How Liquidity Comedy May Turn Into ALM Drama For Banks

Comedy may run headlong into drama for banks as asset-liability management (ALM) risk may bare its fangs for banks that aren’t careful.  It is almost a joke on how much liquidity there is in the system and it would be funnier if banks were not potentially at the butt of the punchline.  Unfortunately, for ALM practitioners, this environment is one that we have never seen so its lessons are likely to stick to the ribs of experience for some time.  It may be ironic as many bankers and analysts believe that higher rates will increase bank earnings.  For some unwitting banks, the opposite may be true.

 

 

Start With The Dots

 

Federal Reserve Interest Rate Forecast

 

Tasseography is a fortune-telling method that interprets patterns in tea leaves or coffee grounds.  Most bankers do not attempt divination to gain insight into the world of interest rates, loan rates or ALM strategies.  However, some are using “Doteography” (we made up that name) to attempt to divine the path of future interest rates.

 

The above chart plots the FOMC members’ projected rates each year out to 2017 (blue dots), the average of those dots (blue line) and the market’s expectation of rates which is represented by the swap rate (red line).  A few observations about the graph above:  First, the Fed and the market expect rates to be higher by the end of 2015.  Second, the long term neutral rate is now positioned by the FOMC at 3.75% (lower than historical average).  Third, beyond 2015, there is a substantial divergence between the market’s expectation of rates and the Fed’s forecast of short-term rates. 

 

The Largest Risks For Banks

 

At this current juncture, the most likely scenario is two rate hikes of 25bps each in 2015.  After that, the Fed is much more hawkish than market expectations.  The Fed’s long-term neutral interest rates view of 3.75% is far higher than the market’s, which sees a peak of around 2 percent.  Given this bias, what should banks should prepare themselves for?

 

Margin Compression – Of the two scenarios, the slow and steady increase of the current market expectations is a worst case scenario.  Given the current floor structure embedded in the loans of banks, Fed Funds needs to rise 75 to 100 basis points before a majority of loans shift to floating.  For CenterState Bank, as an example, only 17% of our loans will reset up upon the first Fed move.  That means margins will compress for the majority of banks hurting earnings.

 

Liquidity Shift - If rates do go up, banks with surge balances should be cautious.  Because the Fed is now data-dependent, should the economy continue to improve, deposit balances that are being “parked” at banks will convert to alternate investments thus causing liability duration to contract and deposit volume to decrease.  That double whammy will quickly shift bank’s asset-liability position and increase the cost of funds as banks will be forced into paying higher rates to replace lost deposits.

 

Asset Duration Shift – Be prepared for your ALM model to show the opposite of reality, particularly in the short-term. Few ALM models handle the negative convexity that is present at the start of a rate cycle.  Most models will increase the duration of a fixed rate asset upon a rate increase and hold the duration steady for floating rate assets.  The problem is that the first 100 basis points of rate movement will cause borrowers with short-term fixed-rate loans to refinance to longer term product.  Thus, the duration will shorten, not increase for a portion of your assets.  The same is true for some floating rate assets as these borrowers will move to lock in longer term rates at other banks.  On the liability side, look for more and more depositors will pay breakage penalties and move into higher rate liabilities. Since most ALM models don’t handle dynamic convexity well, many of these moves will not be reflected in current forecasts.

 

ALM – Should rates go up faster than the forward curve expects, banks will then have to shock their position another 300 or more basis points.  This will create a set of ALM problems as the banks will have to make some changes to bring their balance sheet back into asset-liability committee policy.  For the most part, this will mean taking on longer term liabilities which will further drive up the cost.

 

Flatter Curve – Finally, as rates rise, banks will most likely have to contend with a flatter yield curve as short term rates increase but the dollar remains a strong reserve currency attracting central banks the world over to hold longer dated Treasury Notes and Bonds.  Borrower’s demand for longer dated fixed rate loans will increase as the difference between a floating rate loan and a fixed rate loan will be less. 

 

The Solution

 

Banks need to first understand the limitations of their models and then prepare the management team and board for some tougher times ahead.  The future increase in rates will create more volatility which means banks will have more of their assets and liabilities in play.  As such, it pays to be ready to handle customers that need higher rates on their liabilities and lower risk premium on their loans.

 

Proactive banks will use this opportunity to restructure both loans and deposits now while the forward curve is still relatively low and the future of rates is not fully baked into customer minds.  Banks would be wise to offer more fixed rate loans (hedged using ARC) to customers and receive floating.  Remember that the value of loan floors decrease with rising rates.  Thus, now might be a good time to trade removing the floor for higher floating margins.

 

If you have not taken the opportunity to build out your cash management suite, now would be the time as cash management services is your best mitigate to rising deposit rates.  Our Top 10 Cash Management blog (HERE) is an excellent primer of what banks need to compete for non-interest bearing deposits.

 

Conclusion

 

We are not sure where rates are going to go, but the forward curve and the best Fed minds say higher.  The future of rates will, of course, be data-dependent, but that fact alone will now lead to greater volatility and greater opportunity for many banks.  The ALM situation is rife with ambiguity and provides plenty of tactical moves and lessons for the true ALM practitioner.  As rates move, the comedy of all this excess liquidity will take on an ironic pitch with an ever-sharper impact as reality unfolds the opposite of what many expect.