Industry Insights: Finance

March 18, 2019
Facing a Pause, Banks Must Stay Vigilant
By Scott Hildenbrand, Principal, Balance Sheet Analysis and Strategy, Sandler O’Neill + Partners

The U.S. economy remains strong, but there are clouds on the horizon. Unemployment is low, wages are rising and inflation appears contained. That said, in January U.S. consumer confidence, presumably sapped by the federal government shutdown and market turmoil, touched its lowest level in over two years. Trade tensions remain high, global growth continues to cool and a hard Brexit could send shockwaves across the Atlantic. We fear that renewed market volatility could feed into the real economy through reductions in consumer spending or business investment, thus hastening a recession.

Against this backdrop, the Federal Open Market Committee has decided to take a breather. Since the announcement, some officials have suggested that the Fed Funds rate could even hold the current range for the rest of the year. So what does a pause mean for U.S. banks?

A pause could prolong the economic cycle, which might translate into higher demand for loans and mute credit costs near-term. Still, since the announcement, the yield curve has remained flat, reflecting a strong bid for quality in these uncertain times, while funding pressures have remained acute.

The key question facing bank managers, investors and regulators is whether a pause will relieve deposit cost pressure at small and medium-sized banks. Unfortunately, we don’t see this happening.

Fundamentally, we believe that deposit costs are more a function of market dynamics than the absolute level of interest rates. Since the Great Recession, the deposit market has become even more concentrated, new entrants have been paying up for share, and technology has empowered consumers to find the best rate and transfer funds with one click – debasing or even disintermediating personal relationships from the deposit-gathering process.

Simultaneously, small and medium-sized institutions have been driving net interest margins by depleting on-balance sheet liquidity (cash and cash equivalents, marketable securities, salable loans). Fast forward to today, the median small or medium-sized bank’s loan-to-deposit ratio is approaching a cycle high while its securities portfolio is plumbing a fresh cycle low. Such low levels of on-balance sheet liquidity force banks to pay up to source or retain the marginal deposit. Structurally, small and medium-sized banks are price takers.

We saw more evidence of this phenomenon in the fourth quarter of 2018. On a year-over-year basis, core spread (yield on loans and leases less the cost of interest-bearing deposits) contracted four basis points to 4.16%. As for the dynamics, the yield on loans and leases advanced 35 basis points to 5.19%, while the cost of interest-bearing deposits rose 39 basis points to 1.04%. Moreover, the spread between core spread and NIM continued to tighten. The challenge is that, without remixing, NIM and core spread should move in relative lock-step, potentially pressuring earnings and profitability metrics.

FIGURE I: NET INTEREST MARGIN AND CORE SPREAD 1


1 Average yield on loans and leases less average cost of interest-bearing deposits
Sample: Banks with assets between $1 billion and $10 billion at December 31, 2018.
Source: Regulatory data as aggregated by S&P Global Market Intelligence.


In such a challenging operating environment, banks must stay vigilant and focus on the fundamentals.

8 BEST PRACTICES FOR CREATING FRANCHISE VALUE LATE IN THE ECONOMIC CYCLE

Strengthen your core. The goal is better banks, not just bigger banks. Banks should focus on improving core pre-tax, pre-provision return on assets (core PTPP ROA; core earnings excludes nonrecurring accruals, such as securities losses or one-time gains). Core PTPP ROA excludes volatile credit metrics and tax strategies, exposing a bank’s true earnings power and allowing for apples-to-apples benchmarking to high-performing and regional peers. Critically, a stronger core PTPP ROA protects earnings and capital from higher credit costs. Of course, we fully appreciate that a bank’s primary responsibility is to deliver a compelling risk-adjusted return on the capital entrusted to it by shareholders. Having said that, we believe that at this point in the cycle, focusing on return on assets (ROA) will drive a higher return on equity (ROE) over the long run.

Align incentives with desired outcomes. Specifically, consider incorporating core PTPP ROA into short and long-term incentive plans. Doing so creates space for forward-looking, franchise-enhancing tactics (a loss trade, liability restructure, branch rationalization, etc.). Also, within short-term and long-term incentive plans, make sure that the weights assigned to loan and deposit origination, fee generation and credit look-backs reflect the institution’s objectives and risk tolerance.

