Industry Insights

February 12, 2018
Auto Lending at a Crossroads
By Alec Hollis, Director – ALM Strategy Group, ALM First Financial Advisors, LLC

“Transitions to delinquency show persistent increases for auto and credit card debt; auto loan delinquency rates especially problematic for subprime auto finance loans.”

So reads the press release from The Federal Reserve Bank of New York for a recent Quarterly Report on Household Debt and Credit. Headlines like these are becoming more common in relation to auto lending as regulators cite concerns over several years of strong growth alongside eased underwriting standards and unabated flows into delinquency.

The unprecedented growth in auto debt can be derived in part by the underlying demand for the collateral. Annual auto sales have seen several consecutive years of growth, setting an all-time high of 17.5 million units in 2016. This growth has trickled down to auto lenders, as total auto loan debt notched a new all-time record at $1.21 trillion in outstanding balances at the end of the third quarter of 2017. This represents a 48% increase from ten years ago – second only to a 157% increase in student loan debt – while total household debt increased 7% over the same time period.

This growth has the OCC’s attention – the agency took notice as early as the spring of 2012, citing banks launching new products, services and processes to catalyze asset growth, and specifically mentioning the growth in indirect auto lending. While growth in and of itself is not necessarily bad, the OCC has consistently discussed auto lending, which is why it is important for financial institutions to understand the reasons behind the elevated risk status.

Total originated auto loans surpassed $430 billion through the first three quarters of 2017, with roughly $88 billion of those loans considered to be subprime (credit scores below 620). Subprime auto loan originations have not been growing as fast as in preceding years, as some major market participations have capped subprime production, but overall originations continue unabated, with an ongoing streak of year-over-year increases.

At the close of 2017, roughly 20% of auto loan originations were subprime, compared to 21% in 2016, 23% in 2015 and 29% pre-crisis in 2007. Despite this decrease, Figure 1 shows that subprime origination volume has nevertheless has accelerated to roughly pre-crisis levels today, while originations with excellent credit have far surpassed pre-crisis levels.

Figure 1

Delinquencies in the auto lending space have likewise ticked up. Auto loans 90+ days delinquent measured 3.97% of the outstanding balance in the third quarter of 2017, continuing a streak of quarterly increases. Delinquency flow (newly delinquent loans) has also been increasing steadily for several years. Figure 2 shows the outstanding seriously delinquent balance, which has increased steadily since 2014.

Figure 2

Although widespread delinquencies have yet to materialize, there are certainly problematic sectors. Auto finance companies represent $602 billion – or roughly half of the $1.21 trillion outstanding – in auto loan debt. When it comes to subprime lending, auto finance companies dominate, representing 74% of outstanding balances with credit scores at origination of less than 620.

Auto financing companies might not look quite so dominant, though, when digging into delinquency flows. Figure 3 shows the flow into serious delinquency for auto loans originated with a credit score of less than 620. These flows have diverged from banks and credit unions in a major way, and are currently at levels not seen since the financial crisis for this major subset of subprime auto lenders.

Figure 3

The OCC has been consistently discussing and monitoring the trends in delinquencies since they first mentioned the drift higher in 2013. Asset quality indicators such as delinquency ratios and net charge-offs are trailing indicators, meaning that they take time to materialize as the credit lifecycle matures for a particular vintage of loans. Many are expecting delinquencies to continue to rise, as aggressively underwritten vintages continue to mature. To prepare for this, it is important for financial institutions to ensure collections operations can meet the potential delinquencies and that reserves are appropriate given this expectation.

Indirect Auto Lending
As it relates to auto lending, the OCC has widely discussed fair-lending risk, a result of yielding underwriting decisions to auto dealers or other third parties. Not only does this practice create a risk to credit standards, but it also carries significant compliance risk.

A notable case in 2013 involved Ally Financial, a large lender in the indirect auto space. The Consumer Financial Protection Bureau (CFPB) and the Department of Justice (DOJ) took action against discriminatory lending practices present in Ally’s program. Incentivized by dealer markups, minority borrowers were being charged higher interest rates at the discretion of the auto dealer. As a result, Ally was required to pay a total of $98 million in damages and penalties.

This example demonstrates how crucial it is for financial institutions to have adequate controls and appropriate compensation for dealer relationships. The last thing an institution needs is a dealer making underwriting decisions – not to mention the potential multimillion dollar penalties that may accompany them.

