Long-term yields on interest rates have fallen quickly since the October 2018 “Powell Pivot,” which was when Federal Reserve Chairman Jerome Powell chose not to raise interest rates until inflation accelerates. Frank L. Farone, managing director of Darling Consulting Group in Newburyport, Mass., discusses the challenges CPAs working with financial institutions now face, as well as a few lending and funding strategies they should consider. Farone presented this topic at PICPA’s 2019 Financial Institutions Conference on Sept. 17 at Penn State Great Valley in Malvern, Pa.

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By: Jim DeLuccia, PICPA Communications Manager

Podcast Transcript

Long-term yields have fallen fast thanks to the Powell pivot and U-turn since October 2018. Powell, of course, being Federal Reserve Chairman Jerome Powell. Additionally, slowing loan demand, rising funding costs and margin pressures are affecting the banking industry and the CPAs working in it. Joining me to briefly discuss these issues is Frank L. Farone, managing director of Darling Consulting Group in Newburyport, Mass. Frank will present this topic at PICPA's 2019 Financial Institutions Conference on Sept. 17 at Penn State Great Valley in Malvern.

Frank, thanks so much for joining me on the phone today.

[Farone] Thanks, Jim. My pleasure. Delighted to be a part of this.

What are a few challenges CPAs working in financial institutions may not be aware of yet, that were brought on by the Powell pivot?

[Farone] Well, one of the biggest challenges I think, that bankers are facing right now is, ever since we have the Powell pivot, meaning that, rather than having the automatic pilot of the Fed fund's rate increasing three to four times over the next several quarters, he's pivoted, and now the expectation in the markets is that the next Fed fund's move is not up. But rather we now have cuts built into the Fed funds future in the yield curve. And it typically what happens, when it comes to interest rates, is long rates tend to move in anticipation of Fed rate movements. And we saw long term interest rates snap back up in the latter part of 2018. In October we had a three and a quarter 10-year, because the expectation was, Powell was going to raise three to four more times.

When he did that pivot that you referred to, all of a sudden now, the market's expectations is the Fed's not going to hike and maybe the next move is down. And so, what happens is, long rates tend to move ahead of short rates, and that long in the curve came screaming down. So, we went from three and a quarter on the 10-year point of the curve in October, all the way down to somewhere around, and just below, 2% on the 10-year.

Meanwhile, short rates are at 2.50, and what's happening in the banking industry now is, there's a massive re-fi boom going on as a result of these lower interest rates. A lot of the lower yielding assets that were booked five years ago, when rates were low, a lot of those assets are now coming up for renewal and repricing, and rather than repricing up, a lot of these assets are repricing down.

Meanwhile, a lot of the CDs that were booked over the last couple of years, as those are rolling through, at somewhere in the low to mid 1% range, they're now repricing up. So even if the Fed is done raising interest rates, cost of funds for financial institutions are going to continue to go higher in the near term. And so, I think really, what bankers need to be aware of, is, there is a big squeeze going on and there's not a whole heck of a lot we can do on the asset side, because the horse is out of the barn there. Moving forward, a lot of the attention is going to be on managing cost of funds. And from a CPA's perspective, working with a bank is just looking at what is our true exposure to earnings at risk, given the current rate environment?

A lot of banks right now have not yet modeled, and they're in the process now of modeling their June 30 results, and when they get those results, it's not going to look pretty. When you look at all of the re-investments of investment cash flows, cycling down, loans repricing down, new loan volume going on at rates that we haven't seen in years. And at the same time all the funding costs that are rolling through, continue to price up. And so just making sure that they're aware of, “what is our true exposure in the current rate environment given the changes in the slope of the curve?” is number one. Number two is, revisiting, “what are the underlying assumptions that we have in our model?” And one of the things that we're finding is, given this low rate environment, and the, I'll call it the desperation to continue to grow loans, loan spreads have come down dramatically. Credit spreads have come down dramatically.

It's not uncommon to see 10-year fixed rate commercial real estate loans at four and a half percent. We're looking at treasury plus, two and a quarter treasury plus two and a half, right? Those are a lot lower rates than I think a lot of banks have built into their models. They're assuming FHLB plus 275. So, those spreads are continuing to come down.

