Perspectives: Risk Management/Internal Audit

April 2, 2018
Applications of Risk Ratings
By Alison Trapp, Sageworks

Risk rating is integral to underwriting and managing commercial loans. Regulators expect that lending institutions not only assign risk ratings in an accurate and timely manner, but also that they use them in their processes.¹ Institutions should benefit from this expectation, as aligning processes to risk rating can impact their financial performance and human resource efficiency – particularly when used in the following areas.

New Originations
Risk rating is a means for ensuring an institution is originating and renewing loans in a safe and sound manner. For that reason, the underwriting process should include an assessment of risk rating early, rather than leaving it for a “check-the-box” exercise right before approval (or worse, closing). Accurate rating within the Pass grades is important to ensure that other processes are correlated to the proper risk levels.

An institution may also tie approval authority levels to risk rating. In this instance, so as to avoid biased results, it is especially important that the person responsible for assigning the risk rating is not influenced by the person with the approval authority.

Risk rating may also govern commitment and hold levels, when a guarantor is required, or what structures are available to a given borrower. For example, some borrowers have weaker cash flow that would result in an unacceptable rating unless there are structural enhancements that reduce that risk.

Loan Pricing
Intuitively, risk managers and lenders understand that higher-risk loans should have higher fees or interest, or a shorter tenure. Explicitly tying loan pricing to risk rating allows an institution to implement these structural elements more consistently. It also allows the institution to evaluate any exceptions to the pricing policy within a framework. In certain cases – for instance, the institution may deem it advantageous to stray from its own policy for a bigger purpose – having the policy in the first place allows it to understand the cost of such a move.

Resource Management
Risk rating can be a powerful guide for managing resources. A starting point is to align experience levels with accounts from different risk grades. A more experienced analyst should be the lead on lower-rated assets, while less experienced analysts may have a secondary role on these accounts or a lead role on more highly rated assets with oversight.

When the portfolio is managed with risk rating, the institution can use data to understand how changes to the portfolio will affect the resources required to manage the assets effectively. For example, if the institution is planning to acquire a portfolio of loans and it knows (a) the risk rating distribution of those assets and (b) the amount of a full-time resource that each risk grade requires to manage to its standards, it can estimate the additional resources it will need. The institution can thereby determine if it has enough current resources to absorb the acquisition, if it needs to find efficiencies (perhaps through the use of software or by streamlining processes) or if it needs to hire additional resources.

Portfolio Rhythms
An institution should align distinctions in risk ratings to its ongoing portfolio management processes. For example, the institution can tie the frequency of review to risk ratings. An institution with five grades of Pass along with Special Mention, Substandard, Doubtful and Loss might set account review frequency as follows:



Additionally, the institution can use its data to understand how changes to a process will impact it. For example, if an institution with the above structure decided it was spending too much time in meetings and wanted to move Pass 3 from a semi-annual review to annual, it could estimate how much time would really be saved. Performance of the Pass 3 credits should then be monitored separately for a time to make sure that the change did not have a detrimental impact to overall portfolio quality.

Allowance for Loan & Lease Losses (ALLL)
There is a logical correlation between risk rating and ALLL as supported by the OCC calling risk rating the underpinning of ALLL.² Embedding risk rating in the ALLL process explicitly systematizes what institutions would be doing instinctively – aligning reserve levels with risk levels. Most institutions are already using risk rating in their ALLL process, while those not currently doing so are likely contemplating including it as part of the transition to their upcoming Current Expected Credit Loss (CECL) calculation.

By developing a robust risk rating policy and applying it consistently to all loans, financial institutions can glean benefits across the life of the loan, from origination to portfolio risk management.

¹ https://www.occ.gov/publications/publications-by-type/comptrollers-handbook/rating-credit-risk/pub-ch-rating-credit-risk.pdf page 2
² https://www.occ.gov/publications/publications-by-type/comptrollers-handbook/rating-credit-risk/pub-ch-rating-credit-risk.pdf page 2



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

Alison Trapp leads the credit risk practice for Sageworks’ Advisory Services team, with expertise in the areas of credit administration, risk rating development and policy implementation.