Action Plan
Recent news is riddled with coverage on auto loan delinquencies, subprime auto lending and large institutions scaling back from auto lending. Most recently, TCF Financial Corporation, a Minnesota-based bank holding company with $23 billion in total assets, announced discontinuation of all indirect auto lending. Other big banks have announced the limitation of auto loan originations in general, citing rising stress and protection from credit risk. As far back as 2015, Wells Fargo announced a cap on subprime production, after years of being aggressive lenders in the space. Moves like these could indicate some concern.

Particularly in regards to indirect lending, institutions need to understand the importance of assessing the additional risks posed by dealer relationships, as well as the additional fees. Return-on-capital models can objectively assess the profitability of product lines – if risks are mounting, institutions can take a cue from TCF and perhaps take a step back from the market.

Overall, auto lending can be a very important part of the balance sheet for many consumer-focused financial institutions, and indirect lending and dealer relationships can be an excellent tool to expand the institution’s reach. However, if ensuring safe and steady growth is the goal, history has shown that loosening credit standards to increase loan volume is not often successful in the long run.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Alec Hollis is a Director in the ALM Strategy Group at ALM First Financial Advisors, LLC.

January 29, 2018
Swaps: Margining And Accounting Considerations
By Ira G. Kawaller, Managing Director, HedgeStar

Due in large part to regulatory pressures, an increasing number of swap transactions undertaken by financial institutions have been – or will be – subject to margining requirements. Current industry practice is still evolving, but depending on exactly how these margining practices are implemented, different accounting treatments could follow.

The Case for Margining
In any discussion of margining, it’s useful to first distinguish between cleared swaps and non-cleared swaps. Cleared swaps are reported to clearing entities that apply well-defined and standardized margining practices that require posting of initial margin (i.e., collateral that may be in the form of cash or other qualifying assets) and variation margin that must be settled in cash, every day. Non-cleared swaps, in contrast, are bilateral contracts between two entities – often a swap dealer and an end user – where any margining practices would be carried out independently from a clearing entity.

Broadly speaking, over the next several years, virtually all financial institutions will be subject to mandatory margining for most, if not all, of their derivative positions. The rationale is that margining serves to eliminate credit risk as a function of losses being collateralized or settled in cash. Thus, the process assures that winners get paid. These margin adjustments could be stipulated with specific frequencies (e.g., weekly or daily) and/or when threshold valuation markers are breached.

Cash v. Non-cash Margin
The form of the margin is critical. Specifically, it’s important to distinguish between cash and non-cash margin. In regulated futures markets, where the most well-established margining practices have long precedent, both cash and selected non-cash securities are permissible for initial margin, but variation margin settlements must be satisfied exclusively in cash. Futures market practice further expressly distinguishes initial margin from variation margin, designating the former as collateral, while the latter is a bona fide settlement against the futures position.

For example, with an initial margin requirement of $1,000, a futures market participant would put up the $1,000 in cash or in securities at the start of the trade. This initial margin would be used only if the losing party failed to meet its variation margin obligation. In most cases, however, where variation margin adjustments occur as prescribed, this original margin would remain untouched until the trade is terminated, at which point the initial margin would be returned to the posting party.

To illustrate, let’s say Trader A enters a long futures position at a price of $50 per unit, and at the end of the day the closing futures price reaches $51. In this instance, Trader A would receive a variation settlement of $1 times the number of units per contract (the contract multiplier). It should be clear that the opposing trader (Trader B) would be the loser in this transaction, such that Trader B would be required to pay that same variation margin amount. These types of cash flows are settled at the exchange clearing house at or before the start of trading on the following business day.

In fact, in the futures environment, individual traders don’t deal directly with the clearing house. Instead, all traders are represented by clearing members and futures commission merchants (FCMs) who act as the traders’ agents – both as execution agents and as cash flow intermediaries. Thus, subsequent to settlements between clearing member firms and the clearing house, a parallel settlement between the trader and his or her FCM and then the FCM and the clearing member would be performed (note that clearing members and FCMs may be either distinct entities or the same company performing distinct functions). Initial margin amounts are intended to cover the credit risk associated with FCMs or clearing firms paying out their customers’ variation margin obligations prior to receiving reimbursement from their customers.

