by Todd Taylor and Omar Hinojosa, Taylor Advisors
How important is Net Interest Margin (NIM) to your institution? Community financial institutions are heavily dependent on net interest income (NII). With the majority of earnings coming from NIM, implementing a disciplined approach around “NII management” will make the difference between underperforming and outperforming institutions. To request a comparison of how your institution ranks vs national and in-state peers, click here.
As financial institutions across the nation are dealing with challenges from COVID-19, anticipating next steps to protecting or to improving profitability will become increasingly difficult. Why: Margins are under pressure! Cash positions are growing with record deposit inflows; loan pricing has become ultra-competitive; and many institutions are seeing accelerated cash flows from investment portfolios. In times of uncertainty, it can be challenging to develop and execute a strategy to defend profitability.
As financial institutions across the nation are dealing with challenges from COVID-19, anticipating next steps to protecting or to improving profitability will become increasingly difficult. Why: Margins are under pressure! Cash positions are growing with record deposit inflows; loan pricing has become ultra-competitive; and many institutions are seeing accelerated cash flows from investment portfolios. In times of uncertainty, it can be challenging to develop and execute a strategy to defend profitability.
In addition to profit management, it is important to remember that stress testing your institution’s balance sheet is no longer an academic exercise! Beyond the risk-management applications, stressing the resiliency of capital and durability of liquidity should give your institution the confidence necessary to execute on strategies to improve performance and to stay ahead of your peers. It is of heightened importance to maintain focus on the four major balance sheet positions we discuss below.
Capital Assessment/Position
Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses, and providing resources for seizing opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown. As we navigate this period of uncertainty over the next 12 to 24 months, capital will be tested. Rapid changes occurring within the economy are not entirely cyclical in nature; rather, structural shifts will develop as consumer behavior evolves and business operations adjust to a ‘next normal’. Knowing the ‘breaking points’ for your capital base in terms of growth, credit deterioration, and a combination of these factors will serve your institution well for the Board and regulators.
Liquidity Assessment/Position
At Taylor Advisors, we have a saying, “Asset quality deterioration leads to capital erosion which leads to liquidity evaporation”. With institutions reporting record deposit growth and cash balances swelling, understanding how access to a variety of funding sources can change given asset quality deterioration or capital pressure is critical to evaluating the adequacy of your comprehensive liquidity position. Furthermore, stress testing your profile for a variety of scenarios (including falling below “well capitalized”) should help to give further confidence to execute strategies to protect the margin.
Interest Rate Risk Assessment/Position
In today’s ultra-low rate environment, pressure on earning asset yields is compounded by funding costs already nearing historically low levels. Excess cash is expensive and significant asset-sensitivity represents an opportunity cost as the Fed and the market forecast a low rate environment for the foreseeable future. Focus on adjusting your asset mix, not only to improve your earnings today, but to sustain it with higher, stable earning asset yields over time. Additionally, revisit critical model assumptions including loan reinvestment rate floors to ensure that your assumptions are reflective of actual pricing and rates down deposit beta assumptions as they may be too high for certain deposit categories.
Investment Assessment/Position
Strategies for investment portfolios and cash usually make a meaningful contribution to your institution’s overall interest income. Below are some key considerations to help guide the investment process in today’s challenging environment:
Taylor Advisors’ Take:
Looking beyond 2020, liquidity and capital are taking center stage in most ALCO discussions. Moving away from regulatory appeasement and towards pro-active planning and decision-making will be of paramount importance. This can start with upgrading your tools and policies, improving your ability to interpret and communicate the results, and helping implement actionable strategies.
Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. Why? You must know where you are to know where you want to go. Start by studying your latest Q3 data! Dissect your NIM and understand why your earning asset yields are above or below peer. Balance sheet management is about driving unique strategies and tailored risk management practices to outperform…anything less will lead to sub-optimal results.
Capital Assessment/Position
Capital serves as the cornerstone for all balance sheets, supporting growth, absorbing losses, and providing resources for seizing opportunities. Most importantly, capital serves as a last line of defense, protecting against risk of the known and the unknown. As we navigate this period of uncertainty over the next 12 to 24 months, capital will be tested. Rapid changes occurring within the economy are not entirely cyclical in nature; rather, structural shifts will develop as consumer behavior evolves and business operations adjust to a ‘next normal’. Knowing the ‘breaking points’ for your capital base in terms of growth, credit deterioration, and a combination of these factors will serve your institution well for the Board and regulators.
Liquidity Assessment/Position
At Taylor Advisors, we have a saying, “Asset quality deterioration leads to capital erosion which leads to liquidity evaporation”. With institutions reporting record deposit growth and cash balances swelling, understanding how access to a variety of funding sources can change given asset quality deterioration or capital pressure is critical to evaluating the adequacy of your comprehensive liquidity position. Furthermore, stress testing your profile for a variety of scenarios (including falling below “well capitalized”) should help to give further confidence to execute strategies to protect the margin.
Interest Rate Risk Assessment/Position
In today’s ultra-low rate environment, pressure on earning asset yields is compounded by funding costs already nearing historically low levels. Excess cash is expensive and significant asset-sensitivity represents an opportunity cost as the Fed and the market forecast a low rate environment for the foreseeable future. Focus on adjusting your asset mix, not only to improve your earnings today, but to sustain it with higher, stable earning asset yields over time. Additionally, revisit critical model assumptions including loan reinvestment rate floors to ensure that your assumptions are reflective of actual pricing and rates down deposit beta assumptions as they may be too high for certain deposit categories.
Investment Assessment/Position
Strategies for investment portfolios and cash usually make a meaningful contribution to your institution’s overall interest income. Below are some key considerations to help guide the investment process in today’s challenging environment:
- Cost of carrying excess cash just increased – Most institutions are now earning just 0.10% or less on their overnight funds. There are alternatives available in the market to increase income on short-term liquidity. Cash is not always KING!
- Consider pre-investing – Many institutions have been very busy with PPP loans, and investments have taken a back seat. However, we anticipate this program having a short-term impact on liquidity and resources. Currently, spreads are still attractive in select sectors of the market.
Taylor Advisors’ Take:
Looking beyond 2020, liquidity and capital are taking center stage in most ALCO discussions. Moving away from regulatory appeasement and towards pro-active planning and decision-making will be of paramount importance. This can start with upgrading your tools and policies, improving your ability to interpret and communicate the results, and helping implement actionable strategies.
Truly understanding your balance sheet positions is critical before implementing balance sheet management strategies. Why? You must know where you are to know where you want to go. Start by studying your latest Q3 data! Dissect your NIM and understand why your earning asset yields are above or below peer. Balance sheet management is about driving unique strategies and tailored risk management practices to outperform…anything less will lead to sub-optimal results.
 | Todd is the Founder and President of Taylor Advisors, a Certified Public Accountant and a Chartered Financial Analyst charter holder. Todd has spoken at numerous state and national conferences on balance sheet management, bank investments, and risk management. To learn more, contact Todd at email or visit their website. |
 | A Senior Consultant at Taylor Advisors, Omar Hinojosa holds the Chartered Financial Analyst (CFA) designation and is a member of the Louisville CFA society. Omar works with institutions across the Midwest, Southeast and Southwest regions and has been a speaker at various financial institution programs in these regions. To learn more, contact Omar at his email or visit their website. |
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