Managing the bank’s balance sheet in a historically low rate environment Part I

Managing the bank’s balance sheet in a historically low rate environment Part I

Jim Clarke

We begin our journey toward market risk management article with a discussion of asset and liability management. This addresses yield curves and interest-rate risk as they relate to the current environment.

Asset/liability management is the art of structuring a bank’s balance sheet to take advantage of the current environment as well as anticipated changes. The manipulation of the assets and liabilities will vary from bank to bank. For example:

* One bank may choose to operate with a higher loan-to-asset ratio than others, or it may rely more on borrowing to fund its assets while other banks choose to use deposits.

* Larger banks tend to use more balance sheet leverage than community banks, and there are differences among community banks as to optimal capital ratios and leverage. Regardless of individual preferences, all managers seek to maximize profitability within predetermined risk constraints. What makes this partly an art rather than a strict science is the unexpected.

The choices just discussed are under the control of the asset/liability management committee (ALCO) of the institution. Unfortunately, the operating environment is not under the control of the ALCO. The business cycle can have a major impact on the success of any enterprise, and banking is no different.

Cycles Beget Cycles

In banking, an expanding economy creates strong loan demand, and every loan looks like a slam dunk. An economic recession creates the opposite environment; loan demand slows, and performance problems develop.

A bank’s liquidity position also varies with the business cycle. At the top of a business cycle–for example, in 2000–liquidity shortages develop. In weak economies–such as 2001 and 2002–liquidity abounds.

The phase of an economic cycle and its implications cannot be controlled by your bank’s ALCO, but the committee needs to understand the interrelationships.

Economic cycles create interest-rate cycles, which also are beyond the control of the ALCO. But understanding the interest-rate cycle is equally important for a bank seeking to maximize short-term profitability while positioning itself for the risk associated with possible yield curve shifts.

Yield Curves and Interest-Rate Shifts

In January 2001 the Federal Reserve began to lower interest rates in anticipation of a weakening economy. The Fed has the ability to change short-term interest rates using the Fed Funds rate as the target. During 2001, the central bank lowered the Fed Funds rate nine times. The market bottomed in August 2001 with a rate of 3.25%. The Fed continued to lower the target rate after the terrorist attacks of September 2001. By year end, the rate on Fed Funds was at 1.75%–a drop of 475 basis points in 12 months.

The Fed left short-term interest rates unchanged until November 2002, when they dropped rates another 50 basis points. This latest decline came as a surprise to many bank ALCOs, which thought the nation already was at the bottom of the rate cycle. The present Fed Funds rate is 1.25%–the lowest level in 40 years.

Throwing banks a curve. Falling short-term market interest rates affect asset yields at commercial banks as the rate on floating rate loans declines. This is less of a concern for thrifts unless they are engaged in commercial and industrial lending.

On the liability side of the balance sheet, short-term rates lower the cost of funds for all banks although more so for thrifts than for commercial banks. The current historically low rate environment is placing a lot pressure on commercial bank earnings as asset yields continue to drop, but with the cost of funds at minimal levels, net interest margins are being compressed. The thrift industry continues to experience record profits as its cost of funds fall, although at a much lower rate than was the case in 2001 and 2002.

Short-term interest rates are only half of the story. They may be the more important half from a profitability perspective, but they are the less important half from a risk perspective.

During 2002 the five year Treasury dropped below 3%, and the 10-year Treasury dropped below 4%. With such a drop last seen in May 1961, this represented a record. Rates declined 300 basis points in the past three years.

Although 300 bp is not as much as the fall in short-term rates in absolute terms, it is probably more significant in overall balance sheet effect. There are two important factors to consider:

* Cash flows accelerated from an increase in investment securities called in the last three years. Banks got hooked on the call premium in the late 1990s, and it has come back to haunt them in the past three years. Those good-yielding assets reflecting the top of the rate cycle were called at the worst possible time for returning the principle to the bank investor–at the bottom of the rate cycle. Liquidity is building and asset yields are falling, and there is little the ALCO can do.