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

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

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

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

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

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

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

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



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

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

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


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

About the Author

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


May 24, 2017
Five Ways to Unlock the Full Value of Loan Review 
By  Ancin Cooley, Principal, Synergy Bank Consulting and Synergy Credit Union Consulting

If you grew up north of the equator, you can probably remember the excitement you felt playing in the freshly fallen snow each winter. As you bounded toward the front door, ready to throw yourself into a fluffy pile of wintertime fun, you were stopped by a parent, ready to burden you with a heavy coat, gloves, scarf and hat. As the layers piled on, you wondered who could possibly have fun in all of this. However, once outdoors, you realized that your protection made the snowy adventure even more enjoyable.

A similar analogy can be drawn about loan review. Attempting to quickly grow your loan portfolio or move into new areas of business without a fully functioning loan review program is like trying to play in the snow without a coat on. You’ll never enjoy the snow if you’re not equipped to withstand the freezing temperatures that will undoubtedly accompany it. Likewise, you’re unlikely to see the sustained growth you seek for your institution if you fail to implement key processes that protect you from the imminent pitfalls associated with growing or integrating a new loan product.

Even the most conservative institutions pin growth and profitability as primary goals. However, in order to maintain healthy growth, institutions must keep a reliable pulse on the performance of their loan portfolio and accompanying credit risk issues. Effective loan review keeps that pulse by consistently monitoring the risk management function. With a strong loan review department to keep things on track, the institution will have the freedom to explore new products and industries with confidence.

If it’s true that loan review is the key to monitoring risk, then where was it during the last major downturn? Amid the slew of potential issues that crippled loan review and lead to the last downturn, these primary issues took precedence, and in many cases their continued presence is still putting institutions in jeopardy:
- Insufficient analysis to support the risk rating
- Failure to document major issues and the answers leading to their conclusion
- Failure to discuss credit administration weaknesses
- Insufficient numbers and experience of staff
- Failure to discuss and address portfolio risks
- Organizational and hierarchical missteps
- Lack of follow-up

Today, commercial real estate levels are back to where they stood pre-downturn. Institutions that have a strong early warning system – built by loan review – are able to identify and remediate problems faster.

Once your institution realizes the full value of the protection offered by a high-functioning loan review team, you may actually look forward to having an independent group of professionals hand you a pair of gloves, fit you with a coat and wrap you tightly in a scarf before sending you off to your next deal. To make sure your institution is getting the full value out of its loan review process, be sure to pay close attention to these five practices:

Craft a Risk Appetite Statement
The risk appetite statement helps your institution determine the direction of its lending program in an effort to grow more intentional portfolios that will bolster its overall health. When crafted as part of your yearly strategic planning process, your institution will be primed to grow portfolios by aligning your goals with your unique risk appetite.

This statement serves as a crucial guide by outlining the institution’s risk appetite, risk capacity and risk profiles, driving your institution’s decision-making over the next year.

While risk appetite refers to the amount of risk your institution is willing to accept in pursuit of loan growth, risk capacity quantifies the maximum risk that the firm is able to withstand. Risk capacity is based on metrics like capital, liquid assets and borrowing capacity, among others. Target risk profile represents the allocation of appetite to risk categories (e.g., how many home equity or car loans you will grant?). Actual profile represents risks that are currently assumed.

When gathering information that will eventually become the risk appetite statement, it’s important to engage with and incorporate the input of parties such as the board, CEO, CFO, lenders and internal auditors.

Align Loan Review with Risk Monitoring
For some institutions, this maxim is already a no-brainer. While past industry-wide practices have placed loan review within the purview of internal audit, forward-thinking institutions are making the shift toward aligning loan review with risk management. In fact, loan review is increasingly being referred to as credit risk review, thus highlighting the shift in thinking about the functionality of loan review.

When loan review is repositioned within the organization’s hierarchy, this seemingly small organizational shift can have a seismic effect on the overall effectiveness of the loan review function. This is achieved through utilization of independent authorities that perform candid, unbiased reviews.

