The Great Deleveraging
As we transition into 2012, community bankers find themselves adapting to new realities and changed conditions in their industry. Bank performance is being challenged by increased regulatory burden, asset quality issues, weak loan demand, and excess liquidity during a period of historically-unprecedented low interest-rates. With respect to general economic conditions, the hope had been that the pain would be over by now and a robust recovery well under way. Indeed, the average growth rate of US GDP at this point in a typical post-war economic cycle is 5-6%. As 2012 begins, however, we are barely seeing half that level of output, and the reality is that we will likely continue to see slow, sluggish growth for some time to come.
The reasons for this new environment are well known. The necessary and painful process of deleveraging from unsustainable debt levels is still far from over. American households, banks and governments (state and local as well as federal) all must continue to tighten belts until debt burdens return to sustainable levels. The cost of this deleveraging is slower growth, weaker inflation, and lower interest rates than what we’ve come to think of as “normal”. Similar problems in Europe weigh heavily on the US economy as well. This backdrop raises questions about the proper focus of community banks as they fight for optimal performance, while prudently managing risks.
The Baker Group has always believed in macro-management of bank balance sheets through robust Asset / Liability Management processes. The “new normal” banking environment that we are facing today is punctuated by margin compression as earning asset yields decay lower while the cost of funds for many banks is already as low as it can go. The dynamics of the balance sheet are such that older loans and bonds which were purchased in prior years will continue to mature or pay down and those dollars will now need to be reinvested into the new, lower-rate environment. To the extent that loan growth is not forthcoming, the investment portfolio becomes the critical balance sheet tool. Managing the reinvestment of excess funds is critical in several ways including timeliness, relative value, security selection, and flows of liquidity:
Timeliness – Unless you believe that the rate environment is near a turning point, the deployment of excess cash should not be delayed. A large balance of fed funds earning near-zero is painful from a relative performance standpoint. A prudent high-grade investment earning 1.5 – 2% provides a reasonable earning interest spread whereas sitting in cash earns none.
Relative Value – Every investment decision involves a process of elimination. The first step in that process is relative value analysis between and among different types of bonds and bond-market sectors. This involves determining which sectors are particularly rich or cheap in terms of yield advantage versus others. This assessment also needs to be viewed within the strategic diversification and sector allocation objectives of the portfolio manager.
Security Selection – Once the optimal bond type or sector is determined, we turn to the specific security selection process. This step involves close scrutiny of unique characteristics of individual bonds. For agencies, it’s largely about the call or step-up features. For municipals credit analysis is paramount. For MBS it’s about the loan attributes of the pool that tell us what to expect in terms of prepayment risk. In all cases, it’s about having clear understanding of the unique risk/reward characteristics of different bonds, and how they compare to alternatives.
Cash Flows – Investment decisions should also be driven by an awareness of balance sheet liquidity needs and the projected cash flows required to meet those needs. A bond purchase decision should involve an understanding of when principal will be returned to the balance sheet and, if it’s subject to prepay or call risk, the degree of uncertainty surrounding that return of principal. We have always believed that stable, predictable cash flow is a necessary requirement for prudent portfolio management.
This is a rate environment that requires constant and active management of the balance sheet. Excess liquidity must be prudently deployed and community bankers should use the portfolio as a means of achieving optimal performance for the bank overall. Define, measure, and manage the interest rate risk of the balance sheet, then structure the investment portfolio in a manner that will protect the earnings and economic value of the institution.
Jeff Caughron is an associate partner with The Baker Group and serves as a market analyst and strategist. Since 1979, The Baker Group has provided investment portfolio and interest rate risk management to community banks nationwide. Mr. Caughron will be presenting a session on “Interest Rate Risk” at the 2012 IBA Management Conference on February 8-9 in Des Moines.