Tuesday, May 29, 2012

Sweat the big stuff: Interest Rate Risk

I have been thinking about interest rate increases for some time now. The Fed lowered the Fed Funds rate to a target of 0 – 25 bps in December 2008. Since that time we all knew that the next move would be up, and pundits have been predicting the “when” like sportscasters predict the next champion.

Once the Fed senses economic recovery and inflation indicators start blinking red, they will move. And if past is prologue, they will move relatively quickly. Take the last time the Fed raised rates as an example. On June 29, 2004 the Fed Funds rate stood at 1%. Two years later, the rate was 5.25%. Four hundred twenty five basis points in 24 months. See the recent history of Fed Funds and Discount Rate moves here.

This should give FIs pause as they manage their balance sheet. Some banks, by strategic design, are weighed heavily in 1-4 family mortgages funded by certificates of deposit. In asset liability management (ALCO) parlance, they are funding short and lending long. This means as rates increase, their funding will become more expensive and a significant part of their assets will remain mired in historically low yields.

One such bank, a west coast financial institution with between $10-20 billion in total assets, had greater than 60% of their deposits in CD’s and over 70% of their loans in residential mortgages. Although if you had the time to dig you can figure out the bank because all information I give is public, I will keep them nameless.

In a note in their annual report, the bank reported the following structure to their balance sheet;

According to the same note, the Bank is estimated to experience the following net income impact given rate increases of 100 bps, 200 bps, and 300 bps respectively.

In other words, if the Fed raised rates 300 basis points (3%), the Bank would have $37 million less in net income. A large number, but it only represents 33% of their actual net income. But that number includes many assumptions. For example, in the bank’s 10k, they disclosed that their loan prepayment assumptions incorporate their recent portfolio experience.

Now, I’m no ALCO genius, but I have to believe that residential mortgage loan pre-payments have been up recently due to people refinancing to lower rates. When rates rise, I doubt borrowers will be knocking at the bank’s doors to trade their low rate mortgage for a new, higher rate one. By my calculation, if the Fed raised rates in Year 1 by 300 bps, and the bank had to follow suit basis point for basis point, this bank’s net income would decrease by $43 million, or 39% of their net income. Years two through six would see an additional $58 million decline. If I ran this bank, I would be concerned.

Bank risk is so compartmentalized, and asset-liability management has numerous assumptions that impact results significantly. But at the end of the day, FI senior managers need to use common sense to estimate the collective behavior of their customer base in a rising rate environment. Making strategic decisions regarding the structure of the balance sheet may result in decreased profits today but position your FI to continue serving clients needs, hedge against rising rates, and protect against declining profitability in a changing environment.

Is your balance sheet protected against rising rates? Really?

~ Jeff

Monday, May 21, 2012

Banking School: The ivory tower could be yours.

I am sitting at Gate 124 in Orlando waiting for my ride home from a long journey. Prior to Orlando, it was Dallas. In Dallas, I taught bank profitability and strategic planning at the ABA School of Bank Marketing Management. The school is a two year program designed to transform up-and-coming marketing professionals into well rounded bank leaders.

I have written a post on these pages regarding training programs (see Are your employees ESWS qualified?). My firm asked Are you training for the gold? in one of our quarterly newsletters. Clearly this topic remains on my mind.

Much like the Kansas City Athletics was the training ground for the New York Yankees, large banks served as the training ground for community bankers. Those big bank training programs are long gone. In strategy sessions today, senior leaders are wondering how to replace aging bankers that benefitted from those programs.

I have a few suggestions.

1.  Get your own training program. Lack of resources is the most often cited reason for community FIs not training their own. Their are several resources outside of your FI with outstanding and targeted curriculum taught by qualified instructors. National trade associations are a great resource for training your employees to be the leaders of your FI. See the ABA, ICBA, CUNA, and other trade associations to review what they offer and the relevance to your institution.

2.  Develop a curriculum by functional position. In my experience, many if not most FIs develop ad hoc training programs that reward high performing employees for a job well done by sending them to a school or conference in a nice location. But if execution of your strategy is largely in the hands of your employees, perhaps you should be serious about giving them the tools to execute that strategy. What skills do they need? How much can be accomplished in-house or via on-the-job training (OJT)? Are we teaching them to supervise, coach, communicate, and/or build a book of business. I perceive a training curriculum to be a focused mix of OJT, in-house classroom, coaching, and outside training (either industry training or academic training).

3.  Recognize high potential employees. One way to do this is to send them to a conference or school in a nice location. But another clear recognition is to prepare them to be leaders at your FI. Train them for the next level, or for another functional area. One risk we have in banking is keeping high potential employees in one functional area, developing a myopic view of your institution and our industry. Perhaps a controller or CFO should go to marketing school because they speak such a different language. In fact, there was a CFO at the ABA marketing school. Imagine that!

4. Recognize that training goes beyond the curriculum. Bankers that don't directly compete with one another openly share best practices with their colleagues. I saw it in action at the marketing school. Another benefit is developing lifelong industry contacts that you can call on for different perspectives. See the photo for a visual of the camaraderie that goes on at these schools. This not only builds morale, it can help your FI by expanding the knowledge base outside of your walls.

This may be the fourth or fifth time I have written or spoken about industry training. I intend to keep working the subject because there is not any other initiative you can undertake, in my opinion, to build a competitive advantage and to sustain your institution for future generations.