Weaponize the inverted swap curve to reduce funding costs. Recent simplifications to hedge accounting have made hedging much more viable for community banks, and various off-balance sheet strategies are worth exploring due to these changes and market pricing. One such strategy synthetically creates fixed rate funding, reduces funding costs and creates accounting symmetry in other comprehensive income (OCI), protecting GAAP capital from higher rates. Bank managers must have a firm grasp of their off-balance sheet options, and begin the education process well before they project needing to implement.

Create shelf space for higher funding costs through a securities portfolio optimization. Take advantage of the rally in the bond market to optimize the securities portfolio. Loss programs can be tailored to enhance book yield and core earnings. Since most of the unrealized loss is already housed in OCI, GAAP capital ratios should not move meaningfully (though regulatory ratios will decline). As always, managers have to consider the impact on duration, convexity and credit profiles.

Challenge managers to think broadly about their options. For example, numerous public banks have asked whether they should pursue a loss trade or repurchase stock. In our judgement, viewing these two tactics as mutually exclusive is far too restrictive; for the right story and balance sheet, they can be mutually reinforcing. Imagine a scenario in which management announces a share repurchase program with clearly defined earn-back parameters. This signals that the stock is cheap in the current range. In conjunction, management announces a loss program, which will bolster core earnings and profitability metrics. This signals that management is pulling every lever to drive high-quality earnings, which amplifies the signal from the buyback, creating a positive feedback loop.

Price loans for late cycle risk. The Federal Reserve’s Senior Officer Loan Surveys show that banks are reluctant to increase loan rates over cost of funds, with 80% of respondents to the January 2019 survey saying that loan rates over cost of funds remained unchanged or narrowed over the past three months for commercial and industrial loans or credit lines to large and middle-market firms. Furthermore, 90% of banks that reported loosening credit standards cited more aggressive competition from other banks or nonbank lenders as a reason for doing so. In short, banks are letting other institutions dictate their risk-adjusted return parameters. We’ve seen this movie before and we know how it ends: badly. The bottom line is that corporate credit spreads have widened and we’re in the latter innings of the economic cycle, both of which mean that loan pricing models and new loan rates should be adjusted in turn.

Focus on risk-adjusted returns, not accounting designations. Banks often say that they only take credit risk in their loan portfolios. We encourage banks to be more flexible, focusing more on risk-adjusted returns and less on specific instruments. For example, if the board has authorized the purchase of national syndicated loans, an institution should also take a look at high-quality collateralized loan obligations (CLOs). Of course, everything must be done in moderation – we’re simply encouraging flexibility without overly restrictive accounting designations.

Create “self-help” through expense rationalization. As revenue headwinds gain force, cost takeout will become increasingly important to sustain earnings growth. Branch networks remain ripe for review as consumers migrate to digital delivery channels. Once savings are identified, take a hard, honest look at mobile and online budgets. If you’re light, reallocate a portion of the brick and mortar savings, and let the residual fall to the bottom line. Remember that playing catch-up is always more expensive.

COMMUNICATE PROACTIVELY WITH ALL STAKEHOLDERS


At this point in the cycle, it’s back to basics for banks. A critical but often overlooked fundamental business practice is to communicate strategic or tactical shifts, clearly and succinctly, to all stakeholders – customers, regulators, investors and employees. All stakeholders should readily acknowledge that bankers have to navigate the trade-offs among soundness, profitability and growth continuously with no margin for error. They should also acknowledge, in an honest and forward-looking moment, that safety and soundness is the most important leg of the banking stool. So as you weigh your options, make sure that you can explain how your final decisions reinforce your commitment to these essential, mutually dependent principles.




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

Scott Hildenbrand is a Principal and Chief Balance Sheet Strategist at Sandler O’Neill + Partners, L.P. He heads the Balance Sheet Analysis and Strategy group, which works with financial institutions on asset-liability management, capital planning and investment portfolio funding and hedging initiatives.


December 3, 2018
Hedging to Cope with Interest Rate Uncertainty
By Ira Kawaller, Managing Director, HedgeStar

Most market observers face a conundrum. After seeing a change in prices in virtually any market, it’s difficult to discern whether said change reflects the beginning or continuation of a trend in that direction, or if the change is a temporary distortion soon to be reversed. With interest rates, however, we have a unique consideration – the Federal Reserve (the “Fed”).

