Pub. 7 2012-2013 Issue 2

www.nebankers.org 22 Extraordinary Service for Extraordinary Members. Prolonged Low-Rate Environment Creates ALM Issues Lonnie Harris , Executive Vice President, Asset Management Group Inc. I N THE LAST SEVERAL YEARS, MOST community banks have drifted in the same direction. As rates have continued to decline, loan demand has diminished and loan-to-deposit ra- tios have generally flattened or declined. Overnight funds and investment portfo- lios have grown considerably. Deposits have almost universally increased in the face of declining rates. On balance, most community banks have been able to hold their own, at least when it comes to spread andmargin, but a few “subtle” asset-liability management (ALM) issues have been generated along the way. The “new” (or seriously altered) balance sheet presents a few issues go- ing forward. On the asset side of the balance sheet most banks are feeling more pressure to “make a deal” with their better bor- rowers, as they battle to keep their finite customer base. The offering rates on new loans have been trending down for several years, but it now appears, in some cases, the new rates are far lower than the overall book yield in the loan portfolio. Additionally, as yields decline, the duration on many loan portfolios is gradually increasing. It is not a good thing when a 5.5 percent three-year fixed-rate loanmorphs into a five- or seven-year fixed-rate loan at 4.5 percent. Yet, even though less income and increased interest rate risk exists, in many cases a deal has to be made to keep the stronger borrowers. This trend most likely will continue, so it is extremely important to deter- mine the effect the “duration drift” will have on net interest income (NII) and market (economic) value of equity (MVE) going forward. A good basic “what-if” question might be: What if we reduce the yield by 100 basis points on $10 million (this is just an example) of current loans and increase their ma- turity by five years (let’s assume they were five-year loans originally)? The extension and reduced income may not be a problem, but it is wise to calibrate expected balance sheet changes in rela- tionship to the guidelines for minimum NII and MVE ratios. Though far less prevalent, a trend in some banks has been to offer variable- rate loans with floors greater than the initial index plus spread. For instance, the initial offering rate is Prime plus 100 basis points, for a 4.25 percent coupon. Yet, even with this “rate” the lender ne- gotiates a floor of 5.25 percent. This is, of course, very good. But, this floor rate will prevail even if Prime increases 100 basis points. The lender has locked in some “slippage” as rates increase in the variable loan rate portfolio. Why not make the loan at Prime plus 200 basis points, if the rate paid by the borrower is the same? Again, this points out a criti- cal area of the balance sheet that must be accurately measured and quantified. What floors are present and howdo they affect interest income if rates increase? How much rate movement will be nec- essary to trigger increased income on the floored loans? This information is essential to determining future income in a rising rate environment. The growth of the investment port- folio and dramatic increase of overnight funds are two other issues that deserve attention. Without going into detail, keep a good handle on the potential extension (and negative impact on NII andMVE) in the investment portfolio, if rates rise, and keep a close eye on over- night funds. Overnight funds are a little “tricky” because they are immediately repriceable and tend to skew (to the upside) the increase in NII in a shock simulation. Plus, they may “disappear” if the new deposit relationships devel- oped in the last few years are merely parking money. On the liability side, it is important to understand that historical rate sensitiv- ity may not predict consumer behavior, if rates jump. Overnight rates have been targeted at zero to 25 basis points since December 2008 and the Fed has stated they expect the target to remain in effect until the end of 2014. Why worry? Well, many think our newdeposit friends have shown extraordinary patience and will bolt at the drop of a hat, if rates increase, and if they are not immediately reward- ed. This issue relates to a key assump- tion in all ALM modeling—the “betas” used to measure the rate sensitivity of transaction accounts and time deposits. If rateswere tomove up 100basis points, Q ALM Issues — continued on page 26