Going beyond regulatory compliance - Making ALM and FTP work for you (part 4 - the impact of lower for longer)

How will the recent monetary policy actions and market reaction affect your FY2020 plan and beyond? Are you able to explain the expected impact of this new environment to all your stakeholders? 

How will the recent market events impact your short and mid term financial performance? As most financial institutions should have done by now, we have called for an extraordinary meeting of "IBSM-Bank's ALCO (see *)" to understand the potential effect of a lower rate environment on our FY2020 financial targets and 3-year strategic plan.

Rates and client reaction

IBSM-Bank's FY2020 profit plan assumed rates would remain relatively constant at 2019- year end levels with a flat yield curve around 1.75% to 2.00%. A couple of months into the year, we have been surprised by the Coronavirus: The Bank of Canada (as many other Central Banks) cut its lending rate by 50 bp following the U.S. Fed's move. and the yield curve has inverted, with medium term rates dropping by around 100 bp.

We have adjusted our projections: Our adjusted rate scenario reflects the -50bp adjustment and flatter curve, resulting in lower forward rates. In this scenario rates are falling over the relevant 3-year horizon (3M CDOR rate falling just below 1.4% vs. 2.0% in our original projections)

Understanding the implications of this new rate scenario

Balance sheet and NII evolve as a result of a complex mix of market, customer and self initiated actions. In order to understand the full impact of this (or any) move it usually helps to go step by step.

Direct rates impact: To keep things simple (e.g. not having to explain YTD variations in balances, rates) we will continue to use 2019-year end balances as the starting point and only adjust our rate scenarios starting in March. Other income statement items will also remain unchanged (PCL expense ~0.3%, NIR flat, base case expenses), praying there is no sustained impact to the world economy.

Considering the direct rate impact only (Coronavirus - Rates Only scenario) NII will drop by around 1.4%, 3.4% and 4.4% in following 3 years. That does not sound too bad, right? However, given the significant contribution of NII to total revenues (~2/3) and our limitations in terms of growing NIR or adjusting operating expenses in a meaningful way over this horizon, bottom line impact (NIAT) is around -3%, -8% and -10% respectively impacting ROE by around -100 bp. No chance of meeting our goal of improving C/I ratio.

Second order impact (customer reaction): If only things were that simple. How will your clients react to this new rate environment? Well it depends on the market structure and legal rights. Markets with long term fixed rate mortgages where the client has the right to prepay w/o a penalty have already seen a frenzy of mortgage refinancing activity (e.g. U.S. market), with the only customers not refinancing being the ones who expect the rates to go even lower.

• In the case of or virtual IBSM-Bank we are fortunate to operate in Canada (mainly 5-yr term mortgage loans): Mortgage prepayments above a certain amount (we will assume 20% annual lump-sum; annuity increase of 20% each year) carry an interest rate differential penalty for the client (basically eliminating all financial incentive). Yet we will assume clients take full advantage of these facilities, translating into a CPR of ~25%.
• Commercial clients have also been inquiring about refinancing. Since not all of our contracts include a prepayment penalty and to accommodate for others in the name of preserving the "strategic relationship" (nothing new here), we will assume some level of prepayment (an equivalent of CPR=6%, although a different pattern is probably better suited for this segment, e.g. x% of o/s balances each month during the next say 3 months)

• What will happen with deposits? In a risk-off scenario balances are likely to remain stable if not grow. However, credit spreads are widening which may lead to increased competition from some segment of the market (specially if these deposits are fully insured). Will you be able to adjust your deposit rates proportionally? This is usually not the case. At lower rate levels the relative cost of deposits to market rates tends to increase (not to mention negative market rates, e.g. Europe). In our case we assume a 10-point increase in retail and commercial deposits (an effective floor at the current level). Significant room for margin compression!

As displayed on the table above (right side), the picture starts to get ugly (Coronavirus - Adjusted). Net interest income will drop by around 4%, 8% and 10% over the following 3 years as asset yields continue to reprice down and deposit cost bottoms-out. Projected net income is around -10%, -18% and -25% respectively. ROE falls by some 100, 200 and 300 bp. respectively. C/I ratio goes to 75%, taking away years of cost control efforts.

Why did this happen, how did our Plan get so exposed?

If our projected rate scenario materializes (very much in line with current forward rates) the consequences will be significant. Hedging at this point in time (vs. falling rates) would only lock-in the expected losses, which would make sense if you believe rates will go even lower (anyway, that is now water under the bridge)

The underlying reason was structural interest rate risk. A large portion of our total assets (~C$1.2 Bn) are funded with stable non-rate sensitive deposits and equity:

• On the asset side there is not much duration on our books: Investment portfolio is nominal (C$ 40 MM, fixed rate, maturity ~2.2 yrs); Fixed rate commercial and mortgage loans (~C$ 700 MM) have an average contractual maturity of only ~2.0 years with an estimated effective duration of ~1.5 years.
• Retail non-maturity deposits (C$200 MM) maturity profile is ten years while non-retail (C$180 MM) is five years (assumed linear run-off, all core). Resulting rate sensitivity (effective duration) of ~3.0 years.
• The difference between the asset and liability rate sensitivity already point in the right direction (Rate Sensitivity A < L = margin compression in a falling rate environment)
• A common misconception here is to think about the banking book as a trading book (asset duration is half, but exposure is 2x, we are ok). The problem with this line of thinking (e.g. EVE, duration) is that they assume that the banking portfolios will effectively run-off. They are not capturing the deposit franchise value! If real events had to adjust to the model, this would mean that every customer/dollar of our low cost non-maturity deposit attrition would be replaced by wholesale funding (at full market rates), not with another similar customer/deposit (i.e. we are valuing an average customer deposit, not the deposit franchise). How to think about the effective duration of the non-maturity or low cost deposit franchise will provide material for another article (much longer than expected life, and probably extending under a low or negative rate environment, i.e. annuity like)
• Another element contributing to our current predicament is not establishing a specific interest rate risk profile for equity (own funds). When no decision is made on this, the decision gets taken for you. When not managed client/balance sheet behavior will drive the investment decision for you (usually short term). Good luck explaining to your shareholders why this decision is not under Senior Management/ALCO's control.

Ready for another surprise?

Once you get over all this refinancing activity (i.e. rewriting your asset book at lower yields), what will happen if the Coronavirus situation is under control and a as fast as interest rates went down, they go back up again? Textbook definition of an "ALM double whammy". How can/should you position/protect your balance sheet for this?

Final considerations:

What will this scenario mean for the longer-term viability of your institution?

• Assuming a constant dividend in dollar terms (are you able/willing to cut them?), lower retained earnings will put significant pressure on your growth capacity (in this example RWA would need to be 35% lower vs. base case at end of year 3 to keep capital ratios constant)
• Alternatively, how much additional capital will you be able to attract with a projected ROE below 8% to fund balance sheet expansion and grow out of this problem? The answer is likely to be not much, and we might see additional consolidation in the industry (M&A activity) in an effort to capture cost synergies.

Expectations are that you will be able to explain to all your stakeholders the potential impacts of this new environment and risk/return proposition of alternative actions that you will have to put forward to mitigate them.

• Are your existing ALM risk management capabilities up to the task? 

If you would like to learn more about how to measure and benefit from implementing an ALM and/or FTP framework and solutions please contact us at: IBSM Solutions

* Please see Making ALM and FTP work for you (part 1, part 2 and part 3) for an initial discussion / background of our fictional "IBSM-Bank".

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