Put simply, a loan reviewer must be able to safely “speak truth to power.” The reporting structure should be organized in a manner that allows for both the formulaic testing and critical, open-ended examination allowed under risk management.

Further, compensation levels are another key component of loan review effectiveness. Because the loan review position is critical to the success or failure of a financial institution, the institution must hold it in esteem for internal controls and for external appearances. By providing loan reviewers a proper place in the hierarchy of the organization, the institution communicates the seriousness and intrinsic value of the loan review position and its responsibilities.

Apply Strategy to Price Monitoring
A “one size fits all” approach just doesn’t work in the land of lending. Building a strategic pricing system through close monitoring of loan administration is critical to maintaining a healthy portfolio.

Even after a borrower has been with you for some time, things like credit worthiness, collateral values, and deposit balances all change over time, requiring a change in strategy on the part of the institution. Utilized fully, your loan review department can help keep an eye on these many changes and help steer the institution toward the best set of solutions.

Hone In on Small, Targeted Reviews
While broad, sweeping reviews are seemingly effective, getting down into the devilish details can expose smaller issues before they become significant problems. Specifically, performing deep dives into your appraisal management, special asset and loan administration function create tangible value and ROI.

Perform Post-Mortems on Large Charge-Offs
There really is no better vision than hindsight. Looking at your largest losses incurred over the last three years will allow you to identify whether there are any core themes that recur throughout. When armed with knowledge about what hasn’t worked, you can mitigate similar losses in the future. This is undoubtedly a best practice.

Before implementing these practices, make sure they are codified in a strong loan review charter or policy that is signed by the board of directors. Memorializing these practices solidifies loan review as a strategic asset, and equips the loan review team to objectively and independently unlock the strategic value of loan review.

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

Ancin Cooley, Principal, Synergy Bank Consulting and Synergy Credit Union Consulting
Ancin Cooley is the Principal of Synergy Bank Consulting and Synergy Credit Union Consulting, both of which specialize in loan review and strategic planning.  He can be reached at acooley@synbc.com.

FEBRUARY 2, 2017
FOMC opts to hold steady amid improving conditions  
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Following a two-day policy meeting in Washington, Federal Reserve officials unanimously held their benchmark rate steady in a range between 0.50% and 0.75%, while noting in a statement some recent improvements in the economy.

The Fed provided little direction on when it might next raise borrowing costs, as officials debate the impacts of policy changes with the new administration. The central bank currently projects three rate hikes for 2017, though committee members differ on how proposed tax cuts and regulatory changes may boost growth and inflation.

Looking Ahead
“Measures of consumer and business sentiment have improved of late,” the Federal Open Market Committee said in its statement Wednesday. Policy makers reiterated their expectations for moderate economic growth, “some further strengthening” in the labor market and a return to 2% inflation.

The FOMC also repeated that it anticipates interest rates will rise gradually. The statement said job gains “remained solid” and the unemployment rate “stayed near its recent low,” a tweak from December’s language that the rate “has declined.”

“Inflation increased in recent quarters but is still below the committee’s two percent longer-run objective,” the Fed said. Market-based measures of inflation compensation are “still low,” the central bank said, after suggesting in December that such measures had “moved up considerably.”

The committee left unchanged its stated intention to continue reinvesting its maturing debt holdings until “normalization” of the benchmark rate is “well under way.” The Fed’s balance sheet stands at about $4.5 trillion.
Fed Chair Janet Yellen, who didn’t have a press conference scheduled after this meeting, will have the opportunity to discuss the decision further during her semiannual monetary-policy testimony to Congress in mid-February. The FOMC next meets on March 14-15.

Before the latest statement, investors saw a roughly 38% chance that the first rate increase of 2017 would come at the Fed’s March meeting, based on trading in federal funds futures. The odds rose to about 52% for the subsequent gathering in early May and 75% for mid-June. The market forecast is currently calling for two hikes in the next two years and one in 2019. This would bring the overnight rate to 1.12% for December 2017, 1.62% at year-end 2018 and 1.87% for 2019. 

