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4th and 2: How good's your defense?

Why you may be in for a world of hurt

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4th and 2: How good's your defense?

By Jeff Reynolds, Darling Consulting Group

What to do with the cash? 

None of the answers are great, because the situation stinks.

Right now, most balance sheet strategy seems to hinge on a few factors. It reminds me of a certain football game in 2009, with the New England Patriots facing the Indianapolis Colts.

With about 1:30 to go, up by 6 points, and at their own 28-yard line, Patriots coach Bill Belichick had two distinct choices: 

Punt and hope his defense could withstand one of the most prolific offenses in the NFL, headed up by Peyton Manning, with a lot of time on the clock.


Let his own prolific offense, headed by Tom Brady, try to convert a first down. If they fail, hope like heck your defense can hold him with a short field.

The risk/return trade-off was great.

Convert and run the ball a little to win the game. Fail to convert and you hand the ball over to Manning (a football assassin) deep in your own territory with reasonable probability that the Colts will score a touchdown to take the game.

Bankers face a similar choice.

Making decisions, on the field, in corner office 

Belichick's decision was to give the ball to Brady and go for the first down. If the defense could easily make a stand against the Colts, he would have punted. But the truth was they were older and less talented at key defensive spots than the situation and Manning would allow.

On the other hand, Belichick had Brady and his top-rated offense, which thus far had put up 34 points on the Colt's defense. What is two more yards to them?

The answer seemed clear at the time.

The banking gridiron

Many think that banking is in the final minutes of the low-rate cycle. It might be another year or two before rates rise, but given how long rates have been down, it feels like there is only a "minute or two left" before rates rise.

The problem is we do not know if this game is heading to overtime.

The economy--though improved--is sluggish. Our government is a huge wild card with all the variations on Quantitative Easing. And the international banking/economic situation is sour.

So close, yet so far away, it seems.

With many banks' net interest margins under pressure, should your bank:

"Punt"--do as close to nothing as possible and hope the environment changes?

Or do you

"Go for it"--take action by extending cash that might look bad tomorrow if rates go up?

Game situation? 

I frequently look at a bank's deposit rates and say, "You are only a few basis points from getting them to pay you."  In other words, the "offensive margin mojo" that has been the cost of funds has been played to its fullest potential.

This leaves our aging asset base, now our only defense against rates sideways or down, exposed. Will it hold up and carry us through to the end of the game?

Like the Patriot's defense in 2009, many banks have NIMs that are "weary if not weak."

Residential prepayments were the story last year. Late last year and early this year, it is commercial loan refinancing activity. In my years in this business, I don't think I have seen a more rapid tightening of commercial loan credit spreads than I have in the past 6-12 months. The current result is 10-15bps of forecasted compression of average loan yield per quarter, until rates rise.

The question is: Can you afford to "punt" and wait out the Fed? Or do you have to "throw deep" and redeploy cash more aggressively to make ends meet today?

How old/good is your defensive squad? 

Gut check time:  How good is your defense?  In this case, how old is your loan base?

I ask because this question and a few others matter.

Right now, they might matter a lot.

Every bank is different, every situation is different, and every loan book is different.

Our firm started getting requests to conduct "institution-specific" loan prepayment studies years ago, usually at a regulator's request as a way to improve the accuracy of an interest rate risk model.

As we started doing them in earnest, each one unearthed useful information that was unexpected relative to what many thought the intent was (e.g. "making the regulators happy").

Maybe it is prepayment/modification by coupon band. Maybe it is origination vintage. Maybe it is time to reset or balloon. Maybe the "cause" changes as the rate environment changes. Because commercial loan structuring lacks the conformity of residential lending, prepayment/modification drivers are not the same from bank to bank. That said, vintage seems to be a prevalent factor based on more recent studies we have performed.

Most banks track loans based on distance to maturity or reprice date, usually wanting to know how long until the bank can reset the base if rates rise.

I do not think that is the most important metric you need to know to assess your "margin defense" at this point.

If, upon examination, you find that the majority of your loans is over the 18-month vintage mark ... I think you could be in for a world of hurt.

How prepared are you to size up your defense? 

Try asking these questions at your next ALCO meeting and see how quickly the answers materialize.

"If we isolated the loans that prepaid or were modified in the last 6 months ..."

1. How old were the loans?

2. Was there a similar coupon band?

3. Was there any commonality in regards to time horizon to reset or balloon?

4. Are there certain loan officers that are "churning" more of their book than others?

5. Can we predict which ones are next?

6. Can we develop a strategy to head off future pay-off notices before they materialize?

7. Can we do so in a way that we are not "cutting off our nose to spite our face" rate-wise?

Getting timely data in advance can help a lot when trying to assess your loan book "defense." 

If you have not committed to the process already, ask yourself how valuable the answers to the bullets above are right now. Because right now it is 4th and 2 with perhaps a minute to go for many community banks.

Play call options? 

You have a pile of cash sitting on your balance sheet. You know that if rates go up, it is a better situation than the one you live in. Margin pressure is intensifying until we do see rates change.

Do you "go deep" and invest or price loans for volume versus yield? 

Or do you "punt" and take a more passive approach to investing and lending?

For the record, Belichick went for it.

The Patriot's Tom Brady hit Kevin Faulk for a short pass over the middle, appeared to pick up the first down, but got a ball spot by the ref that was shy of the 1st down mark. The ball went to the Colts' Manning, who passed to Reggie Wayne for the touchdown, win to the Colts, and the second guessing of Belichick and "4th and 2" begins.

In a tough situation with few good options, you have to play the one that you think gives you the best chance for success. If you do that, one can always look at the "Monday Morning Quarterbacks" (we have them in banking as they have them in sports) and say "fire away."

The question is whether you have the information you need to make the best decisions possible. If not, do your best to get the information quickly; the play clock is winding down.

About the author

Jeff Reynolds is a managing director at Darling Consulting Group. After serving as an auditor in the insurance and banking industries, Jeff joined DCG in 1996. His analytical and managerial skills led him on a career path within DCG that culminated in his current role as Managing Director. In this capacity, Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions. Jeff is a frequent author and speaker on a variety of balance sheet management topics and has served as a guest faculty member for the ABA’s Stonier Graduate School of Banking.


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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