The Fed has unparalleled influence in this sector, and seasoned forecasters know better than to ignore the Fed’s public statements. As of this writing, the Fed is unambiguously projecting interest rate increases. Of course, this projection rests on an expected continuation of the current economic expansion, as well as a sanguine outlook for inflation. While both of these forecasts will likely be tested at some point in the future, the Fed can be expected to signal any revision of its sensibilities if and when they were to change. Until then, however, higher interest rates seem most likely.

The more relevant question, then, is not whether interest rates will rise, but rather how high they are likely to go. Answering this question requires at least enough humility to admit that nobody knows for sure – not even the Fed. That said, interest rate futures markets offer clues as to consensus expectations for a variety of benchmark interest rates. For example, with one of the most actively traded futures contracts, three-month LIBOR is one such benchmark rate. These contracts effectively reveal where this key interest rate is expected to be at three-month intervals over the next 10 years. And while futures prices adjust with trading every day, they offer explicit, objective forecasts at any point in time.

We can also look to bond and note futures, fed funds futures and swap futures for analogous forecasts of other benchmark interest rates. Besides offering rate-specific forecasts, these various futures prices serve as the foundation for pricing a broad array of over-the-counter interest rate derivatives.

Building a Hedge
While it’s generally understood that interest rate derivatives can protect against rising or falling interest rates, the starting point for the protection derives from futures pricing curves as of the date the derivative is transacted. Thus, if a hedger wanted to use a derivative to lock in an interest rate today, the rate that would be available to that firm would be consistent with the consensus forecast. In other words, the hedger seeking to lock in rates would have to accept the consensus forecast rate as its hedging objective – regardless of whether the spot interest rate happens to be higher or lower than that consensus forecast rate at that time.

Depending on the nature of the exposure, the difference between current spot interest rates and the implied forecasted rates underlying interest rate derivatives might be adverse or beneficial. These days, for instance, with consensus forecasts anticipating rate increases, hedging with derivatives tends to impose somewhat of a cost for hedging against rate increases, while at the same time offering a benefit to entities faced with the opposite risk of falling interest rates. (If you can borrow today at 5%, but the market offers the opportunity to lock up a future funding cost of 5.5%, you’re forced to accept a 50 basis point penalty; on the other hand, if you can invest at 5% today, that same derivative would let you invest in the future at 5.5%, thereby offering a 50 basis point benefit.)

Consider the case of a commercial entity that expects to issue three-year debt in the coming four months, where the prospect of higher interest rates has stimulated interest in entering into an interest rate swap to lock in the interest rate on an intended funding. Three critical questions would have to be asked:

1. What benchmark interest rate can be secured for the three-year period starting in four months? (This question distills to getting a quote for the fixed rate on a forward starting three-year swap.)
2. What is the credit spread that the firm would likely bear, relative to this benchmark interest rate?
3. Given the expected all-in rate (i.e., the swap’s fixed rate plus the expected credit spread), what portion of the interest rate exposure that the firm is facing should be hedged?

In the current environment, this all-in interest rate should be expected to come in at a rate higher than the cost of funds that the company would bear if it were to issue debt today. This higher-than-today’s interest rate might discourage the company from hedging, but it shouldn’t preclude it. The appropriate question is how much of the exposure should be addressed with a derivative, given the fixed rate level that the derivative allows the firm to access?

Dealing with Uncertainty
Along with the implied fixed rate available with the derivative, a complementary consideration is the business judgement as to the probabilities associated with interest rates ultimately falling below, reaching or rising above the implied rates underlying the derivative. It should be clear that if the market for swaps allowed this prospective borrower to lock in an all-in cost of funds at, say 5%, while at the same time expecting rates to rise even higher, hedging would be particularly attractive. On the other hand, hedging would be less attractive if the firm didn’t expect market interest rates to rise above 5%. Extending this line of thinking further, it may be interesting to realize if the consensus forecast reflected in the pricing of the derivative were actually realized (which shouldn’t be expected), the swap wouldn’t generate any payoff whatsoever – the company would realize identical earnings regardless of whether it hedged or not.

