Pub. 6 2011-2012 Issue 6

www.nebankers.org 12 Extraordinary Service for Extraordinary Members. A S WE TRANSITION INTO 2012, community bankers find themselves adapting to new realities and changed condi- tions in their industry. Bank perfor- mance is being challenged by increased regulatory burden, asset quality issues, weak loan demand, and excess liquid- ity during a period of historically un- precedented 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 U.S. GDP at this point in a typical post-war economic cycle is 5 percent to 6 percent. 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 environ- ment 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 lo- cal 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 U.S. economy as well. This backdrop raises questions about the proper focus of community banks as they fight for optimal performance, while prudently managing risks. Managing Performance The Baker Group has always be- lieved in macro-management of bank balance sheets through robust asset/ liability management processes. The “new normal” banking environment 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 that 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. Manag- ing 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 percent to 2 percent provides a reason- able earning interest spread whereas sitting in cash earns none. RelativeValue –Every investment decision involves a process of elimina- tion. The first step in that process is relative value analysis between and among different types of bonds and bond-market sectors. This involves de- terminingwhich 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. BANK INVESTMENT MANAGEMENT: Embracing New Realities Jeffrey F. Caughron , Associate Partner, The Baker Group LP