How Did Your ALCO Model Hold Up?

My firm did a sample data run for a client that included all commercial banks in NY, NJ, PA, and MD between $500 million and $1.5 billion in total assets to see how various banks did in balance sheet and income statement ratios during the course of the Fed tightening run from year end 2021 until the third quarter 2023. Some interesting insights relating to their 1-year cumulative repricing gap that the banks reported on their call reports:

• At 12/31/21, of the 68 banks that met the criteria, only 10, or 15% had a 1-year cumulative negative gap. This is defined as rate sensitive assets (assets that are expected to mature or reprice within 1 year) less rate sensitive liabilities (liabilities that are expected to mature or reprice within 1 year). If rates went up, so the theory goes, the 85% of banks with a positive 1-yr cumulative gap, should see net interest margin go up as assets reprice faster than liabilities. This made sense because the Fed Funds Rate at this time was 0-25 bps and bankers positioned their balance sheets accordingly.

 

• At 12/31/22, after 450 bps of Fed rate hikes, 48 of the 68 banks, or 71%, had a better net interest margin for the quarter ended 12/31/22 than the quarter ending 12/31/21. Since 85% of them had positive one-year cumulative gaps, their ALCO assumptions mostly worked.

 

• At 9/30/22, only 13 banks, or 19% showed a negative one-year cumulative gap. Meaning 81% thought their net interest margin would increase in a rising rate environment. Between 9/30/22 and 9/30/23, 53 banks, or 78%, had a lower net interest margin. How could their ALCO assumptions be so wrong?

• By 9/30/23, the 1-year negative cumulative gap had nearly tripled to 30, or 44%. Interesting because the Fed Funds Rate was zero-25bps at 12/31/21 and almost everyone knew rates would inevitably go up. It makes sense that so few considered themselves liability sensitive at 12/31/21. I'm actually surprised so few (44%) consider themselves negatively gapped right now. Declining rates are far more likely than rising rates. The most recent Fed dot plot predicts Fed Funds declining in 2024.

When I asked my colleagues what they thought, here is what a couple of them had to say:

If I recall from my ALCO committee days… ALCO models largely did not rate shock 450-500 points and if they did, that type of move seemed quite far out of the realm of possibilities.  In a 200-300 model, spreads would have mostly held up. My guess is that the duration of money market accounts in most ALCO models were in the 3-6 year time frame but when rates went up 500 points in the real world, these longer duration "core deposits" actually left the bank or repriced much faster than anticipated as banks worked to retain these accounts.  Also, many banks were using CDs to retain these accounts and shifting deposits out of these longer duration products into 6-12 month CDs shortened the liability duration averages (in models) and increased the liability sensitive nature of most banks.

Deposit duration assumptions in ALCO models built for 'normal' markets simply did not hold up in recent quarters.

~ Ben Crowley, Managing Director, The Kafafian Group, Inc.

I think bankers overestimated the loyalty of their depositors following the pandemic & PPP, coupled with a sustained low rate/high liquidity environment. These factors led to a false sense of security that low-cost deposits were there to stay. When the national and super regional banks began raising rates they were reluctant to follow – until it was too late. They quickly learned that customers were not loyal and deposit attrition happened so fast that they had to raise rates more aggressively than anticipated to retain remaining deposits and attract funds to replace what they had lost.  

Service is important. But you still have to price competitively.

~ Chris Jacobsen, Managing Director, The Kafafian Group, Inc.

~ Jeff

Four Reasons for the 2007-08 Financial Crisis

A recent Bank Think post by ConnectOne Bank CEO Frank Sorrentino regarding restoring Glass-Steagall got me thinking about how far the debate has drifted from the root causes of the 2007-08 financial crisis.

There have been quite a number of research pieces offered as to the root causes (read a good one here by University of North Carolina). In researching this post, I sifted through some interesting, and some not so interesting opinions. Which reminds me that the old axiom "figures don't lie, but liars figure" may be closer to accurate than we would like.

Here is what I think caused the financial crisis based on what I read, what I experienced, common sense, and my interpretation of the facts.

1.  People borrowed more than they could repay if they experienced a modest financial setback.

If you know me personally, I will always put more weight on personal responsibility than the boogeyman. Yes there was some degree of fraud perpetuated on the borrowing public. But, by and large, people knew how much they were borrowing, what their payments were, and that some of their mortgage payments would rise if rates rose. 