Unfortunately, the calculus becomes more complicated because we live in a world of uncertainty. The idea of not hedging at all because we don’t expect market rates to surpass the threshold of the implied forecast of the derivative is problematic because we might be wrong. Thus, even if we might not believe the rate will move beyond that critical value, it may still be reasonable to hedge some portion of an existing exposure. Put another way, even though the market conditions force the hedging entity to lock-in an implicit rate increase dictated by the price of the swap, it’s the probability that interest rates could move even higher that would justify hedging, even at a seemingly elevated interest rate.

Employing the swap serves to eliminate the uncertainty that would otherwise prevail if the exposure were left unhedged. With the swap, the company should have a high degree of confidence that the anticipated all-in funding costs initially calculated would be realized (subject to accurately forecasting the credit spread) for the portion of the exposure that the company chooses to hedge.

Managing a Hedge
Thus far, the discussion has focused on how much to hedge at the start of the hedging process, but hedging deserves reconsideration both periodically and whenever economic circumstances change in material ways. Suppose, for example, an initial hedge was initiated to protect against a rate increase that ultimately materializes. But suppose further that with time remaining before the hedge expires, the market has evolved, and now it now seems more likely that interest rates could retreat. Does it make sense to maintain the hedge in the face of these changed circumstances? Probably not. As time passes and perceptions change as to the probabilities associated with adverse price moves, or if the company’s risk tolerances change, the degree of hedge coverage could be adjusted – either up or down. Critically, just because a derivative contract hasn’t expired doesn’t necessarily mean it’s prudent to maintain hedge coverage.

Clearly, an orientation that favors a dynamic hedge adjustment process could open the door for abuse. Consider the case of the company that starts out with a hedge of 50% of some exposure. Assume that the firm perceives the risk as being more pressing, thus adjusting its hedge coverage to 75%. Later, the company reassesses conditions and decides that the expected adverse rate move has run its course such that rates now are expected to move beneficially. With this reassessment, the firm decides to reduce its hedge coverage down to 25%.

Throughout this adjustment process, this firm could represent that it is mitigating risk, albeit at varying degrees. Still, while it might be appropriate to observe these kinds of hedge adjustments over weeks or months, an objective observer would likely have a problem with these kinds of adjustments if they were made over the course of a single trading day! The moral here is that hedge adjustments should be implemented on the basis of some previously devised plan that reflects the company’s risk management orientation and policies. Thus, a mechanical rule that imposes an objective discipline on the hedge-adjustment process is preferable to ad hoc assessments relating to adjusting hedge positions. Unfortunately, it’s not clear that any single rules-based approach will be appropriate in all circumstances.

When considering an objective hedge management plan, it’s critical to be sensitive to two opposing concerns: if you’re starting with partial hedge coverage and interest rates move adversely, it’s natural to want to increase the degree of hedge coverage; on the other hand, at some point, the prospect of interest rates achieving a top (or bottom) might gain greater currency. Prudent managers will periodically review their hedge coverage and adjust their plans accordingly, reflecting a forward-looking orientation as to the changing probabilities associated with future interest rate changes.

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

Ira Kawaller is a Managing Director of HedgeStar, a Minnesota-based consulting firm that specializes in derivatives strategies, valuations and hedge accounting services.


September 24, 2018
Evaluating the Liquidity Within Your 1-4 Family Portfolio
By Mark Cary, Sr. Vice President, FTN Financial Capital Assets

As loan-to-deposit ratios and liquidity ratios reach five-year highs and lows, respectively, now is the time to take stock of all of your potential liquidity options. While most liquidity contingency funding plans include options for raising deposits, selling investment securities or obtaining other funding (such as FHLB advances), one often overlooked option as a valuable source of potential liquidity is the 1-4 family first lien mortgage portfolio.

As loan-to-deposit ratios and liquidity ratios reach five-year highs and lows, respectively, now is the time to take stock of all of your potential liquidity options. While most liquidity contingency funding plans include options for raising deposits, selling investment securities or obtaining other funding (such as FHLB advances), one often overlooked option as a valuable source of potential liquidity is the 1-4 family first lien mortgage portfolio.