~ Jeff

Tuesday, May 08, 2012

Risk Adjusted Return on Capital (RAROC) for Financial Institutions

How do you measure the profitability of lines of business, products, or customers? The simplest form is in dollars. But does that measure the profits against the investment required to generate those profits? For example, the riskiest banking products most likely deliver the greatest dollar profits, all other things being equal. At least until the risk comes to roost.

Another means to measure profits is the ratio of profits to the size of the portfolio being measured. In banking, we call it the Return on Assets (ROA). For example, a $500 million commercial loan portfolio will have a greater dollar profit than a $100 million consumer loan portfolio, all things being equal. But the ROA of the consumer loan portfolio could be greater. But ROA does not measure the risk of what is being measured, just the relative profit contribution regardless of size.

Banking is a risk business, and has many internal and external factors that impact the amount of risk per activity. This is one reason that financial institutions are getting serious about viewing risk across the entire franchise instead of in the organizational silos where they most exist. See my post on Enterprise Wide Risk Management on this subject here.

But through it all, risk requires capital. Look at the capital needed through the recent recessionary period for credit losses provided by either private investors or the US Treasury. Regulators assign risk weightings as a proxy for how much capital is needed based on the perceived risk of the asset. For example, a security in the investment portfolio may be 20% risk weighted, versus a loan that is 100% risk weighted. The total risk based capital ratio required by regulators to maintain "well capitalized" status formally remains 10%. So $100 million of 20% risk-weighted bonds requires $2 million of capital ($100 x 20% x 10%) versus $100 million of 100% risk-weighted loans requiring $10 million of capital.

If the amount of capital needed for a line of business, a product, or a customer varies based on risk, then it makes sense to measure the profitability of what is measured based on capital required. In industry parlance, we call that Risk Adjusted Return on Capital, or RAROC.

Financial institutions should assess on their own the amount of capital needed per product based on past experience, perceived risk, and potential loss. The table below shows how capital is allocated to each loan category based on a limited risk spectrum (credit, interest rate, and liquidity). Although for loans, these are probably the greatest risks, the financial institution may quantify other risks, such as operational (could it lose money due to fraud, hacking, etc.) or pricing (does the value of the asset fluctuate in the market, causing volatility and therefore risk).

I perform such an analysis for an ABA School of Bank Marketing Management course that I teach every May.  For my efforts I have been criticized that the topic was too complicated and I should remove it. But the course is on product profitability. How should I measure the relative profitability of business checking versus a home equity loan? Risk and the capital to support that risk should be the denominator in that equation. Agree? I say the topic stays. I'll take my lumps in the course evaluations.

What does your FI use as the profitability denominator?

~ Jeff

Wednesday, May 02, 2012

Is branch profitability out the window?

About 10 years ago my firm analyzed the hundreds of branches in our profitability database to determine exactly what is "critical mass". We sorted by pre-tax profit contribution as a percent of branch deposits, and further sorted by "direct" profits and "fully-absorbed" profits.

The results were not surprising to me. In order to be profitable on a direct cost basis, a branch needed to be $9.5 million in deposits, on average. Fully absorbed cost bases... $18.7 million. In order to deliver a pre-tax profit of 1.5% of average deposits, the branch needed to be $23.6 million.

A note about the data: Branch spreads are calculated using funds transfer pricing (FTP) on a co-terminous basis. This means that interest rate risk is removed from the equation. Deposits receive a funds credit for a similar or identical duration market instrument, such as a Federal Home Loan Bank borrowing. Branch loans similarly receive a funds charge. Fully absorbed costs include allocations from support functions such as Deposit Operations and IT, and overhead functions such as Finance and Executive.

In preparation for a banking school where I am scheduled to teach this month, I recreated the analysis, knowing that the average branch deposit size went up. The results were alarming (see table).

Today, based on the revenues generated and expenses incurred, a branch must have $31.3 million in deposits to break even. To absorb the army of support personnel, systems, and facilities serving it, the branch must be $61.5 million. To generate a 1% pre-tax profit, it must grow to a whopping $121.8 million. That's New York City big, folks.

How can this be? One reason is the extended interest rate environment, where checking accounts can't go lower than 0% interest. The market based credit, or re-investment rate, has been very low for quite some time. Perhaps you hear your CFO lamenting that he/she has no place to put more deposits. This has caused the spread on deposit products to be a historic low of 1.23%.

Another reason is declining deposit fees. When bankers began implementing automated overdraft protection, the bounce in total deposit fees as a percent of deposits was palpable, typically 50 - 60 bps. Today, due to regulation and customer behavior changes, deposit fees as a percent of deposits range between 30 - 40 bps, a noticeable decline.

Lastly, bankers have not adjusted the branch model fast enough to compensate for declining revenues. We typically have six or seven staffers, mostly tellers, in spite of transaction totals being low and trending lower. We maintain the high real estate costs from the branching boom of the late 90's through the mid 2000's. So branch expenses remain around $600 - $700 thousand per year in operating expenses. Indirect expenses to run a branch (Deposit Ops, IT, overhead, etc.) add another $500 - $600 thousand to the expense pool. This is quite a millstone to overcome when the average branch is generating 2.02% in total revenue as a percent of deposits.

In order to bring back branch profits, three things need to occur, in my opinion: 1) drive more revenues through branches in the form of small business and consumer loans, and right size our deposit mix to maximize spread, 2) re-tool the branch model, using fewer full-time equivalent people with multiple skill sets including business development, customer service, and transaction processing... and have less space, and 3) hope for the spread miracle that will come when the Fed has had enough with zero percent at the short end of the yield curve.

Yes, I said hope. How do you think FIs can increase the profits in their branches?

~ Jeff