In 1974, household debt stood at approximately 60% of annual disposable personal income. In 2007, that number climbed to 127%. It should be noted that in 2006, 40% of purchase mortgages were for investment or vacation property. But you won't see the real estate investor losing his/her shirt on 20/20.

Absolving people of personal responsibility is a problem in our society. As one of my Navy lieutenants once told me: "Be careful pointing the finger, because the other fingers are pointing back at you". Words to live by.

So, in my opinion, number one exceeds all others. It will not get me personal kudos in the news media.

2.  Credit risk was too far removed from the loan closing table.

This is the moral hazard argument, where the people that have the relationship with the customer, that stare the customer in the face and say "yes" or "no" to the loan, were not the same people assuming the risk should the customer default, in most cases. The shoulders where credit risk ultimately came to rest, investors, were placated by insurance and bond ratings. 

Community financial institutions make their debut here, as they purchased bonds, typically highly rated, backed by mortgages that also had insurance applied to them.

3.  There was a lot of money looking for investments, and Wall Street met the demand. Mortgage-Backed Securities (MBS) almost tripled between 1996 and 2007, to $7.3 trillion, as investors lined up to participate in the US housing market. This led to creative means to take a risky mortgage at the closing table, to a perceived "safe" investment in the bond market after it was combined with hundreds of other mortgages, parsed into traunches, insured by a bond insurer, and rated by a ratings agency. What could go wrong?

See the list of top 10 sub prime mortgage lenders from 2007. Note the absence of anything resembling a community bank. BNC was owned by Lehman Bros. EMC-Bear Stearns. First Franklin, a JV between National City Bank (emergency sale to PNC) and Merrill Lynch (emergency sale to BofA). Option One was sold to shark investor Wilbur Ross for its servicing rights. Ameriquest was purchased by Citi, and its origination arm shut down. The table indicates that loans were closed in these banks'/entities' names. A community financial institution that sells its loans in the secondary market would typically close the loan in its own name, and then sell it. So the absence of community financial institutions implies that these loans were originated by mortgage brokers or the listed banks themselves, and not a community FI. This is consistent with my experience. 

The MBS bond-creation engine was a well oiled, end-to-end machine designed to satisfy the appetite of investors.

4.  Government's participation in the mortgage market. Way back to the Great Depression, when mortgages were typically five-year balloons, the Federal Government has intervened in mortgage lending. When the five years were up, the government didn't want people tossed from their homes because they couldn't refinance due to economic hardships. A respectable goal. But this intervention played a role in what we have today, a separation between the borrower and the ultimate lender. 

Note that Presidents Reagan, Bush, Clinton, Bush, and even Obama openly encourage home ownership because it has a causal relationship with household wealth creation.

But the reason why community financial institutions shy from putting 30-year, fixed rate mortgages on their books is because there is no 30-year, fixed rate funding instrument. It creates unpalatable interest rate risk. 

If interest rate risk drives the wedge between borrower (i.e. homeowner), and the desired lender (i.e. local bank that retains the credit on their books), then perhaps a 5/1 mortgage should be the norm. This answers the interest rate risk problem, while allowing borrowers to keep their mortgage and therefore their home if they befall some economic setback after five years.

And note, a local financial institution has more flexibility to alter the terms of the loan if it is on their books, rather than owned by an investor.

Back to my original point regarding re-instating Glass-Steagall. What does this have to do with the four points above? We should ask the same question about every article within Dodd-Frank.

~ Jeff 

Is That a Risky Bank Customer?

Customer risk assessments are a fact of life in banking. Banks must determine how a new customer will affect its overall risk profile. Most, in my experience, do it in the form of a Q&A form, to be filed with the rest of the customer paperwork. What I see as papering the file.

But let's think about how it could and should be.

It is prudent to determine the risk profile of a customer and how it will impact your bank. Taken alone, it is highly unlikely one customer will impact the bank in a significant way. But grouped together, customers with similar profiles that act similarly within the economy can elevate risk. Think loan concentrations. As a matter of course we measure loan concentrations by loan type, such as construction or non-owner occupied real estate.

And there are red-flag industries that elevate risk, such as check cashing or marijuana businesses.

