Industry Insights

March 25, 2019
Banking M&A 2019: The What and the Why
By Neil Dhar, Partner and Head of Financial Services, PwC

In all of 2017, there were $33 billion in announced deals among U.S. banking and capital markets firms. After six weeks in 2019, we had already passed that level.

What’s going on?

There are many factors that underlie any given transaction. But there are also some broad themes at work in the market, and we expect them to continue for the foreseeable future. Whether you’re a would-be acquirer or a potential target, this is a good time to review some trends and consider how they might apply to your own institution. In fact, two recently announced transactions – the $28 billion proposed merger between BB&T Corporation and SunTrust Banks, and the $3.6 billion combination of Chemical Financial Corporation and TCF Financial Corporation – say a lot about where the industry may be heading.

Innovation and digital capabilities
For several years now, the largest U.S. banks have grown significantly faster than their regional competitors. We believe this trend is due to two factors: a sustained push to develop strong digital capabilities at scale, and more successful, better-funded marketing efforts. Some of the strongest customer growth in retail is being driven by millennials and older, wealthier clients; PwC analysis shows that both of these groups tend to be especially responsive to digital and marketing strengths.

Between 2011 and 2014, the biggest U.S. banks accounted for nearly two-thirds of deposit growth and virtually all the net growth in debit cards, which is a good proxy for consumer checking accounts. Given their scale, these players can significantly out-invest other banks in brand marketing, data analytics and digital products and services. The converse is also true: financial institutions that don’t, or can’t, invest to achieve digital capabilities at scale are finding themselves at an ever-greater disadvantage. With both of these deals, the banks involved cited their desires to invest in innovation and digital capabilities as a strategic reason for the deals.

Favorable deal economics
Higher-priced deals typically require aggressive synergy and growth targets to create attractive returns. Our research has shown that more than 50% of banks fail to achieve their growth-adjusted cost synergy targets. However, recent deals referred to as “mergers of equals” (MOEs) have found a sweet spot, where both sides structure a deal with book value multiples and targets that might reward all stakeholders.

Recent transactions are setting a new standard for attractive bank deals. In 2018, bank transactions averaged above 1.8x a target’s tangible book value (TBV), and as high as 3.2x. At around 1.7x, the BB&T-SunTrust and Chemical-TCF mergers represent great prices for strong organizations. These deals appear to have been priced reasonably, and this increases their chances of generating the desired return on investment.

Further, when banks link up, they typically announce that they will see synergies (cost savings) ranging from 10-45% of the acquired bank’s non-interest expense. Our experience with bank integration shows that synergy targets in the 20-30% range tend to be conservatively achievable. Synergies greater than 30% usually require rationalizations of branch networks, products and operations that are far more ambitious, and therefore harder to accomplish. In the first transaction, the banks have announced a target of 29% of SunTrust’s non-interest expense. In the second, they are aiming for 18% of TCF’s non-interest expense. We believe that if other banks can create deals with relatively low TBV multiples and achievable synergy targets, we are likely to see many more similar transactions in the market.

Regional, digital tie-ups
MOEs traditionally bring together complementary strengths, such as uniting a strong commercial bank with a strong community bank franchise, distinctive product sets or adjacent territory. If both firms in a transaction can effectively distribute their combined product portfolios across their combined geographies, they may boost top-line revenue. Digital capabilities may provide an additional path to these kinds of synergies: the new variable in bank M&A.

Receptive investors
The total number of U.S. banking deals has remained relatively flat for awhile. Despite equity markets getting increasingly skittish, shareholders have reacted well to these transactions; the MOE deals have traded up on announcement. With such optimistic responses from investors, we’re likely to see more of these types of transactions in the year ahead.

No deal is a slam dunk. Integration issues associated with change management, data and technology can limit the payoff from a deal that looks good on paper. These challenges may be harder for MOEs relative to outright acquisitions, because the two firms often have comparable processes and teams. Leveraging the best of both cultures, choosing what to preserve, aligning and retraining everyone to follow a new operating model and a set of desired behaviors, thinking through location strategy, transparency around how people and communities will be affected: these all require work. But when MOE deals are integrated properly, there can be winners on both sides of the transaction – as well as shareholders, customers and employees.

