Can lightning strike ALCO twice?

By Darnell Canada, managing director, Darling Consulting Group

I love this time of year. New England cold goes away; outdoor concerts can be enjoyed again; lobster rolls become a more frequent meal; and best of all, baseball!

As a former collegiate player and a parent of young boys, I happily coach Little League every year. Over the years I’ve learned that our success at the end of the season will be determined by three key strategies. First, developing the weaker players, to help absorb the risk associated with the potential loss or unavailability of our stars. Second, repeating drills so we are prepared to respond instinctively as plays develop. And finally, pre-planning potential field rotations for the game based upon a variety of different pitching scenarios.

This simple success formula can be applied at a bank, too, in this way:

1. Optimizing growth in a well-diversified set of assets that best positions the balance sheet to absorb unanticipated losses.

2. Analyzing forecasts for financial performance under a variety of economic conditions.

3. Developing a game plan to help ourselves best navigate the balance sheet as scenarios develop—whether normal or stressed.

This prompts us to a commonly overlooked exercise in the risk management process—capital planning and related stress testing. Virtually, all banks run a budget annually and many run a longer-term growth plan through their financial modeling systems.

The goal is usually to project earnings growth and predict financial ratios in the context of business expansion. However, few analyze these planning models under more than a single scenario. You seldom see banks apply a narrowed focus on managing capital allocation across asset classes or self-regulating proper degrees of utilization and leverage.

Back to the future

The lack of a meaningful stress testing process on capital (and liquidity) played a key role in the financial strife experienced by many community banks during the financial crisis of 2008-2010. In this regard, it would be wise for bank executives to reflect on this mistake and take action to ensure it doesn’t happen again.

Why the concern? Because the environment today is eerily consistent with that seen before the downturn that started in the fall of 2007.

Only two years prior, in 2005, the economy was sluggish, hovering between 2%-3% annualized GDP growth. Unemployment ranged between 5% and 5.5%. Economists struggled to rationalize low inflation rates and justify swollen asset valuations across markets.

The consensus outlook for interest rates was very similar as well. U.S. Treasury rates had already reached their lowest levels in several generations. Although the Fed had already begun to increase short-term rates from a low of 1%, the market was anticipating a Fed policy that would implement a slow and gradual increase in short money rates and not much action with long-term rates—or more simply stated, a modestly higher yield curve but with significantly flatter slope.

Banks, industry-wide, found themselves in a bout against margin compression. The low/flat yield curve and unattractive bond market triggered a widespread battle for loan market share and abnormally low spread pricing levels. After widening soon after the financial crisis, credit spreads have returned to levels very close to those observed from 2004-2006.

However, there does exist one significant difference today. New Basel rules require banks to allocate more capital to credit assets, thereby reducing comparative returns on each loan underwritten. The reality is that risk-adjusted returns on capital are much lower in the loan portfolio today than during the pre-crisis period.

We all know how this story sadly ended in the prequel.

Don’t get struck again

Interestingly, we hear the same arguments today from banks that we did back then to justify asset strategies focused on near-term income growth without much regard for real returns on capital over the long term.

My point is not to judge the merit of strategies that leverage risk-based capital vis-à-vis lending at again historically tight credit spreads in a vulnerable economic environment. What I want to emphasize is how community banks would be wise to, at a minimum, take a more serious approach to analyzing and forecasting capital under a variety of economic scenarios.

It is not common, but lightning can strike twice in the same spot.

If it does, our economy may be more vulnerable should another credit downturn emerge in the next few years.

The safety net will not be as large a second time—not given limited capacity in fiscal policy and already extremely easy central bank monetary policy.

Capital planning and stress testing

As an extension of the typical 3-5 year financial plan model, capital planning models should not only forecast/project key capital ratios, but should also extract and quantify two critical pieces of information:

1. Capital bullpen strength.The degree to which forecasted capital ratios are strong enough to support growth above your financial plan.

This measure is important to help hedge the risk that growth occurs faster than expected; materializes in greater volumes than expected; and/or is driven by more credit risky assets than expected.

Each places greater upward pressure than anticipated on the denominator in capital calculations.

2. Reliable bench strength. The degree to which forecasted capital ratios are strong enough to absorb unanticipated loss is also important.

This is not just in the context of potential deteriorations in asset quality, but also to help gauge your ability (or inability) to self-govern earnings retention rates and dividend payouts. Further, this exercise may highlight issues related to capital structure.

While your three-year operating projections may serve as a baseline forecast in a capital plan, it is important to also evaluate the potential impact of various stress scenarios that could impact the bank’s earnings outlook.

Therefore, you must consider your bank’s ability to consistently generate sufficient retained earnings to support ongoing balance sheet growth demands; provide adequate resource for ongoing loan loss provisions; maintain dividend payouts; and ultimately sustain a high level of confidence amongst depositors, shareholders, and regulatory bodies during periods of duress.

Stress scenarios should be acute, yet plausible. They should emphasize:

1. Credit (e.g. potential for increased net charge offs).

2. Interest rate risk (e.g. potential for margin degradation).

3. Liquidity (e.g. potential for above plan loan growth and/or need for depreciated asset sales).

4. Any combinations of the above.

Management may view stress conditions as low- probability scenarios. However, the exercise can be critical for executives to fully appreciate the bank’s capacity to handle uncertainty and withstand financial strain should their outlook be incorrect.

Remember, few foresaw the financial crisis materializing until it was too late to adjust balance sheet size/composition or add sufficient provisions to loss reserves.

In this regard, prudent capital risk management should also include a formal risk monitoring system that compliments the aforementioned financial modeling. Very much like the Federal Open Market Committee, which uses a variety of data points and indicators to help judge whether the economy is expanding or contracting, banks should employ a pre-determined set of indicators to help judge if capital ratios need to be strengthened and/or  asset composition needs to be modified. Metrics for asset concentrations, loss provisions, delinquencies, and excess capital buffers should be reassessed periodically and stress tests revisited accordingly.

If stress tests highlight areas of concern, the bank should then have a game plan formulated to control related risks if conditions do in fact deteriorate. Drafting a contingency “play book” ahead of time is a smart move as you’ll want to be as efficient with strategy execution when stress conditions are already underway and capital adequacy is at risk of breaching policy guidelines or worse “well-capitalized” thresholds.

Putting preparation into action

This approach of coupling forecast modeling with risk metric monitoring and contingency planning enables the bank to be appropriately pre-emptive in managing growth (volume and mix) as the economic environment shifts, the local competitive  environment begins to improperly discount pricing for risk, and/or the financial condition of the institution weakens due to unforeseen circumstances.

In turn, it positions the bank to best determine where to steer targeted capital buffers over and above regulatory guidelines or when (and where) to seek additional capital. Conversely, this approach could also highlight areas of opportunity for growth and expansion to help strengthen earnings performance.

As an additional natural byproduct, this approach reinforces the importance of risk based pricing in your lending practice.

All of this is especially important in the “new world order” given how the new capital rules interlink the financial condition of bank executives with that of the strength in the risk management process of their institution.

Don’t be the lame duck manager on a team that misses in the play-offs because you weren’t prepared to handle different game situations. Take action to learn from the mistakes of those that didn’t survive the last crisis.

About Darnell Canada

Darnell Canada has worked at Darling Consulting Group since 1996. As a managing director, he has experience working directly with community banks and credit unions, providing guidance and advice on strategies to strengthen overall performance through proactively managing balance sheet risks and prudently making use of capital markets instruments. Additionally, he is an active educator at various banking schools across the country.