/by

Borrowing Options – Return and Risk Considerations

, , ,

5 minute read – It’s no surprise that borrowings have increased significantly over the last year.  With non-maturity deposits shrinking, institutions have been filling the gap with borrowings.   

As more borrowings are being added and used more actively, it is important to keep a few points in mind. *  

First, borrowing strategically can be a good move for institutions.  For some, there can be historical mindsets around “we do not borrow” and seeing borrowings as an indication of financial instability.  However, borrowings are a helpful and important tool for managing liquidity and interest rate risk, both of which are present in the current environment.   

Second, it is important to continually understand your borrowing position and your remaining capacity.  This may sound straight forward but while there is liquidity pressure now, it can be easy to lose sight of how remaining borrowing capacity is impacting the financial institution’s ability to respond to future liquidity events.  Said differently, usage of borrowings today may limit a financial institution’s capacity to address an unforeseen external event should it need to access funds quickly. 

To help understand this, decision-makers can start by revisiting the contingency funding plan and the institution’s identified liquidity scenarios.  If the solution to your contingent liquidity event includes adding borrowings or is solely depending on borrowings, then it is critical to understand the potential magnitude of reliance on 3rd parties and adjust as needed.   

Third, understand thoroughly the impact of the borrowings being added and how they will help achieve your objectives.  Clarity on objectives from preserving the lowest cost of funds possible today, locking in liquidity for a particular length of time, or reducing interest rate risk/stabilizing earnings across a range of environments.  There are many choices of borrowings from bullets, amortizing, or options that can be called or put.  For each path considered, it is important to clearly communicate to decision-makers in the organization the risk/return trade-offs.   

Let’s take a deeper dive by evaluating a 10-year putable (at the lender’s discretion) with a 1-year lockout.  Thinking of the objective, why would an institution choose this option?   In this case, they may just need the money for a year and think rates will stabilize or increase a little over the next year.  Given the inverted yield curve, recently a financial institution could get a 10-year putable for 3.79%* vs. paying 5.48% on a 1-year term borrowing.  What’s clear is that the institution is trying to save money in the short term.   

This is where understanding the broader risk/return picture is important and potentially confusing.  Because the putable can behave like both a 1-year and a 10-year term borrowing, the comparison of risk and return is not straightforward.  If rates go down, the putable will behave like a 10-year term borrowing whereas the putable will behave like a 1-year term borrowing if rates go up.   

In down rate environments, the institution would have been happier with a 1-year borrowing even though they were paying ~170 bps more because they could add lower cost funding after the borrowing matures.  Looking at the economic value impact, the putable borrowing hurts about 23% compared to 3% of the 1-year term borrowing.  So the 1-year potential benefit turns into 10 years of risk. 

Note, when comparing the putable to a 1-year fixed term, if rates were to go up, the putable would have the same length but some additional benefit due to the lower rate. 

The risk to a structure of locking in 10 years of commitments could be a material hurt if rates go down.  Often for that risk, a purchaser would want more upside which you see in the example of the 10-year fixed term because it shows material benefit if long-term rates were to go up more.   

The reality is that a putable is designed to provide benefit in a very narrow band of rates for a short amount of time.  However, financial institutions can and should understand this by gaining clarity on what level of rates there would be a benefit to the putable versus a fixed structure.  Testing the borrowings in your ALM model can help financial institutions see this.  Note that looking at a 12-month static income or NII simulation will not help decision-makers understand the trade-offs because the optionality does not start until 1 year out.   

The message here is not that putable borrowings are bad – the lower rate does add some benefit especially as the cost of funds continues to rise.  The message is to be clear on the financial institution’s needs and objectives and then work through to fully understand the risk and return trade-offs of the borrowings being added.  Below are questions that can help financial institution’s think through the considerations and other factors in advance:   

  • What is the objective for adding borrowings?   
  • How should interest rate risk be considered as well as liquidity when evaluating the borrowings?  
  • What are other funding alternatives and how do they compare to the borrowings being considered? 
  • If there is optionality, in what range of rates is the borrowing a “good deal” for the institution? 
  • If rates change and the optionality of borrowing is triggered, what are the options to replace the funding?  
  • How does potential timing of the optionality in the borrowing line up with other funding pressures, such as other borrowings maturing or member CD promos coming due? 