Got Liquidity?
In 2014, the national marketing arm for the dairy industry retired the popular “Got Milk?” ad campaign that featured celebrities in milk moustaches, but let’s use a twist on the once-popular ad campaign to highlight the need for liquidity in today’s market. Figure 1 below highlights the increasing loan/deposit ratios for banks. This increase, coupled with an increasing cost of funds, can put a real strain on liquidity (and earnings).


Figure 1: U.S. Commercial Banks and Savings Banks (250M-$25B) - Loans-To-Deposits Ratio


Cost of Funds Is Also Rising (Significantly)
As Figure 2 indicates, cost of funds – which is comprised largely of interest-bearing deposits – has increased recently, and it does not seem like this will be ending anytime soon. With digital deposits on the rise and the availability of information on the internet about competing deposit accounts, the war for deposits will likely be more intense than it has ever been.


Figure 2: U.S. Banks ($250M-$25B) - Cost of Funds, Trailing 8 Quarters


Traditional Sources May Not Be Enough
While it has yet to be seen, the impending war for deposits may cause financial institutions to consider sources of liquidity outside of their usual arsenal. Normally, a financial institution’s potential remedies for a shortfall in funding include, but are not limited to:

1. Selling Available-for-Sale (“AFS”) securities
2. Raising rates on deposits
3. Tapping non-core sources such as brokered deposits, FHLB advances or other lines
4. Loans from correspondent banks


As rates rise, the costs for implementing the above strategies could get very expensive. A potentially more efficient option is the liquidity that resides within the on-balance-sheet portfolio of 1-4 family mortgage loans.

The 1-4 Family On-Balance-Sheet Portfolio as an Alternative
The 1-4 family loan portfolio represents an often overlooked source of potential liquidity. Of all loan product types, the 1-4 family portfolio often includes the most liquid and most price-efficient loans from a secondary marketing standpoint, and can be segregated into three separate liquidity grades as follows:

Agency Grade
Loans in this category meet all the general criteria for purchase by one of the agencies (Fannie Mae or Freddie Mac) subject to a loan file documentation review. These are loans that were agency-eligible at origination or could be agency-eligible as the loans season or some corrective action is taken.

Private Grade
Loans in this category may meet one or more of the criteria for being eligible for purchase by the agencies, but are acceptable for purchase by private investors (usually other financial institutions) subject to a loan file documentation review. These loans would be subject to standard secondary marketing guidelines as related to FICO score, LTV, DTI, etc.

Portfolio Grade
The loan data fails one or more criteria for purchase in the standard secondary mortgage market. The loan may be a good credit risk and a performing asset, but from an economic perspective, its profile indicates it should be retained in the portfolio rather than being sold in the secondary market. In other words, the price to sell into the secondary market is quite a bit lower than the value to hold the loans to term.

Agency and private grade loans are collectively referred to as “investment grade” and are the MOST LIQUID loans within the entire loan portfolio. Over 80% of the loans in the average portfolio meet these criteria, representing a large source of untapped liquidity.

Strategies to Improve Liquidity Using Whole Loans
As with any strategy involving the balance sheet, it is important to understand all potential options. When evaluating funding strategies, one additional option to consider is the sale of a pool of loans. Strategies utilizing whole loan sales can be structured as follows:

1. Bulk seasoned MBS securitizations using one of the agencies (Fannie Mae or FHLMC) as a guarantor
2. Whole loan transactions from one institution to another
3. Participation transactions

Each of these strategies can be accomplished on a serviced, released or retained basis

Another “Liquidity” Arrow in Your Quiver

When preparing your Liquidity Contingency Plan, it is important to include the 1-4 family portfolio as a potential source of liquidity along with other more traditional sources. Doing so will provide you with another arrow in your liquidity quiver.


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

Mark Cary is a senior vice president and loan sales manager for FTN Financial Capital Assets, drawing on his more than 30 years of experience in the a financial institution industry to assist clients in developing strategies to better manage their loan portfolios. He is a member of the AICPA and the Tennessee Society of Certified Public Accountants, and is an adjunct professor in the Finance, Insurance and Real Estate Department of the University of Memphis.


September 3, 2018
Manage Vendors to Manage Risk
By Terry Ammons, Systems Partner, Porter Keadle Moore

Banking at its core is the business of managing risk for others. From deposit accounts to payment options and loan products, the entire culture of an institution is centered on identifying, controlling and responding to risk. Despite this, however, one area where the financial services industry is still struggling to succeed is vendor risk management.

