Pub. 8 2018-2019 Issue 6

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S May • June 2019 11 Are We Too Asset Sensitive? B anks have historically been better prepared for rising rates than falling rates. Following a decade of antic- ipating higher rates, most balance sheets are even more asset sensitive/liquid than normal. This elevated asset sensitivity has served banks well over the last few years. Banks have increased NIM and ROA to levels not seen in almost two decades. However, in being optimistically asset sensitive, banks have also left themselves exposed to falling rates, more so than in previous economic cycles. A compounding problem is the low level of cost of funds (COF). Ex: Following the Great Recession, Colorado banks were able to drop their COFs to an all-time low of 0.21%. They have increased 20 basis points to 0.41% over the last few years, but that is still low. Yield on earning assets is currently 4.08%. Simply put, asset yields have much more room to fall than deposit rates. Last month, the 3-month T-Bill and the 10-year US Trea- sury inverted for the first time since 2006. An inverted curve is the market forecasting lower rates, and an inverted curve has preceded each recession over the past forty years. Each inversion is different, and the current economic environment presents new assumptions —negative rates, global quantitative easing, and interest rates have never remained this low for this long. A recession may or may not be on the horizon, but it is an appropriate time to evaluate the exposure. Management should ask two questions. 1. How much lower can our deposit rates reprice? 2. How quickly will our yield on earning assets reprice down? With few exceptions, COFs will be relatively unchanged, and increased cash flow/liquidity will lower yield on earning assets which will place pressure on NIM and ROA. This expo- sure to falling rates is a reoccurring theme on discussions with management and in A/L reports. ALCOs and portfolio managers often wait too long to hedge down rate risk. They do not act until rates are already falling, and revenue is being impacted negatively. This reactive approach generally delays action until it becomes too expen- sive to protect earnings. If your institution is asset sensitive, then you should currently be looking at strategies to extend the bond portfolio’s duration, purchasing bonds with positive convexity, and overweighting prepay/call protected bonds. If rates continue to fall, these protective attributes will become increasingly expensive. Sometimes, we get too caught up in making the right rate call, or we fall in love with one economist’s rate prediction. The goal of banking and A/L management is not to get it cor- rect. The goal is to be profitable in a range of environments. If your institution is exposed to falling rates, get ahead of it now, and layer in protection.  BY ROBERT BIGGS, MARKET ANALYST, DEBT CAPITAL MARKETS