Again, borrowings can be an important and strategic tool for liquidity and IRR management.  It is important for financial institutions to think through their objectives and the potential impacts the borrowings are adding.   

*All rates are based on FHLB Chicago Rate Indications from August 18, 2023 

*All data is from Callahan and Federal Reserve Board from August 18, 2023

/by

c. myers live – Strategic Thinking Around Your Approach to AI & Its Role in Your Institution

, ,

In the age of rapidly evolving technology, it seems the conversation around Artificial Intelligence grows by the day.  Financial Institutions have found themselves at the threshold of opportunity, but sometimes the pace of evolution can be overwhelming.  In this episode of c. myers live, we delve into strategic questions about AI that every leader should be asking to understand how this can impact their business model now, and in the future.  We will explore how AI is not only a technology topic, but a business topic.  

About the Hosts:

Adam Johnson

Adam, CEO and one of five owners of c. myers, leads a client focused team of 50+ professionals who are passionate about helping our clients position themselves to remain relevant, sustainable, and differentiated.  In his 20+ years at c. myers, Adam has been a key contributor to the philosophy and design of c. myers’ proprietary financial models and ALM processes.  He helped design c. myers’ approach to assessing business models and strategic planning processes.

Learn more about Adam

Sally Myers

sally myers headshotSally is a founder of c. myers corporation and one of five owners. Driven by a deep commitment to helping financial industry leaders and regulators for more than two decades, her guidance has shaped c. myers’ focus on helping clients create opportunities and approach problem solving from a scalable perspective. She has also been a strategic force behind the development of c. myers’ financial models.

Learn more about Sally

Other ways to listen to c. myers live:

listen on google podcasts listen on spotify listen on apple podcasts

/by

Think Critically About Your ALM Conversation & Decision-Making

, ,

4 minute read – Unprecedented.  We hear this word used every day. However, if you are a student of history, you know that there are no new stories and we’ve read a version of this story before, except now it has new economic twists and technological turns.  The questions being asked, and the assumptions being made about risk and opportunity in ALM, need to be changed to reflect the changes in the world in which this story is unfolding today. 

Historical government interest rates: 

Looking back at historical government interest rates, we know that short-term rates have risen over 300 bps fourteen times since 1971, four of those instances since 2000.  In the early 80s, rates went up 1000 bps in eleven months – compare that moment in history to the 500 bps over the last year.  We’ve seen money move for rates, and we’ve seen money move from fear.  We’ve seen the yield curve twist.  What we didn’t see in the past was the ability for consumers to move money with a few swipes on their phones.  We didn’t see FinTechs cutting into deposits at traditional depository institutions.  And we didn’t see internet pop-ups advertising high-rate CDs at financial institutions thousands of miles away.  So now we must walk into the future with the wisdom of the past in our pocket and awareness of current happenings.  

Consider the following as you engage in critical conversations around ALM with your leadership team: 

  • Be proactive.  Run What-ifs throughout the year, practice scenario planning, and evaluate risks beyond 1 or 2 years.  As you assess risk, understand absolute levels of rates rather than just relative shifts.  Plus 300 from 1% is a far different situation than plus 300 at 5% rates.  Don’t get laser focused on rates continuing to go up.  There is enough uncertainty that you need to keep your eyes on the down rate environment as well.  Anticipate potential challenges – like credit risk – even if they aren’t causing problems just yet.  We can’t always guess the end of the story, but we can think through a range of possibilities. 
  • Reevaluate your KPIs.  As the environment changes, assess the relevance of your KPIs. Will the KPIs of last year or five years ago indicate what you need to understand today or tomorrow?  ROA and Net Worth can show you part of the picture but what else do you need to know?  For example, many institutions have goals related to loan production – are those goals leading to unprofitable loans?  
  • Scrutinize assumptions.  How might the story take a different direction if you see your deposit mix shift from non-maturity deposits to CDs?  What is your risk of withdrawals? Delve into the connection between deposit migration and deposit pricing assumptions. How might different pricing strategies impact your effective cost of funds?  What will be the impact on your reputation as you navigate credit risk, liquidity risk, and interest rate risk?  
  • Illustrate the horizon of pain.  History has taught us that sometimes things work themselves back into balance.  Exploring multiple potential paths can help you understand when to take action and when to let the story play out.  Gather data and increase frequency of monitoring to reflect the quick twists and turns of the economy and environment.  
  • Play out the story. The numbers behind ALM build a framework, but spend time asking the whys.  Why are the numbers doing what they are doing?  Including the critical thinking of the leadership team in the strategic discussions around ALM can help bring the story out of the numbers and lend a variety of perspectives to the situation.  

