Recently we had a meeting that few banks have. It was a rarity for us, but it was eye-opening for all that attended. It brought an important clarity about the future, a clarity that would be helpful for any bank to achieve, no matter what their size. This meeting was an asset-liability committee meeting (ALCO) of sorts, but it was also strategic. As we have written about before, a good meeting starts with a good question and the question before the group of ALCO practitioners was, “What is the interest rate sensitivity of our people, products, branches, and technology?”
The Implications Of That Question
In ALCO, you discuss and plan around the duration, convexity, liquidity and general risk of your loans, investment, and the liabilities. This analysis is largely centered around how interest rate movement will impact your balance sheet and income statement. If you are an advanced ALCO team, you probably also discuss how pricing and marketing impact volume and how this would change over different interest rate cycles. This is where you get a dynamic ALCO model. If you are an expert level team, then you also calculate the interest sensitivity of fee income lines to arrive at a duration and convexity of those revenue streams. This gives you a holistic, dynamic ALCO model. However, this is likely where your discussion stops. At least, ours used to.
Stopping your analysis at the financial instruments listed above could be a mistake as how you handle the rest of your bank has profound implications for your future and one could argue is equally and even more important for your future than the rest of the discussions. Understanding the interest sensitivity of staffing, brick & mortar and other inputs helps answers vital questions about a long-term time horizon. This forces your bank to be more proactive about its legacy.
The Duration Of People
Staffing is the easiest to understand. It is likely that your branch staffing model is trimmed for speed right now without too much excess capacity. With net interest margins below 3%, there is little room to keep people standing around on the platform. However, what will the future hold? That is, if rates continue to rise, will your people become more or less valuable?
Given our current level of rates and the flat shape of the yield curve, you might conclude that your branches, hard assets, and staff are becoming less valuable. Rising costs and decreasing operating margins may force you to conclude that you need to reduce staff and branches plus replace those assets with technology. You may decide to invest more in the universal banker model and train your staff to handle sales, account opening, and customer support.
Conversely, you might look at today's rates and yield curve and conclude the opposite - your staff and assets are getting more valuable. Before deposit beta gets too high you want your team selling and managing interest rate sensitivity at the customer and product level. In addition to your staff and assets getting more valuable, your products and customers might be getting more valuable as well. Your natural conclusion would be to invest more in new products and spend more on customer retention and acquisition.
As you create a financial model for the above scenarios, you then can figure out a ballpark return on equity (ROE). By understanding the duration of your people, assets, products, etc. in a flat interest rate environment your investment decisions will naturally flow.
Now Add An Interest Rate Shock
The above analysis we did was for a static scenario. Next, let's assume that short-term rates go up 1.00%, as the forward curve predicts while longer-term rates go up just 0.80%. Credit margins, due to improving credit quality and tax reform continue to come in. The yield curve is flat to negative for a portion of next year. How does that change your investment thesis?
What happens to your transaction volume, your profitability, and your tactics?
Does increasing deposit beta make your staff and branches more valuable? If your branches are more valuable, does that also increase the value of technology such as mobile banking since that channel as well is used to gather assets and liabilities? Alternatively, do you conclude that mobile banking is a substitute for your branches and your technology becomes less valuable as branches increase in value?
It is also logical to conclude that if interest rates are cresting and all rate changes are already reflected in the current yield curve then we are near the top of the interest rate cycle. This might lead to the conclusion that staff and branches are less valuable as transaction volume and traffic may be further decreasing with flat to lower future rates.
Alternatively, if you think the economy is stronger than expected and rates go up faster than the forward curve expects, then you might forecast your margins will increase and that your deposits are now valued at more of a premium. This might have you adding branches, staff, and technology as your return would increase on all channels.
Extending the economic value of equity to items like staff, physical assets, technology, and cash flow streams casts asset liability management in a different light. As can be seen by the scenarios and chart above, the effective duration, or interest rate sensitivity for branches and people can exceed the impact of interest rate changes to loans, investments, and deposits. Thinking through how you would add or subtract to your physical and digital infrastructure forces you to think about business planning on a longer-term time horizon under a different set of conditions that most bankers are used to.
For many banks, working through this framework will make the path forward clearer. People and technology, for example, may become more valuable in a variety of interest rate scenarios while branches may be more valuable in only a few scenarios. You also might make the same asset allocation, product, technology, investment and staffing decisions in the majority of the scenarios. In fact, the above framework would give you a methodology to quantify the impact of those decisions and how important they are to your long-term performance. Thus, not only might you conclude that the clear path forward is to invest in both people and technology but the amounts you would invest over the course of the year to optimize your return.
These realizations driven from this framework will likely lead to better strategic decisions.
It doesn’t matter if you are a $100mm sized bank or a $100B sized bank, joining ALCO and strategic planning together at this granular of a level sets up your bank to be more proactive in its decisions. Give these exercises a try at your next ALCO meeting and see if it helps provide clarity on your future.
Submitted by Chris Nichols on September 19, 2018