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

Could Net Interest Margin Woes Spell Opportunity?

When an in-person strategic planning retreat has to be hastily switched to a virtual one, sacrifices must be made. And in this case, I simply didn't have the time to review the long-term implications of the Fed's guidance that they were not inclined to raise the Fed Funds Rate until inflation hit or passed 2%. And they didn't anticipate that until 2023.

So we're in this environment together. Negative rates are not likely. Fed Chairman Powell is against that approach. The change from 2.25%-2.5% in 2019 to the 0%-0.25% year to date has resulted in the revenues per product to go down in all deposit products with the exception of money market accounts (see table).

The table is from my firm's profitability peer database, where we measure product profitability for dozens of community financial institutions. The above are peer averages.

The net revenue decline in business loans makes sense because these portfolios tend to have a high proportion of variable rates. What we learned from 2007-08 was to put floors in them, so hopefully the downward trend won't continue. Residential mortgages net revenue went up although we intuitively know that the 30-year rate has gone down. But for measuring product profitability, this number represents what the bank portfolios. Which is probably very little given the rate environment. The coveted gain on sale revenues from secondary market activities goes in the secondary market product, and the residential mortgage line of business.

In 2009, being armed with the above product profitability data, plus the profit trends in their branches, the very large financial institutions began closing branches en-masse. And since the floor fell out on the Fed Funds Rate this year, several including PNC, Wells, and US Bank announced more accelerated closures. From March through August, banks submitted closure requests to regulators for 893 branches. During the same time last year, 967 were submitted. So there was an 8% drop.   

But I think, faced with the declining revenues and their high depositor retention from past closures, more will be announced. Does this signal an opportunity for the financial institution with a long-term view to aggressively pursue core deposits in the face of reduced short-term profitability of those deposits? Especially if the bank could put those deposits to work at some positive spread, which we have to believe we can. 

It wouldn't bode well for your net interest margin. But could certainly generate growth in net interest income. And position your bank for the often repeated cycle of positive economic growth where loans grow faster than deposits for multiple years. When that happens, your competitors will start offering $400 for customers to switch deposit accounts. 

But you would have already won them.

~ Jeff

Note: The above data was taken from my firm's profitability peer database. If you want to learn how you can measure product profitability, line of business profitability, or customer profitability, click here.  

The State of Banking

Where are we and where have we been? Trends are telling. In 2013, there were 6,812 FDIC-insured financial institutions. At September 30, 2017 there were 5,737, a 16% decline. There were 166 mergers, and four new charters in the first three quarters of 2017. As an industry, the trend is down. Ski slope down.

What about the financial performance and condition of our industry? The Presidential State of the Union address was supposed to report to Congress the Administration's view of the condition and performance of our country. It has turned into a sea of words amounting to nothing more than a wish list and priorities. Because the nation's balance sheet and income statement is not improving.

But what of banking? 

I broke down banking's financial condition, performance, and trading multiples into thirteen charts, seen below. Charts 1-6 are financial condition trends, 7-10 are financial performance, and 11-13 are trading multiples.

The numbers are medians from all publicly traded financial institutions between $1 billion and $10 billion in total assets. That yielded 291 total institutions, broken down by region. 

Financial condition ratios are promising. So I will say to you that the condition of the industry is strong. Assets, Loans, and Deposits continue to grow, although at a more moderate pace. And capital ratios have held steady and strong. In fact, if you listen to some institutional investors, the industry is over-capitalized. Many view an 8% leverage ratio as the "right" number. Although this should depend on an institution's risk profile and growth trajectory. And I have never heard a regulator say the phrase "over capitalized".

Non-performing asset ratios are in a long term downward trend. They have leveled off in the 60-80 basis point range. Some regions are experiencing slightly elevated non-performers from the previous year. A trend to watch.

The challenge with industry balance sheets is that loans have grown faster than deposits over the past few years. And loan/deposit ratios are steadily increasing as liquidity positions steadily decrease. Many bankers are less concerned about this citing their access to wholesale funding to bridge any shortfalls, or that they have been mopping up excess liquidity.

But rates have been rising slowly, and I believe Fed rate increases will accelerate this year, perhaps crossing the rate threshold where depositors now care what you pay them, and dooming those Betas in your ALCO assumptions to irrelevance. My opinion is that one or two more rate increases will trigger more skirmishes on the deposit battlefield. Those that have not positioned their bank to have strong liquidity will have to compete, giving back deposit mix gains they have worked so hard to achieve.

Net interest margins have leveled off from long-term industry declines. Good news! In 2017, NIMs ranged from a high of 3.8% in the West and Southwest, to a low of 3.1% in the Northeast. Are these anomalies due to region, competition, or business models? I would argue a mix of all three. But if I were a Northeast bank, I would ask why other regions achieved between 3.5%-3.8% NIMs and we're at 3.1%. That's a tidy sum to leave on the table.

Efficiency ratio trends look fantastic! And since NIMs are holding steady, it leaves me to think that operating expense control or increased profitability in fee-based businesses are at work. Based on my firm's experience with the profitability of fee lines of business, I am guessing the former. As balance sheets grow, operating expenses grow less, creating greater efficiency. Positive operating leverage!

