Publications & Resources

May/June 2012
Balance Sheet Management

Turning Excess Liquidity into Earnings Liquidity
Our Industry’s Earnings Dilemma

By Tom Nelson & Mark Farrell

These past four years have certainly provided the banking with industry some interesting challenges. Among those that have been the most difficult are; managing through the first significant non-performing asset issue in nearly 20 years, managing net interest income in the lowest rate environment many of us have ever witnessed, and finding solutions to grow balance sheets in the face of unprecedented weak loan demand. It is to the industry’s credit that they have faced these issues so well and are clearly climbing out of this crisis.

In 2009, the industry actually lost $9.9 billion – one of two years of losses over the past 20. The turn-around in 2010, in which reflected a profit of $85 billion, was dramatic as was the continuation of that trend in 2011, which shows $119.5 billion in net income. Truly, great strides have been made in overcoming all of these challenges. However, even with that improvement, the 2011 industry Return on Assets (ROA) of .88% and Return on Equity (ROE) of 7.8% is still a long way from the peak performance in 2006 when standards of 1.28% and 12.27% were achieved, respectively.

There is no crystal ball, and it is difficult to see the kinds of returns posted in 2006 repeating in the near future given the many headwinds on the horizon. However, in order to attract capital, the industry will clearly have to figure out a way to do much better than its performance in 2011. There are many strong competitors for capital and investors will have many choices for placement in companies and industries with returns that far exceed 7.8%. Therefore, it is our assumption that the industry will have to find more ways than ever to achieve returns that are competitive with that available elsewhere in the market today. Putting every dollar to work will be crucial and the industry will have to make certain that the leverage it has historically been given continues to support profitability efforts.

For example, regulatory capital standards provide for leverage of 20 times. With that kind of “booster”, ROE in 2011 would have been more in the range of 17.6%. Instead, with industry capital of $1.57 trillion supporting assets of $13.88 trillion at year-end 2011, base leverage of 9 times created only half that figure. No doubt, there will be a need for more capital given the difficult asset issues still ahead, but leverage in the 9 times range will likely not be what is needed to compete on the ROE playing field. With certainty, the leverage issue will work itself out over time as the industry and its regulators come to agreement on that issue. But, for now, it should be assumed that leverage will be less robust than desired until the non-performing issues become much more manageable than exists today.

It is also interesting to note that liquidity has not been much of a problem in the past four years. Much of that credit belongs, we think, to the FDIC for both increased insurance coverage on certificates of deposit and the expansion of coverage on demand accounts through the currently named Dodd-Frank Deposit Insurance Provision. Though the program has, we believe, created an excess of liquidity for the industry, there has also been a bit of a dilemma for many as to what to do with that excess funding. This kind of assistance is always appreciated, however, when combined with a low rate environment, it has caused some issues with profitability. The first Transaction Account Guarantee Program (TAGP), coincided with the Federal Reserve action to drop the Fed Funds target to 0-25 basis points at the December 2008 FOMC meeting – a level which has stayed in place since that meeting. As funding poured into the industry in what we would suggest was a “flight to safety” by corporate treasurers abound, the ability to invest that liquidity was somewhat hampered by concerns over how long it would remain. Many banks actually took the safe route and simply placed those funds in either Fed Funds Sold or in a Federal Reserve Account with a very safe 25 basis point (or less) return. Others felt that they needed a larger spread than the maximum 25 basis points this entailed and these institutions found investments further out on the curve. The pick-up in yield for these institutions typically was in the 200 basis points range and, as it turns out, that strategy tended to be the better one given the environment that followed the December 2008 meeting.

Where does that leave the industry today? There really is nothing to be gained by doubting this historic strategy – that is in the past and cannot be changed. However, with the Federal Reserve strongly suggesting this rate environment may continue for another three years, it just doesn’t seem like a good idea to continue the Fed Funds Sold/Federal Reserve Account strategy. To do so would likely end up costing banks that spread difference for a total of six years and even worse, losing considerable profit at a time when profitability is under attack. We believe that the time is right to switch strategies, or at the very least, begin migrating some of that excess liquidity out on the curve. We understand that if the Dodd-Frank Deposit Insurance Provision is sunsetted at years’ end, banks could find themselves in a squeeze if they do not have a strategy in place.

In addition to suggesting an investment change, we are also recommending a plan for countering the possibility of much of the excess leaving the industry in 2013. Your ALCO Policy holds the key and the Funds Management section of your policy is where you should be focused. A clearly defined strategy for using non-core funding coupled with a plan for raising core funding as we get close to year-end is prudent. We recommend all of those who embrace a higher yielding strategy (we suggest this for all institutions) to make this high priority discussion at your next ALCO meeting. Understand which wholesale sources of funds make sense for you, place limits on their overall and specific use, and make sure you give your Board information on this usage at every Board meeting. Have a ready strategy for expanding your core funding if that becomes an issue as well. Deposits at rest tend to stay at rest. We believe a more prudent strategy is to put your excess liquidity to work in a safe credit risk strategy that can potentially improve returns by more than 200 basis points – the decision to do nothing is a decision that has been and will be one that hampers profitability at your institution. If you do decide to take this path to enhanced profitability, there are some investment ideas that make sense today.

Professional Money Management

While the reasons to pursue a safe credit strategy may be compelling for your bank, the level of necessary expertise that can be obtained in-house or through your local brokerage relationship may prove to be a non-starter. Engaging a third-party, experienced professional money manager to actively manage an MBS portfolio of Agency securities can serve as an effective loan surrogate. Such a program contains minimal credit risk, and the interest rate risk within these portfolios can be customized. Additionally, as loan demand strengthens, the need for such managed portfolios will decline, at which point you can reduce the cost of the program by decreasing the size of the outsourced portfolio or by eliminating the program entirely.

A money manager who specializes in managing portfolios of MBS securities can provide value to a bank’s ALCO committee by working to structure a portfolio that is within the bank’s investment policy and IRR models. A manager engaged to run such a program should have the ability to customize the duration of each portfolio and provide simulation analysis so banks can determine how changes in the value of the portfolio will impact earnings over time.

Value of Professional Money Management

Professional money managers are paid a flat fee for carefully managing portfolios on a daily basis in accordance with a banks’ ALCO policy. Fees paid are not a factor of each transaction – where the price of the service is imbedded in the price at which the security is sold to the client, as is seen with most brokerage relationships. The money manager serves as a fiduciary to the bank and is charged with building a portfolio that is managed to predetermined benchmarks and is tailored to each bank’s unique circumstance.  Such managers identify the securities that best meet the needs of their client and then source these securities through multiple brokers where the best price for the targeted security is executed, enabling the bank to extract the most value for its investment.

Building in-house investment expertise and the trading capability needed to oversee such managed portfolios can be a costly endeavor. The flexibility in utilizing a professional money manager is inclusive of the market environment, whereas when loan demand strengthens, the need for such managed portfolios declines. Banks then have the flexibility to reduce the cost of the program by decreasing the size of the outsourced portfolio or by eliminating the program entirely – and not being saddled with the fixed costs of in-house management.

Each day a decision is not made ensures that your deposits at rest will stay at rest. Professional management enables banks to gain controlled access to a well-qualified extension of their ALCO team, and the specific expertise needed to quickly turn excess liquidity into earnings liquidity.

Tom Nelson is chief strategist for Reich & Tang. He can be reached at 212-830-5243 or tneslson@rnt.com. Mark Farrell is director of institutional marketing for Vaughan Nelson Investment Management. He can be reached at 713-224-2545 or mefarrell@vaughannelson.com. WIB endorses Reich & Tang’s Demand Deposit Marketplace.

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