I could tell you loan volumes right now, for a lot of the clients that we work with, we're seeing slowing loan demand and in many cases we're seeing negative loan growth, because of not just refinances but sales. And, looking at budgets moving forward for the rest of the year, I think a lot of banks are going to have to revisit where are we relative to what we expected? And what is the impact of the current rate environment having on our earnings at risk? And so, just making sure that you understand, number one, what is the current position of the institution? What is our exposure to changes in rates given what's already happened? And what happens if the Fed does cut another couple of times in 2019? What's the impact to the institution's balance sheet?

Those are some of the things that I think are creating a lot of pressure in the industry, that I think, a lot of folks really haven't thought about until now.

What is the most important action asset liability committees or I guess, as our audience will know them as ALCO, what should they take now and why?

[Farone] There are a lot of actions, number one, that I think ALCOs need to take. I don't think there's just one, but if I had to come down to one, what the most important action is, number one, getting the position right. Making sure that when we sit down with the asset liability management committee, each quarter, to make decisions, to assess what our risk is from an earnings perspective, what our liquidity position is, what our capital at risk is, understanding where are our exposures, what's creating those exposures? Where are our opportunities? Number one, just getting the position right is step number one.

And then from there, what we believe is the function of ALCO, it's not just for regulatory appeasement, checking off all the boxes. It's basically using that asset liability management function as a little, mini strategic planning session, to get a better understanding of our risks, our opportunities, and then developing strategies, meaningful strategies that lead to higher levels of income while managing our risks.

And so number one, getting the position right, is the starting point for all strategies developed within the organization. Every bank is different. They have different structures; they have different risks. And so, understanding that is the first step in assessing what are meaningful strategies we've got to be thinking about in the current environment. And just as an example, last October we've talked about rates snap back up, in October of last year, in anticipation of Fed rate hikes. All too often what happens is, people that sit around the table making decisions as to do we hold long-term fixed rate loans? Do we sell them? Do we extend our deposits? Do we extend our funding? Where should we be along the points of the curve on the asset side? On the funding side? How should we price CDs? Should we increase our money marketing accounts? All of these decisions at the end of the day come down to ALCO decisions based upon, what we know about our balance sheet.

For example, now, we have an inverted yield curve. The Fed funds rate is 2.50, the 10-year treasury is to the 2. The two-year treasury is 1.75. The curve is inverted. So in effect, bankers today, have ... It's like getting tomorrow's newspaper today. Basically, what the bond market is telling us, is. rates are coming down. Knowing that the rates are likely, because there's never a guarantee. Because we already had that Powell pivot back in October, they could pivot again. But right now, the cheapest alternative for funding right now is wholesale. I can go to the brokerage CD market and get 2% money out for two years, rather than going to my local market and paying 2.75 competing with some of the other village fools, I'll call it, that haven't recognized that rates have come down significantly and they're expected to come down.

I don't want to compete for one-year, two-year, three-year, four-year, five-year CDs. I'm going to invert my CD curve right now. I'm going to try to incent all my depositors to go somewhere below one year. Anywhere from five to nine months, is a sweet spot where I would be trying to attract funding, to give the bank the ability to reprice these funding sources down. That's number one. And then number two, not getting locked into longer term funding at high rates. That's going to be painful if, and when, the Fed starts to go lower. And one of the things that ALCOs really need to understand is, and I don't care what your balance sheet looks like, I would submit that every single financial institution out there, in this banking industry, is exposed to falling rates. Falling rates is not your friend.

Despite the fact that most bankers loathe and are always focused on rising rates. When they sit around ALCO, they run interest rate shocks up 300 and they look at what happens to the balance sheet if rates go up 300 in the shock fashion. First of all, rates don't go up like that, and number two, given the current rate environment that's a low, low, low, low, low probability, that's not very plausible. Why are we wasting our time and spending on it? I'd be looking at the exposure we have to falling interest rates, and then taking action today to offset that exposure. And for each and every bank it's different, but I can tell you what banks are going to need to do is, they're going to have to start to add duration on the asset side, make sure they don't overextend their funding on the short side, and they're probably going to have to grow to offset some of that margin compression, until we get slope to the curve.

Frank, you mentioned in your response there - inverted yield curve - and that was actually going to be my next question here. I know you will speak at greater length on this particular topic on Sept. 17, but what is one lending strategy in an inverted yield curve environment that you can share with our audience right now?

[Farone] Think about it from a consumer's perspective. We're all consumers. Logically, if the curve is inverted, meaning long-term rates are lower than short-term rates. There's a high probability most borrowers are going to want to have a lock in long-term fixed rates, particularly if it's cheaper than funding short, meaning an adjustable rate type of loan. Therefore, if the demand is for longer term fixed rate loans, then the question becomes give the customer what the customer wants.

