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HTM Impact on Economic Value of Equity?


socratesMy recent post about using Held to Maturity (HTM) to help address interest rate risk in the investment portfolio has hit a few nerves.  I know this because I've quickly received some emails back questioning different aspects of the idea.

I love it when my readers respond back with questions.  First of all, it means they are reading what I wrote.  Second, it shows they are really thinking about the nuances of applying techniques and what it might mean for their bank.  

Idea leads to questions followed by answers, and then the whole process repeats itself.  My daughter, who studies the classics, would call it the Socratic approach.

I just call it proof that community bankers are working hard to do right for their institutions.

So anyhow, on to the EVE question.  My reader writes...

"In terms of EVE, the actual value of the HTM securities should be determined by discounted cash flows. Despite the HTM accounting designation, the value of those securities would decline in an instantaneous upward shock."

Not only do I love it that this reader took the time to think about EVE, I'm also flattered that they wrote to me seeking further info.  That's a win / win scenario.

Now, here's the important part.  My reader is exactly right.  

In the EVE analysis, the HTM security values will be determined by discounting the asset cash flows.  And, in an upward shock the value of the HTM portfolio would indeed be expected to decline.

Just like the AFS portfolio.  Only without that messy reduction to the AOCI capital account.  

But that's enough theory.  Let's look at a practical application.

Using March 2014 data from the FDIC's SDI database, focused on banks less than $1 billion asset size, we can sketch out the rough parameters of the average bank's balance sheet.  It looks a lot like this:

Securities     24%                 Deposits      89%

Loans           65%                Other            1%

Other             1%                Capital         10%

Total Assets 100%               Total L&NW  100%

To make the math easy, let's just assume this bank has $100mm assets.  That means they have a $24mm securities portfolio.

So if as much as 10% of the bank's securities fit my earlier description of 4%+ long munis then they would be talking about "risking" a whopping $2.4mm move into HTM.  Hardly an earth-shaking portfolio reallocation.

And if they took it to the extreme like those big banks have and put a full 20% into HTM, even if we round up we're only talking about $5mm total.  

I dare say that's not going to put many banks over the edge.  

And if it would strain your bank to commit somewhere between 2% and 5% of assets to HTM, or if you have other asset quality, liquidity, interest rate risk, or capital issues then just say "No" and look for another alternative.

But for the vast majority of well capitalized and well run banks, moving a small security position that we've already decided we're going to keep for the long term (funded with dedicated term funding...don't forget that piece) to HTM is pretty much going to be a nonevent.  

It's just that we've been trained to not do this.  That's what makes it so hard.  It's always hard to break old habits.

So anyhow, back to the EVE specifics.  Let's review a few base assumptions.

1) We assume the discounted cash flow approach is relatively accurate in estimating security values.

2) We assume that both an AFS or HTM security were added at 100 or par.

Then the fact that the muni is AFS or HTM is not going to change your EVE calculation at all.  Base EVE is the same, and the rate shocked EVE will not significantly vary between AFS or HTM.

But what about if the security has already suffered some price deterioration?  In that case we're depending on the book - to - base adjustment to initial EVE to accurately capture the price decline in the HTM security.  The AFS price decline is automatically captured.

Again, no real difference exists.

Don't let the fear of the unknown keep you from using all the tools available to you.  

Just be sure to use them in a thoughtful and responsible way, consistent with your bank's overall size, complexity and risk position.

And please keep those questions and comments coming.  It helps us all becomes better bankers to thoroughly discuss and debate these ideas.



Photo provided by Ben Crowe

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HTM: Solution for Interest Rate Risk From Securities?


simpleplanI've got good news for community bankers trying to balance higher interest rate risk on investment securities with the immediate hit to income associated with risk reduction.  

But before I share this "new" strategy, let's review the interest rate risk regulatory environment.

We're all familiar with recent warnings from OCC and FDIC about the interest rate risk in our securities portfolios...especially longer duration securities.

And these warnings come with good reason.  After all, unrealized losses in our available for sale (AFS) portfolio reduce our AOCI capital account and can cause increased regulatory scrutiny.  For instance, consider this FDIC warning from earlier this year...

"More troubling to bankers is the prospect that regulators will likely be downgrading bank capital adequacy and liquidity ratings despite the fact that unrealized losses on securities will, for the most part, not directly reduce regulatory capital.

This may occur as a precautionary measure in advance of banks that may be forced to mark down GAAP capital or in the event that depreciated securities must be sold transforming unrealized losses into realized losses."

Not wanting to be left out of all the regulatory fun, OCC weighed in on the topic as well.