Under this process for futures contracts, variation margin assures that gains and losses will be settled every day, such that the value of the futures contract effectively resets to zero with each variation margin settlement. These aggregated gains or losses are considered to be unrealized until the contract is liquidated, at which point all unrealized gains or losses are redefined as realized. This terminology obscures the fact that unrealized gains or losses results are “real” in the sense that the money that moves from the loser to the winner does so without restriction – that is, any funds in excess of the initial margin requirement can be redeemed from the FCM and used for any purpose.

Contrast this margining process with one that allows for all margin adjustments to be satisfied with non-cash collateral. The trade would still involve an initial margin, but subsequent margin adjustments would be made periodically – up or down – as position values change, and securities (i.e., non-cash) may be used for this purpose. Ultimately, all collateral posted would be returned to the posting party following the termination of the contract.

Margining for Swaps
With the evolution of clearing facilities designed to handle swaps and other derivatives, a margining practice has evolved that mimics that of futures margining, with a twist. In this arena, (a) the initial margin obligation can still be satisfied with cash or securities, (b) variation margin requires a cash settlement and (c) variation margin is settled no less frequently than daily. The twist is that an extra cash flow adjustment is added into the mix – the price adjustment amount or price adjustment alignment (PAA), formerly termed the price adjustment interest (PAI).

What is the rationale behind the PAA? Prior to the advent of cleared swaps, when bilateral swaps operated with an International Swap Dealers Association (ISDA) credit support annex that required non-cash collateral adjustments, whichever party posted collateral still enjoyed the earnings that the collateral generated (e.g., dividends or accrued interest). In other words, posting collateral is purely a custodial issue, but it doesn’t alter the security’s ownership. Thus, it should be clear that a key difference between posting cash collateral and non-cash collateral is that, unless otherwise compensated, those posting cash give up the earning potential from that cash, while those posting non-cash collateral get to keep the associated incremental earnings. The PAA adjustment compensates for this difference – and thus strives to equalize the two practices – by returning an amount to the losing party (i.e., the party that pays the variation margin) roughly equal to this incremental income that would otherwise have been earned on the cash settlement.

Under existing and proposed margining rules, a single net settlement amount is calculated daily by the clearing entity, composed of the PAA netted from the variation margin. While these combined values will typically be settled with a single cash flow, if one wants to evaluate gains or losses of derivatives under different margining regimes, these two components should be differentiated. Put another way, the PAA component of an aggregate gain or loss associated with any derivatives position would more appropriately be considered to be other interest income (or other interest expense), as opposed to a component of the derivative’s gain or loss.

Different Accounting Approaches
Unfortunately, at this point, accounting practices are less than scrupulous in distinguishing between these two different margining orientations – variation margin as a settlement or variation margin as a type of collateral. While some entities account for variation margin as collateral and others account for it as settlement against derivatives values, the different treatment seems to be largely independent of underlying economics.

In fact, these two orientations foster distinct balance sheet presentations. When variation margin is treated as a settlement, gains or losses from derivatives are entirely reflected in the trading entity’s cash balance position, and simultaneously the derivatives carrying value reverts to a zero balance with each variation settlement. On the other hand, when financial reporters treat variation margin as collateral, adjustments to the value of posted collateral have no effect on the carrying value of the derivative.

Although both of these methods are widely practiced, the underlying economics should be the key to determining the proper approach – the critical factor should be whether cash is transferred to the winning party with or without restrictions. If those funds are available to be spent or used by the winning party, treating it as anything other than a settlement (i.e., treating it as a collateral adjustment) is frankly at odds with reality. Unlike traditional collateral, which is expected to be returned, the return of unrestricted cash settlements would be predicated upon a price reversal for the derivative in question – it could happen, but it certainly shouldn’t be expected.

Consider a case where cash variation margin settlements are treated as collateral. If the position generates a gain of $100 during the first accounting period – such that the entity receives $100 of cash designated as collateral – this receipt of cash must be journalized where the counter journal entity would be a payable. Assuming the position is liquidated in the next accounting period with no further value change, both the derivative position and the payable would have to be reversed. Thus, the associated journal entries (assuming no hedge accounting) would follow as in the table below.

Under this approach, at the end of the first period, the balance sheet shows assets consisting of (a) cash and (b) derivatives – both valued at $100 – while liabilities include a $100 payable account, and recognized earnings for the period are $100. In the second period, with no further market value changes, no further income is realized, and both the derivative and the cash collateral are treated as if they were cash settled, but the associated cash amounts are equal and opposite, such that no cash movement actually happens in the second period.

