Do you remember the actor Ben Stein? My generation knows him as the monotone teacher in Ferris Bueller’s Day Off (“Bueller...Bueller...”). I’ll bet you didn’t know that his father, Herbert Stein, was actually the more famous member of the Stein family. Herbert was an economist of some repute to whom credit is given for Stein’s Law. Stein’s Law states that if something cannot go on forever, it will stop. Consider Stein’s Law and how it impacts the current combination of low interest rates, low growth and low inflation.
- Real GDP growth has averaged 2% since 2010. Preliminary figures on Q4 2019 results are indicating 2.8%
- Inflation (CPI) has averaged less than 1% for the same time period, well below the Fed’s target rate of 2%.
- Interest Rates (Fed Funds) are averaging 1.5%
GDP of 2.5% - 2.8% is just good, not great. The recent growth that we have seen in output is attributed mostly to productivity gains, not so much growth in labor. This is evidenced by a historically tight labor market. As this continues, we have seen upward wage pressure which will eventually trigger consumer spending and drive GDP higher. With very low inflation, there’s no reason to expect the Federal Reserve Board to intervene any time soon. Fed Chair Jerome Powell shared in October 2019 that we would need to see a really significant move up in inflation that’s persistent before they would consider raising rates.
Considering all this, the relationship between low growth – low yields – low inflation can’t continue forever. So, it won’t. The COVID-19 virus caused the Fed to unexpectedly cut rates 50 basis points with the expectation that growth will slow. After the pandemic stabilizes, growth should accelerate, driving up inflation and consequently rates along with it. Or, growth will stall, and the Fed will cut rates in order to achieve the desired growth.
Not one single part of this economic discussion is an original idea that I am claiming to take credit for. In fact, Cornerstone Advisors recently reported that the interest rate environment is the #1 concern in 2020, according to their recent survey of 300 community banks.* I’m also not trying to forecast the next recession, but a drop in GDP seems more likely in the current environment than a continued increase. Some economists propose that the low rate environment can be sustained indefinitely so long as central banks can print money. Some even argue that the low rate environment should be sustained indefinitely. The key takeaway here is that after a decade of low rates, banks and credit unions continue to have significant interest rate risk exposure to low rates and downward rate shocks.
The standard FFIEC rate shocks for stress testing interest rate risk on Economic Value of Equity (EVE) and Earnings at Risk (EAR) continue to be plus and minus 300 basis points (bp) immediate and permanent change in all rates. Because average cost of funds is hovering just above 100 bp (11th District Weighted Monthly Average Cost of Funds Index (COFI) for December 31, 2019 was 1.035%), deposit costs floor out at 0% while loan yields continue to drop when performing negative rate shock analysis. Because of this margin compression, many balance sheets breach regulator-imposed policy limits for both EVE and EAR at -200 bp. Some asset liability committees (ALCO’s) have become numb to being out of compliance. Others have changed their stress tests to exclude the down 300 bp scenario, arguing that it’s not relevant since rates cannot go below 0%. To reiterate, margin compression (the action of asset yields dropping more than funding costs and causing net interest margins to decline) makes negative rate shocks all the more relevant because that’s where the greatest risk lies.
What should Asset Liability Committees (ALCOs) do? At Jack Henry, we continue to see these best practices across our client banks and credit unions that have strong risk profiles:
- Do not ignore the -200bp and -300bp rate shocks. Include them in your policy limits and continue to model and report the results.
- Continue to analyze depositor sensitivity to rate changes. Update your assumptions at least annually.
- Focus efforts on growing your net interest margin. The larger your margin, the more volatility you can withstand. Invest in resources that help your lenders make informed pricing decisions that account for all the risks and costs in each new loan. Smart pricing is a competitive advantage.
- Develop non-interest income strategies to diversify sources of revenue. Reward customers that bring a full range of products to the bank and understand each customer’s contribution to total income.
The key to risk mitigation in this case is not risk avoidance or restricting certain types of assets. The key is to grow baseline income to a level that can absorb the adverse scenarios. Learn how a hosted asset liability management solution can help.
* Cornerstone Advisors ‘What’s Going on in Banking 2020’ Report