I have written about banks determining their own well-capitalized by allocating capital to different balance sheet categories based on the bank's perceived risk of those categories. It is a top down approach. But what if this analysis starts at the most granular level... every customer? And the bank uses its customer risk assessment process to determine the amount of capital allocated to that customer?

If built appropriately, it could be a desktop app the lender, branch, or call center employee could complete in front of the customer. See a sample of what I am talking about in the accompanying table.

Multiply this times every customer and every account and you would be able to calculate the capital required to support your balance sheet from the bottom up.

You can integrate ROE hurdles to feed pricing models in order to meet or exceed the hurdle. You can calculate customer profitability in terms of ROE, and create actionable customer tiers, giving platinum service to top tier, active cross-sell to middle tier, and efficient service to lower tier. And when regulators review your customer risk assessment process, and see that it is integrated into your pricing and profit models, capital plan, and strategic plan, trumpets will sound.

Sure, there will be challenges. I'm no compliance or risk expert so I'm not sure what other risk information should be collected on the customer. And what if Joe's year over year profit picture changes, or reality determines that Joe is bringing in bags of cash twice per week. A well designed system could send ticklers to the relationship officer to revisit the customer risk assessment based on the new information.

A disciplined, yet simple design that is integrated into your systems and processes could yield more accurate capital needs based on the sum total risk by each of the bank's customers. 

Do you think this is how it should be?

~ Jeff

Loan Pricing: Must It Be So Complicated?

When it comes to pricing loans, my experience tells me we use competitor pricing as our de facto pricing model. For consumer and residential loans, where rates and fees appear on the competitors' websites, it's not so difficult. But for commercial loans, I suspect we follow anecdotes such as what customers tell us or what friendly competitors murmur to us at a cocktail party. We tell loan committees that this is the rate and structure needed to "get the deal done".

In comes the loan pricing models. Some are expensive. Some are free, such as the one recently mentioned by my friend Dallas Wells of Asset Management Group, an ALCO consulting firm based in Kansas City. 

Now, I have never been a commercial lender. But I'm a student of the lending function, and listen intently to senior managers discuss loan pricing in profitability improvement meetings that I moderate. That's where I hear the stories of the competition, irrational pricing, yadda yadda yadda.

I recently had two students from the Pacific Coast Bankers School (PCBS) ask me about how to risk price loans. Why they asked me, I don't know. Although I'm no loan pricing expert, I have my opinions. And my opinion is it should not be as complicated as those "in the know" would like us to believe. So for you, fair readers, I developed this simple loan pricing model (see table).

Four inputs, you say? Well, there is some back room gears at work too. For example, the loan duration should be calculated by the loan cash flows and repricing characteristics. Is it a five year, 20 year amortizing commercial real estate loan? Then perhaps the cash flow calculation pegs the loan duration at 4.3 years, as it does in this model.

The transfer price, or charging the lender a cost of funds for the borrowed money, is typically derived from a rate index, such as the Federal Home Loan Bank yield curve, for the same duration borrowing. That would have to come from Finance and be blended for odd-lot terms, such as 4.3 years.

Capital allocation should be determined by a risk adjusted return on capital model (RAROC). I described this in greater detail in a previous post. But this analysis would have previously occurred, and be assigned based on loan type code and the internal risk rating.

If your bank performs product profitability, a natural calculation from this model is operating cost per account based on type code. If you do not have product profitability, you can analyze your approximate operating cost per account or use industry benchmarks.

And lastly, the provision expense associated with this type of loan and risk rating should be driven by your Allowance for Loan and Lease Loss (ALLL) methodology. You already do this, I guarantee it (insert Men's Warehouse founder voice).

There you have it. Now you have a well priced loan that accounts for credit risk through the provision and RAROC calculations. Interest Rate Risk is accounted for in the transfer price, as this is taken from the same duration market instrument. You also account for other key risks through RAROC such as liquidity and compliance risk. 

Price by this method, and you are accounting for the risks, costs, and desired margin of each loan. You can overlay deposit products to hit your ROE targets in a similar vein.

Price by this method, and you can determine if doing a loan at a certain price point, as told to you by your borrower, may or may not be a mutually beneficial pricing structure. Banking is one industry where success is driven not only by your ability to build relationships that are not price driven, but also by not being as stupid as your competitors. If the market price is too low for your appetite, have the courage to walk away.

What else should be considered in pricing a loan?

~ Jeff

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