Reconstruct coronavirus-busted budgets to find new insights, opportunities 

Banking, like many other industries, has a “downturn playbook,” a set of common strategies designed to help individual institutions weather economic dips. However, today’s circumstances are different from every previous recession and depression, both in speed and in the sense that the economic dive is (in large part) voluntary. The novelty has resulted in some very interesting and impressive moves by the Federal Reserve (a new version of QE, MMLF, lending to securities firms, repo operations, etc.), but also an “oldie-but-goodie": slashing the federal funds rate. 

Karen MitchellHowever, interest rates seem more all over the map than they really are, according to Karen Mitchell, senior manager – risk advisory at Wipfli LLP (pictured, right). The pivot point was when rates went down in both August and October 2019, and then the two emergency cuts in April 2020 pushed things over the edge. “Balance sheets have been fairly stable, for community banks especially, with steady loan growth over the past few years which were largely offset by a decline in AFS securities,” said Mitchell. “The banks were in a fairly decent position at the beginning of the crisis.” 

Marc GallDuring the last rising rate cycle, bank cost of funds moved up slowly relative to the Federal Funds rate. Many community banks faced risk to margin compression in a very low rate environment, as asset yields could fall more than liability cost savings would offset. With the rapid decline in market rates, many banks have been quick to drop deposit rates, according to Marc Gall, vice president at BOK Financial Corporation (pictured, right). In addition, alternative deposit funds have become less costly, which will help banks reduce interest expense and minimize margin compression. More banks may turn to brokered deposits, FHLB, or the Federal Reserve’s PPP Liquidity Facility for low-cost funding options. 

Perhaps the biggest risk for bank leadership is getting stuck in the moment. Putting out fires often feels productive and has many rewards—praise from coworkers and customers, and even media attention—but comes at the expense of evaluating long-term concerns and focusing on future opportunities. 

Reconstructing a 2020 budget is an essential exercise to help bank management pay attention to the line items that will lead to long-term success, even as they triage immediate concerns (such as credit quality and margin compression). “You have to figure out what you should be focused on for longer-term success instead of constantly putting out fires,” said Gall. “Spending the time to put together a new budget will force you to think about those other elements that may not otherwise be top-of-mind.” 

Rebuilding Your Budget 

The majority of banks craft budgets in alignment with the calendar year, which means most 2020 budgets are now completely defunct. On the loan side of the balance sheet, PPP and other crisis-relief lending will create a spike in loan balances, intensified by consumers and businesses drawing on existing lines of credit in order to maintain cash flow. 

On the deposit side of the balance sheet, Mitchell says cash will move around based on consumer perceptions of strength and stability. “Just like in the great recession, there could be a flight to quality, so banks that are perceived as being strong may see an influx of deposits,” she explained. In addition, fee income (especially NSF and ATM fees) are likely to fall sharply. 

On the investment side, Gall cautioned against becoming too conservative. “Having excess liquidity on the balance sheet in this environment will ultimately become more and more expensive,” he said. “Even though investment yields have come down, the takeaway is that you need to realize where we’re actually at... We’re in a super-low rate environment.” 

All of this means one thing for 2020 budgets: “Redo them,” said Gall. Keep a copy for comparison purposes, but nearly every line item has changed significantly. The key to bank survival, as with every time of disruption, is to act. “Doing nothing is not a great strategy,” said Gall. “What will help banks through this is making decisions.” 

If making decisions feels impossible because of all the uncertainty, it’s not getting better anytime soon (it’s a Presidential election year, on top of everything else). Get unstuck by thinking of this exercise as forecasting, rather than budgeting. After all, if a weather forecast for the week is 70% right, everybody thinks that’s pretty good! Also, forecasts are designed to be revised as new information becomes available. As Mitchell put it, “budgets are static, but forecasts can be a more dynamic tool.” 

What’s Next?
Both Gall and Mitchell said banks should anticipate changes in consumer behavior in their forecasts. “Don’t use old assumptions about how consumers will behave in the new normal,” Mitchell warned. Two months of sheltering in place has disrupted old habits and formed new ones for most people. For example, banks can expect that the transition to online and/or mobile banking will accelerate. “This will change the landscape of banking, so don’t get left behind,” said Gall. 

5 Questions Bank Leaders Must Answer Now to Reconstruct 2020 Budgets: 

1. What’s our appetite for risk in this environment? 

The bank’s risk appetite throughout the COVID-19 crisis and recovery will determine loan pricing and which markets and/or sectors the bank is ready and willing to serve (for both loans and deposits), as well as how much the bank funds its loan loss provision, according to Gall. 

From an enterprise risk management perspective—the service line Mitchell leads at Wipfli—evaluating the full context of the current environment is key. “Look for the appropriate strategy in context of the risks this situation is presenting,” Mitchell advised. “Risk isn’t always a bad thing. It can be a good thing if you find the opportunities to serve your customers.” 

Banks should evaluate their credit risk, in particular, in the wake of the Paycheck Protection Program. “PPP might create some good opportunities, but the profitability of those loans is different from regular loans,” Mitchell said. 

2. Where can we increase income? 

Recalibrated 2020 budgets should incorporate new sales objectives that reflect today’s market. For example, while rates have been pushed down, banks could potentially make up some of that loss in volume. “There’s so much focus on PPP that it’s a bit lost that mortgage rates are extremely low,” Gall explained. “That could potentially be a nice additional revenue source this year if banks continue to focus on it.” 

3. What do we know about our customers? 

“Evaluate the current situation for your bank, your community, and your customers,” Mitchell advised. “Understand your customers’ experience right now and you might find strategies you wouldn’t normally have seen. You don’t need to stay on defense.” The detailed data banks can glean by being proactive with their struggling customers will also help generate models that can be used to craft stress scenarios, perform sensitivity testing, and conduct non-parallel rate shock scenarios. 

4. What ratio should we use for IRR management? 

Typically, net interest margin is measured as a ratio (cash divided by total assets). Gall recommends measuring return on equity instead. “Otherwise you could be making less dollars, that is, shrinking the bank, in order to get a better ratio,” he explained. “Unless they need to for a capital reason, we’re advocating banks not shrink at this time.” 

Whichever tools and tactics (ratios, models, etc.) the bank uses, Mitchell emphasized the need to avoid taking outcomes at face value. “Keep a critical eye on reviewing the results you’re getting [from current actions],” she said. “You’ll be using tools in new ways, so make sure the results make sense.” 

5. What’s fair for our staff? 

“At many banks, compensation is tied to performance and staff have been working around the clock to serve their customers under adverse conditions,” Gall pointed out. "Making your forecast more achievable for the rate and operating environment you’re in is a fairer way of looking at things.” Adjusting sales and other revenue metrics to be achievable in the current market may also lead to discovering new areas to pursue (see question #2). 

Save the date! Margin Management Workshop, Oct. 6-7 at the WBA Office in Madison

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BOK Financial Institutional Advisors is a WBA Gold Associate Member. 
Wipfli LLP is a WBA Silver Associate Member. 

Seitz is WBA operation manager and senior writer.