Perspectives: Strategic Issues

July 2, 2018
Managing with a Forward View
By Mary Ellen Biery, Research Specialist – Sageworks

Dealing with the day-to-day challenges of operating a bank or credit union can keep top management “in the weeds” of lending or credit operations. This can leave little to no time for surveying the entire “field” of the portfolio, its risks and its impact on the institution’s financial results.

It’s the same challenge the institution’s small business customers often face. When owners’ days are filled with handling current-day issues and reviewing recent results, they end up with little time for big-picture planning. It’s not until these businesses begin forecasting sales and expenses, and managing with a forward-looking perspective, that they are able to generate meaningful growth.

Banks and credit unions, many of which are small businesses themselves, can also make more informed strategic decisions that aid growth when they manage with a forward view. Managers may currently rely solely on Excel-based reports of last month’s loan delinquencies, charge-offs and the like. But executives can quickly understand trends in the portfolio and use insights to inform strategic planning by incorporating forward-looking indicators, many of which can be generated automatically through technology.

Indeed, in a recent FDIC Supervisory Insights article, an analyst for the FDIC’s Division of Risk Management Supervision emphasized the importance of forward-looking risk indicators. Such indicators, senior analyst Michael McGarvey wrote, “can be indicative of future performance and should be the focus of a sound credit management information system program to proactively identify and mitigate risk exposure.” The article described a scenario where one bank relied heavily on lagging risk indicators, resulting in inadequate risk identification. Another bank, meanwhile, was able to be more proactive in risk management, thanks to forward-looking metrics.

According to the FDIC article, an example of incorporating forward-looking credit metrics would be monitoring concentrations in relation to capital so that the institution can establish strategies to decrease, maintain or increase exposure to a certain concentration or identify concentrations approaching or exceeding limits. Metrics to aid in this approach include data related to:

- Loan category (C&I, CRE, unsecured, auto, etc.)
- Industry breakouts on C&I loans
- Individual and related borrowers
- Geographic concentrations

Another example of incorporating forward-looking data would be monitoring the institution’s performance and risk indicators against policy limits and the risk appetite statement. Tracking the volume of loan exceptions, underwriting trends, loan grade migrations and concentration risks would aid in developing this type of report, the FDIC analyst wrote.

“The FDIC is absolutely right to focus on this issue,” says Neill LeCorgne, vice president of Sageworks and a former bank president. “What typically happens in the banking world is when the economy goes well and everybody’s doing well, there’s not a deal that a bank doesn’t want to take a look at. When the economy starts to turn down, everyone starts to pull back. Now is the time to start getting your management information systems established and working and following some of these practices.”

LeCorgne says a banking technology platform that has heavy analytical capabilities at the portfolio level makes it easier to slice and dice concentrations and global relationship exposures, and to provide custom visual summaries to share with the board, auditors and examiners.

Data generated using technology at the front end of the origination process – such as an online loan application – can interact with an automated tickler system to track correspondence and data requests on a go-forward basis. That way, banking staff don’t have to manage all of the quarterly or annual reports on borrowing-base analyses, quarterly/annual reviews or renewals. Instead, time previously spent on those tasks can be used to look at the big picture regarding the potential future impact of credit exposures and underwriting trends.

At the other end of the loan’s lifecycle, technology that helps banks leverage the results of calculations for the allowance for loan and lease losses (ALLL) – especially results under the upcoming current expected credit loss model, or CECL – can also provide forward-looking insight. Institutions can use the results of CECL calculations to back-test risk rating models and scorecards and develop sound risk-based pricing systems. In this way, executives can more effectively manage profit in a CECL world.

While historical performance metrics typically convey what has occurred in the past in the portfolio, forward-looking metrics throughout the life of the loan can help financial institutions identify underlying risks that could potentially affect not just future performance but also future strategic decisions. Banks and credit unions strengthening credit management information systems with the assistance of automated data generation and tracking, as well as sound governance, will be better able to respond to emerging risks in the years ahead. Like their business customers utilizing forward-looking information, these institutions can aid their growth when they rise above “the weeds” to survey the entire credit and business landscape.