Today, third-party vendors are ubiquitous within modern businesses, and financial institutions are no different. Working with technology partners requires institutions to accept a certain level of risk that must be managed both internally and externally. While regulatory, compliance and security issues still resound as top priorities for bankers, when choosing to work with new tech providers, the best approach to risk management is not avoidance, but a deeper understanding that helps the institution identify, prioritize, control and respond to any event that may cause a business interruption.

The hard truth is that responding to risk after a breach or incident has occurred is potentially more expensive – to the bottom line and to reputational brand equity – than implementing the necessary steps to safeguard the institution from the beginning.

Not All Vendors Are Created Equal
While regulatory compliance is not specific to banking, compared to most other industries, banks and credit unions have a much higher bar to reach when developing internal risk management programs. Federal regulators are closely evaluating the institutions they are charged with overseeing, and bankers must be vigilant in holding risk management programs to the highest level of scrutiny. Since a disaster in one area of the bank or credit union can affect the entire institution, risk management is an enterprise-wide concern and should be dealt with as such. This includes incorporating risk management efforts into the institution’s culture, organization, processes, technologies, personnel and physical infrastructure.

The first step toward creating a successful vendor management program is to categorize risk on a sliding scale of priority. Some institutions mistakenly apply the same level of risk to each of their vendors – regardless of the service provided, the level of access granted or the type of data shared. This can be a time-consuming and oftentimes damaging approach, as some vendors pose a larger threat to an institution than others. For example, some vendors will pull more sensitive information from a bank, which naturally necessitates a higher level of scrutiny on the bank’s part. By categorizing vendors based on risks, institutions can help focus their efforts and better ensure that nothing slips through the cracks.

Build Your Safety Net
While an institution may lack direct control over its vendor and their systems, it is nevertheless the institution’s responsibility to ensure that proper safeguards are in place to protect itself, its customers’ information and the integrity of the institution/vendor relationship. After evaluating and determining the risk profile of each vendor, the institution must conduct its own due diligence to ensure that the vendor is upholding its end of the contract.

The vendor bears some responsibility here as well. Regardless of risk assignment, a vendor must provide documentation that demonstrates its security arrangements and controls. While this usually occurs in the beginning of a vendor relationship, institutions should require their partners to provide quarterly and annual reports and analysis of their systems to satisfy not only the institution’s requirements, but its regulators as well.

Ideally, evaluation will be an ongoing effort that does not impede day-to-day operations. After all, even if everything is in place in the beginning of the relationship, those same controls may not necessarily be sufficient in the future. Specialized access to consumer information not only requires protections to be in place, but also to evolve with the changing cybersecurity landscape.

The relationship between vendor and banker needs to be a symbiotic one. For example, banks and vendors alike should work closely to outline the steps necessary to ensure services are restored in the event of an outage, with both organizations assuming responsibility for their part of the equation. To create a comprehensive due diligence program, vendors should provide their own internal and external IT audits to validate the controls they have in place. While this is the ideal, it is too rarely the reality.

Response Tactics
With an extensive range of risk touch points for financial institutions, even seemingly innocuous events such as missing a patch or an employee clicking a malicious email link can lead to enterprise-wide threats. Thus, a bank or credit union’s risk management strategy must also include steps for how to mitigate damage once a breach has occurred. Even with a robust due diligence process and regular audits to ensure compliance, an event can occur – hackers, unfortunately, are still very good at their jobs.

There are a few options to deal with an interruption once it has occurred: remediation, mitigation and acceptance. With an effective risk management and vendor management program in place, these attacks will be limited in scope and occurrence, but still may cause an inconvenience for the institution at the least and a breach of sensitive data in the most severe instances. It is at this point that an institution can learn firsthand where any missteps may have occurred, and if the vulnerability was previously unknown. Of course, every institution wants to avoid this situation, but when and if it does occur, it is certainly better to emerge with more robust controls and an example to assist other institutions in protecting themselves.