We expect the trend toward M&A in the community and regional banking sector to continue. Consolidation is a strong path forward for many banks in the sector, especially those that are beginning to invest in customer-focused digital transformation. The BB&T-SunTrust and Chemical-TCF mergers suggest that fairly priced deals with reasonable synergy targets will nearly always attract interest, especially when shareholders believe that the integration is achievable.


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

Neil Dhar is an experienced partner at PwC who currently serves as the head of PwC’s financial services business, which includes all matters (consulting, tax and audit services) associated with the asset & wealth management, banking & capital markets and insurance sectors. Functionally, he is a seasoned deal consulting professional with over 20+ years of experience advising on over 200 transactions representing billions in transaction value and/or capital.


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.


February 11, 2019
Is Your Financial Institution Prepared to Meet Clients' Technology Expectations?
By Joseph Lowe, Commercial Lending Marketing Manager, Abrigo

Ultimately, all financial service institutions – large, small, community, national or alternative lenders – share one common goal: to meet customer expectations.

But it’s 2019 – customer expectations for banking have shifted toward digital platforms, and community bank leadership is on notice. According to the American Bankers Association’s (ABA) 2018 Community Bank CEO Priorities report, which surveyed 440 community banks, 71% of respondents planned to offer digital processes for small business lending last year, and 57% planned to offer digital processes for consumer lending.

Whether or not those respondents ultimately made good on their goals, it’s apparent that technology disruption is top of mind for community bank CEOs. From quicker loan decisions to streamlined credit analysis to customized workflows, financial technology offers a competitive advantage when it comes to internal banking processes. Perhaps more importantly, however, customer-facing technology is increasingly becoming an expectation among banking customers, putting pressure on banks and credit unions to quickly adopt tech solutions or risk becoming irrelevant.

According to Salesforce, 57% of consumers say it’s critical for companies to provide an easy-to-use mobile experience

Offering mobile banking in an effort to attract Millennials is a popular strategy, as 62% of consumers in this demographic do most of their banking on a phone. But it’s important to remember that Baby Boomers, Generation Xers and Generation Z are equally important to keep in mind as well, as mobile phone ownership across all generations has increased dramatically over the past seven years. For example, the Pew Research Center found that the share of Americans with a smartphone has jumped from 35% in its first survey in 2011 to 77% in 2018. Further, Pew also notes that more adults are reaching for their handheld devices for their banking needs as well, with 51% of U.S. adults banking online, and 35% of those individuals doing so from a mobile device.

Large banks caught on to this trend early, with giants like Citi, Wells Fargo and USAA offering account management, money transfer and conversational banking services from the convenience of customers’ pockets. What does this mean for community banks and credit unions? It’s time to catch up. Community financial institutions that want to level the playing field with big banks must offer an optimizable and seamless mobile experience for banking customers, whether it’s something as simple as online account summaries or offering online loan applications.

According to the ABA, 45% of loan applicants complained of long waits for a credit decision

Have you ever wondered how much the glut of business meetings or inefficient processes – such as lenders traveling to client meetings – ultimately cost your financial institution? Over $25 million is wasted per day on meetings, and $37 billion is spent on unproductive meetings each year. It’s become so much of a problem that the Harvard Business Review came up with a calculator that allows management to review how much money is wasted via unproductive meetings.

Automating timely front-end bank processes such as meetings, signatures and data entry through digital loan origination systems can be a time-saving and cost-saving endeavor for community banks, with lending automation helping to reduce loan processing time by over 50%, while also decreasing costs by up to 54%.

But according to the ABA State of Digital Lending report, financial institutions aiming to please consumers still have a lot of ground to make up. Community banks and credit unions can start by simply offering a digital loan origination process in the first place. While several banks have a functioning digital branch, only 50% of banks over $1 billion in assets and 38% of banks under $1 billion in assets offer digital loan origination in some capacity.