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

Mary Ellen Biery is a research specialist at Sageworks, a financial information company that provides lending, credit risk and portfolio risk solutions to over 1,200 financial institutions across the country.

April 9, 2018
Leadership For An Industry 4.0 World
By David E. Perry and Ron Wiens

The world is entering its fourth Industrial Revolution, often called Industry 4.0. While Western economies ruled the first three industrial revolutions, the economies that will dominate the 4.0 World have yet to be determined. With the future up for grabs, what will the differentiator be for winning organizations?

Ushered in by the steam engine, the first Industrial Revolution led to the mechanization of work. The second, led by the electrification of factories and machinery, enabled mass production on a grand scale. The third, occurring in the second half of the twentieth century, introduced computers to the workplace and led to the automation of everything from back-office administration to the teller’s window.

The common theme of these revolutions has been a decline in the dependence on human capital. But Industry 4.0 is about to change that.

Knowledge + Connectivity = Industry 4.0
Industry 4.0 is driven by an electronically connected world. In the emerging 4.0 World, people are connected not only to each other, but also to each other’s knowledge. The impact of this connectivity is best summed up by the following observation from Dr. Nick Bontis of McMaster University: “In the 1930s, the cumulative codified (i.e., written down) knowledge base of the world doubled every 30 years; in the 1970s… it doubled every 7 years.” Bontis predicted in 2000 that by 2010, the world’s codified knowledge would double every 11 hours.

Maybe we haven’t reached that fateful 11-hour figure, but we now live and work in a world in which knowledge is growing exponentially. Since knowledge equals opportunity, the opportunities available to organizations are also growing exponentially. And because everyone is connected to this knowledge, everyone is connected to these opportunities. Therefore, competitive advantage today lies in an organization’s ability to exploit this knowledge and spot opportunities before anyone else – companies that can consistently do this faster than their competition will thrive.

An interesting by-product of this knowledge explosion is that the days of the all-knowing, all-seeing manager are over. Knowledge workers today are often more aware of new knowledge than management is. It’s not that managers have gotten dumber, but rather that employees have gotten smarter – or at least better educated.

Organizations are ripe with highly educated knowledge workers. That’s a key difference between now and the first Industrial Revolution, when our current management systems were invented. Here’s a nice bit of alignment: we have an explosion of knowledge, and at the same time that we have growth in the capability of the organization’s employees to understand and make use of this knowledge. The continued prosperity of already successful organizations now depends directly on the ability of their workers to continuously generate new value. Winning organizations have awoken to this fact.

The Power of Leadership
What does ‘waking up’ mean? At its core, it means a fundamental shift in how people are managed and led. The 4.0 World is all about leadership.

The current approach to managing people tends to focus almost exclusively on maximizing the productivity of individuals. This is Leadership 1.0 – steam age leadership, in which the whole is viewed as the sum of its parts. Industry 1.0 leadership can be summed up by the following philosophy: “We all have a job, and if we each do our job we will be successful.”

In an Industry 4.0 World, the view is quite different – the whole can be much more than the sum of its parts. 4.0 leaders still work at maximizing the performance of the individual, but they also focus on maximizing the performance of the team. This means looking at recruiting leaders through a new lens. In a 4.0 World, the skills and behaviors needed in a leader have changed considerably.

Building an environment that facilitates the ongoing creation of new value means managing not only the individuals who make up a team, but also the interaction space between these individuals. A lesson learned from the IT industry – which was the forerunner to Industry 4.0 and provides insight to the 4.0 World – is that between any two individuals on a team there is a hidden creative force. When the interaction space between individuals is effectively managed, this force emerges and the creative impact of the team is multiplied. In a 4.0 World, an organization’s ongoing prosperity now directly depends on its leaders’ ability to draw out this creative energy.

Building an organizational culture that facilitates the ongoing creation of new value is not rocket science. But it requires a fundamental change in perspective on the part of the organization’s managers – a change that will challenge current management practices, including how a manager’s performance is measured and evaluated. To be successful in a 4.0 World, organizations will now need to evaluate their managers not only on the basis of what they have delivered, but also by the readiness of their teams to deliver in an unknown future. Contrary to popular belief, winning in the fourth Industrial Revolution is not about speed – it’s about non-stop strategic change that constantly advances the organization toward its stated goals.

