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Asset/Liability Deposit Pricing Strategy Portfolio Risk & CECL

Growth in a rising-rate environment: 4 moves for bankers

Susan Sharbel
October 3, 2022
Read Time: 0 min

Financial institutions must plan to take advantage of rising rates.

Several factors make this rising-rate environment different, so strong asset/liability management is critical for increased earnings.

 

You might also like this checklist, "6 Reasons to update your core deposit analysis."

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Takeaway 1

Banks and credit unions can increase earnings in a rising-rate environment with careful asset/liability management.

Takeaway 2

Profitability is based upon spread, not necessarily interest rate, so strategic pricing on both sides of the balance sheet is imperative in this cycle.

Takeaway 3

Innovation and continued digital transformation are necessary to pull ahead of your competition and take full advantage of rising rates.

5 rate hikes

ALM: Key to growth in a rising-rate environment

In October 2021, I wrote about how the management of banks and credit unions could position institutions for growth as they waited for the Fed to begin hiking interest rates. At the time, financial institution earnings across the board were less than stellar, and institutions were poised to take advantage of a rising-rate interest rate environment.

Fast forward to 2022 and we have just that. Five rate hikes this year for a grand total of 300 basis points. Financial institutions can certainly increase earnings in a rising-rate environment. However, careful planning is warranted to seize full advantage.

Chart of Fed rate hikes YTD in 2022

Chart showing the Fed funds rate

To achieve growth

The importance of pricing during rising rates

Most financial institutions are asset sensitive. In other words, assets are more rate sensitive than liabilities. Shorter-term assets funded by longer-term liabilities typically place an institution in a position to gain earnings as rates rise. Assets (earnings) reprice up quicker than liabilities (cost), leading to stronger earnings and growth in a rising-rate environment. Is that what we are seeing? I will give you the analysts’ answer: yes, but…

 

Long-term instruments from the low-rate cycle

During the very long, low-rate cycle, many institutions went out further on the yield curve in the securities portfolio chasing yield, leading to long-term instruments and less asset sensitivity from an earnings perspective than would be “typical.” Additionally, institutions often have option risk in the form of calls held by the issuer of the instrument. If rates move (drop) to a point that it is advantageous for the issuer to call the instrument and reduce the rate paid, they will.

As rates rise, most instruments in an institution’s security portfolio are out of call range and behave like long-term, fixed-rate instruments. This means they now carry additional value at risk. The only way “out” of this contract is to sell the instrument at a loss. Few institutions need the liquidity now, so they will keep the longer-term, less-earnings-at-risk-sensitive assets. Less earnings sensitive means just that, less earnings when rates (fall or) rise.

You might also like this webinar, "Deposit strategies for the 2022 funding challenge."

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Effect of slowing prepayments

Meanwhile, prepayments on mortgage-backed securities slow down, reducing cash flow coming back into the institution to be reinvested at a higher rate. These issues in the security portfolio work to reduce earnings opportunities moving forward. If these behaviors were not taken into account when rates were flat, projected earnings may have been overstated.

The loan portfolio, likely the largest portfolio at an institution, also has challenges in this rising-rate environment. First, and similar to the mortgage-backed security portfolio, prepayment speeds slow to a crawl. Again, this reduces the cash flow back into the institution that can be reinvested at higher interest rates. Secondly, where can cash be reinvested? Loan demand, particularly in the real estate sector, has fallen significantly. Many institutions forecasted loan growth to continue to be strong and were poised to take full advantage, thinking increases in earnings would most certainly follow.

However, higher interest rates mean less qualified borrowers. Combine this with falling consumer confidence, and loan growth is difficult to come by. This reduced loan demand also increases rate competition among financial institutions. To obtain qualified credit, institutions often resort to offering attractive interest rates that undercut typical pricing strategies. While loan rates in previous rising-rate environments priced up with the market close to 1:1, institutions are often finding that in this rate cycle, perhaps they price up only 75-80% of market rates, reducing their spread.

Finally, and the most concerning is the possibility of a credit crisis as inflation creeps up and consumer earnings power falls. Not only is loan growth slow and rates less than previously expected, but current customers are quickly losing the ability to pay you back.