Cash $100
           Collateral payable $100
Cash collateral settled in period 1

Derivative $100
           Gain on Derivative $100
True-up derivative at period 1 end

Cash $100
           Derivative $100
Close-out derivative in period 2

Collateral payable $100
           Cash $100

On the other hand, if variation margin is treated as a settlement, the following journal entries would apply:

Cash $100
            Derivative $100
Variation margin during period 1

Derivative $100
           Gain on Derivative $100
True-up derivative at period 1 end

Under this second orientation, there are no derivative-related non-cash items on the balance sheet at the end of the first period or after. That is, cash is the only asset, but the same $100 of earnings arises in the first period. To be clear, the two methods yield identical reported earnings amounts, but the balance sheet presentations are different.

Note that the above journal entries ignore the treatment of the PAA amounts. When PAA is received, cash should be debited and (most likely) other interest income should be credited; when PAA is paid, other interest expense should be debited and cash should be credited.

As noted, both of these accounting methods appear to have been sanctioned by audit firms, but the indiscriminate application of the two methods is unjustified, as the “cash collateral” label is a source of confusion. The proper accounting should follow from whether cash settlements are exchanged between the derivative counterparties and, if so, whether those cash amounts are restricted in any way. Unrestricted cash settlements shouldn’t be treated the same way collateral is treated. Posting collateral is a custodial concern that generally has no impact on a firm’s balance sheet. Moreover, collateral is typically deposited with an independent party, and is something that is expected to be returned in full, assuming all associated cash flow obligations are satisfied. If a cash settlement is not handled in this restricted way, it shouldn’t be considered to be collateral, making the term “cash collateral” inappropriate.

Whether reporting entities or audit firms come to respect these economic distinctions is yet to be seen. If no consensus develops, however, resulting balance sheet presentations will be inconsistent, making it difficult to compare assorted financial ratios across institutions. When financial institutions issue debt and add an equal volume of assets, the net worth is unchanged, but such an action adds to the riskiness of the enterprise (assuming those balance sheet items are real). In the context of derivatives, when derivative positions are cash settled, credit risks pertaining to those positions evaporate. Therefore, to the extent that financial ratios fail to respect this economic reality, the associated credit risks and leverage calculations will be misstated.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

As a managing director with HedgeStar, Ira Kawaller draws on his more than 40 years of industry experience to provide hedge strategy services, training and hedge program implementation.

January 22, 2018
Kick-Start Your Institution’s Cybersecurity Awareness
By Emily Larkin, Chief Information Security Officer, Sageworks

Just as information security awareness programs are a regulatory requirement for many financial institutions, they likewise represent a major pain point for most. The value of a strong awareness program is often difficult to quantify and thus gets little funding or attention, but once implemented, it can be an invaluable defense against both internal and external cyber attacks.

There are countless options for those looking to pay for security awareness materials or consultants to deliver those materials, but these measures only cover part of the challenge. How do you make information security part of your institution’s culture? How do you get buy-in across departments and leadership?

Getting started is often the hardest part for financial institutions. Here are five proven ways to kick up the buy-in and acceptance:

Start at the top
While board and executive buy-in is widely believed to be essential to a successful information security awareness program, getting to that point can be a challenge for some financial institutions. The key is to find what drives your leadership team, and in most cases, it is the revenue – presenting the potential financial impact of a cybersecurity incident and breach will quickly get the board’s attention.

This is not a scare tactic, but rather an educational opportunity for those who focus on growth and financials. There is an assumption that information security lives with the IT team and that a strong firewall will protect the company, but an effective 15-minute presentation on the risks and vulnerabilities that exist at the employee level will quickly turn around executive and board perceptions. Such a presentation might highlight:

- The regulatory requirements for an information security program;
- The average cost of a breach;
- The potential for reputational risk; and
- Some examples of the current vulnerabilities within the institution

Make information security part of every employee’s orientation
A formal introduction to a member of the information security team and hands-on training in the information security program will go far with new employees, helping to demystify information security and make it part of the welcome package. Employees will appreciate meeting new people and gaining a better understanding of the importance of information security at the institution.