In the end, despite the number of customers who continue to visit physical branch locations, over 90% of mobile bank users prefer using their app over walking into nearby branches – which means that offering an easy-to-use online platform for clients will continue to be a vital component of a community institution’s success.


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

Joseph Lowe is the commercial lending marketing manager at Abrigo, a leading technology provider of compliance, credit risk and lending solutions for community financial institutions.


January 7, 2019
FMS Quick Poll: 2019 Priorities
By Financial Managers Society

In putting together “The War for Deposits” as the cover story for the March-April 2018 issue of FMS forward, it became clear that concerns about deposit growth for community institutions would not be subsiding any time soon. In fact, it seemed at that time that things were just beginning to really heat up on the deposit front – as competitive pressures were increasing and loan portfolios were swelling, banks and credit unions were on the hunt (in some cases, desperately on the hunt) for reliable funding sources to maintain liquidity and keep pace.

So it wasn’t terribly surprising to see deposit growth lead the pack as the most pressing goal or focus heading into 2019 for a majority of FMS members in our latest Quick Poll. What was surprising, however, was just how thoroughly deposits dominated the discussion. Among the nearly 75 respondents – 79% from members representing banks/thrifts and 22% from credit unions, with nearly two-thirds coming from institutions between $200 million and $2.49 billion in asset size – an outsized 44% tabbed deposit growth as the topic or issue that will occupy most of their focus in the year ahead.

WHAT IS THE MOST PRESSING GOAL OR FOCUS FOR YOUR INSTITUTION IN 2019?



While it’s probably safe to say that almost every institution will be keeping an eye on deposit growth in 2019 to some degree, 12% of respondents said they will be more focused on technology in 2019, with projects ranging from product upgrades to core conversions to cybersecurity initiatives. Meanwhile, 10% of respondents are going to be spending some quality time with CECL in the year ahead, as implementation deadlines inch closer and the need for quality data becomes ever more apparent. Elsewhere, smaller pockets of FMS members will be honing in on growing revenue, managing the challenge of margin compression or working through an M&A deal in 2019 (4% each).

Of course, an open-question survey such as this one also provides a great opportunity to discover some of the more individualized issues to which members will be directing their attention this year, which is how the “other” category swelled to a full 15% of responses. And even if most respondents will be focusing on the higher-charting topics noted above, it is certainly likely that at least a few of the issues from this miscellaneous collection will be on their minds in 2019 as well, including:

- Profitability management
- Compliance
- Succession planning
- Talent recruitment and retention
- IRR management

Thank you to everyone who took the time to share their thoughts in this FMS Quick Poll!





December 24, 2018
Data Needed to Comply with CECL
By Toby Lawrence, President, Lawrence Advisory Services and Owner, Platinum Risk Advisors

Having attended more than 20 different CECL seminars offered by accounting firms, software companies and industry regulators, one common question continues to come up time and time again.

What data is needed to comply with CECL?

Some of the speakers respond by listing everything except the kitchen sink to ensure they don’t leave anything out, while others state that no additional data is needed because their solution relies only on the data within an institution’s Call Report. One concern with these so-called “simple models” is that when we experience another economic slowdown, the adequacy of these models may come into question and/or may result in a small amount of losses tainting an institution’s entire portfolio – resulting in a higher provision for the allowance for loan and lease losses (ALLL) than what is actually necessary.

Many institutions likely already have the data they need to calculate CECL in their current loan subsidiary ledgers (with the possible exception of the additional information needed to calculate prepayment percentages). For the actual CECL calculation, however, you need to be thinking about the following information.

Data needed for loans that are currently outstanding
- Customer / member number
- Loan number
- Loan type
- Ability to distinguish between term loans and line of credit loans
- Date the loan was originated
- Maturity date of the loan
- Original amount of the loan
- Current interest rate
- Unpaid balance at month-end
- Additional amount that can be draw on the loan (for line of credit loans)

For CECL, you may want to use more loan types than what are currently in your loan subsidiary ledger. This will help prevent significant losses in one loan type from tainting a large portion of your loan portfolio, leading to your institution having to record a higher ALLL balance than necessary. Additionally, the more collateral types you use, the better your ability to segment the loan portfolio and truly analyze the opportunities and risks within.