Tough Decisions
With bond yields still near historic lows, investors in fixed-income securities face a dilemma. Short-term bonds offer sub-par yields, but provide reinvestment opportunities in a rising rate environment. On the other hand, longer-term bonds secure a higher yield, but present larger losses if market rates rise.
 
Ten-year Treasury notes currently yield about 2.50%, not a great return given the interest rate risk in holding the security over the next decade. If yields were to climb 100 basis points to 3.50%, the price would drop almost 9%.  In this scenario, a five-year Treasury issue yielding 1.9% would lose 4.6%, and a 1.2% two-year note would drop 2%.  Even if bonds are held to maturity, experiencing price losses only on paper, the investor still foregoes the opportunity to earn higher returns if yields rise. 

The opposite would occur if rates fall, resulting in a sharp rally and producing sizeable unrealized gains. If this were to happen, the investor benefits from having locked in above-market yields. The investor is faced with the challenge of managing a portfolio structured to perform in either scenario.

One solution is to create a “bond ladder.” A laddered portfolio consists of securities that mature in successive years, starting in a few years and extending out to five years or longer. Assembling a stable basket of cash flows avoids locking in all of one’s funds at “low” yields, while enabling the investor to pick up some additional income. 

The benefit of a ladder is that as rates move higher, bonds coming due in the near term can provide funds for reinvestment when the alternatives may be more attractive. Depending on the investor’s preference and individual situation, the principal can be put to work at the desired maturity. If current yields are higher than the bonds rolling off, the investor is able to increase overall returns and boost portfolio performance.

At the close of every year, it seems the market prognosticators predict higher rates for the ensuing twelve months. Heeding these warnings, many investors flock to ultra-short-term bonds, sacrificing income. According to academic studies, by investing the bulk of the portfolio in short-term, low-yield bonds, investors are exposed to a different risk over time: earning low yields. There is an opportunity cost of sitting at near zero and waiting for higher rates, as the conventional wisdom about bonds does not always play out. Just as a well-balanced portfolio consists of several types of investments, so too should it contain a well-structured schedule of maturities.

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

Robert B. Segal, CFA, Founder/CEO, Atlantic Capital Strategies, Inc.
Robert B. Segal, CFA is founder and chief executive officer with Atlantic Capital Strategies, Inc. Bob has been in the banking industry since 1982, having worked in several community banks with roles in mortgage banking, sales and trading, and asset liability management. He is a frequent speaker at industry events and contributes to many regional and national finance publications. His firm provides investment advisory services to community-based institutions. Bob can be reached at bob@atlanticcapitalstrategies.com or 781-276-4966.




AUGUST 29, 2016
How Hard is it for a Small Lender to Make a Qualified Balloon Mortgage 
By Tim Tedrick, Partner, Wipfli LLP

With the ongoing changes by the Consumer Financial Protection Bureau (CFPB), some lenders are still not sure about whether they can easily make qualified balloon mortgages.

The first step is to determine whether the creditor is eligible for the small portfolio lender balloon qualified mortgage exception contained in 12 CFR 1026.43(f). There are three standards that need to be met:

1. Together with all affiliates who regularly extend first-lien mortgages, total assets were less than $2.060 billion (adjusts annually)
2. Together with affiliates, the creditor originated 2,000 or fewer mortgages during the prior calendar year (loans originated and kept in the portfolio are not counted among the 2,000)
3. The creditor extended at least one first-lien covered mortgage secured by a property located in a rural or underserved area during the prior calendar year

For all three of these conditions, if the application is received before April 1 of the current year, then each condition must have been met for at least one of the two preceding calendar years.

Once the creditor has determined eligibility for the small portfolio lender balloon qualified mortgage exception, the next step is to ensure the loan product meets the regulatory limitations and protections. There can be no interest rate increases, no negative amortization, no interest-only payments and the loan term can be no less than five years and no more than 30 years. The creditor generally needs to keep the loan in the portfolio for three years.

