Have you heard? The Federal Open Market Committee (FOMC) of the Federal Reserve is telling us to get ready for three more hikes in 2018. If they're good at their word, we'll be looking at overnight rates approaching 2 percent by the end of the year. It's been a full decade since we've seen those levels. Most community bankers I've talked to can't wait as they believe their earnings are going to improve.
I think their optimism is based on two separate but correlated beliefs: First, that community banks will continue to stick to their responsible loan underwriting standards, and second, that they'll be able to control their margins, even as money-market rates are on the rise. So far, the FDIC confirms there haven't been any cracks in the credit quality dike among community bankers this time around. So maybe it's time to check out the interest rate risk profile of a typical community bank to see how that's shaping up.
Let's review the regulators' take on the subject. The counter-argument to bankers' enthusiasm about margin improvement comes from your friends at the FDIC. The June 30, 2017 Quarterly Banking Profile mentioned that "some banks have responded […] by 'reaching for yield' through higher-risk and longer-term assets." This was not really news as similar comments had been made in recent quarterly releases.
In a separate Supervisory Insight from last summer, the FDIC mentioned increased loan demand, shrinking supplies of liquid assets and increased use of wholesale funding. The report stated rather clearly that "liquidity risk is generally increasing for [community banks] as a group." It recommended that contingency funding plans be reviewed and tested and that cash flow projections for the entire balance sheet be challenged.
From the view of ICBA Securities and its exclusive broker, Vining Sparks, you've already addressed these issues. Vining Sparks is the interest-rate risk modeler for about 300 community banks, so it has an eyewitness view of the rate risk exposure (or lack thereof) for a large segment of the industry. And I'm pleased to report that, for at least these banks, they're built for the 2018 forecast.
Recent additions to the risk management lexicon include Earnings at Risk (EAR), Economic Value of Equity (EVE), and Capital at Risk (CAR). As we've come to learn, your examiners will expect you to know what your community bank's posture is for these and other risk measurements. It's also helpful to recall that the standard range of interest rate shocks that you're expected to calculate is from "down 300" to "up 400" basis points.
Back to our sample of 300 community banks. As of Sept. 30, 2017, this group is estimating that it'll have a positive EAR in any rising-rate scenario of a parallel nature. It also is projecting to have a larger positive EAR than the previous quarter and year. This is a good thing if 1) it's accurate, and 2) the FOMC does what it says it will. The exact same condition exists for this group's EVE; in any rising-rate forecast, economic value of equity will increase.
What's even more encouraging is that most banks had negative projections for these metrics in rising-rate scenarios just two years ago. This means that community bankers have been diligent and disciplined about addressing their interest rate risk. And the ultimate backstop to risk, a bank's capital, has similarly been fortified. The average community bank's CAR shows a decline of only about 16 percent in a severe (up 400 basis point) rate shock. This is well under the regulators' general guidelines about capital exposure to interest rate changes.
Observations and Recommendations
It is true that the liquidity measurements for community banks are showing some ebb in the last two years. Your examiners have commented on it, and there is plenty of evidence to back it up. However, it's not like the well has run dry. For example, while wholesale deposits are trending upwards, the typical community bank still has borrowing capacity of almost 40 percent of assets. It looks like contingency funding is in place.
If you're unsure how much liquidity your balance sheet will produce over the next 24 months, here are some suggestions:
- Have a shocked cash flow ladder compiled by a third party, like your favorite broker.
- Take a good look at recent prepayment speeds on your mortgage securities.
- Consider adding securities that will produce near-term cash flow, like highly callable agencies, premium mortgages, or well-structured collateralized mortgage obligations.
- Get indications of market prices on government-guaranteed loans or other liquid portions of your loan portfolio for possible future sales.
Your community bank is probably in relatively good shape for the interest rate environment. The industry has had plenty of time to prepare and the Fed these days is very transparent. Also, it's never been easier to measure your exposure to a wide range of interest rate shocks. So remain vigilant, and here's to a prosperous 2018.
Reber is president and CEO of ICBA Securities and can be reached at 800/422-6442 or email@example.com.