There is a balancing act between evolving business requirements and meeting the latest security standards – one that provides little room for error. Integrity of data must be ensured on the vendor’s side, with the institution setting expectations early on in the relationship, and then reevaluating those expectations throughout the life of that partnership. There is no finish line in reaching and maintaining compliance – it is an ever-moving target that requires constant monitoring.


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

About the Author

Terry Ammons, CPA, CISA, CTPRP is Systems Partner at Porter Keadle Moore (PKM), an Atlanta-based accounting and advisory firm serving public and private organizations in the financial services, insurance and technology industries.



August 10, 2018
Securing the Most Favorable Prices for Securities Transactions
By Robert Segal, CEO, Atlantic Capital Strategies, Inc.

Banking regulations require that financial institutions implement robust systems to monitor, manage and control risks related to investment activities. The agencies state further that effective management of the risks associated with securities represents an essential component of safe and sound practices. The FDIC, for example, says it is prudent for management to fully understand all relevant market and transaction risks. Accordingly, management has the responsibility to put systems in place to assure that all reasonable efforts are made to obtain the most favorable price for each securities transaction.

The market for fixed-income securities has evolved significantly in recent years. However, according to the Financial Industry Regulatory Authority (FINRA), the amount of “pre-trade” pricing information (bids and offers) is still relatively limited as compared to equities, and generally not readily accessible by the investing public. While new technology and communications in the fixed-income market have advanced, the market remains decentralized, with much trading still occurring on an over-the-counter basis.

Compared to equities, transaction costs for fixed-income securities remain stubbornly high. Academic studies have shown that transaction costs for even small orders of equities are a few pennies per share, while commissions for corporate and municipal bonds can be several dollars per $100 of bond principal value, or one hundred times higher or more.

Approximately ten years ago, the SEC instituted a “post-trade” reporting system that distributes information about bond transactions. Under the program, dealers are required to report, with a 15-minute delay, the price and quantity of every transaction. Corporate bonds were the first sector in the platform, followed by municipals and agencies, and more recently, Treasuries and mortgage securities. This innovation improved transparency by allowing investors to obtain more current information about market values.

In a recent regulatory notice, FINRA reiterated its commitment to best execution as a key investor protection requirement. The agency noted that in light of the advanced nature of fixed-income markets, brokerage firms need to regularly review their procedures to ensure they are designed to incorporate and reflect best execution principles, as the broker is “under a duty to exercise reasonable care to obtain the most advantageous terms for the customer.”

FINRA requires that brokerage firms establish, maintain and enforce robust supervisory procedures and policies regarding “regular and rigorous reviews” for execution quality. As part of its own regulatory reviews, FINRA conducts statistical analyses, establishing pricing parameters for comparison to other transactions in the same security. In fact, if certain transactions show a meaningful variance, FINRA may deem the firm to be in violation of best execution principles.

It is important to keep in mind that best execution does not always mean the lowest possible price. In its Trust Examination Manual, the FDIC said management should consider other factors when determining the quality of execution, including quality of research provided, speed of execution and certainty of execution. Regulators also recognize that obtaining quotes from too many sources could adversely affect pricing due to delays in execution and other factors.

Given the regulatory environment and improvements in transaction reporting, bank management may wish to implement a “back-testing” program to assure that the institution is receiving the most favorable prices for securities transactions. This surveillance tool could compare the institution’s pricing to prevailing market prices at the time of the trade, while also analyzing the bid/offer spread to confirm that the transaction “mark-up” was fair and reasonable.

A direct benefit is that the financial institution should see improved profitability as it routes business to brokerage firms that provide the lowest overall transaction costs. Corporate governance can be enhanced as risk management policies and procedures continue to be strengthened.

As the programs evolve, bank treasurers can ultimately establish a system for evaluating broker/dealer performance. The FDIC requires that financial institutions develop and approve an effective vendor management program framework. What the FDIC is looking for, according to industry observers, are well-defined documentation processes. The regulators see vendor risk management as needing continual monitoring and ongoing risk assessments.

Finance officers typically scrutinize the P&L in a finely-tuned manner. At the same time, most bankers acknowledge they don’t know what they’re paying for brokerage costs for securities transactions. Transaction costs can vary greatly based on the scope of the transaction and access to the most liquid dealers. A review of individual transactions indicates that investors may be “leaving a lot of money on the table.” Thus, a more diligent approach toward trading efficiencies could help support the bottom line.