The creditor should also make sure the loan is not a higher-priced mortgage loan (HPML), because for these loans the creditor would have a rebuttable qualified mortgage, not a safe harbor qualified mortgage (assuming the loan meets the qualified mortgage requirements in the table below). For the HPML limit, the APR cannot exceed the APOR by 3.5% or more. As of August 22, 2016, that would have required an APR of less than 6.42% for a five-year balloon.

The creditor should also ensure the points and fees do not exceed the various thresholds based on the loan amount, and these numbers adjust annually.



Finally, for underwriting purposes, the creditor must consider the consumer’s debt-to-income ratio. Because there is no specific percentage prescribed in the regulation, however, it is incumbent on the creditor to set its own
debt-to-income ratio.

The creditor must also verify the debt obligations and income used in the underwriting, but is not required to verify employment – only to consider this factor in the underwriting. The use of a credit report is also not specifically required, but the creditor may consider this factor when underwriting the debt and determining the debt-to-income ratio. The only items to verify specifically are income, debt, alimony and child support, if applicable, along with debt-to-income or residual income.

In conclusion, eligible small rural creditors looking to make a five-year balloon loan should keep the following factors in mind:

1. Keep the points and fees within limits
2. Keep the APR below the limits
3. Underwrite the loan reasonably
4. Verify the income and debt

If a creditor does not meet the small creditor balloon QM criteria, the creditor could still originate a balloon loan as long as the loan complies with the ability-to-repay requirements – it just would not be a qualified mortgage. 

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

Tim Tedrick, Partner, Wipfli LLP
Tim Tedrick is a partner with the accounting firm of Wipfli LLP. He has over 40 years of experience, the first eleven with a bank and the remaining with Wipfli, where he heads up the compliance team. A graduate of the ABA National Graduate Compliance School in Norman, Oklahoma, he is also a Certified Regulatory Compliance Manager and a Certified Risk Professional.






AUGUST 22, 2016
FMS Quick Poll: Using Derivatives to Manage Interest Rate Risk
By Financial Managers Society

For our latest FMS Quick Poll, we decided to revisit a polling question that we last took to the membership almost three years ago, asking how many of our member institutions are using derivatives to help manage their interest rate risk and, if so, what types of strategies they’re employing.

Given the fact that only 90 individuals participated in the 2013 version of this poll – compared to well over 200 this time around – any apples-to-apples comparison of the results would be somewhat skewed. However, the general notion one can draw is that not much has changed – for the most part, FMS members still aren’t diving into derivatives.

Of the 236 respondents in the current poll, only 16% are currently using derivatives, with another 23% indicating that while they’re not doing so now, they are considering it (see Figure I). The remaining 61% of poll participants aren’t using derivatives now and don’t expect to anytime soon.

FIGURE I


 In 2013, meanwhile, 23% of respondents were using derivatives and 31% more were considering the possibility, with 45% steering clear altogether (see Figure II).

FIGURE II



Back in the present day, the decision to use or not use derivatives was fairly consistent across both banks and credit unions in the current poll, with the exception of those not currently using derivatives but considering them, where 40% of credit unions were thinking about the possibility, compared to only 17% of banks. In terms of asset size, the poll shows that in general, the larger the institution, the more likely it is to be using or considering using derivatives to manage interest rate risk (see Figure III).

FIGURE III



 In terms of which derivatives strategies FMS members are utilizing, interest rate swaps stood out as by far the most popular choice, with caps a fairly distant second (see Figure IV). These results, too, were fairly similar to the strategies members were favoring back in 2013.

FIGURE IV



Is your institution considering derivatives to manage interest rate risk? If so, why are you moving in that direction? If not, what is holding you back? Share your thoughts on this Quick Poll in the comments section below or on FMS Connect!




JULY 29, 2016
Getting Better: FOMC Leaves Rates Unchanged Amid Improving Economic Picture 
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Once again, the Federal Open Market Committee (FOMC) decided to maintain the target range for federal funds at 0.25% to 0.50% following a meeting in Washington. The Committee upgraded its assessment of the economy, stating that near-term risks to the outlook have diminished while labor utilization has shown “some increase,” though inflation remains too low.

