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REGIONAL NEWS

• Louisiana’s Investar Acquiring Highlands Bank

• Lake Michigan CU Acquiring Florida Bank

• New Jersey’s Valley National Expands in Southeast

• Washington’s Heritage, Puget Sound to Merge

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The Leading Magazine for Bank Management Teams

September 2017 banknews.com

Managing net interest margin continues to be a chal-lenge even as the Federal Reserve continues down

its path toward monetary policy normalization. Those institutions with top-quartile margins likely attribute the bulk of their success to their practice of using asset/liability management as a strategic balance sheet management tool. Such proactive management practices have evolved from a purely static view of risks to a scenario-driven projection of sensitivities and income changes. Although regulatory friendly, static ALM simulation is of limited use in strategic planning. Simply stated, shifting from static to dynamic ALM simulation is key to best manag-ing margin as balance sheet composition and interest rates continually change.

Dynamic analysis must include a flexible set of levers and buttons that can be combined to replicate business situations and simulate realistic outcomes. This means the ability to change balance sheet mix, assumptions, key driv-ers, sensitivities and rates with flexible, easy to understand reporting. Institutions that understand the power of ALM have upgraded from solely a report package generator to a full-on risk analytics machine. By doing so, bankers have better positioned themselves to develop appropriate bal-ance sheet strategies to manage margin especially when the Fed and the markets continually disagree on the cor-rect policy action.

As a whole, the banking industry has positioned itself for rates up. Over the years, regulatory guidance as well as Fed-speak have helped prepare the industry for higher rates. Banks of all sizes have become asset-sensitive, preparing for the Fed to raise interest rates. In theory, asset-sensitive banks expect greater margin expansion when interest rates rise, since their assets reprice faster than their liabilities in a given time period. But, in reality, not all rates-up scenarios are the same, meaning not all points on the curve shift in unison.

To illustrate this point, let ’s review the change in Treasury yields since the end of the Great Recession in Q3 2009. Although short-term yields have increased nearly 90 basis points, 10-year yields have decreased 100 bps. Since the Fed first started to increase benchmark rates

in Q4 2015, short-term Treasury yields have increased as much as 80 bps while seven- to 10-year yields are actually unchanged. Intermediate-term yields, the basis of where most fixed-rate assets get priced, have declined 50 bps since 2009 but are up 12 bps since Q4 2015. As a result of these types of non-parallel shifts in the yield curve, even asset-sensitive banks have watched their margins decline.

As we transition to the next phase in the business cycle, the banking industry will likely be challenged with managing earnings and risk in a much different rate envi-ronment than in prior cycle shifts. Whether it’s a mild bear-flattener or an aggressive bull-flattener (resulting in a Japanese rate environment), ALM is tasked with providing the bank with consistent earnings regardless of changes in rates. Institutions need to manage to plausible rate scenarios and ensure that their balance sheet strate-gies appropriately consider the full range of risks that are present, meaning, even in periods when the direction of rates is nearly certain, institutions need to ask themselves: What if we’re wrong?

The implementation of over-protective risk strategies (material overnight liquidity positions, extremely asset-sensitive balance sheets, short earning-asset duration, etc.) almost always leadsto weaker earnings and less capital accretion, which can actually increase the institution’s overall risk position over time.

Using the tools of rate, balance sheet volume and balance sheet mix, asset/liability committees are expected to man-age the bank’s exposure to interest rates in a manner that provides a stable net interest margin. In today’s economic/rate environment, ALCO strategies that challenge common thinking may actually be appropriate and suitable.

While appropriate ALM strategies are institution-specific based on individual drivers affecting each bank’s interest rate risk profile, asset-sensitive banks should at least consider the idea of selectively extending asset duration as a means to help current earnings by slowing margin compression. For those banks that are approaching their established IRR policy limits, shifting asset dura-tion out of the bond portfolio into the loan portfolio will increase margin — all else equal.

Effectively Managing Net Interest Margin

investments Dennis Zimmerman is manager of asset/liability services for the Capital Markets

Group of Commerce Bank in Kansas City.

18 BankNews September 2017 banknews.com

Although bankers are starting to feel the pressure of increased funding costs primarily as a result of increases in short-term interest rates, margin will con-tinue to be driven chiefly by the decisions made on the earning-asset side of the balance sheet. Even though the Treasury curve has flattened, banks should develop strategies to improve earning-asset mix with emphasis on shifting out of lower-yielding assets (overnight and bonds) into higher-yielding assets (loans). Consistent with most community bank business models, bank-ers should focus on growing loans (organic growth preferred, secondary market if necessary). When appropriate, selectively give on loan price/rate but not on credit quality. Low ROE-based rate loans are still a higher-yielding asset than bonds.

Depending on how long this current rate environment persists, institutions that continue to lend are the ones that are going to win, not necessarily by widely expanding their net interest margin, but just by maintaining. Lenders that believe they have to keep loans priced high to main-tain margin may be doing nothing more than shrinking their higher-yielding earning-asset base. By funding new loan volume with overnight cash and/or bond portfolio runoff, you can improve the earning-asset mix. Bottom line: Focus on improving your asset mix by growing

loans. Do not lose an appropriate loan opportunity to the competition because of price.

While loans are the preferred earning asset, bonds offer a yield premium over cash with little to no credit risk depending on the investment sector. The last eight years have taught us that staying heavy in cash (a com-mon overprotective risk strategy) leaves money on the table. When in the market for bonds, make sure that your most-trusted capital market broker/dealer has access to your institution’s current ALM report. Ask that they show you only bonds that complement your bank’s balance sheet risk profile. Brokers that best understand your overall balance sheet risk profile provide the greatest return on investment to you and your bank.

ALM is the process of making risk/reward trade-off decisions. At this point in the business cycle, bankers are realizing that they have been managing current earnings to the theoretical up side of materially higher rates rather than to the current rate environment. Don’t hesitate to reach out to your ALM team if you wish to better under-stand how an effective ALM program can help improve bank profitability. An effective ALM framework — one that includes dynamic analysis with challenger thinking — is key in best managing current earnings in the context of the bank’s overall risk position. BNIm

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banknews.com September 2017 BankNews 19