So, now that we're properly warned and we can practically see that examiner focusing on our securities portfolio, let's look at our "solution".  In this case, we can simply mimic our larger TBTF banking brethren.

So what's the groundbreaking strategy?  

Use Your Held to Maturity (HTM) Portfolio

As of March 31, 20 out of 25 (80%) of the largest banks in the US (including all of the "Top 10") are using their HTM portfolio.  And they're not just putting a few securities in here and there.

In fact, these 20 banks are averaging a full 19.6% of their aggregate $2 TRILLION portfolios in the held to maturity category.

Now I know we've all been scolded for the past 20 years about how it's taboo to use HTM, but instead of worshiping at the altar of the AFS, let's take this "Big Bank Strategy" and turn it into something we can use in our community banks.

In fact, let's make it something we can explain and defend when we talk to our regulators.  Because if all we do is put some bonds in HTM we won't escape the regulators' scorn.

We're not going to sell our 4%+ long munis, so we might as well adopt a rolling strategy of dedicated term funding that lets us lock in some profits while we wait for clearer direction on interest rates.  

So let's turn it into a practical strategy.  One we can use at our community bank and not an ivory tower strategy we need to use calculus to explain.

Here's the idea:

  • Take some long 4%+ munis
  • Fund with intermediate term 2% FHLB Advances
  • Lock in several years of 2%+ ROA in a 1% ROA environment
  • As the funding rolls toward maturity, book your profits and reevaluate

The key to making this work is the combination of dedicated term funding while we wait for a clearer picture of where rates might go.  Most of all, discuss this in the boardroom, document it fully, and prepare minutes to show your intent and action.

I'm not sure what you think, but if we get a big rate move, I'm not so sure that muni yields will be tracking up alongside the overall market.

 Now, let's be clear.  This is not a strategy for every bank.  If you have other capital, liquidity or IRR challenges, you might want to go slowly.

Similarly, we're really only talking about a specific use case where you have a security (in my example long munis) that you have really already determined that you are indeed going to hold to maturity.

To the extent that you have the desire, intent and capability to hold this security to maturity, then why shouldn't you use HTM, particularly when you combine it with dedicated funding and informed board approval?



Photo provided by PhotoSteve101

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Why Your Community Bank Needs a Deposit Study...And How to Get One


PlanIt's no surprise given regulatory pronouncements that community bank deposit studies are a hot button topic with regulators.  What is a surprise is just how far down the foodchain the regulators are pushing this concept.

I understand the need for bank-specific deposit assumptions.  You know, non maturity deposit decay rates and beta assumptions.

Bank-specific assumptions are always preferable, especially with NMDAs where small assumption changes can drive big reported interest rate risk sensitivity changes.

But I have recently had several clients less than $50mm in assets tell me their regulator has demanded bank-specific deposit assumptions from them.  I think that's overkill.

There are only 2 groups that community banks can find themselves in right now:

  1. Their regulator has already demanded a bank-specific deposit study; or,
  2. Their regulator will soon demand that they produce bank-specific deposit assumptions.

So what's a community bank to do?  I think you should prepare to create your own deposit study.  

Here are a few pointers to get you started on the right path.


Static Pool Method:  Static deposit study analysis relies upon the selection of a beginning year cohort set of deposits, and tracks the behavior of these specific accounts over time. Because the static method requires identifying and tracking specific accounts over time, the static method requires more extensive IT resources and involves a greater risk of privacy issues, due to the specific account identification required.

The static approach delivers results that illustrate the year-by-year decay for a finite set of accounts opened during one specific cohort year.  Results attributable to any specific cohort are likely to vary greatly from year to year.

Dynamic Pool Method:  The dynamic pool method uses all the change in all existing balances to derive the decay rate associated with your NMDA account balances.  It has the advantages of being easy to calculate and understand, does not require extremely difficult IT extracts, and does not involve personally identifiable account information, so privacy concerns are minimized.

For almost all community banks, I recommend the static pool methodology.

Determine Level of Detail

You must determine the level of detail you will need for your assumptions.
a) I suggest at least separate analysis for Non-Interest Bearing Checking, Interest Bearing Checking, Money Market, and Savings accounts.
b) If you have tiered accounts with significantly different rates, consider adding additional levels of detail in the future.  

Just keep in mind that a simpler study that is completed and documented beats a more sophisticated study that remains a theory or "what-if" project.  There's always time to extend your study to a more detailed perspective later.

Data Requirements

For each type of account you wish to study, you will need...

a) Monthly history of total balances per that deposit class.
b) Monthly history of new account balances per deposit class.
c) Rate history for each deposit account type being studied.
d) Monthly history of total time account balances.
e) Monthly history for total bank assets.

