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How to handle Fed's defined roadmap?

Federal Reserve jettisoned all the mystery. Riddle now is: How to cope?

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By George Darling, Darling Consulting Group

Net interest income--the difference between what a bank earns on its loans and investments and what it pays for its funding--remains under pressure because of:

• Weak loan demand in a lethargic economy.
• Aggressive competition for qualified borrowers.
• Unattractive investment yields in the current low-rate environment.
• Inability to lower funding costs to offset lower yields on assets, as many of a bank’s deposit rates approach their floor of zero.

The Jan. 25 announcement by the Federal Open Market Committee (FOMC) that it intends to keep rates low until late 2014 will place additional stress on bank margins and profitability. Immediately following the FOMC announcement, the five-year U.S. Treasury yield dropped over 10% (from 0.92% to 0.81%) to end the day only one basis point above its all-time low. Bankers will be inundated with requests from their best borrowers for modifications of their current loan agreements to both reduce rates and lengthen maturities.

At the same time that loan yields are falling, the yields on most bank investment portfolios are also dropping precipitously. The Federal Reserve Bank’s “Operation Twist” has driven investment yields down to levels at which it is impossible for a bank to safely invest cash at income levels that will allow for coverage of a bank’s overhead. Most banks’ overhead approaches 3% of assets and the spread on invested cash without excessive credit or interest rate risk is only 1.5% to 2%.

Historically, the response to lower yields on a bank’s assets would be to lower rates paid on deposits. Unfortunately, with deposit rates approaching zero, there is minimal ability to offset lower revenues from assets with reductions of interest expense.
Bankers’ quandary
The issues surrounding the projected decline of net interest income are primarily caused by conditions that are outside a bank’s control. For many banks, the decline of net interest income cannot be eliminated, only reduced in severity. However, the strategies that can be implemented may create other stresses of their own. These strategies include:  growth at narrower margins; acceptance of more credit risk;  increasing interest rate risk; and/or  continuing to reduce rates paid for deposits. Let’s examine each of these strategies.
• Growth at narrower margins--When balance sheet margins contract, one way to offset reductions in net interest income is to grow the size of the asset base to have more assets earning at the narrower margin.

In the current environment, this strategy would require aggressive loan pricing if the growth were to come in the loan portfolio. However, it might not end there.

Aggressive pricing could lead to more modifications in the current portfolio as existing borrowers discover (as they will) the pricing on loans being “pirated” from other banks. If the growth focuses on the investment portfolio, the bank will probably need to add duration or credit risk to the portfolio (see below) to realize acceptable yields. In either case, a growth strategy in today’s environment will require the use of a bank’s capital at historically low returns.
• Accepting more credit risk--Another way to help offset declining levels of net interest income would be for a bank to take on more credit risk to its balance sheet in either the loan or investment portfolio. This strategy would not be acceptable to many bankers in today’s regulatory or economic environment. (It might not play so well with examiners, either.)
• Increasing interest rate risk--The addition of extension or duration risk is another way to help reduce compression of net interest income.

Many bankers are opting to hold qualifying mortgage loans that they might ordinarily sell in the secondary market as an alternative to purchasing mortgage-backed securities at significant premiums. Bankers are also tending to extend maturities on commercial loans beyond their traditional five- year maturities. Investment portfolios are also being used to extend maturities through the purchase of longer-term callable agency and municipal securities.

Bankers contemplating any type of extension strategy need to fully understand their current exposures to changes of interest rate and the ability of their balance sheet to carry these securities should rates rise.
• Continuing to reduce deposit rates--This choice entails being willing to accept the potential loss of customers and the loss of balance sheet liquidity. With many bank deposit rates near zero, this strategy may have limited potential.
The current and expected economic and political environment will be very challenging for the banking industry. Net interest income will continue to be pressured. The options available to slow the rate of decline are limited. Each bank must decide which alternatives, if any, are best for their situation. For most banks, it will probably be some combination of the strategies described above.
About the author
George Darling is CEO of Darling Consulting Group, Newburyport, Mass. Darling and the consultants of his asset-liability management firm write the "ALCO Beat" column. Darling’s professional experience includes: thirty years with his own company, two years as a senior executive with a $2 billion financial institution, two years with a Big Five Accounting firm, and ten years with IBM. He is a nationally-recognized resource for assisting financial institutions in the areas of interest rate risk management, liquidity management, and capital planning.

ALCO Beat articles featured exclusively on are written by the asset-liability management experts at Darling Consulting Group. Individual authors' credentials appear with their articles. DCG's consultants have served the banking industry for more than 30 years. You can read more about the firm's history here.

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