By understanding the past and challenging assumptions about the present, your organization can better prepare for the future.  Balancing strategy, risk tolerance, and desired financial performance while learning from the past, can contribute to a more informed and proactive approach to navigating the uncertainties of today and beyond. 

/by

Five Sticking Points To Building Process Efficiency

,

6 minute read – The following blog post was written by c. myers and originally published by CUES on June 5, 2023.

Big recession?  No recession?  Rising cost of funds?  Regardless of what’s happening in the environment, building a more efficient organization brings big benefits, including cost control, and better employee and customer experiences. 

A good percentage of strategic plans include efficiency-related initiatives, many of them geared toward embedding process improvement into the culture, or creating a culture of continuous process improvement.  If you’re on that path, here are a few of the sticking points we’ve observed that you’ll want to avoid: 

1.  Executives not knowing when to hit the gas and when to back off – Executives know that they play a key role in shifting the culture to one that continuously thinks about and acts on building efficiency.  They need to clearly and consistently message the objectives of the culture change and their support of it.   

But when it comes to standing behind their words with actions, we see some executives struggling with too much or too little involvement.   

Initially, executives should be involved in deciding on the organizational changes that will serve as the foundation of the culture change (see #5) and they should ensure that the changes are adhered to over the longer term.  And high-impact or high-volume processes will likely require deeper executive involvement.  But beyond that, the role of the executive suite is to ensure that process improvements support the strategy and don’t, for example, fly in the face of personalization, customization, or customer service in the name of efficiency.  Let go where you can, gradually if necessary – partly to build trust and capacity and partly because most executives don’t need anything extra to do.   

2.  Expecting a few individuals to make it happen – Hiring or training some people with expertise in process improvement is part of the foundation for building a culture of continuous process improvement.  But it’s only the beginning.  Having your process improvement expert observe processes, interview individuals, and prescribe changes will miss the mark.  To truly understand processes, why they work the way they do, and get buy-in for change, facilitated group discussions that include the key players – doers, managers, and systems experts – will uncover far more opportunities and creative solutions.  Not only will this result in better processes, it also exposes more team members to process improvement which causes them to think differently about their processes, leading to cultural change.  

3.  Believing that technology is THE solution – In the end, just about every efficiency improvement an organization wishes to achieve involves human behavior.  Focusing first and foremost on engraining the necessary mindset and habit changes in your people will result in positive, high-impact and sustainable gains that will permeate the organization.  Technology does deserve focus during process improvement, and while you may determine you need different software or modules, how the software is used is often the area that holds bigger opportunities, which can go a long way toward getting a better, faster return on your technology investments.  The process steps that happen outside of the software also typically offer major opportunities for efficiency gains. 

4.  Not enough discipline around the power of the blended mindset – We often see organizations take an either-or approach to process improvement – either process improvements are all huge, beastly projects, or they are a series of one-off quick wins.  Yet the powerful impacts come when they can draw on both.  Not all improvements require an extensive formal process, but you shouldn’t shy away from those because you don’t have the time or energy to step back and really challenge the way things are done, especially for high impact or high-volume processes like getting a consumer auto loan or opening a new account.   

The key is clarifying what a quick win looks like and when a more comprehensive approach is called for through intentional conversations and the creation of working agreements.  Incremental or quick win improvements can provide speedy relief to employees and customers with a minimum of fuss.  At the same time, viewing an entire process from start to finish, mapping all the steps, and revamping or reimagining it from the ground up with all the right players involved can bring about transformative change and efficiency.  Effectively incorporating a blend of approaches keeps the organization moving forward with quick wins while leveraging the more transformative process improvements. 