Note: Almost no one has the data complete when they start a project like this.  For the first iteration, work with what you have and collect more data for better future results.

Also, no account specific or personalized identifiable data is needed, so there are no additional privacy issues.

Deposit Study Steps

From these balance and rate histories, make progress in the following fashion.
1) Identify and segregate any surge balances.  Surge balances will be subject to a more aggressive assumption on decay.
2) Identify balances not sensitive to rates.
3) Calculate decay rates on remaining core balances that are rate sensitive.
4) Calculate and document the rate sensitivity (beta) of each deposit type or category studied.

Over time, as additional data is collected, the analysis will be updated, refined and perhaps expanded as needed.

There are really 3 ways that you can approach a community bank deposit study project.
1) Take the blueprint above and work it out on your own.
2) Let me teach you how to do it in a more detailed training focused on each of these steps.  At the end of the training, if you have been doing the "homework" along the way, you will end up with a functional and documented assumption process.
3) Give me the data and let me do it for you.

Download your bank's asset liability report.


Bank Ratings and Bank Failures July 18 2014


Piggy BankOn Friday July 18, the FDIC was named receiver for Eastside Commercial Bank (GA).

A link to our bank rating report is shown below.

Eastside Commercial Bank

As is typical, an examination of the financial position of this bank indicates well below normal capital levels and generally above normal noncurrent loans.

You can learn more about our bank ratings system, including video tutorials, on our website.

Photo provided by Nina Matthews Photography

Download your bank's asset liability report.


Practical Interest Rate Risk / Yield Trade-off and Timing Issues


BalanceTSeveral clients have recently asked about handling the trade-offs between higher yields associated with fixed rate loans or securities and interest rate risk exposures.  Regulators have also expressed an interest in this issue.

The relationship between higher returns and higher risk is central to modern finance theory so it's no surprise that it's present in this discussion.  

But I know you are not looking for some ivory tower're looking for practical guidelines you can use.  So focus on these key points.

Background:  After years of low, near-zero short term interest rates, banks have migrated toward longer duration assets seeking to maintain their net interest margins.  Despite Fed assurances of continued low rates, bankers (and regulators) grow nervous over the pending ramifications of inevitable interest rate hikes.

Short Term Risk:  Short term measures of interest rate risk (dynamic gap and earnings at risk) show bankers actually becoming more asset sensitive.  It's important to keep in mind that while individual parts of the bank's balance sheet might suffer from rate hikes, the overall bank just might see improved net interest income.

Long Term Risk:  Longer term interest rate risk measured by the economic value of equity (EVE) on the other hand shows increased liability sensitivity and the promise of deterioration in profitability.

Yield Curve:  As of July 8, 2014 the 7yr is about 212 bps higher than the 1 month rate (swap rates vs 1month libor). With a continued steep curve, bankers are being well compensated for taking modest amounts of intermediate term interest rate risk.  

Implications:  This means that if you hedged your interest rate risk, rates would have to rise over 2% just to get your cash flow back to where it starts on an unhedged basis.  

For most banks, I actually recommend adding to your intermediate term fixed portfolio, especially if you can book high quality loans.  I almost always suggest loans over investments as loans offer 3 key benefits that investment securities do not:

  • Fee Potential
  • Relationship Building
  • Possible Cross Sells

Timing:  Cost effective risk reduction requires that the bank be correct on both direction and timing.  I think direction is a given.  Rates will inevitably rise.  

The real question is timing.  When will rates rise?  Applying risk reduction too soon results in lost NIM, which community banks can not afford to squander.

Solution?  I suggest you implement an Interest Rate Risk Contingency Policy, which helps you to separate the "What" from the "When" of reducing your interest rate risk.  

You can read more about it here.  

You can download a sample Interest Rate Risk Contingency Policy (in MS Word format for easy editing) here.

Community banks no longer have the luxury of applying risk reduction without considering the opportunity cost of forgone income.  An Interest Rate Risk Contingency Policy helps assure that you reduce risk when the time for action arises.


Photo provided by Hans Splinter

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Community Bank Declaration of Independence


Flag BackgroundCommunity bank survival is at stake, and we would do well to heed the warnings of FDIC Vice Chairman Hoenig.  

Every revolution requires a call to arms, and Vice Chairman Hoenig has clearly sounded the alarm.  This is more true than ever this Independence Day. 

Read the text of his speech here.

Hard as it may be to believe, Hoenig sees a vison of greater financial concentration, and even more government control over the allocation of credit in our national economy.  

Correctly, he understands that this will result in both a diminished competitive position for the US within the global economy as well as regional restrictions on credit access within the US.

