Predicting the economic future is nearly impossible. Players in every industry wish they could shake a magical eight-ball that tells them where to head next based on the future economic environment. Banks are no exception. It seems with every flip of the calendar, banks ask questions like: how much should be added to the loan portfolio?; are we taking on too much risk if there is a downturn?; and where do we go from here?
The reality is banks do not have a fortune teller guiding them in decision-making. However, they do have two important weapons in their arsenal: economic forecasting and planning for the economic future.
“Planning for the economic future involves understanding key industry trends, how those are going to impact your bank’s balance sheet, and what action steps to take,” said Marc Gall, vice president of BOK Financial Institutional Advisors. “Not only do you need to be aware of where interest rates and the economy are headed broadly, but how other elements are changing the way banking is done, including technology, consumer preferences, and local demographics.”
Piece of cake, right? Of course not. Banks’ balance sheets are impacted by fluctuating factors such as the general economic and financial environment, interest rates, and the price of financial instruments. This means forecasting can often be inaccurate. In response to the industry’s volatility, banks devote hours to developing forecasting activities such as asset liability management, interest risk modeling, and credit stress testing. These activities guide banks in making everyday decisions that influence the future success of the bank.
“In the short run, banks use economic growth projections as a basis for determining the percentage growth in loans and deposits anticipated for the forthcoming year,” said Fred Siemers, executive vice president and chief credit officer at Choice Bank, Oshkosh. “These projections then influence the bank’s budget, departmental growth plans, and immediate hiring needs.”
In essence, economic forecasting touches all aspects of a bank’s decision-making. Therefore, banks should use the plethora of information that is available to help forecast and get a realistic picture of where the economic future is heading, instead of facing an unexpected surprise later down the road.
“Having a viewpoint of what you expect the economy to look like over meaningful time horizons can help you make better strategic and financial decisions, while also preparing you for questions, conversations, and challenges from regulators and shareholders,” said Nick Hahn, risk consulting director at RSM US LLP.
Deciding how far out to forecast.
There are mixed opinions about how far out banks should forecast for the economic future. According to Gall, when banks create a long-term economic forecast and use it to develop a strategic plan, they typically forecast three to five years in advance. However, Siemers cautions against planning too far into the future due to instability in the economic environment.
“I think the economic outlook or economic future is pretty important inside of a year,” said Siemers. “I think when you get beyond a year, it gets a little murkier because economic forecasts and predictions are seldom accurate during a long-term planning horizon.”
Banks often use long-range forecasting as an indicator of the direction of the bank. This forecasting is used to create a budget, which tends to be narrower in scope and time. According to Gall, the budget should be based on national economic variables that are available at the time that the budget is set, like interest rate forecasts as an example. A bank’s budget is typically set on an annual basis; the bank looks out a year ahead and determines what its achievable goals are.
In contrast, long range forecasting and planning tries to anticipate the future and where industries are headed. This planning should be broad and created with the understanding that it will be revisited and likely revised.
“Your strategic plan should be your long range forecast: where are we headed and what’s happening in the state,” said Gall. “Those are great conversations for the board and management, as both can provide insight for the bank’s future opportunities. In contrast, budgeting is shorter term – what do we see over the next year.”
It is important to differentiate these two processes, as budgeting is quite narrow, and forecasting is the overall direction over a long period of time. Hahn often sees banks hesitant to use forecasts on the longer time horizon; he advises banks to rethink this hesitation and see the value of looking further into the future.
“While shorter economic forecasts tend to be more accurate, the potential volatility of longer economic forecasts scare some banks away,” said Hahn. “However, doing the hard work to understand what might drive that volatility is critical to understanding factors that might have a significant impact on your bank and making appropriate strategic and tactical decisions to manage your balance sheet and the bank’s infrastructure.”
Paying attention to national, regional, and local influencers.
Despite their differences, all banks traditionally watch how the economy influences interest rates. Much of a bank’s profit is driven by interest rates and how a bank manages in terms of pricing loans and deposits for the future. Banks should also pay attention to other macro-level indicators such as unemployment rate, gross domestic product, and industrial production. However, according to Hahn, focusing on performance indicators that are tailored to the bank’s loan portfolio often outweigh the national data.
“I think what could be more valuable for banks outside of the interest rate forecast is just saying what exactly is going to be impacting our customers and how is that going to manifest itself in our balance sheet and things that we need to manage from a risk and operational perspective,” said Hahn.
As a bank looks at the economic future, it needs to take the geographical location in which it operates into consideration. Banks should look at their community’s economic data to determine where it can use local factors to either grow or enhance the bank. This is especially true for community banks, which often fund the local markets and can be severely impacted by local businesses.
“We pay attention to who our local employers are and how they’re doing financially and how they’re performing economically,” said Siemers. “It takes one major employer announcement, whether it’s good or bad, to really shift the direction of the local economy.”
Because there is no one-size-fits-all model for economic forecasting, this process will look different in various markets. For example, banks operating in a metropolitan area like Milwaukee will ultimately pay attention to different economic triggers than a rural town along the Mississippi River that mostly produces agricultural products.
Involving the whole bank.
Just as banks do not work in isolation from the community in which they reside, executives should not work in isolation from the rest of the bank when assessing economic forecasts and using that data to drive future bank decisions. Bringing multiple perspectives into the conversation will ensure that banks are considering all factors that could influence their future balance sheets.
“We typically see economic forecasting and planning activities centered with the Finance and Treasury function, or with the CFO if there is no separate Finance and Treasury function,” said Hahn. “While these groups or individuals tend to lead forecasting and planning, it is important to incorporate cross-functional input and feedback as a part of these routines. There’s a wealth of information available within the organization that we want to make sure banks are not ignoring.”
Gall also recommends including the board of directors in planning for the economic future. Because many board members come from a variety of industries, they can offer key insights regarding economic environments that the bank may not have thought of before. However, he cautioned that the board should not make strategic decisions without including lower levels of management in the process. Gall recommends involving mid-level management positions in strategic planning so they can communicate this vision to all levels of the bank.
“Get more people involved in the process of deciding what’s achievable for the bank,” said Gall. “Otherwise, the employees don’t know what they’re working toward.”
Ultimately, these are all best practices that banks should be doing already to be successful, no matter the economic environment.
“The best thing a bank can do in the long run is endeavor and build a bank that can survive under a variety of economic conditions because the economic future is uncertain,” said Siemers. “You have to build a bank that you plan optimistically for the future, but you also hedge your bets to the extent that you know you’ll remain prosperous and thrive even if the conditions are not as rosy as you hope they would be.”
Kallien is a content creation associate/editor at WBA.
BOK Financial Institutional Advisors is a WBA Gold Associate Member.
RSM US LLP is a WBA Silver Associate Member.