Data needed to calculate prepayment percentages for term loans
- Amount of contractually due principal payments received by vintage or year of origination
- Amount of total principal payments received by vintage year

Data needed for charge-offs
- Date of the charge-off or recovery
- Loan type
- Unpaid balance of the loan at the time of charge-off
- Estimated selling costs incurred to liquidate the related collateral
- Net proceeds received from the liquidation of the collateral
- Amount of the charge-off or recovery
- Year the loan was originated
- Amount of any remaining accrued interest
- If using migration analysis, the last risk rating (commercial loans) or FICO credit score (consumer loans) and the date the loan was assigned to that risk rating / FICO credit score
- Loan officer assigned to the loan
-If using the probability of default / severity of loss method, the number of net charge-offs and number of loans originated by each loan type and vintage year (year of origination)

Additional data will be required to justify the subjective adjustments to the CECL historical charge-off percentages. To help with this, be prepared to segment your loan portfolio by:
- Collateral type
- Ranges of the loan-to-value ratio
- Ranges of the debt service coverage ratio for commercial loans and debt-to-income ratio for consumer loans
- Risk rating for commercial loans and FICO credit scores for consumer loans (assuming the institution doesn’t risk consumer rate loans)
- Separating the loans located inside and outside of the normal trade area
- Loans acquired through participation
- Loan officer responsibility codes (to determine if there are any trends in loan officers’ individually-managed portfolios)
- Delinquency status
- Spec versus presold loans for commercial construction one-to-four family loans
- Level of policy and technical exceptions
 
In order to segment a loan portfolio as noted above, lenders will need additional data for their loan subsidiary ledgers.

Data needed to justify subjective adjustments
- Collateral type (to do this correctly most lenders will need to add significantly more loan types to their loan subsidiary ledgers)
- Risk ratings for commercial loans
- FICO credit scores for consumer loans
- Cash flow generated from on-going operations (commercial loans)
- Principal and interest payments due to the institution (commercial loans)
- Principal and interest payments due to other lenders (commercial loans)
- Estimated market value of collateral pledged against the loan
- Debt-to-income ratio for consumer loans
- Number and type of policy exceptions
- Number and type of technical exceptions
- Zip code for real estate loans (this information is already in the loan subsidiary ledger)
- Whether the loan is on nonaccrual status or a TDR (this information is likely already in the loan subsidiary ledger)

The good news for most institutions is that their data processing systems are already set up to store this additional data. An interagency statement issued by the FDIC, OCC and the Federal Reserve Bank in 2006 required banks to segment their loans for major loan concentrations. This statement hasn’t been enforced well to date, but regulators will be expecting institutions to do a better job of segmenting their loan portfolios going forward. These same types of data will also be needed to properly stress test a loan portfolio.

Getting this data for the current year will take some effort and will require a data scrub of all the loans currently in the loan portfolio. However, after the initial data scrub tracking this additional data should be relatively painless. The most challenging issue with implementing CECL will be obtaining this same level of data for prior years. To ensure you have enough data for your CECL calculation it is strongly recommended that institutions implement whatever model they’re planning to use for CECL adoption as soon as possible, since at least 3 to 5 years of verifiable data will be needed to perform a proper CECL-compliant ALLL calculation.


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

Toby Lawrence is the president of Lawrence Advisory Services and the co-founder and owner of Platinum Risk Advisors.



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.


November 19, 2018
How to Determine Millennial Borrowers' Credit Worthiness
By Joseph Lowe, Marketing Manager, Sageworks

When assessing the potential risks a borrower presents an institution’s portfolio, the typical starting point for most lenders is the “five Cs of credit” – capacity, character, capital, collateral and conditions. But as a younger generation, burdened with excess debt, becomes the prime demographic for commercial and consumer loans, community banks and credit unions may want to reconsider that approach if they want to capture this increasingly important segment.