Hoenig sees 3 main factors that have set banking on this path.

  • Branch banking liberalization.
  • Expanded permitted activities (insurance, investment banking, broker-dealer and trading activities) associated with Gramm-Leach-Bliley.
  • Rising fixed costs of additional regulatory burden

All of these factors act both directly and indirectly to marginalize community banking.  And Hoenig asserts that none of these factors contributing to consolidation are likely to change. And this will continue to result in what he calls "consolidation for the wrong reason" on page 6 of the PDF.

Hoenig's key insight is that the government safety net designed to support public confidence in the financial system has been co-opted, if not fully highjacked, to provide outsized and unintended benefits to a few select institutions.

In his words, "However, some commercial banks have been permitted to extend the benefits of this safety net to activities beyond its original, limited purpose" (Hoenig PDF page 4), providing an enormous competitive subsidy.

To his credit, not only does Hoenig identify this dislocation, but he also questions if this has been wise or appropriate and then he directly lays the blame for the most recent crisis at its feet.

He goes on to observe 2 key points.

  1. Until this advantage is remediated, community banking will continue to shrink; and,
  2. The burden of more and more complex regulations stems from the misdeeds of "the most complex commercial banking firms, engaged in a host of non-commercial bank activities."

At this point we must acknowledge that Hoenig gets it, he doesn't shy away from laying blame where it belongs, and he recognizes the damaging nature of this environment on credit allocation generally, and community banking in particular.

Now for the bad news.  

Because community banks are commercial banks, and because the industry has rallied behind a mantra of "One Industry", Hoenig sees no reason for the public or for Congress to distinguish simple community banks from large, universal commercial banks engaged in widespread activites and abuses.

In other words, we have met the enemy and he is us.

So what are we, as community bankers, to do?

Hoenig says we must stop the missteps and the abuses in commercial banking,while improving confidence in both bank management and regulatory effectiveness.  Only then could Congress and regulators reduce regulatory burden without undermining economic stability or risking public funds.

To be clear, Hoenig states that absent action to reduce and confine the government safety net to limited commercial banking activities as was originally intended, the largest firms will continue to gain while community banks struggle.

Hoenig's conclusion (page 7) gives us the right message...

"The community bank model is viable, but its success relies on a market system that is being undermined."

Increased financial concentration for the wrong reasons, built upon the unintended and inappropriate extension of a public safety net and increased government control over credit allocation is a nightmare scenario for our industry and our nation.

As community bankers, it's up to us to keep this nightmare scenario from occuring.

Here's my call to action for all community bankers.

  • Spread the word.  Forward this article to all of your community banking associates.  We must educate others in the industry and the public if we are to succeed.
  • Take the pledge.  Click here to add your name to the list of community bankers demanding action. There is strength in numbers. We must stand up and be counted.
  • Contact your elected representatives.  They work for you.  Grass roots actions that make them aware of this issue will be most effective.

Here's a list of US Senate contact info.

Here's a search for the House of Representatives.

I wish you a wondeful Independence Day and hope to hear your feedback soon.


Download your bank's asset liability report.


Net Interest Margin Compression


ProfitabilityA client recently asked about how to deal with compression of their net interest margin.  This is a critical area impacting community banks today so it's a natural to discuss more about this topic.

At the risk of sounding overly simplistic, at its core, building your NIM boils down to some combination of 2 tasks:

  • Increasing interest income
  • Decreasing interest expense

The real question is how to accomplish these tasks in a competitive market.

A big hint to the answer lies in the last sentence.  The ability to increase your asset yields and decrease your liability costs lies in your competitive advantage.  Having a competitive advantage is the key to earning higher market yields or paying lower funding costs.

Step 1 is to survey your market.  

Perform your own local peer analysis.  Compare your bank's YEA, COF and NIM with those of the banks in your local market area.  The goal here is to see if you already have a particular advantage because if you do, we want to build upon your success.

Step 2 is to increase your YEA.

For most community banks, this means earning higher yields on loans.  Sure, investments are in the mix, but you will never have the same earning potential with investments as you do with loans.  The takeaway here is to shift your mix from investments into high quality loans wherever possible.

You probably already know I'm a big believer in a systematized loan pricing approach.  You must cover the interest rate risk of the loan, then properly price for the credit risk.  Do these 2 things right and you're 80% there.

To really optimize your pricing, be sure to fully cover your administrative expenses.  I suggest full absorption costing.  If you want to learn more about my approach to loan pricing, check out my Loan Pricing Success Course.

