re-pricing risk, yield curve risk, and options risk.

Re-pricing Risk: Re-pricing risk results from differences in the timing of rate changes and the timing of cash flows that are built into the pricing and maturity structure of a bank’s balance sheet. For most banks, re-pricing risk is the most visible source of interest rate risk, and is measured by comparing the volume of a bank’s assets that mature or re-price within a given time period with the volume of liabilities that do so. Rate differentials are then applied to the re-pricing balances so that income and expense changes can be projected.

Yield Curve Risk: The nature of banking is such that banks borrow short and lend (or invest) long. The shape of the yield curve is dictated by the relationship between short-term rates and long-term rates. From the bank’s perspective, it’s the difference between funding cost and earning asset yield. Relative rate changes cause the yield curve to flatten, steepen, or become negatively sloped (inverted) during the course of an interest rate cycle. Yield curve variation can exacerbate the risk of a bank’s position by magnifying the effect of maturity mismatches. To further complicate things, these maturity mismatches are often uncertain and difficult to predict due to options risk.

Options Risk: Options risk has to do with the uncertainty of cash flows due to various types of options that are attached to or embedded within some financial instruments. These options may alter the level and timing of cash flows and create an unpredictable liquidity situation for the bank. Unscheduled paydowns of principal, for example, or call options attached to bonds are common reasons for sudden shifts in balance sheet cash flows.

Summary

Sound management decisions require an understanding of the unique dynamics of the balance sheet. We must model the expected behavior of re-pricing balances, changes in rate structure, and uncertain cash flows under different market conditions and yield curve scenarios. Asset/liability managers must make reasonable assumptions that makes sense for the particular type of business they do and the customer base they serve. Importantly, this requires the right tools and the right way of thinking about interest rate risk and performance.

The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.

Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.

*The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions, Inc.

For More Information

Jeffrey F. Caughron

Chairman of the Board
The Baker Group LP

jcaughron@GoBaker.com
800.937.2257

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