RISING RATES The Calm Before the Storm

By Adam Mustafa, Invictus Chief Executive Officer

Rising interest rates are already causing pain in the community banking industry. The most visible sign is the increasing cost and diminishing supply of deposits.  But there are additional problems bubbling beneath the surface you cannot see with traditional bank analysis. A Perfect Storm is forming, though how long it will last and when the eye will arrive is uncertain.

Best case scenario, this storm will lead to historically compressed net interest margins (NIMs) and reduced profit margins for many banks. In the worst case, it will cause liquidity challenges that will force many banks to find a merger partner.

Our BankGenome™ bank intelligence system, which is driven by loan-level and deposit-level data from across the country, has been flashing warning signals for months. We wrote about the hidden challenges that banks will face in a rising rate environment in the August 2016 issue of Bank Insights. This was viewed as contrarian, since most experts predicted that rising interest rates would be a boon, citing history in previous rate cycles.

The Fed is preaching a ‘patient’ approach toward further rate hikes, so the good news is that this buys a little time, but banks need to take advantage of the lull. Absent an economic downturn (which would present even bigger problems), the Fed needs to continue to increase interest rates over the mid- to long-term. This is not so much because of inflation, but because the Fed is desperate to restock its ammunition to combat the next recession, without actually triggering it. Don’t make the mistake of thinking that sunny days are ahead when it’s really just the calm before the storm. Now is the time to act.

The first step each community bank should take is to educate its management team on the potential problems and quantify their impact. To do so properly, bankers must breakdown the Perfect Storm into the following three components:

1. The Loan Portfolio’s Ability to Absorb Higher Rates

How well positioned is your bank’s loan portfolio to absorb higher interest rates? For most community banks, the answer is not very well at all. We performed an analysis using BankGenome™ to test this. Shockingly, over 4 out of 10 community banks have a poor loan portfolio rate absorption profile, with less than 50 percent of their loans scheduled to mature or reprice over the next three years.

This statistic flies in the face of what most ALCO models are telling bank executives. In prior rate cycles, increases in loan yields exceeded the rising cost of funds to the point that the NIM would expand. However, unlike prior rate cycles, banks accumulated loans with historically low interest rates over a prolonged period following the 2008 Financial Crisis. Many of these loans are ‘locked in’ at these low rates over the next three years. As cost of funds rise AND because increasing the loan-to-deposit ratio is no longer an available lever for banks to pull, the NIM will be under assault.

Every bank will have a different rate absorption profile. The characteristics of its loans will be different in terms of loan type, vintage, structure, and duration. It is critical that banks calculate their rate absorption profile on their loans. This is the part of the balance sheet that the bank controls the least, so any meaningful analysis must start here.

2. The Deposit Portfolio’s Ability to Absorb Higher Rates

The cost of deposits is likely to increase at an accelerated rate. The first reason has to do with the supply of deposits. The Fed’s policy to normalize its balance sheet represents a never-before-seen massive headwind. Competition will only intensify, which will exacerbate the rising costs. The second reason has to do with the mix of deposits. Interest rates had been so low that there was little incentive for customers to have money tied up in money market accounts and CDs. The percentage of deposits in non-interest-bearing accounts was significantly higher than the historical average, as the chart below shows.

As interest rates normalize, we are already seeing the percentage of non-interest-bearing deposits decline and a corresponding increase in the more expensive deposit products such as CDs:

Think of this as “intra-disintermediation”. Deposits may not leave the bank, but they will move from lower yielding products to higher yielding ones. This can impact the cost of funds in a significant way. The turbulence experienced so far this year is going to get worse, not better. This must be quantified in advance of the storm so that all potential strategic actions can be properly measured.

3. The Marginal Cost of Funds to Drive Growth or Replace Lost Deposits

The cost of the next additional dollar of funding will not be the weighted average of the cost of funds, but instead will be skewed toward the cost of the most expensive source of funding available. For most community banks, this usually means CDs, brokered funds, or FHLB money. As of the writing of this article, the costs of these sources of funding are approaching 3 percent. As these very expensive and price-sensitive products become a larger percentage of the liabilities portfolio, the marginal profitability of new loans will fall off a cliff and compression of the NIM will quickly accelerate.

The Playbook Banks Should Follow Immediately to Prepare for the Storm

Not everyone will be losers in the Perfect Storm. There will be winners, so the Perfect Storm also presents an opportunity. Here is a roadmap every bank should follow immediately:

• Quantify your unique rate absorption profile by breaking down the impact into the three aforementioned components.
• Benchmark your rate absorption profile against your peers.
• Educate your board.

If you have a vulnerable profile, you need to act immediately. Your ALCO process is not designed to solve this challenge. It is also important to recognize that tactics and gimmicks to increase deposits via organic means, such as opening new branches, hiring consultants to help with marketing, branch staff training, or creating trendy new deposit products will be very difficult and take too long in an environment where the pie is not growing.

The best way to address these vulnerabilities is through acquisitions, but you need to move fast because those targets that address these needs will be soon picked off. First-movers will win, but the approach to M&A and the way acquisitions are analyzed needs to be dramatically different; EPS accretion and TBV dilution analysis does NOT work in this situation. Neither does waiting for banks to come up for sale in an auction.

Winners and Losers to Emerge

The Perfect Storm is coming. This is not a prediction, but a simple extrapolation of a trend that will inevitably continue. We’re in the calm before the storm. We don’t know when it will arrive or whether it will be sharp but fast, or gradual but very long, but it will create carnage either way. Yet the Perfect Storm is as much as an opportunity as it is a threat.

Winners will be those banks that are already well-positioned so they can exploit the weaknesses of those that are not, as well as banks that are vulnerable today, but immediately act to shore up those vulnerabilities via acquisitions. Losers will be those banks that fail to recognize or accept the fact the storm is coming.