5.  Lack of a good process for improving processes – That sounds circular, but it’s important to establish a good process that ensures sustained dedication to process improvements, which builds the culture.  Highly important is the devotion to doing a certain amount of process improvement, ongoing.  Many accomplish this by holding a few project slots for process improvements every year.  Also, key are dashboards or similar means of tracking progress, maintaining a list of staff suggestions, prioritizing which ideas will be tackled first, and scheduling periodic evaluation of key processes.  The process should also include monitoring previous improvements to make sure the efficiency gains stick, as well as celebrating successes and continuing to keep process improvement top of mind in the organization. 

Being good at improving processes is necessary, but it takes organization-wide behavioral shifts to build a culture of continuous process improvement.  Building a more efficient organization can help control costs and enhance employee and customer experiences, regardless of the external environment.  Don’t let these pitfalls hijack your progress.  Engrain these changes and establish a culture of continuous process improvement to reap the benefits of greater efficiency and productivity. 

/by

Monitoring Future Risk Is More Critical Than Ever

, , ,

4 minute read – Risk often comes in pairs, and right now, interest rate risk (IRR) and liquidity risk are the dynamic duo putting pressure on financial institutions’ balance sheets.  In looking at paths to address these risks, the options don’t always look that great.  In some cases, they may create other issues with earnings and capital and impinge on the organization’s ability to move forward strategically at the needed pace.   

Giving the balance sheet time to heal 

An approach to consider is to be patient and let your balance sheet heal.  An immediate concern from decision-makers might be that being patient looks an awful lot like doing nothing.  They worry that examiners won’t like it.  Also, the Board and leaders may not be comfortable being passive and feel an understandable desire to “get ourselves out of this situation quickly.” 

But the key is that being patient is not doing nothing; on the contrary it’s an active process that requires analysis and monitoring.  Given enough time, many sources of IRR and liquidity risk will resolve themselves, but leaders need to understand whether they have the time.  This requires a two-step process that includes effective analysis that illustrates whether giving the balance sheet time to heal is a viable option, and beefed-up monitoring to ensure the healing is on pace as the future unfolds. 

Step 1:  The time horizon for pain – target financial structures bring clarity 

To start, see what the interest rate risk and liquidity position will look like at a point in the future if the budget comes true.  The budget contains detailed projections for at least the next year or two for a reasonable view into the future.  Using year end balances, model a target financial structure that shows the IRR and liquidity positions one or two years down the road.   

With this information, decision-makers can evaluate whether patience and giving the balance sheet time to heal is a viable path:  How does the model’s assessment of IRR and liquidity look at that point in the future?  Is the financial institution better prepared for market rate volatility, or did the financial institution increase its risks?  How do the results compare to our policy limits and guidelines?  How satisfied are we with the direction and speed of progress?  Understanding that positioning today and weighing options with the Board and Management are incredibly valuable.   

Step 2:  Strong ongoing analysis and monitoring 

After the target financial structure analysis, regardless of whether the decision is made to be patient or take action, closely monitoring the IRR and liquidity situation of the current balance sheet as the future unfolds is critical to make sure the results are following your desired path.   

Things are happening fast.  Expected changes in interest rates are still fluctuating, which means that a range of interest rate environments should be modeled for better decision-information.   

Given how quickly the environment is changing, many institutions are moving to beef up their monitoring of current IRR and liquidity to monthly simulations, sometimes just for a short period of time, to make sure they are staying on top of their risk.  As part of monitoring the situation going forward, returning to Step 1 periodically for an updated view of the time horizon for pain may also be called for.  Strong ongoing analysis and monitoring allows decision-makers to understand their risk position sooner and move quickly to identify options and take action as needed. 

In addressing the one-two punch of liquidity risk and interest rate risk, careful evaluation of the available options, including the option to give the balance sheet time to heal, is the necessary first step.  A wrong decision in this challenging environment can be very costly, both in terms of dollars and opportunities.  But on the flip side, the impact of good decisions is potential material improvement in earnings, risk, and strategic progress.  It is necessary to look beyond traditional methodologies to address this risk environment and provide the intel you need.  Analysis that looks to the future to help in understanding the time horizon for pain, along with frequent monitoring of the actual changing risk profile, are critical pieces of decision-information that are invaluable when making the best decisions for your institution.