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

About the Author

Robert Segal is the founder and CEO of Atlantic Capital Strategies, Inc., which provides investment advisory services for financial institutions. He has over 35 years of experience in the banking industry, having worked in several community banks with roles in mortgage banking, sales and trading and ALM. Bob is also currently a Director-at-Large on the FMS Board of Directors.



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.

Originations
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
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.


OCTOBER 16, 2017
Understanding discounted cash flow modeling as an option for CECL  
By Brandon Quinones, Risk Management Consultant, Sageworks

One of the main impetuses for changing the prevailing model for estimation of the allowance for loan and lease losses (ALLL) was the FASB’s view that reliance on historic information to determine “incurred-but-not-realized” losses in reserve calculations did not allow institutions to adjust reserve levels given a reasonable and supportable expectation of future events. Thus, a new standard requiring institutions to “… estimate expected credit losses over the contractual term of the financial asset(s)…” and “…consider available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts.”1

Contractual v. Expected Cash Flows
When estimating losses using a discounted cash flow (DCF) approach, expected cash flow models are appropriate for reserve calculation under the new standard. A few material differences between the two calculations are modeling factors such as prepayment, default estimates, loss estimates and recovery activities that otherwise would not be used in a contractual cash flow calculation.

Track movement of loans by segment
to identify trends in portfolio growth
Approach
To calculate and apply these tendencies, the following inputs are critical to the calculation of discounted cash flow:



Of all the portfolio assumptions noted in the table, perhaps the most important to calculate are the Probability of Default (PD) and Loss Given Default (LGD).

PD and LGD are parameters that can be leveraged by institutions in a standalone measurement. Institutions currently using a PD and LGD approach for current GAAP may make an effort to calculate a lifetime PD and a symmetrical LGD to determine a rate for loss in an attempt to accomplish life-of-loan requirements as part of the new standard.

BENEFITS
Long-Term Assets
Calculating and understanding the average life and/or prepayment rate of a loan/loan type (e.g., CRE, Mortgages, C&I) is mandatory when calculating the expected credit losses.

An institution calculating its life-of-loan loss experience utilizing methodologies such as Vintage Analysis, Migration, PD and LGD, and/or Static Pool analysis will require look-back periods sufficient to cover the expected life of the pool. For example, if a loan pool has an average life of four years, an institution would need four years of data to conduct a single four-year observation of losses, and such a data set would only be inclusive of loans that were on the balance sheet four years prior.

A DCF approach can employ recent, shorter-term observations for deployment in a forward-looking amortization schedule. DCF is, and will be, a preferred methodology for calculating the reserve of longer-lived assets.

Readily Available Industry/Peer Data
In instances where loan pools lack loan-counts to be statistically relevant, haven’t experienced a material amount of defaults/losses during periods where data is available and/or have new portfolios that are more analogous to industry/peer experience, a DCF best accommodates alternative measurements while maintaining institution-specific risk.

In using DCF, financial institutions may deploy industry-level PD, LGD and CPR (Conditional Prepayment Rate) toward their own loan structures for a reasonable and possibly more relevant expectation of life-of-loan loss.

Forecasting
The CECL standard frequently references concepts related to making adjustments based on reasonable and supportable forecasts2, concepts that are most logically addressed by using a DCF methodology. In projecting expected cash flows, each period within a forward-looking amortization schedule can/will vary slightly based on future expectations of external/economic data.

CHALLENGES
By its very nature, executing an expected cash flow schedule for each loan every month/quarter may not be practical in a spreadsheet environment. On the other hand, institutions utilizing a third-party provider may run into challenges recording the loan data required to build an accurate amortization schedule.

The process starts and ends with developing policies and procedures around the ongoing maintenance of loan-level data. Every institution should begin to define rules for storage and/or maintenance of data. By taking steps now, financial institutions will find themselves in a position to calculate a reasonable and supportable reserve.

1 ASU 326-20-30-6
2 ASU 326-20-30-7


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

Brandon Quinones, Risk Management Consultant, Sageworks
Brandon Quinones is a Risk Management Consultant in the Bank Division at Sageworks, where he primarily focuses on helping community banks and credit unions manage their allowance for loan and lease loss (ALLL) provisions.