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March 14, 2011 by Steve Williams Steve Williams

The Wild Ride Up the Yield Curve

There is an anxiety growing today in the minds of shrewd investors and in the bowels of bank finance departments … it is a pressure that has been building and now seems to be tipping into something more serious and worthy of every bank executive’s FULL ATTENTION. The anxiety is centering upon the pending ride up the interest rate curve and what revenue and risk will look like in a potential roller coaster environment.

Whether it is the Fed’s quantitative easing, rebellion in the Middle East or a natural disaster in Japan, the Bloomberg terminals and scrolling CNBC headlines are just feeling jumpier. The Los Angeles Times summarized it nicely this week: “We’ve reached a point where inflation has become Topic A in many discussions about what comes next for the U.S. economy and financial markets.”

In the past few weeks of strategic planning meetings, I have heard these conversations get more frequent and louder. What’s bizarre is that we still have one high-profile major league weenie claiming that all is well.


It’s interesting to note that while Bernanke pontificates calmly before Congress, “bond king” Bill Gross has reduced the government bond holdings in his Pimco Total Return Fund down to zero. Euro Pacific’s Peter Schiff, who called the 2007 housing crisis spot on, is worried about “a much more tragic economic opera for which the curtain is just now rising.”

Maybe we should have faith in bearded Ben. Just look how successful his QE2 initiative has been since November when loose money was pumped out to keep rates low – we’re up 100bp!


It’s time for bankers to slap themselves in the face and wake from the calm droning voice of Bernanke and meaningless blue chip rate forecasts. Bankers are the stewards of $1.5 trillion of “other people’s money” and right now should be sweating about the potential implications for a ride up the yield curve.

Full disclosure: I, Steve Williams, am a died-in-the-wool, Milton Friedman-loving monetarist. There are many folks with great Ivy League pedigrees and quantitative forecasts who would support Bernanke’s “serenity now” mantra. In all candor, I am one of those worry warts who feared inflation too soon during a time when taking interest rate risk has been lucrative. However, just because my house didn’t burn down last week doesn’t mean my Allstate insurance policy was a waste of money. Right now it’s important for bankers to remember that all major market movements are non-linear, and they come when a certain tipping point in market conditions is reached. Although I hope and pray we avoid a tipping point, reading the blogs and talking to investors and sitting in meetings with CFOs compels me to think that tipping point risk is much higher than it was a year ago.

Which brings me to bank asset-liability management (ALM) committees.

If ever there was an institutional process that needed a swift kick in the rear, it’s the ALM meeting. With anxiety in the air, we simply have to move behind rote discussions about loan and deposit rates, regulatory shock reports and regurgitating our financial results for the month. It’s time to turn up the heat in the ALM committee and create more of the feeling of a trading floor than a study group in the university library. I am convinced that great differences in earnings and stock performance will arise between those banks that were mentally prepared and war-gaming for what’s ahead and those nodding off from Bernanke serenity tapes.

So, GonzoBankers, as you set the agenda to crank up the heat in the ALM committee, here are a few key priorities I’d like to share.

#1: Recognize the revenue loss building from low lending activity

Most bank 3-year forward-looking financial forecasts are revealing the serious revenue challenges that a pullback in lending is causing. Let’s put things in perspective. In 2005, banks ran at a 93% loan-to-deposit ratio. By December 2010, that ratio had dropped to 76%. If one assumes a 2% yield premium of loans over securities, banks have given up $40 billion in revenue from dropping loans – that’s two to three times the potential impact of the Durbin Amendment! While banks may wish to hold a bit more liquidity than during boom times, all would agree that 76% loan-to-share is just too low. Bank executives need to seriously discuss how they can re-enter lending markets while still dealing with the hangover of the past four years.

#2: Remember that medium term CRE alone can’t fill the bucket

One of the real conundrums for banks right now is planning what the loan mix should and will look like over the next three to five years. In ages past, revving up loans was simply a matter of cranking out more commercial real estate and construction loans. However, even when/if housing and commercial rental rates recover, we are in a new age where CRE exposure will be frowned upon and limited. Banks with assets under $10 billion still have construction/CRE exposure at nearly 250% of capital – there won’t be a lot of room to grow this lending bucket. Instead, banks will need to be prepared to fight for the commercial borrowers when they rear their heads to begin growing their businesses. They will need to have a clear mortgage portfolio strategy and may want to consider stronger cross-sell of consumer loans to the majority of bank depositors who do not borrow from the bank today. Certain niche lending businesses may also be an avenue banks will be forced to explore to drive loan-to-share to a better level.

#3: Go beyond “blue chip” rate forecasts to support balance sheet strategies

It’s peculiar that banks load up “blue chip” rate forecast information in which management has very little confidence and then they project bank financial performance with a false sense of certitude. For the past three years, the blue chip has simply kicked a modest rate uptick forecast down the road. Remember, rate shifts usually don’t happen in a slow, linear fashion and we are still sitting in an abnormally low rate environment. It’s important to remember, the average rate on the 10-year bond since 1954 has been 6.30%, almost a full 300 basis points of what we have today. Remember what happened in the late 1970s to 10 year rates – 650 bps in five years. Are we able to mentally grasp such a scenario today?