* The 30 year fixed rate residential mortgage loan is priced to the 10-year Treasury. As the Treasury hits record low rates, fixed-rate residential mortgage loans also have recorded their lowest rates in 40 years. One result is accelerated cash flows from prepayment and declining yield on assets. Another result is more important for thrifts: the declining yield on the mortgage portfolio has neutralized some of the positive impact from the lower cost of funds.

Pressure chambers hurt. The net result of record low short and long-term interest rates is that asset-sensitive banks (most commercial banks) are experiencing margin compression. This compression is likely to increase as rates remain at these levels. However, the same banks are well positioned for a rising rate environment. Whereas liability-sensitive banks (many thrifts) will continue to experience good profitability as long as rates remain low–especially short-term rates–they are exposed to serious interest-rate risk if rates increase.

What Next?

What is the next episode in this interest-rate drama–a drama that is totally outside the control of the bank’s ALCO? I don’t know–I wish I had the answer. More important, however, the alleged experts have mixed views. The implied forward rates indicate a bias towards rising rates as do the futures market forecasts. It is difficult to determine when rates may start to increase. The entire forecasting process has been clouded by the war with Iraq. If the war ends soon and international events begin to stabilize a clearer picture may arise. In the meantime, however, it is difficult to make a judgment as to the direction of rates and the timing of any possible change. I will be the first to admit that the timing is difficult to pinpoint, but I do know that rates will increase at some point, and community banks better prepare their balance sheets for an eventual rising rate environment.

Regression to the mean. There is a concept in statistics referred to as “regressing to the mean.” To use a baseball analogy, if Sammy Sosa hits two home runs in April, May, and June, be careful–he is likely to hit 50 in July, August, and September to maintain his lifetime average. When rates sit at historical lows, we can draw the same conclusion from statistics and baseball–rates will eventually regress to their historical mean.

That said, at this point in the interest rate cycle, bank ALCOs need to understand the sensitivity of their balance sheets. Asset-sensitive banks are seeing their margins squeezed as short-term interest rates remain at historically low levels. These (mainly commercial) banks are in a good position, however, for a rise in rates. Liability-sensitive banks are experiencing good margins and profitability, but are in a position to experience a serious negative turnaround as rates increase.

This is the important question for all ALGOs: Are you sure you are correct in your assessment of the sensitivity of the balance sheet? That is, is your model accurate and are your assumptions realistic? Many banks claim to be asset sensitive; I recommend they rethink their assumptions to ensure that the balance sheet is truly asset sensitive. There is an awful lot at stake at this juncture.


Risk and reward are usually intertwined, a truism ALCOs need to consider. Asset/liability managers surely realize that moving to a more asset-sensitive balance sheet is prudent with respect to risk, but there is a cost. To become more asset sensitive, a bank must either shorten asset duration or lengthen liability duration, either of which will reduce the risk from a rising rate environment but will reduce profitability as well, given the slope of the current yield curve.

The greatest threat in community banking today is liability sensitivity, but the problem is compounded because banks or thrifts that demonstrate moderate to serious liability sensitivity also tend to originate and hold fixed-rate mortgage loans on their balance sheet. Interest rates on 30-year fixed-rate mortgage loans have dipped below 6% for the first time in 40 years. The threat actually is two-fold:

* As rates rise these loans will extend, causing serious sensitivity problems on the balance sheet.

* Simultaneously, relatively low asset yields will be locked in during the coming months.

In this environmen,t the prudent bank either should become very proficient at selling loans or should leave the market until rates become more favorable to portfolio strategies.

This is a job for Super ALCO. The job of the community bank ALCO team has seldom been more difficult, but prudent decision making has seldom been more important. Record low interest rate environments mean just that–a bottom from which rates will eventually rise. An asset-sensitive bank seeking to balance risk and reward may err in favor of reward, but a liability-sensitive bank should forsake short-term profitability and begin to adjust its balance sheet for the coming storm.

[c] 2003 by RMA. Jim Clarke, Ph.D., is founder and president of Clarke Consulting, Villanova, Pennsylvania. He is currently working with RMA to develop materials for a course on market risk.

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