Publications & Resources

February/March 2007
Focus: Balance Sheet Management

Increasing Returns without Increasing Loans or Deposits

By Joey Vandergrift

Back in 2004, you positioned yourselves to be more asset-sensitive, and the interest rate bet paid off. You, for awhile, were able to immediately reprice your loans, while lagging your deposit costs and riding the wave of the low-cost advances you had purchased. The investment portfolio was not your biggest concern. You were primarily focused on all of the new loans you were putting on the books. Life is good; rather, life was good. Fast forward a couple of years; you’re still asset-sensitive, though many economists are now calling for a decline in interest rates. Loan demand is waning. Your securities portfolio is still underwater and yielding less than it could. Your depositors are becoming more and more savvy (it is no longer uncommon to see 1-year CD rates at or above 5.50 percent and money market account rates paying more than 4 percent). And to top it all off, your advances are repricing upward (some to the tune of more than 200 basis points). So, in this unusual interest rate environment, how do you maintain, if not improve, the return to your shareholders? It may be necessary to utilize some non-core means to boost the returns or hedge the risks of natural banking practices.

First things first—utilize capital. The FDIC states that the industry’s core capital is at its highest level since inception. The most efficient way to go about this is through a securities or whole loan leverage. Securities leverages are not as appealing today as they were three to four years ago (the curve is inverted, remember). That does not mean, however, that leverages are a bad idea. I could argue that anywhere between 50 to 100 basis points in spread, though not extremely appealing today, could be structured to satisfy a need, e.g. to add liquidity, provide margin protection in a rising interest rate environment, pay for a newly issued trust preferred security, pay for the premium associated with an off-balance sheet product, etc. If for no other reason, why wouldn’t you leverage your capital today and use the cashflow from the securities to fund future loan growth? Remember, leveraging capital at a positive spread will increase current ROE.

Second, clean up your securities portfolio. When interest rates were at all-time lows and you were flush with cash, you had to invest in something. The 3% security yields were much better that the 1% fed funds rate. You did what you had to do. That is no excuse, however, for holding on to those bonds today. Take the loss, restructure, and pick up 200+ basis points in yield. Chances are you will be able to make up that loss within 12 to 18 months. Plus, if you restructure your securities portfolio in the context of your asset/liability report, you should be able to not only increase yield but also reduce the risk of your entire institution. Always remember that a securities portfolio serves three purposes: income, liquidity, and risk management. Unwillingness to reevaluate your securities portfolio, at least quarterly, negates all three objectives.

Finally, consider wholesale funding. Banks are in business to take in deposits and make loans. But what are your choices when competition forces the cost of the deposits to unbearably high rates? Historical banking practices would tell us to pay whatever it takes to get the deposits, and we’ll eventually be rewarded from the customers’ loyalty. Though ideal, this situation is no longer a reality. There is no loyalty in banking today. With this being said, it seems almost counterintuitive to pay exorbitant retail CD rates when you could go to the brokered CD market or Federal Home Loan Bank and get the structure your institution needs, for interest rate risk purposes, at a cheaper cost. Through these wholesale borrowing sources, you can also utilize options. If you choose to buy the option, you would pay a slightly higher cost but have less risk. Conversely, you can sell the option and increase your risk, but doing so will further lower your cost.

Everyone wants to grow, become more profitable, and mitigate risk. Moreover, you would like to accomplish all of these goals through organic banking practices. Unfortunately this can’t always be accomplished efficiently. When it can’t, it makes sense to utilize other means in order to give your shareholders the returns they require.

Joey Vandergrift is first vice president, fixed income research, for Morgan Keegan & Co. in Memphis , Tenn. He can be reached at 901-374-7826 or joey.vandergrift@morgankeegan.com.

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