Performance is the common denominator that soothes many stakeholder expectations. Given the current market and regulatory environment, the big question is: How do we produce performance that is sustainable over various economic/ rate environments? Put another way, how do we produce consistent, quality earnings that are not dramatically impacted by movements in market interest rates?

"A recent survey of community banks by Vining Sparks, ICBA Securities' broker-dealer, tells us that bankers believe the interest rate/economic environment is second only to the regulatory environment as the primary obstacle to performance—with many bankers expressing concerns about what will happen if and when rates rise.

This concern is well founded given the number of banks that exhibit exposure to rising rates. In fact, of the banks using ICBA Securities asset/liability management services (Risk Manager) roughly 50 percent exhibit liability sensitivity (i.e., an exposure to rising rates as indicated by earnings at risk (EAR) and economic value of equity (EVE)). Indeed, an "excessively" liability sensitive risk profile, where the term "excessively" is defined from the perspective of stakeholders, can be a significant hazard to producing consistent, quality earnings (e.g. earnings that are sustainable over various economic/rate environments).

The solution for those institutions that are too liability sensitive is to increase asset sensitivity (or reduce liability sensitivity). Of course, there are many strategies to increase asset sensitivity (or reduce liability sensitivity). However, the purpose of this article is not to list all of those strategies, but to illustrate a comprehensive balance sheet management approach that can be used for any strategy development/decision making process. What follows is an introduction to our balance sheet-centric approach that allows banks to fully understand the performance ramification of multiple strategy alternatives.

Balance Sheet Impact Analysis (BSIA), begins with education and incorporates four fundamental steps for selecting and executing  an optimal balance sheet strategy:

1.  Understand current performance and establish goal(s);
2. Develop alternative strategies that achieve goal(s);
3.  Evaluate the performance impact of alternatives; and
4.  Select and execute alternative acceptable to stakeholders.

Balance Sheet Impact Analysis (BSIA)

The first step in the process is to assess and understand current performance. Table 2 below provides a view of the baseline performance for client bank. As can be seen, BSIA uses common performance measures that are familiar to management. BSIA shows that the bank is exposed to rising rates (+300 EAR -17.7 percent, +300 EVE -34.9 percent).

Basic Strategies

After one community bank evaluated its current performance, its management decided it would be prudent to reduce the bank's rising rate exposure. Following our process, the bank established specific goals of reducing EAR to below -10.0 percent and EVE below -25.0 percent. To achieve these goals, we helped the bank develop three basic strategies. The following image shows output from our BSIA tool. All three basic strategies would achieve the goal of reducing the bank's EAR and EVE to below target levels. However, the bank did so at a significant cost to current net interest margin (NIM). A detailed description of each basic strategy follows.

Strategy 1:

Improves EAR 63 percent and EVE+30 percent This is a simple bond portfolio restructure out of fixed rate, higher price volatility bonds into floating-rate SBA securities. This bond swap strategy has the lowest negative impact on NIM (-$126,000 or -1 percent impact), but does require a one-time loss on sale that is not reflected in the NIM numbers. Because of the one-time loss, the bond swap has the highest cost as measured by the impact on year-one earnings. This strategy results in a substantial improvement in EAR (-6.6 or +63 percent impact) and EVE (-24.5 or +30 percent impact).

Strategy 2:

Improves EAR +63 percent and EVE +31 percent This is a leverage strategy that involves borrowing five-year fixed rate funding (brokered CD or
Federal Home Loan Bank advances) to purchase floating-rate SBA securities. This leverage strategy has a negative impact on NIM (-$352k or -3 percent percent impact), but does not require incurring a one-time loss on sale. This results in the leverage strategy having a low cost as measured by the impact on year-one earnings. The leverage strategy also requires the use of capital (110 basis points) in this case and may not be appropriate for capital constrained institutions. As with the bond-swap strategy, the leverage strategy also has a positive impact on EAR (-6.8 percent or 63 percent impact) and EVE (-24.0 percent or +31 percent impact).

Strategy 3:

Improves EAR +74 percent and EVE +35 percent This is a hedge using a pay fixed interest rate swap. The pay fixed interest rate swap can be used to convert a fixed rate asset to a floating rate or convert a floating rate liability to a fixed rate. The hedge strategy has the largest negative impact on the NIM (-$705,000 or -7 percent impact), but does not require incurring a one-time loss nor does it have any appreciable impact on capital. The hedge strategy also has the biggest positive impact on EAR (-4.9 percent or +74 percent impact) and EVE (-22.5 or +35% impact).

Summary                                                                                     

As your community bank strives to satisfy stakeholder expectations, producing sustainable performance must be a top priority. If your bank's goals include enhancing performance (such as reducing risk, increasing earnings, etc.), it is essential to recognize that there are many portfolio management strategies available. Evaluating those strategies and selecting the one most acceptable to stakeholders has traditionally been a complicated process. A balance sheet-centric approach simplifies this process—taking the guess work out of the decision making process and making it highly intuitive.

For more information, visit ICBA Securities or call (800) 422-6442.