What does a 4.0 leader look like? 4.0 leaders not only manage the space in between people while building a high-performance culture. They never rest. They never allow the organization to crest. They know success is not a sprint but a marathon. Change is ongoing in a 4.0 World, which is why the 4.0 Leader is constantly developing and strengthening the organization’s change muscle. The successful organization in a 4.0 World reflects this kind of leader by constantly moving forward – never stopping, never resting.

Building a 4.0 Team
The goal in hiring isn’t to find the best talent looking for work, or at least it shouldn’t be; what it should be is finding the best talent period. Today that means recruiting leaders who are comfortable in a 4.0 world, and therein lies the recruiting challenge. The best leaders – the 4.0 talent – already have good jobs. The key to recruiting successfully in a 4.0 world now means going after talent that isn’t looking for work.

But hiring the best is not about money – it never was. Surprisingly enough, the best will come to an organization not to make more money, but because of what the organization stands for and what it’s trying to achieve. Work is personal to 4.0 talent, which is why you have to first engage their heart. Once you’ve spoken to the heart, the next step is to speak to their head – the best will want to understand the organization’s business goals, its challenges, its assumptions and its blind spots. Once the head is engaged, you next have to address the feet – the best will want to understand the organizational culture that drives the way people interact and how things get done. To do all of this, you need a systematic approach to finding 4.0 talent by engaging their interest and assessing their alignment with your goals.

Two Alternatives
In the ‘Old West’, it was said that there were two kinds of people – the quick and the dead. In the Industry 4.0 world, there are just two types of banks and credit unions – the quick and the dying.

The quick embrace new ways of leading and creating value, while the dying hang on for dear life to what brought them success in the past. Which will you choose to be?

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 Authors

A well-known name in executive search circles with over 30 years of work as an executive recruiter under his belt, David Perry helps companies find and bring aboard Industry 4.0 leaders as the founder and managing partner of Perry-Martel International. A noted speaker on the topics of leadership and cultural change, Ron Wiens ( has spent the past 35 years helping organizations build high-performance cultures.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

About the Author

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

December 26, 2017
Community Mindset: Bearing the Burden

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

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

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

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

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

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

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

December 18, 2017
Community Mindset: Millennial Musings

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

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

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

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

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

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

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

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

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

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

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

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

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

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

December 7, 2017
Community Mindset: Reassessing the Branch Network

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

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

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

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

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

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

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

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

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

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

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

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

AUGUST 16, 2017
Building an Optimal Investment Portfolio
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Bank investment portfolios are an increasingly important part of balance sheet management. As portfolios have grown by 5.9% over the past year, according to the FDIC, they also produce a larger share of earnings. However, regulatory challenges and the low interest rate environment have pushed some into lopsided positions, such as high concentrations of agency notes and collateralized mortgage obligations (CMOs), with those institutions dealing with what are now sub-optimal portfolio allocations.

These investment portfolios show heightened risk exposures, whether through maturity extension, early call features or declining levels of income – less palatable sources of risk in an industry currently focused on improving earnings. In order to boost long-term performance while mitigating risk, investment officers should keep an eye on the following key areas.

Target Duration
Investment policy statements describe the framework by which the institution manages its portfolio. One goal is to enhance profitability within the overall asset/liability management objectives, while a second aim is to establish a process for implementing specific measures to manage sensitivity to interest rate changes.

Accordingly, management should establish a target level of duration that reflects the institution’s asset/liability position, income requirements and risk tolerance. Academic studies consistently show that longer-duration portfolios provide higher levels of income. At the same time, highly-leveraged institutions need liquidity to fund loans, and this may reduce the desired level of price sensitivity, causing the investment officer to “shorten-up.”

Maintaining duration, moreover, is an essential factor in preserving margin and maximizing net interest income. As portfolios age, duration can decline unless cash flows are reinvested back out on the curve; this “opportunity cost” limits earnings potential. Similarly, portfolios comprised exclusively of mortgage securities can extend if prepayments lag initial projections, creating unexpected interest rate risk. Investment officers should closely monitor their portfolios and take steps to ensure target durations are preserved to protect net interest income.