In a sign of improving confidence about the strength of the recovery, the Fed said the labor market has “strengthened” since its June gathering. The weak employment report in May (38,000 new jobs) was a significant cause of concern for the Committee. The solid rebound in the June figure (287,000 new jobs) seems to have given the group encouragement that the May report was an aberration. Officials described spending as “growing strongly” amid robust retail sales figures, and said economic activity was expanding at “a moderate rate,” a mild upgrade from its assessment in June.

According to analysts, the Fed left open the possibility of an interest rate increase later this year, possibly as early as September, as the FOMC statement was more hawkish than expected. The Committee is keeping a close eye on inflation and inflation expectations. In the most recent report on prices at the consumer level, the Bureau of Labor Statistics said core inflation is rising at a 2.3% annual pace. This compares with 1.6% as recently as early last year.

Fed officials project the median federal-funds rate target at the end of 2017 will be 1.625%, down from an earlier forecast of 1.875%. They predict the rate at 2.375% at the end of 2018, lower than the 3% they called for in March.

At this time, markets place the chance of a rate increase by year-end at 45%, down from 65% after the Fed’s April 27 meeting: this compares with only 10%, however, at the end of June. The yield on the benchmark 10-year Treasury note traded recently at 1.50%, compared with 1.85% at the end of May. Further in on the curve, the five-year note currently yields 1.10%.

In this environment, it’s helpful to revisit the institution’s investment process. Some investment officers use a “shotgun” approach for selecting securities. Based on the recommendation of a few brokers, the investment officer will often buy the “cheapest” bonds available, regardless of the composition of the existing portfolio. This method can lead to a portfolio with sub-optimal allocation; less diversification means more risk on the balance sheet.

A more effective approach is to develop an investment plan that takes into account the institution’s balance sheet and business plans. The plan should integrate with the asset-liability position, with the goal of increasing income and reducing interest rate risk over time. When putting together the strategy, the institution should set targets for the following areas:

• Sector allocation
• Portfolio duration
• Projected cash flow
• Price volatility

Each institution’s balance sheet is comprised of a unique asset mix. Some are heavily weighted in long-term fixed-rate residential loans. In a falling rate environment, however, the loans could shorten dramatically, providing significant cash flow. On the other hand, commercial banks usually make a large number of floating-rate C&I loans. These assets provide higher levels of income in a rising rate environment, but expose the institution to “income-at-risk” in a stable or declining rate scenario.

For the mortgage lender, unexpected changes in the market may cause significant volatility in cash flow. When rates rise, the loans extend, providing minimal funds to redeploy at higher yields. Falling rates lead to faster prepayments, and those funds must be put back to work at lower levels. Here, an allocation to short- and intermediate-term bullet securities, such as agencies and corporate bonds, may be appropriate, since the cash flows are known in advance. As the bonds season and roll down the curve, the price volatility declines, offsetting the potential economic valuation impact of 30-year mortgage loans.

Municipal bonds may be appropriate for the commercial lender. Long-term municipals provide high levels of current income, boosting earnings should the environment remain unchanged. They provide call protection for periods of up to ten years, enabling the institution to hold on to the yield for some time. The risk weighting (20% for general obligation bonds) serves as a buffer against the 100% risk weight of commercial loans.

One of the most important roles for the investment officer is to manage the institution’s asset allocation strategy. A number of academic studies have shown that sector allocation is a big determinant of outperformance. With an effective investment plan, the institution should be able to improve income over the long run while minimizing unwanted surprises.

About the Author

Robert B. Segal, CFA, Founder/CEO, Atlantic Capital Strategies, Inc.
Robert B. Segal, CFA is founder and chief executive officer with Atlantic Capital Strategies, Inc. Bob has been in the banking industry since 1982, having worked in several community banks with roles in mortgage banking, sales and trading, and asset liability management. He is a frequent speaker at industry events and contributes to many regional and national finance publications. His firm provides investment advisory services to community-based institutions. Bob can be reached at bob@atlanticcapitalstrategies.com or 781-276-4966.

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.