The world has changed. The nation’s economic lockdown has given previously confident consumers a new and cautious attitude of frugality. The propensity to borrow and spend has turned into an inclination to deleverage and save. Once prosperous businesses struggle to stay afloat as society and culture adjust to a new, post-pandemic playbook. Municipalities and political subdivisions are faced with the challenges of impaired revenue streams and eroding tax bases. The nature of community banking is not immune to the changes being wrought and will no doubt be further changed by variables not yet contemplated. Something that few contemplated as recently as year-end, a return to a Zero Interest Rate Policy (ZIRP), is now upon us and will likely be upon us for the foreseeable future.
Risk Comes to Work Every Day
As bankers across the country rally to meet the needs of their customers and communities, it’s understandable that the intricacies of interest rate risk management may have taken a back seat to more pressing issues. But, like an essential employee, interest rate risk shows up at the bank every single day and that’s not going to change. What has changed for most, if not all, community banks are the characteristics of their balance sheets’ risk profiles.
The direction of repricing has become universally down for both asset dollars and liability dollars, but not by the same degree. The volumes of those dollars subject to repricing may have significantly changed too as the ultra-low rate environment affects the prepayment behavior of mortgage-backed securities along with the likelihood of optional call features being exercised by bond issuers. Not to be forgotten, the level of prepayments experienced by banks’ own notecases are being affected also. Don’t forget about liquidity, either. The establishment and maintenance of reliable sources of funds is a perennial priority with bankers and supervisory agencies alike, and in the present environment, the regulatory scrutiny of such things is likely to be intense.
Don’t Assume Your Assumptions Are Still Valid
The regulatory scrutiny of the many assumptions used for interest rate risk modelling exercises is also not new and may be just as intense while society transitions from almost total lockdown to partial reopening and ultimately to a new, “new normal.” No one knows exactly how these processes may play out nor how human behavior may be affected by them. Humans, after all, make up the vast majority of community banks’ customers; how they behave influences how those banks, and the risks they contain, are managed.
History May Not Repeat Itself, But It Does Tend to Rhyme
This is not a new consideration and the establishment of ZIRP by the Fed during the sub-prime meltdown and resulting Great Recession sparked many of the same uncertainties faced by risk managers today. Will low market yields create disintermediation and an erosion of core deposits? That was an outcome feared by many back then even while the majority of community banks continued to watch those deposit balances grow ever higher. What will happen this time? What about the costs of those deposits? How much did your deposit rates rise during the nine rate hikes the Fed promulgated during its normalization phase? How much did they fall while rates were again cut during 2019? Now that we’ve returned to ZIRP, could those NMD betas be due for another change? For external sources of funding, how much will they cost and what changes have occurred in their availability and terms? What new hoops might need to be jumped through?
On the asset side, will growing loan demand soak up all available cash flow or will the opposite occur thus adding more stress to already stressed net interest margins? Will lenders have any pricing power or will competitive pressures control what borrowers ultimately pay? What are your loan betas and reinvestment rates? Should they be adjusted? For the investment portfolio, keeping an eye on the degree of embedded optionality might help avoid unwanted volatility in cash flow along with unwanted changes to duration. And don’t forget about your economic value of equity. Many portfolio managers have been loading up on long municipals this year, and there are some very sound reasons for doing that. Remember, though, an extension of duration also means more exposure to market risk that will accelerate depreciation if rates rise. As unlikely as that prospect is, this whole year has been an unlikely prospect. And even though the evaluation of credit risk is not typically within the scope of interest rate risk management, don’t forget that those munis come with some. Outright defaults have not yet become a problem, but downgrades to an issuer’s credit rating can damage market value and liquidity.
Take a Deep Breath and a Fresh Look
The plates of bankers, particularly community bankers, are pretty full these days, and pausing to review the esoteric elements of a process that can sometimes be cumbersome can also be easy to defer. Assuming the assumptions driving your modelling exercises haven’t changed, however, could lead to misleading results. A review of those assumptions is not only a good idea, it’s a regulatory requirement. Unless you’re performing this review by yourself, stay at least six feet away from everyone else; the world has changed.
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.
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