Many portfolios become heavily weighted toward certain “comfortable” sectors. The returns fixed-income investors receive are determined by various factors, such as volatility of rates, credit and yield curve slope. An emphasis on callable agencies, for example, implies a reliance on returns from taking extension risk or prepayment risk.

With an expected drop in market rates, this institution will receive unwanted funds which must be reinvested at lower yields. Conversely, calls slow down in a rising-rate environment, providing less cash to put to work at better yields or to fund loans. A diversified portfolio (more call-protected assets, in this case) would keep cash flow fluctuations to a minimum, leading to improved portfolio performance.

Cash Flow
It is recommended that the treasury group prepare cash flow projections in a base case, as well as several alternate scenarios. An institution exposed to mortgage security prepayments, for example, can act in advance to protect against a decline in income in a falling-rate environment by either pre-investing or realigning the portfolio. The cash flow projections provide the information necessary to understand the position and evaluate suitable strategies, with the ultimate goal of establishing an optimal cash flow profile.

Bond Ladder
A laddered portfolio consists of securities that mature in successive years, starting in the short term and extending out to five years or longer. Assembling a stable basket of cash flows avoids locking in all 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 institution’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 institution is able to increase overall returns, boosting portfolio performance.

Fixed vs. Floating
Many investment officers wonder about the optimal strategy for deploying assets – whether to put on longer-term fixed-rate investments that pay a higher coupon or add floating-rate instruments that would benefit if rates rise. The investment officer might be considering two options: a five-year fixed-rate note yielding 2.4% or a similar term floating-rate bond priced at 90-Day LIBOR (1.3%) plus 50 basis points, for a current yield of 1.8%.

If the market forecast is correct, then the yield for the floating-rate bond will increase 25 basis points in September 2018 and a similar amount the following year – bringing the yield to 2.3% at September 2019. By contrast, the institution will have received a constant 2.4% for the fixed-rate option. Assuming a $1 million investment, the fixed-rate bond provides interest income of $72,000 over the three-year time horizon, compared with $65,250 for the “floater.” Even as the yield curve has flattened, fixed-rate assets may still provide higher levels of current income than floating-rate alternatives in the intermediate term.

Best Execution
In light of recent advances in technology, regulatory agencies such as FINRA have reiterated their commitment to ensuring best execution as a key investor protection requirement. FINRA stated in a November 2015 regulatory notice, for example, that the market for fixed-income securities has evolved significantly and transaction prices for most securities are widely available to market participants.

Broker/dealer transaction costs can vary greatly based on the scope of the transaction and access to the most liquid dealers. For example, the Bid-Ask Spread Index from MarketAxess shows that block trades on actively traded corporate bonds currently have a 3-basis-point bid-ask spread, and “odd lots” trade at 7 basis points. Individual transactions often trade at higher spreads, indicating that investors may be “leaving money on the table.” A more diligent approach toward trading efficiencies could help support the bottom line.

Municipal Bonds
Banks have boosted their holdings of municipal bonds steadily over the past decade, according to Federal Reserve statistics. Industry reports generally show that institutions holding larger percentages of municipal bonds tend to be the high performers, and banks holding at least 30% of their investment portfolios in munis are typically found in the first quartile for investment yield.

A primary benefit of municipal bonds is the long period of call protection. Bank treasurers may be relatively certain they’ll hold on to the initial yield for seven to ten years, regardless of interest rate movements. With considerable optionality on most bank balance sheets, municipals provide much-needed predictable cash flow. In addition, the municipal curve remains steep, providing some price protection for a rising-rate environment.

The Bottom Line
Taking some of these steps may enable management to build more efficient investment portfolios that generate higher levels of income over time. Building predictable cash flow characteristics provides the flexibility to manage the portfolio effectively within the context of the balance sheet, while also leading to stable returns.

Of course, the institution should consider its asset-liability position when making these decisions. Investment officers should also continue to maintain robust risk management practices, keeping interest rate risk exposure at reasonable levels.

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, Atlantic Capital Strategies, Inc.
Robert B. Segal is the founder and CEO of Atlantic Capital Strategies, Inc., and 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 asset-liability management. Bob is also currently a Director-at-Large on the FMS Board of Directors.