GonzoBankers, I think there is enough in the tea leaves to take a very conservative posture on the asset side of the balance sheet. Don’t stretch for earnings with investment rate risk and leverage, no matter how mad the shareholders will get over the next four to six quarters. It’s also time for the ALM committee to seriously argue about whether it’s time to hedge the liability side of the balance sheet. Strategies such as layered borrowings, longer term CDs and swap/swaptions should be part of a detailed discussion at the ALM committee.

#4: Turn ALM committee into a command center mentality

It’s important for bank senior managers to acknowledge that the responsibility for navigating the roller coaster ahead is everyone’s, not just our poor CFO. Lenders, retail executives, marketing, risk management – it’s time for you to go deeper with your knowledge of balance sheet management. It’s time for everyone on the senior management team to keep top of mind the sheer amount of value at risk on the road ahead. A basis point of margin compression in the banking industry today is over $1 billion in revenue. A basis point at even a small $1 billion community bank is close to $100,000. Here are a few suggestions I have to heat things up in the ALM committee:

  • Keep an eye on the trades of the high profile investors. To keep the real-world present at ALM meetings, make sure some quotes, blog posts and article copies of major institutional and hedge funds investors are shared. Get in the proper mood for thinking about finance by hearing what Bill Gross, George Soros, etc. are thinking – comb the blogs on Seeking Alpha to see what type of trade mentality debates are occurring.
  • Play with your own rate forecast. Each month, have a running “closest to the pin” contest where each member of the ALM committee guesses the 90-day T Bill and 10-year T Bond rates. Maybe include a $100 prize each month to keep members engaged and the competitive juices flowing. Then, track your team’s aggregated rate forecast versus the blue chip and actual rates to start learning about your perceptions versus market realities.
  • Install a plasma TV blasting CNBC. Nothing gets a team more in a market mood than the sound of Squawk on the Street talking heads booming as the team comes into the room for an ALM meeting. Mute the sound during the meeting, but keep the headlines and tickers on screen. It sets the right ambiance.
  • Build a margin scorecard versus peers and benchmark rates. One way to keep the team focused on the stakes of solid asset liability management is to build a simple scorecard that tracks margin management. A simple, one page report that shows the bank’s cost of funds versus peers and a benchmark (e.g. 1-year Treasury) and yields of specific loan types (commercial, mortgage, consumer) versus peers keeps everyone focused on the prize. One high performing bank I work with tracks the percentile of its asset/investment yields and cost of funds versus peers and sets percentile goals as part of its strategic plan.

No one knows when rates go up, but everyone is certain that they will go up. It may not be the good news of economic recovery that makes it happen. It may instead be a return of stagflation and the misery index of high unemployment coupled with inflation. The worst thing a good ALM committee could do right now is to believe that any of the conventional wisdom has any wisdom about what’s ahead. It’s time for bank ALM committees to be the venue to war game, debate and learn what lies ahead and to mentally prepare for more of a fast-paced trading floor mood rather than the rote calm of a bank staff meeting.


What Happens Now?

You just spent two days in strategic planning meetings and left feeling your time could have been spent more effectively just about anywhere else. The content was insufficiently prepared, the facilitator spoke in textbook generalities, and the participants, not feeling the least bit unified, came away wondering what, exactly, is supposed to happen now.

Enter Cornerstone Advisors. The experienced and industry savvy facilitators at Cornerstone Advisors have helped countless banks and credit unions get – and stay – fired up about their institutions’ strategic plans and future direction.

Visit our Web site or contact us. We’d love to talk about helping your institution develop a cohesive plan for a profitable, predictable future.

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3 Responses to “The Wild Ride Up the Yield Curve”

  1. Mark Ingalls says:

    What the ALM needs less of, not more of, is forecasts. Interest rate guessing games -are you kidding me? The only less-useful exercise for ALCO than forecasting interest rates and economic activity would be watching others do so on the Squawk Box infortainment-type cable shows. Sheesh!

    What ALCOs need to focus attention on is how individual and portfolios of assets and liabilities will perform in various rate environments via cash flow analytics. Sell or don’t buy assets that offer no outperformance potential, originate/acquire those that do. Same analytics used to determine good risk-reward assets can be used to manage liabilities too.

    Analytics helps minimize the most underrated of all balance sheet risks -label risk. All loans aren’t better than all investments, all deposits aren’t better than all whole fundings.

    While it is interesting to know that Gross dumped all his Treasuries, I’d find it more useful if he did so as CFO or investment portfolio manager of a $500MM savings bank. Doesn’t it make more sense instead to use analytics to proactively manage my balance sheet (like Bill Gross) rather than be influenced by past decisions by others (like Bill Gross) who do?

    • I found this a very thought provoking and guiding article. I didn’t find it as contrary to Mr. Ingall’s comments as perhaps he did. If I were running an institution today I’d certainly include his recommendations as part of my management. If “Turn ALM committee into a command center mentality” isn’t happening in most banks and CUs today those institutions are headed for yet another crash or being left behind in the market.
      A great article. Thanks.

  2. Guy says:

    Very poignant and informative post Steve, but I’ll take a heavy dose of Zero Hedge and Bloomberg TV with a just dash of Seeking Alpha and CNBC!

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