Both ROAA and ROAE declined 2016-17, although efficiency is better. So what doesn't the Efficiency Ratio measure? Provision, and income taxes. Most of the institutions, if not all of them, probably took a Deferred Tax Asset (DTA) writedown in the income tax line item, impacting these bottom line ratios. But this probably doesn't account for all of the decline. Are assets growing faster than profits, therefore reducing ROAA? Is equity accumulating faster than an institution's ability to deploy it, therefore reducing ROAE? Or, is provision expense up throughout the industry. I believe a combination of the three. But if provision expenses are rising, credits could be moving from pass, to watch, to substandard, and onward. Take note.

Trading mutliple trends are jolting. Banking is not a long-term growth industry. In a past blog post I wrote about the PEG ratio (P/E divided by EPS growth), and to keep an eye out for anything that moves too far from 1. I further deconstructed a bank's p/e ratio because the industry is more capital dependent than most, if not all industries. I estimate that a bank's p/e can be reduced by 5-7 times to calculate PEG due to high capitalization. If I took 7x, and applied it to the Mid Atlantic's 22.1x p/e (the lowest of the six regions), then those banks would have to achieve earnings growth rates of 15% to earn that valuation. Note that p/e measurements for the below charts were done on 12/31, after the new tax law passed, and after most bank's announced their DTA writedowns. But prior to their earnings releases, so the reduced earnings were not yet baked in the cake.

Banks might earn that valuation depending on how they take advantage of the new tax law. Do they take the one-time earnings injection, or make strategic investments for longer term earnings growth. If the former, I do not believe the p/e's will last long term. And therefore I believe, as an industry, bank stocks are likely at peak valuations.

Or as industry stock analysts put it: Neutral.


What are your thoughts on the state of banking?


~ Jeff


Note: I make no investment recommendations in my blog. Please do not claim to invest in any security based on what you read here. You should make your own decisions in that regard. FINRA makes people take a test to ensure they know what they are doing before recommending securities. I'm sure that strategy works well.


Source for all charts: S&P Global Market Intelligence

Guest Post: Managing to the Margin by Mike Higgins Jr.

It's that time of year when every CFO is trying to "predict" what is going to happen with rates as they construct their budgets for the new year. Rather than trying to predict rate changes in the budgeting process, consider a slightly different approach that manages to the margin.

In a nutshell, budget rates flat. Do allow assets and liabilities that are maturing to reprice at current offer rates, and budget growth at current offer rates too; just don't kick any rate hikes into the budget.

Here are the benefits of this approach:

1.  If budgeting rates flat, as described above, and margin is improving, then some of it could be due to repricing at current offer rates, but it also could be because of a strengthening product mix (i.e. higher mix of loans vs. investments and/or higher mix of low cost of funds vs. high cost of funds). Either way, it presents the truth about where you are at right now.

2.  If budgeting rates flat, and margin is declining, then it may signal a weakening in product mix, or simply a weak product mix to begin with, and that will lead to some very hard questions about the direction the bank is headed. It forces the bank to confront their financial reality and identify strategies and tactics to improve it. Banks that rely upon rate hikes to hit a number in their budget scare me. It's normally because they are covering up a weak or weakening product mix and that's akin to allowing a sickness to go on undetected.

3.  Lastly, budgeting rates flat makes things easier to explain to the board each month. If margin stays unchanged, then there is nothing to report. If margin changes, then you can simply explain why it happened, which is a lot easier than explaining why something did not happen. Remember, you report earnings to the board twelve times a year; you won't have to remind them in each meeting that your "prediction" about a rate hike was wrong.

On the flip-side, there is one benefit to including rate hikes in your budget; when they don't materialize as planned, and you miss your earnings target as a result, it gives you someone else to blame.

What are your thoughts on this topic?

Mike Higgins, Jr.

Mike Higgins, Jr. is managing partner in the firm of Mike Higgins & Associates (MHA). His consultants work with clients in the financial services industry. His primary areas of focus are performance management, performance-based compensation, board education and strategic financial planning. He can be reached at (913) 488-4506 or mhigginsjr@mhastakeholders.com

For Banks, What Is Top Quartile Performance?

What is top quartile financial performance? I am often asked this question, and top quartile performance appears as stretch goals in many strategic plans. And I say bravo! Nobody wants to be average.

Usually top quartile performance is compared to a bank's or thrift's pre-selected peer group. Executive compensation is often tied to it.

I won't belabor the point. A key benefit of being a blogger is that I can use research I perform for my own knowledge to benefit my readers. 

The below statistics are from all FDIC insured financial institutions either for the year-to-date ended or period ended September 30, 2017. This period end was largely driven by the significant number of financial institutions taking deferred tax asset write downs in the fourth quarter, which would have skewed ROAA/ROAE for the year ended 2017. I used Call Report data, so the calendar year is the fiscal year.