Make sure information security awareness is presented as part of the company culture. Encourage new employees to report any suspicious activity – assuring them that no question or incident is too minor to report, and outlining the protocol for reporting such potential incidents.

Put information security as an agenda item on your institution’s staff meetings and individual team meetings
Give the institution’s information security team a captive audience and a high-profile platform from which to speak and share news to help create positive energy around cybersecurity awareness and encourage participation.

Topics can range from recent vulnerabilities and projects in process to new controls and, most importantly, a thank you to users for their ongoing input and vigilance. Users tend to respond to statistics and data, such as the number of threats detected or the number of phishing attempts blocked in a month, so be sure to include some numbers that will help employees understand that they are part of a company that is committed to protecting the overall business.

Exercise your information security program
One of the most effective ways to raise cyber awareness is to involve users, and phishing tests represent a great example of this effort.

There are a number of tools available that allow organizations to send a mock phishing email and track who opens the email, who clicks on the links or who opens the attachment and/or provides their credentials. The key is to pick an influential figure in the organization and have an email come from some variation of his or her email address. While some may argue that this type of exercise sets employees up for failure, in truth this is simply the reality of how attackers infiltrate institutions – since most organizations have leadership teams posted on their public websites, this information is all a potential attacker needs to launch an effective phishing campaign. Employees can benefit from seeing how easy it is to gain confidence with a short email from the right sender.

Once the data from this type of exercise is collected, it is critical to share it with employees. Of course, there’s little value to be had in shaming people by name, but certainly showing the percentage of users who bit on the phish and how they could have spotted it is extremely beneficial for everyone. Phishing tests also allow an institution to exercise its incident response plans and better understand its employees’ comfort level in reporting suspicious activity. With this type of test data, the institution can then tailor targeted training for teams that fell below the company average and improve the means for reporting incidents.

Require an annual acknowledgement of your information security awareness program
While this is a regulatory requirement for many companies, it is a best practice for all companies. The acknowledgement should apply to all employees, including executives and board members. An efficient way to do this is to make it part of the annual information security policy and program approval process – thus promoting buy-in at the top, while also receiving the required approvals.

There are countless ways to deliver and track awareness training, with online delivery that interacts with the user and allows the organization to reach remote employees being one of the most effective and efficient options. This can be accomplished through a company intranet or learning management system that provides short quizzes after the training, thus ensuring accountability and easy tracking.

Often, one of the greatest challenges in the annual training and acknowledgement process is getting full participation. Be sure to set expectations up front with the initial delivery of the annual training, then reach out to non-compliers with a friendly nudge or reminder when they miss the deadline. As a last resort, work with the IT team to have a non-responsive employee’s email and/or chat account suspended until he or she completes the annual training.

When it comes to cybersecurity, improved employee awareness is often an institution’s best defense – it just takes the right strategies and consistent and timely delivery to get your employees on board. They will appreciate your efforts, understand the importance of protecting the institution and its assets and recognize that doing so is part of everyone’s job.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Emily Larkin is the chief information security officer at Sageworks, where she helps manage corporate information security, business continuity, disaster recovery and technology-related audit and compliance activities.

December 26, 2017
Community Mindset: Bearing the Burden

One of the most welcome developments for financial institutions over the past several years has been the optimistic conversation – and occasional action – surrounding the topic of regulatory relief. Particularly for community institutions, many of which felt unfairly scapegoated and unduly put-upon in the wake of the financial crisis, efforts by several agencies to ease the burden and costly drain on scarce resources associated with often disproportionate regulation have been long in coming.

The truth, however, is that there is quite a burden to unload, and it’s going to take time for institutions to truly see and feel the effects of this easing. Perhaps that’s why so many of the executives surveyed for Community Mindset: Bank and Credit Union Leadership Viewpoints 2017 still view the regulatory burden to be among the greatest challenges facing their institutions (Figure 1). At 62%, it registered as the top concern from a slate of eleven possibilities, outpacing the challenges posed by competition from other institutions and attracting new/younger customers.

Although responses across all asset ranges reflected the challenge of the regulatory burden to roughly the same degree, those institutions in the smallest asset category ($200-$499 million) stood out as the most challenged – likely due to the proportion of resources encompassed by regulatory-related tasks in a smaller institution – with 40% of these respondents identifying it as their top challenge versus 31% on average of other asset sizes. Likewise, banks seem to be feeling the pressure more acutely than credit unions, with almost 66% of bank executives viewing the regulatory issue as either extremely or somewhat challenging, compared to just 51% of their credit union counterparts.

