The truth is that your bank should discuss balance sheet rebalancing every time credit spreads or rates are expected to materially change, any time the risk tolerance of the bank changes or at least once per year. 2016 just happens to coincide with the start of a rising interest rate cycle so now is the perfect time to have that conversation with your board and management team if you haven’t done so already. Every fund manager knows that making the right asset allocation decision is one of the best ways to stay ahead of the competition. Since a bank is more leveraged than most hedge funds, deciding where to risk capital in 2016 will be perhaps the most important performance decision that you can make. Today, at the start of the year, we look at some trends to see what changes your bank might consider.
Banking has had an unbelievable run over the past 6 years, as falling rates, a strengthening economy and increased deposits have helped banks heal and generate positive total returns. Now, as rates increase, it is highly likely that liquidity, interest rate and credit risk elevate. As such, many banks may see negative total returns in a majority of their sectors for the first time since 2009. This occurred in December and is likely to continue through 2016.
After hitting a low point in 2010, real estate lending risk has grown repeatedly and is either at or near the peak of record highs. With both capitalization rates and credit spreads near their lows, the probability of increasing risk is now greater than decreasing risk. The same can be said for C&I lending, as it is highly likely that corporate and small business earnings production growth will slow and flat line. For that matter, consumer lines, such as mortgages, autos and lines of credit are likely to start to revert to the mean.
As can be seen by the chart above looking at 25-years of loan performance history, only residential mortgages and home equity lines are still suffering from the downturn and are above their long term average non-current loan rate. The rest of the loan categories are an average of 46% below their median value.
What Is Your Risk Tolerance For 2016?
Hopefully, along with your budget you have also proactively set your risk tolerance for 2016. Now, if you are looking to add both return and risk for 2016, then by all means you should grow your current lines of business. However, if you are looking to maintain or reduce your current risk level, then we are getting to the point over the next three years (our prediction) that you want to reduce your lending risk by a combination of reducing leverage, tightening credit standards and/or shortening asset duration.
Taper Loans and Increase Fixed Income Investment
The highly likely outcome of the above thought process is that your bank may want to start to think about reducing lending risk and moving some of that liquidity into investments. This is the opposite of conventional thinking where banks keep putting on risk regardless of an increase in risk. Think back to 2006 and the start of 2007 when banks were striving for double digit loan growth despite pricing being tight, capitalization rates being low, and expected loss projections larger.
This isn’t to say we are at the peak of the economy or in forward lending risk. In fact, as rates rise, credit risk usually improves for the following year or more before reversing course (due to a lag). However, since we very well could be near a peak, now is the time to start planning allocation changes. How and when you change depends on how fast rates increase and the movement in portfolio risk. Since risk management isn’t a digital decision, chances are in 2016 you want to start the process of reallocating your balance sheet. If you believe the current market, rates will peak some 3% to 3.5% higher over the next three years. That means that banks should gradually rotate out of lending risk into more liquid fixed income securities with a minimum of optionality.
Of course, not all lending sectors, industries, products and demographic segments are the same. In the coming week, we will also be looking at some micro trends that might be of greater concern. Until then, we encourage all banks to start thinking about their current risk level, their current risk tolerance and the timing of capital reallocation. The dozen or so banks that started this process during 2004 through 2006, outperformed in 2008 and beyond. Giving up some income now in exchange for principal protection later may absolutely be the right call. At a minimum, it should at least be a discussion in both your risk committee and board.
Submitted by Chris Nichols on January 04, 2016