I also excluded extraneous performers by category, as noted in the footnotes of each table. For profitability numbers (ROAA, ROAE), I excluded Subchapter S financial institutions. Quite a large cohort at over 1,900. Sub S bankers can gross up those numbers to come up with their equivalents.

See where your financial institution ranks!

Different Paths to Superior Bank Profits

I frequently moderate strategic planning retreats. A recent discussion surrounding bank peer groups was very interesting. I have written and spoken about using peer groups constructively versus striving for "above average". This discussion related to the different paths superior performing banks took to achieve their notable profits.

There were many more than three banks in the peers we reviewed. But the three banks highlighted in the table below achieved superior results. So the board and management team wanted more discussion on what their numbers were telling us.

Bank 1's superior profits start with their yield on loans, complemented by their loan to deposit ratio, which resulted in a very good net interest margin in spite of their relatively high cost of funds. This is a typical profile of what I term an "asset driven" bank. It leads with the loan, solving for funding as it fills its pipeline. This usually results in a relatively higher cost of funds, as the quickest way to line up funding tends to be rate. I also suspect that this bank, absent seeing more data, might have had a one-time event such as recapturing some profits from the loan loss reserve. Because it's profits, at 1.51% return on average assets, seems high based on its other ratios, even though it sports a great yield on loans.

Bank 2 has a relatively low loan to deposit ratio which impacts its NIM, even though it has a solid yield on loans. They just have fewer loans relative to their balance sheet than Bank 1. And we know that the bond portfolio delivers smaller yields than loans. Rather, this bank achieves superior profits by an impressive efficiency ratio. This ratio measures how much in operating expense it takes a financial institution to generate a dollar of revenue. So the lower the better. In Bank 2's case, it takes 52 cents to generate that dollar. Since they don't generate significant fee income or have the NIM of Bank 1, we can assume this bank is cheap. As I often say, they can squeeze a nickel through the eye of a needle.

Bank 3 does have a +90% loan to deposit ratio, yet has the lowest net interest margin of the lot. The reason for their low NIM is their yield on loans. I suspect this bank prices aggressively to get loan deals. What this bank does considerably better than most, is in their Cost of Funds. In other words, it generates low-cost, core deposits. In fact, it's percent of CD's to total deposits was 14%.  I often comment that low cost of funds banks, or high core deposit funded banks, receive favorable stock trading multiples because they have built something that is difficult to replicate. This bank currently trades at 195% of book value. A significant premium to market, even though their earnings multiple is in line with the market. The bank is a strong earner.

It is important to note how strong earning banks achieve their results. Because when setting strategy, you have to chart how the strategy leads to profits. If you intend to generate superior results by creating a difficult to replicate core funded bank, it would be good to set sail with that course in mind. 

Because without identifying your destination, no wind is favorable.

~ Jeff 

Why Are Bank Net Interest Margins Under Pressure?

Industry analysts are beating the drum of net interest margin (NIM) decline. Irrational pricing by competitors is often cited in strategy sessions.

But in picking through the numbers, there appears to be something else at work. Factually, NIMs were actually greater in 2013 than in 2007 for Bank and Thrifts, according to the financial institutions included in SNL Financial's Bank & Thrift Index (2.91% in 2007 versus 2.94% in 2013). But NIM has been on the decline since 2010 when it stood at 3.31%.

Is it irrational pricing by the competition? I think all bankers will attest that at the forefront of the financial crisis, credit spreads worked their way back into pricing decisions. Banks were not only more cautious about the quality of the credit, but the yield on the loan too. And this partially explains why the NIM rose from 2007-2010. But has irrational loan pricing driven the NIM south since that time? The below chart shows differently.

                        Source: The Kafafian Group, Inc.

The largest loan categories on bank balance sheets actually showed spread gains during this period, until they finally began to wane in 2013.  This analysis measures loan spreads by taking the actual yield of the loan portfolios, and charging a transfer price for funding the loans using a market instrument with the same repricing characteristics. In plain English, it removes interest rate risk from the spread, often called co-terminous spread. 

How do we explain rising loan spreads, combined with decreasing NIMs? Well one reason can be the reduced benefit of deposit repricing. Financial institutions have benefited by the significantly reduced funding costs brought about by the historically low Fed Funds rate. But that benefit has been mostly exhausted. Leaving re-pricing of loans to be offset by, well, nothing.

The second culprit behind NIM decline since 2010 is the continued decline in loan to deposit ratios (see chart). Perhaps you hear talk of this in your FIs senior management meetings over the last couple of years. "We don't need more deposits because we have no place to put them." "We have tons of cash to lend." Etc.

But loan pipelines are getting fuller as the tortoise-like economic recovery grows deeper roots. With many FIs still mopping up excess liquidity, competition remains strong for those "good" credits, whatever that means. Presumably it means borrowers who will pay you back. This will continue to put pressure on NIMs. Once rates rise, there will likely be additional pressures as the least liquid FIs start pricing up their deposits to keep funding their pipeline. 

Will deposit rates rise faster than the loans those deposits will fund? Time will tell. 

Do you think NIMs will continue to decline, even when rates rise?

~ Jeff