Further, nearly two-thirds of survey participants ranked regulatory compliance first or second among a slate of five risk management priorities (Figure 2).

While 53% of respondents are getting by with what they feel to be a “reasonable or manageable” regulatory burden, 34% characterized their regulatory load as “a little too heavy” and 14% labeled it “overwhelming.” Trying to pinpoint the most common regulatory headache plaguing institutions, however, yielded an extremely wide range of responses – compliance costs (14%) and changing laws/regulations (14%) were the only two concerns to muster double-digit percentage consensus.

Regulation is, and will continue to be, a reality and cost of doing business for financial institutions. And while regulators’ incremental efforts to help reduce the burden are likely well appreciated throughout the industry, it’s clear from the opinions of community bank and credit union leaders that there’s still a long way to go to get to a level that both sides can accept as reasonable.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

December 18, 2017
Community Mindset: Millennial Musings

As they have grown into the largest segment of today’s workforce, Millennials have garnered more than their share of the industry press, with endless studies and pieces focusing on everything from their attachment to cell phones to their comparative lack of savings compared to other generations.

What has been easy to overlook amid this onslaught, however, is the plain fact that the future is now as far as Millennials are concerned. According to generational researchers, Millennials in 2017 range in age from 22 to 40, and by this measure, they made up at least a third of the respondents surveyed for Community Mindset: Bank and Credit Union Leadership Viewpoints 2017.

In other words, Millennials are no longer just hard-to-please and hard-to-keep young employees and customers. They are now the leaders at community institutions across the U.S., interested in bringing their generational brethren into the fold. But even with these eyes on the inside of many institutions, this has proven to be an ongoing challenge.

Attracting the Young
Asked how difficult it was to attract new and younger customers, 22% of respondents deemed it extremely challenging, while another 32% found it somewhat challenging. Survey participants ranked attracting new and younger customers third among a list of eleven challenges facing their institutions – behind only their regulatory burden and competition from other banks and credit unions.

Nevertheless, while respondents may find it vexing to woo Millennials, many seem confident that they’re stepping up to meet the challenge, with 61% of all respondents either very or somewhat satisfied with their institution’s appeal to Millennial customers. While 61% is a healthy number, when respondents were asked to rate their satisfaction with six items, appealing to Millennial customers still had the lowest rate of satisfaction – lagging behind areas such as digital banking (74%) and payment technology (76%).

The Importance of Improving
Even as community institutions might not be uniformly enthusiastic about their appeal for young customers, they do recognize the importance of getting better.

Of those respondents who expressed less than a “very satisfied” opinion of their appeal to Millennial customers, 69% saw this as an important area in which to improve. To put this in perspective, branch delivery, which was ranked only slightly higher than appeal to Millennials in satisfaction (65% compared to 61%, and fifth out of the six items), was not similarly prioritized for improvement by respondents (56% compared to 69%, and last out of the six).

In other words, the importance of improving was not based on how badly the institution felt it was performing; rather, these leaders seem to realize that catering to the younger generations is a key factor for their institutions’ future success.

The Struggle is Real
As the financial industry continues to struggle to figure out what Millennials want from their bank or credit union, the conundrum is proving more difficult for some institutions than others.

For example, the challenge of attracting new and younger customers was greatest for those institutions on the low end of the asset scale, with 61% of these respondents (in the $200-$499 million asset range) finding the problem tough to tackle, compared to a 52% average among the other asset sizes. Further, community banks (57%) see the Millennial issue as a much bigger challenge than do credit unions (45%).

Likewise, when it comes to measuring their institution’s appeal to Millennials, the smallest institutions ($200-$499 million) again see the biggest issue, with 21% in this range expressing dissatisfaction with their appeal to Millennials, compared to an average of 12% among the other asset sizes. The largest institutions ($2-$4.9 billion), on the other hand, were most likely to be pleased with their efforts, with 65% expressing satisfaction, compared to 59% on average from the asset sizes below them.

Those community banks and small institutions that see themselves as behind the curve with Millennials, however, are also among the most eager to try and catch up – 34% of community bank executives who weren’t “very satisfied” with their institutions’ appeal to Millennials said it was very important to improve, versus just 24% of those in credit unions with the same outlook. Similarly, 41% of executives from institutions with $200-$499 million in assets said it was very important to improve, while only 29% from the larger asset sizes on average prioritized improvement.