Judging by the numbers, the American economy is on an uptick. The national unemployment rate sits at its lowest rate since 2000 (3.9%), the average FICO credit score is at its highest point ever (704) and median household income is at its highest mark in over 30 years ($61,372). In addition, young borrowers’ share of the lending market is growing.

Despite these positive figures, however, the financial outlook for young borrowers is not on par with the national averages. For example, the average FICO credit score for young borrowers (ages 21-34) is 638, while the average income for Millennials is $35,592.

Given these disparities, it will be difficult for community institutions to grow revenue if they choose not to factor in metrics other than the five Cs when analyzing young borrowers. Let’s take a look at the five Cs of credit in consideration with the young borrower market.

Capacity – Young borrowers earn an average salary of $35,592 and owe an average of $25,000 in student loan debt alone, making for a poor debt-to-income (DTI) ratio.

Character – Young borrowers’ average credit score of 638 is considered fair or poor for most financial institutions that rely on credit scores as the only gauge of character.

Capital – Young borrowers are spending more on bills than previous generations, leaving less money to put toward loan payments.

Collateral – Young borrowers are postponing major purchases such as homes and cars, opting instead for renting and public transportation.

Conditions – Young borrowers are starting new businesses, which, due to their limited credit history and high debt burden, can be too risky of a loan for community banks and credit unions to offer.

In light of these realities, community financial institutions looking for a share of the up-and-coming young borrower market may consider including supplemental factors within their credit analyses and implementing technology to better evaluate credit risk.

Analyzing a young borrower’s entire relationship through global cash flow
Global cash flow refers to a lender or credit analyst’s ability to review a borrower’s financial relationships with his or her peers in the community and, more importantly, the financial institution. Rather than solely focusing on the borrower’s financial history as a key determinant of creditworthiness, financial institutions can determine how businesses, properties and family members connected to the young borrower will affect credit risk for the institution.

For example, consider a loan application from a young borrower named Jack for a $5,000 commercial loan to pay equipment costs for a moving business. When analyzing his financial statements, you see that not only does Jack make a lower-than-average income of $29,000 per year, but he also owes a total of $25,000 in student loans. Your initial reaction is to deny the line of credit. However, upon reviewing the global cash flow analysis, you realize that his student loans have a guarantor on the account – his mother, Linda. Linda earns an income of $110,000 annually and has a credit score higher than 750. She co-owns two businesses with other prominent community members and has banked with your institution for 20 years.

By considering relationships through global cash flow, you have more evidence to potentially justify the line of credit and offer the loan to Jack based on conditions that mitigate his credit risk. By using global cash flow analysis, lenders can identify opportunities, increase defensibility of loan decisioning and take informed, calculated risks.

Using technology to determine credit worthiness
In a recent article published by the Wharton School of the University of Pennsylvania, Benjamin Keys, Wharton professor of real estate, and Richard K. Green, director of the University of Southern California’s Luck Center for Real Estate, both pointed to technology as a way for banks and credit unions to pull in other factors during credit analysis to provide supplemental evidence that borrowers can repay loans.

Implementing credit analysis technology allows lenders to identify portfolio risks based on both internal factors (such as probability of default) and external factors (such as data from other financial institutions) through automated credit risk models and APIs. APIs layer on another source of bank data for lenders to include within credit analysis as well – third-party data.

An automated commercial credit risk model can determine credit worthiness using predictive financial factors and limited data entry from lenders or credit analysts. Furthermore, automated credit risk models can quickly compare probability of default with broader industry trends and examine the industry’s risk to the institution. For young adults with limited access to capital, a better understanding of industry trends can provide another factor to be taken into account when examining credit.

As the demographics of community financial institutions’ customers shift to younger borrowers with less credit history and higher DTI than previous generations, it’s important for banks and credit unions to focus on more ways to help them find good risks that represent profitable growth from a core of young borrowers.


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

As a commercial lending marketing manager at Sageworks, Joseph Lowe helps educate bankers on ways to optimize their lending and credit risk processes.






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