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Fundamentals of Banking: How Higher Rates Impact Depositories

Despite the current conversations regarding rising interest rates and depositories’ bond portfolios, now is the time to look at long-term, sound asset liability management. Comments and questions such as “Rates went up and I should have locked in those gains” or “With the ten-year rising am I going to lose money on my investments?” should be the jumping off point to a deeper conversation about the fundamentals of banking and the overall impact of higher rates on financial institutions.

Focus on Your Core Functions

After all, if you had a crystal ball and knew the direction of interest rates BEFORE they moved, you would be the richest person on earth.  The reality is that banks and credit unions run “funded” portfolios and should be less concerned with the direction of interest rates and more concerned with the level of interest rates. When interest rates go up, fixed rate asset prices do go down and that includes bonds, fixed income mutual funds, loans, etc.  That is how present value math works. Of course, when interest rates increase, the value of the core deposit franchise moves in the opposite direction.

That is why sound asset liability management is so important to a bank or a credit union. Our clients and mutual fund investors are depositories first and mutual fund and bond investors second. Looking at a financial institution’s securities portfolio in a vacuum is not effective. Fundamentally, banking has its roots in the management (and ultimate success) of three main functions:

  • Deposit gathering and the building of a deposit franchise.
  • Lending, asset pricing and diversifying credit risk at a portfolio level.
  • Liquidity, securities portfolio, and risk management.

For years, high performing financial institutions have not only perfected the management of these three functions, successful leaders have also understood how they work together as interest rates and markets ebb and flow. When interest rates move higher, credit costs generally move lower and deposit franchise values increase (in many cases the deposit franchise value is the largest driver of firm value and profitability). This makes higher rates a good thing for a bank or credit union, not a bad thing.

Look at the Big Picture

Unfortunately, the accounting for these three areas can be very different, which many times shines a brighter light on the bond portfolio and liquidity management vs. the other core areas. The message for all of us is that looking at one area without taking all three core depository functions into account is not good management. If your bond portfolio value falls, but your institution’s value is moving higher and your projected margins are increasing, that is arguably a positive event overall. The investment portfolio is pulling its weight today to help pay the bills. When interest rates increase, the portfolio’s value will fall but it is not permanent. They are bonds and will ultimately pay down and be reinvested into securities with higher current market rates. That’s simply how institutional investment portfolios work.

The bigger issue is understanding how much better the other two legs of your depository’s stool are holding up and that the “accounting” picture that you are seeing does not reflect it (yet).  The institution’s value should be higher as should projected net interest margins. These longer-term trends should be more important to stakeholders than short term accounting measures. None of us can predict interest rates, but we should all agree that higher interest rates are generally better for banks and credit unions – not worse.  Sitting on the sidelines when you “think” interest rates are low and not actively managing your liquidity and securities portfolios is not an effective long-term strategy. Low-rate environments put downward pressure on margins and a depository’s value and their portfolios need to work overtime in these environments to help make up for that deficit. These fundamental principles of banking and financial intermediation cannot be stressed enough.

About Author:
Robert Perry,
Principal

Robert Perry is a Principal at ALM First, joining the firm in 2010. Mr. Perry leads ALM First’s ALM and Investment Strategy Groups and is responsible for the development of asset liability and investment portfolio themes for the firm. He also provides strategic focus for financial institution client portfolios that are primarily invested in the high credit quality sectors, and is instrumental in balance sheet hedging strategy development.

Mr. Perry has more than 30 years of experience in the banking and bank-consulting businesses. Mr. Perry has shared his in-depth knowledge and financial management background at many conferences, training and educational events in the areas of ALM and investment strategy, profitability and portfolio strategies, as well as hedging and derivatives use. Mr. Perry has been quoted and published in various publications including WIB CFO Digest, WIB Directors Digest, Credit Union Business, Bloomberg News, and many more.

Before joining ALM First, Mr. Perry previously served as Managing Director of the ALM and Investment Strategy division of DataTech Management in Los Angeles, California, and Chief Investment Officer for First Coastal Bank in Manhattan Beach. Previously, Mr. Perry was a Principal and Product Portfolio Manager at Smith Breeden Associates, Inc., where he managed Smith Breeden’s Enhanced Cash and Enhanced Equity Strategies. He also managed Smith Breeden’s bank consulting group, which included the non-discretionary asset management and risk-reporting businesses. Prior to joining Smith Breeden in 1991, he worked as an analyst in the risk management area of Centura Bank in North Carolina.

ALM First Financial Advisors is an SEC registered investment advisor with a fiduciary duty that requires it to act in the best interests of clients and to place the interests of clients before its own; however, registration as an investment advisor does not imply any level of skill or training. ALM First Financial Advisors, LLC (“ALM First Financial Advisors”), an affiliate of ALM First Group, LLC (“ALM First”), is a separate entity and all investment decisions are made independently by the asset managers at ALM First Financial Advisors. Access to ALM First Financial Advisors is only available to clients pursuant to an Investment Advisory Agreement and acceptance of ALM First Financial Advisors’ Brochure. You are encouraged to read these documents carefully. All investing is subject to risk, including the possible loss of your entire investment.

The content in this message is provided for informational purposes and should not be relied upon as recommendations or financial planning advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. While such information is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented.

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