Community Banking and Risk Premia

By Corey Chambas, CEO, First Business Financial Services, Inc.

As a fundamental economic principle, there is typically a fair trade-off between risk and return. In the investment world, where risks are taken on various asset classes, risk premia are the returns received above the risk-free rate earned in exchange for taking that risk. Where there are sufficient buyers and sellers of assets/securities, the market is assumed to generally be efficient, with an appropriate level of reward for a commensurate level of risk. For example, a company’s bonds pay a lower expected return than the same company’s equity because bondholders are paid first in a liquidation, and thus, equity has higher risk. Therefore, the equity will have a higher return to fairly compensate for the higher risk.

When it comes to risks taken in banking, however, this risk/return trade-off does not always hold. I posit that there are three major categories of risk for community banks — credit risk, operational risk, and balance sheet risk — and the compensation for these risks is not necessarily commensurate with the degree of risk taken.

In community banking, credit risk is the one risk that follows the rule of providing a proportionate return for the risk taken. Fundamentally, banks take in deposits that are relatively risk-free for the depositor — either explicitly insured by the FDIC or, based on most historical precedents, implicitly backed by the FDIC. Therefore, depositors accept a fairly low risk-free rate on their deposits for both convenience reasons and for reasons of risk and return. On the other hand, when banks lend money, they are taking on real risk of loss. Therefore, they earn a higher rate than they pay on deposits and thus generate spread income. This net interest margin is the fundamental earnings stream of community banks.

Since the vast majority of community banks’ income is earned via spread income, their business model dictates accepting credit risk by lending money to local businesses and individuals.  Therefore, they must be expert at pricing for the risk they are underwriting. It is necessary for banks to take this risk and earn the fair/market reward to generate a return for their shareholders, pay their employees, and support their communities.

On an editorial note, this fundamental aspect of banking makes community banking an honorable and critical endeavor, as this local lending activity is the financial lubricant that allows businesses to grow and individuals to fulfill their dreams. Healthy community banks help create prosperous local businesses and thriving communities.

On the other end of the spectrum is operational risk, which is a risk that has no return. It is simply the ante for being in the banking business. This area includes things like compliance, fraud protection, cybersecurity – the list goes on. This cost of doing business is an ever-increasing challenge. Banks are not only prime targets for the bad guys because, as Great Depression-era bank robber Willie Sutton famously quipped when asked why he robs banks, “That’s where the money is”, banks are now also where the potentially even more valuable data is.

For this uncompensated risk, community banks need to diligently mitigate operational risk in the most effective and efficient manner possible.

The third risk area, balance sheet risk, encompasses interest rate risk, liquidity risk, and risk of capital loss. The first two risks discussed are mandatory – banks cannot make money without taking credit risk and, by virtue of the industry, they take on operational risk. Balance sheet risk is more interesting because much of it is optional, and the associated return is relatively small and can even be negative. So, the question to be answered is whether this risk is worth taking.

In a “normal” upward-sloping yield curve environment, banks earn additional return by taking interest rate risk – funding short with floating-rate deposits and lending long with fixed-rate loans. However, much of the time, the differential earned is really not very significant and clearly not as substantial as the premium earned by taking credit risk. Lending spreads for most banks are typically in the 3% to 4% range. However, the spread between the three-month Treasury bill and the five-year Treasury has averaged a much less 0.50% over the last 10 years. This spread, which is indicative of the interest rates in the part of the yield curve in which banks most often fund and lend, has varied widely from negative 1.91% to plus 2.24% over that timeframe and sits at negative 1.35% as I write this.

The only way to really win is if the bank can accurately predict what is going to happen with rates, and studies have shown it is extremely hard to predict future inflation and interest rates. In fact, it could be called a fool’s errand. See the graph below, which shows that even the Fed — who sets the fed funds rate — cannot accurately predict the fed funds rate!

I remember how very sure I was after the Great Financial Crisis that rates had to go up, and the rate forecasts all showed rising rates. That position was wrong for over a decade.

More recently, banks were caught wrong-footed as very few anticipated and prepared for a 500 basis point rate increase, as evidenced by Accumulated Other Comprehensive Income (“AOCI”) adjustments and mismatched loan books that resulted in severely squeezed margins.

As Yogi Berra said, “It is difficult to make predictions, especially about the future.”

When doing a risk assessment, ranking a risk in terms of its likelihood and severity is often used. The real concern when taking interest rate risk is the severity, not just because of the impact on net interest margin but also because of the correlation with the other balance sheet risks. The compounding issue is the confluence of the timing of risks, whereby margins are squeezed, and thus earnings accumulation is degraded, precisely when securities portfolios lose value, both putting pressure on capital levels. In addition, as we have seen, this type of environment can potentially cause concern for the health of the bank and a resultant loss of funding and liquidity. There is also no quick fix to the situation, as it takes a significant amount of time to unwind this mismatched position during an inverted yield curve. While you can liquidate a mismatched and underwater securities portfolio, it comes with an additional hit to capital. As for the mismatched and underwater loan portfolio, even beyond the capital impact, liquidating those assets is not really an accessible option.

Making matters worse, the typically available option of selling the bank is also likely off the table, as an acquirer not only needs to pay something for the bank but will also need to raise enough new dilutive capital to fill the mark-to-market hole, as the whole balance sheet of the acquired bank is marked in the acquisition. This creates a perfect storm of losing a valuable strategic option on top of a poor future performance outlook and a degradation of capital.

Consequently, while there is often an incremental return to be gained from taking interest-rate risk, the overall balance sheet risk and the resultant risk of impairing the inherent value of the business, may be analogous to the concept of picking up pennies in front of a steamroller.

In many ways, community banking is simple but not easy. Discipline and diligence are necessary. Choosing which risks to take and which to avoid, and how to manage and mitigate the risks taken, are key decisions for bank management teams and their boards. Community banks are the backbone of local communities, their businesses, and their citizens. Consequently, prudent management of community banks is not only important for their shareholders, but for all the stakeholders relying on them to facilitate local prosperity.

Corey Chambas is CEO of First Business Financial Services, Inc., parent company of First Business Bank. Member FDIC. For additional information on balance sheet risk management strategies for your bank, visit firstbusiness.bank/bank-consulting.