3 minute read

Enjoy The Fireworks (While They Last)

Blog-2019-07-03

Tomorrow will be our country’s 243rd birthday as an independent nation. During the celebration, hopefully all of you get a chance to enjoy some good company and good barbeque. There is also another milestone that we could hit later this month, although I’m not aware of any firework displays or parades happening for it. If the current US economic expansion lasts through July 2019, it will be the longest expansion in the country’s history – a period of 10 years and counting. This milestone is also worth celebrating!But even if this milestone is achieved, economists will be busy speculating about how long the expansion will continue. After all, it’s the nature of the economic cycle – what goes up must eventually come back down. As economists are busy trying to determine when the economy may hit its inflection point, this is a great opportunity for financial institutions (FIs) to look at how the Federal Reserve’s actions on short-term market rates could impact their financial performance.

Since the current economic expansion has persisted for so long, it can be challenging to recall the last contraction period. A lot has changed over this time. Global economics has tightened, trade tensions have increased, the US Fed Chair has changed twice, and the Chicago Cubs have even won the World Series. Clearly, it’s a new world. But regardless of one’s personal outlook, hopefully FIs have been planning properly by conducting a variety of scenarios for interest rate risk (IRR) exposure. If not, now is the time to begin.

Although the fed funds rate has been on the rise since late 2015, a reversal is becoming a greater possibility. In the event of a falling fed funds rate, FIs may not have the same tools available as they did during the last rate downturn. Today’s deposit rates are notably lower than they were a decade ago. Consequently, FIs won’t be able to lower deposit rates by the same magnitude as they have been able to in the past. This could result in accelerated margin compression. 

To properly assess a balance sheet strategy’s impact on FI earnings, a variety of different interest rate scenarios should be reviewed. A variety of scenarios is key, since it helps an FI plan for all possibilities, not just the most plausible one at a given time. After all, when FIs were planning their annual 2019 budget six months ago, most of them were estimating either a rate uplift or a neutral position. Today, there is a good likelihood that short-term market rates could be declining. Falling rate forecasts are not an assumption I’ve seen in a lot of FI’s 2019 budgets!

Take into consideration the current outlook. As of the writing of this article (June 12, 2019), the federal fund futures market shows the following probabilities for changes to the fed funds rate at the July 31 meeting:

  • Rate ease: 83.7%
  • No change: 16.3%
  • Rate hike: 00.0%
  • Compared to the end of 2018, when a lot of FIs were preparing their budget plans, this is a complete reversal of what the futures market indicated and could translate into some large variances between budgeted and actual income statement results if the outlook holds true.

Here is an example that illustrates how a market force can change an FI’s earnings over a year. Using a typical, albeit hypothetical, community bank’s balance sheet composition of fixed/variable loans, investments, deposits and borrowings, here is the difference in annualized earnings under two different market rate scenarios:

  • 100 bps increase in short-term market rates (the FI’s budget assumption): $16.35M
  • 100 bps decrease in short-term market rates: $12.32M

That is a $4.03M swing in net income over a 12-month period. Even if this hypothetical FI hits its other budget targets perfectly, the net income is reduced by 25% because of its miss on what short-term market rates did over the budget period. A 25% miss on net income is not something that most people would like to have to explain to their board of directors!

Again, congratulations if you are already running a variety of different market rate scenarios for your IRR planning. If not, now is the time to get started. For effective IRR strategic planning, consider these suggestions:

  1. Review incremental changes, such as +/- 25 and 50 bps rate changes, since these are more likely to occur than 100 bps rate changes typically run for regulatory purposes. Modeling these scenarios will help to fine tune how your financial results could end up, particularly if the economy takes a turn that the market wasn’t anticipating.
  2. Review ramped rate changes versus immediate rate changes. Again, this more closely reflects how rates move and will therefore provide insights into possible earnings exposure.
  3. Review varying yield curves, such as an inversion, bear flattener, or bull steepener. Since twists such as this best represent how a yield curve moves over time, this will provide the greatest insights into how much a specific yield curve scenario impacts financial performance.
  4. Run multiple sensitivity analyses that vary a single model assumption at a time. Both controllable assumptions (such as pricing) and uncontrollable assumptions (such as economic factors) should be reviewed. Then compile the results into a table to show which assumptions have the most dramatic impact on earnings. This will provide insight into which assumptions are most critical to review, refine, and get as accurate as possible.

So, enjoy the milestones that we’ve hit. But once the smoke has cleared from all the fireworks, make sure you prepare for a variety of different outlooks to have a better understanding of their impacts. Unlike our country, FIs are not able to declare independence from market forces such as economic conditions and rates.

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