Chart of CPI from 1950 to 2022

Deposits, yield curve

Other potential roadblocks to increased earnings

On the deposit side of the balance sheet, while rates are still historically low, volume is up dramatically, which is costly even at low(er) rates.

Chart showing deposits at commercial banks

There are many “new” competitors in this space than with the last rising-rate cycle. More competition in online account opening means more consumer rate sensitivity. In other words, your depositors have more options to chase yield. These options do not simply refer to types of institutions but also products available. Additionally, technology has made it easier to move money than ever before. A couple of clicks and you have moved your funds. The branch model of banking is aging fast and being replaced with speed and ease, something that research reveals time and time again is important to customers.

 

Treasury yield curve

To add just a bit more rain on this rising-rate cycle parade, the yield curve is also currently inverted, a double inversion in fact. An upward sloping yield curve shows that long-term rates are higher, in relative terms, than short-term rates. Financial institutions perform much better with an upward-sloping yield curve as assets (yield) are priced on the long end of the curve while deposits (cost) are priced off the short end of the curve. The current yield curve “inverts” this paradigm. The 1-year rate is higher than the 10-Year rate and the 3-Year rate is higher than the 30-Year rate. Inverted yield curves are often precursors to a recession.

Treasury Yield Curve

Achieve growth

Four moves to succeed in a rising-rate environment

Given these obstacles to profitability, here are four moves financial institutions should make to still take advantage of opportunities available to generate growth in this rising-rate environment.

Take steps to ensure strategic pricing on both sides of the balance sheet.

This is key, since profitability is based upon spread, not interest rates. This is absolutely the best time for an institution to perform core deposit analysis, as well as engage in strategic discussions with advisors. How you navigate the pricing on both sides of your balance sheet will determine how effectively you can take full advantage of the opportunities of this rising-rate cycle.

Chart of net interest margins for all U.S. banks

Lean on innovation.

Innovation has created challenges for financial institutions by way of increased types of competitors and products, and innovation can help you lead the pack. Are there products and/or services that you would “never” offer? Markets that you would “never” enter? Pricing strategies that you would “never” employ? As my colleague Dave Koch routinely says, “Never is a long time.” Perhaps now is the time to re-evaluate these options to take full advantage of the changing landscape during this cycle to foster growth in a rising-rate environment.

Use technology to get ahead of the pack.

With uncertainties tied to how inflation and the Fed’s moves will impact the U.S. economy into 2023, a natural impulse might be to postpone advancing the digital transformation that institutions have accelerated since COVID. That type of move might seem quick and easy, but it is not clear-headed thinking. Now is the time to access the technology that makes staff more efficient, that gives you more visibility into performance and risk, and that pleases customers or members so much they will not consider going to a competitor or a fintech.

Now is the time to be stress testing liquidity levels thoroughly.

Do not wait until liquidity becomes an issue in your institution to stress test and begin liquidity conversations. Historically when rates are high, there is less liquidity. While addressing liquidity proactively is not necessarily a growth move, it is financially smart because it avoids having to look for other, potentially more costly forms of liquidity in the future.

Earlier I mentioned slowdowns in cash flowing back into financial institutions in both the investment and loan portfolios as well as the possibility and ease of deposits leaving to chase yield. Add to this the possible loss of principal from credit issues, and the excess liquidity that we have seen can evaporate quickly.

Take full advantage

Deploy growth strategies in a rising-rate environment

The previous long, low-interest rate cycle coupled with a pandemic, supply chain issues, and political unrest left financial institutions struggling for earnings. We simply could not wait for rates to rise. Now we have just that, with more rate hikes on the horizon.

Now is the time to deploy asset/liability management strategies to take full advantage of the earnings potential during this rising-rate cycle, while carefully managing pitfalls unique to the current economic conditions.

Abrigo has resources to help you navigate credit, interest rate, and liquidity risks in an uncertain environment.

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About the Author

Susan Sharbel

Senior Consultant
Susan Sharbel brings over 35 years of expertise in the banking industry, with a focus on asset/liability management and regulatory compliance. Prior to joining Abrigo, she was an ALM consultant leading ALM model implementations and managing the quarterly ALM process, support, and analysis for nearly 40 banking clients. As a

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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