One last comment on loan pricing.  Whatever you do, don't fall victim to matching pricing in your market.  If you do that, instead of fully calculating the pricing needed for a particular loan, you are letting the dumbest banker in your market set prices.  That's the recipe for a race to the bottom...and it doesn't end well.

Step 3 is to lower your funding costs.

Take a critical look at your funding costs and ask yourself a few questions.  First, am I overpaying in my market?  If so, start reducing your deposit yields immediately.

Next, compare your COF with wholesale funding sources, both internet deposit listings and FHLB advances.  FHLB is a sophisticated and active participant in the capital markets.  If you ever are tempted to copy pricing, make sure you use FHLB, and add a spread to cover other variables.

Finally, consider your NMDA yields compared with money market mutual funds.  Money market mutual funds are going to closely track the funds market, so they'll quickly reflect changing market conditions.

But remember, you have a huge advantage over money market mutual funds...your deposits are insured.  Since your deposits are insured they are less risky and you should always pay a lower yield than money market mutual funds.

Now, let's get back to competitive advantage.  Everything I've shown you above is applicable to all banks.  Long term, the way you outcompete is based upon your unique competitive advantage.

Your bank has a particular reason to exist.  You serve a special community or group of clients.  You specialize in something, and that's the key to pricing advantages.

Don't make the mistake of thinking you can compete on price.  It's a sure path to lower profitability.  Instead, compete on your personalized service, local approvals and full service in your chosen markets.



Photo credit: Lending Memo

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Bank Ratings and Bank Failures June 27 2014


piggy bankOn Friday June 27, the FDIC was named receiver for Freedom State Bank (OK).  This is not your ordinary case of a bank slowly deteriorating and sliding into closure.

A link to our bank rating report is shown below.

Freedom State Bank

In a somehat unusual situation, an examination of the financial position of this bank indicates stable capital levels and low levels of noncurrent loans, based on the March 2014 Call Report.

This assessment of the bank's financial condition is very much at odds with the FDIC's Prompt Corrective Action Directive dated May 2 and released earlier in the day of June 27.

In the PCA, FDIC noted a negative capital position and notified the bank of a critically undercapitalized position on April 7. This assessment is markedly different from that reported as of the March Call Report.  

Take a look at our report, and the FDIC PCA and draw your own conclusions.

You can learn more about our bank ratings system, including video tutorials, on our website.

Photo provided by Nina Matthews Photography

Download your bank's asset liability report.


Attracting Low Cost NMDA Deposits


After Hours DepositA client recently asked about how to attract local deposits.  And the best local deposits are non-maturity deposits.  

Lower cost wholesale funding (both deposit and borrowing based) is plentiful, but this banker is looking ahead to the future.

While this particular bank is a newer institution, the concepts are relevant for all of us.

According to an ABA Banking Journal article, the number one reason why customers choose a bank is location, specifically a convenient branch location.  Since we can't pick up our branch and move it, let's focus on the things we can influence.

The possible paths to outperformance include:

  • High quality service
  • Market segmentation
  • Competitive pricing

'I'm a big believer in customer service and this can be a powerful tool in deposit success.  Educate your staff on customer service issues and insist on top performance.  Here's an area where your staff's attitude can directly translate into success.

It's no mistake to have service and segmentation ranked higher than pricing.  As bankers, we often have that knee-jerk reaction to immediately turn to pricing.  But I think that's a costly and ineffective strategy.

All deposits are not the same, and in building our long term profitability we are ultimately better off attracting the least price sensitive deposits instead of the most price sensitive.

I'm also a big believer in the power of targeted segmentation.  Draw a circle around your branches on a map and specifically target prospects within a convenient distance to the branch.

With commercial prospects, do some groundwork first.  Make an appointment and start building your relationship.  We all prefer to do business with those we know, like and trust, so there's no time like the present (while we are awash in liquidity) to invest in a long term effort to build relationships and future profitability.

Finally, once we start building those NMDA balances, your regulator will not be far behind seeking some bank specific deposit assumptions (decay and beta) from your deposit study.  You can find a brief overview here.

What are your thoughts?  Please let me know.  Like this question, all responses will be treated confidentially.



Photo provided by Dave Wagenknecht.

Download your bank's asset liability report.


Bank Ratings and Bank Failures June 20 2014


piggy bankIn an unusual twist, on Friday June 20, the FDIC was named receiver for 2 banks with the same name...Valley Bank (IL) and Valley Bank (FL).

A link to our bank rating reports is shown below.

Valley Bank (IL)

Valley Bank (FL)

As is typical, an examination of the financial position of these banks indicates well below normal capital levels and generally above normal noncurrent loans.

You can learn more about our bank ratings system, including video tutorials, on our website.

Download your bank's asset liability report.


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