Whether reevaluating branches or expanding their digital presence, community institutions know that bringing Millennials into the fold is crucial to their future growth. The question going forward will be how best to get the attention of these customers of tomorrow, and how best to show them the value of a long-term relationship with their community institution.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

December 7, 2017
Community Mindset: Reassessing the Branch Network

Branches have been a touchy subject for community institutions for some time, with the industry split between the idea that the physical branch has outlived its utility as a viable channel and the notion that it is but a glittering high-tech makeover away from reclaiming its former prominence for today’s customers.

There may be no clear consensus in this debate, but one thing is certain – thousands of branches have closed since the financial crisis of 2008, and the march in that continued direction is fairly clear. While they cannot dispute the numbers, proponents of the physical branch remain optimistic about its future prospects, attributing many of those closings to the consolidation of larger institutions in the wake of mergers and downsizing.

Yet whether or not the physical branch is actually dying, it is indisputable that the strategic value of their branch networks has changed dramatically for community institutions over the past decade.

Low Priority
When asked to rate the importance of a variety of potential factors for growth in their institutions, respondents in the FMS study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017 placed a low priority on adding branches, with 47% viewing it as either very or somewhat important – good for last place among eleven choices; an additional 31% of respondents were neutral on whether or not adding branches would help them grow. While such attitudes do not necessarily portend doom for the future of the physical branch, neither do they demonstrate the robust confidence in a longstanding delivery channel that may have existed just a few short years ago. Further, respondents did not prioritize branches when it came to potential cost-saving measures within their institutions, with only 18% identifying branch expenses as the best opportunity for cost management. On the bright side, this could indicate that institutions have no plans to scale back their branch networks in search of savings. However, it may also signal that institutions are running their branches as close to the bone as possible already, thus leaving them with little left to trim.

Despite the seeming lack of enthusiasm for branches, 65% of respondents said they were satisfied when asked for their opinion on branch delivery at their institution, with those in the smallest asset grouping ($200-499 million) most likely to be very satisfied. However, when ranking a variety of their concerns, satisfaction with branch delivery came in only fifth out of six possibilities, lagging behind options such as satisfaction with payment technology (76%), digital banking (74%), cybersecurity (73%) and data analytics (68%).

Respondents who were not “very satisfied” with the six presented concerns were further asked how important it was for them to improve in these areas. Of the respondents who weren’t very satisfied with branch delivery at their institution, 56% deemed it important to improve while 35% were neutral on whether it was important. In this case, branch delivery ranked dead last in the six areas considered important to improve, falling in line behind cybersecurity (79%), payment technology (71%), appeal to Millennial customers (69%), digital banking (67%) and data analytics (64%).

Holding Steady
Why has the branch network fallen on the to-do lists of community institution leaders? Perhaps the best answer might be the easiest: if it’s not broken, there’s no need to fix it. For example, 46% of respondents said that they’re satisfied with their current branch network, and don’t feel the need to either add or close branches – an opinion held most strongly among those institutions in the smallest ($200-499 million) and largest ($2-4.9 billion) asset groups.

Supporting the “if it’s not broke” hypothesis, only 18% of respondents said they were looking to close branches, while 36% said they were actually hoping to expand and add branches. After all, why change anything when 72% of respondents said their customers were satisfied with the branch experience? These institutions might just be keeping things how their customers like them (for now).

Additional insight on the future of branches comes from looking at what’s rising to the top of priorities as branches drift toward the bottom – namely, technology. Among the eleven growth priorities offered for ranking, technology came out on top (73%) while branches languished in last. Similarly, when respondents were asked about the best opportunities for cost management, 65% saw improving efficiency through technology as their best bet, compared to the 18% that went with branch expenses. Finally, when asked about their satisfaction with and investment in a variety of areas, improving branch delivery fell behind a host of technology-related concerns, including cybersecurity, payment technology, digital banking and data analytics.

The Evolution of the Branch
Of course, technology investment and a healthy branch network aren’t necessarily mutually exclusive pursuits. In fact, incorporating technology into branches was important to many respondents in the survey. When asked about branch upgrades, 36% said they planned to add features, with 33% expressing specific interest in interactive tellers. An additional 24% were redesigning, while 27% had no plans to change or update their branches at this point.

Perhaps that 27% were waiting, like the rest of the industry, to see just where branches might be headed. The drumbeat of technology is, of course, inexorable, but it’s hard to say for certain what the ultimate affect will be on the look, feel and ultimate viability of the community institution branch.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

December 5, 2017
Can Risk Management Be Profitable?
By Alec Hollis, Director – ALM Strategy Group, ALM First Financial Advisors, LLC

As regulated as the banking industry is, risk management can seem like a “check-the-box” activity. In a great piece titled “The Profitable Side of Risk Management,” Michael Giarla rejects the perception of risk management as a necessary evil that detracts from bank profitability, and instead promotes the idea that proper risk management is an important factor to an institution’s success. While overregulation certainly is a hot topic today, proper risk management remains a timeless element in long-run profitability.

Central to most risk management programs is managing interest-rate risk (IRR), although strategies to manage and target this risk vary across the industry. Ultimately, an institution’s tolerance for IRR is set by its board. Given that some institutions are comfortable operating with higher levels of IRR than others, it’s worth asking whether higher levels of IRR are correlated with higher levels of profitability.

The answer is not so straightforward. There are many other, more material factors driving long-run profitability, such as lending standards and cost management. As such, one can see IRR management not so much as a profit center, but as a natural hedging response of a business focused in financial intermediation. Great institutions have strong risk governance programs in place, allowing them to scale and grow in a safe manner, and continue to do what they do best – serve their customers and their institutions without betting on interest rates.

As with any risk management program, minimizing risk isn’t a valid goal, all else equal. Risk avoidance can create shortfall risk, which can be detrimental to profitability. Instead, asset-liability management (ALM) programs should focus on quantifying risk and managing it to ensure the institution is making informed decisions. Ultimately, earning adequate reward per unit of risk is the name of the game. High-performing institutions often do this by integrating risk management with strategic planning, through the development of new products, services and processes.

High-performing institutions are also very aware of the current profitability and risks of their product lines. As the old saying goes, “a bank’s assets are its liabilities, and its liabilities are its assets” – meaning a stable cost of funds is a valuable asset, and credit concerns stemming from the asset side can bring a bank down. Having superior expertise in managing credit risk is extremely important to long-run profitability, which is why many institutions rely on risk-adjusted return on capital analysis.

Keeping track of all the risk-adjusted analysis acronyms might be harder than understanding the techniques themselves – RAROC, RORAC and RARORAC to name just a few. But despite the potential confusion, the goal is to get to a risk-adjusted return on allocated capital, which can in turn help the institution become a better capital allocator.

When making capital allocation decisions, capital is best allocated to its most efficient use. Efficiency is an idea discussed in modern portfolio theory, and one that applies to building a balance sheet. The general rule is that for any two investments (capital allocation decisions) with the same level of risk, the institution should choose the option with the higher expected return; conversely, given the same expected return, the investment with lower risk should be chosen. Additionally, the investment’s risk-adjusted expected return – adjusted for the associated marginal operating and credit costs – should exceed the marginal financing costs of the institution.

The table above shows a return on capital comparison of three potential investments – two loans and a securitized product. Despite the disparity between the three assets, all potential investments should be boiled down to their marginal impact on return on allocated capital to allow for cross-comparison. While an asset may have a lower gross yield, it may demonstrate a higher return on allocated capital after accounting for its risk-adjusted expected return, its marginal costs and its leverage resulting from the required capital allocation.

Such is the case in the following hypothetical example – the agency CMBS product has a lower yield than the auto loan, but after adjusting for expected credit cost, operational expense and capital allocation, it ultimately has a higher return on capital. Just as one shouldn’t judge a book by its cover, don’t judge an asset by its yield.

Risk management is important for many reasons, and shouldn’t be reduced to a regulatory task or seen as solely playing defense. To the contrary, proper risk management can provide CFOs and management with the confidence needed to support a robust offensive strategy. As history has shown, crises come and go – risk management should serve to protect the institution from the fluctuations of the business cycle, which is why risk-adjusted product profitability analysis is paramount.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Alec Hollis is a Director in the ALM Strategy Group at ALM First, where he performs asset-liability management strategy research, implements firm-wide ALM modeling procedures and helps execute balance sheet hedging programs for financial institutions

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