Here's the challenge. Rates have already come down significantly. We're looking at mortgage rates again at three and a half to three and five eights. What a lot of bankers are going to do is hit the panic button as they tend to often do when rates fall like this, and decide I'm not going to hold fixed rate assets at these low rate levels. I'm going to sell these things off.

The challenge is, or the problem is, how are you going to replace that income as the rest of your balance sheet continues to recycle lower from a yield perspective? And so, one of the things I would challenge everybody to look at, is, what is our capacity to hold long-term fixed rate assets in our portfolio, particularly on the loan side? Understand what that number is. That all comes back to ALCO understanding your current risk position.

I'll talk about how you get to that number in September, but given that, how much capacity do we have and how do we fund it? And for every bank it's different, but given the inversion in the yield curve, one of the things I'm going to talk about a little bit at the session is, utilizing two strategies for holding long-term fixed rate assets.

One is going to be using derivatives, and we have a lot of clients that are small community banks that utilize derivatives. And for example, right now I can lock in 10-year fixed rate money with a 25-year AM, below 2%. I can get that done somewhere around 1.90 right now. So, if I'm a banker that has a lot of fixed rate loan demand right now, I've got two choices. I can say no, I can originate and sell, or I can hold. For many of those banks, they should be holding those long-term fixed rate assets, despite the low rate environment. The question becomes how do I fund it? Do I have the capacity to fund it with my existing funding that resides in the balance sheet, in the form of core funding or do I need to hedge some of that? And if I do, what's the least expensive way to do it?

Derivatives is the new accounting rules. Speaking of CPAs, the rules have changed and it is a game changer, and so I would encourage every single CPA out there to get a better understanding of how to utilize directors to manage interest rate risk within the bank.

Holding long-term fixed rates is going to give you a competitive advantage. If I can fund the balance sheet long-term, fixed rate assets, with the least cost of funding, at the margin, that gives me a competitive advantage against anybody else. I can also use derivatives, as an example, to do forward starting loans, forward starting swaps. And one of the things that our clients have been doing over the last year or so is reaching out to their existing clients that have loans coming due in 2019 and saying, rather than wait six, nine, 12 months forward for these things to reprice, we can lock you in today. Because when that curve came screaming down, I can lock you in to a long-term fixed rate today, now that rates are low. And then just have this loan or this derivative set in at the time of your repricing. The cost of doing that today is basically zero. I can lock in long-term, fixed rate funding six months down the road without any premium.

I can do that using a derivative and that's a tool that a lot of the large banks use, but small community banks really ought to be taking a hard look at this. Otherwise it's going to be a huge competitive advantage.

I see. Transitioning to funding now, what is one important point to keep in mind when trying to determine the right funding mix?

[Farone] There is no one size fits all strategy or right funding mix. Clearly the right funding mix would be 100% DDA or checking accounts. We’d all like to fully fund the balance sheet with low cost, no cost checking or DDA accounts. The problem is, it's becoming more and more difficult to raise deposits, because of number one, the competition, two, the stock market.

When it comes to the right funding mix, you know what it all comes back to? What is the composition of the balance sheet? How is your balance sheet structured? At the end of the day, what we want to do is, make sure that we manage our earning streams so that regardless of the direction of interest rates, we don't get wild swings in our income. The one thing I would avoid is, putting on too much in the way of long-term funding. If I don't need it, in effect, I'm oversharing against rising rates, only to have it come back to haunt me if, and when, rates start to fall. And all of a sudden that's my worst-case scenario of falling interest rate environment, and I get double whacked. I get whacked on the yield side from investments in loans and then I get double whacked as I've locked into long-term fixed rate funding for fear of rising rates.

I can tell you, back in October of last year, when long-range backed up, as I indicated earlier, 10-year went to three and a quarter, Fed funds was going from two and a quarter to probably three or three and a quarter. There were a lot of financial institutions, despite the fact that they did better as rates rise, locked into long-term fixed rate CDs and Federal Home Loan bank borrowings, which is exactly the opposite of what they should've been doing.

But those are making decisions not based upon what our current position is, but in effect, speculating. And so, when it comes to the right funding mix, it all is a function of what's happening on the asset side of the balance sheet, because ultimately what we want to do is, have a relatively well-matched balance sheet, from a duration perspective. And I would submit that most banks have more long-term funding within their balance sheet than they're using to fund long assets. Most banks would be better off continuing to fund wholesale very short, and yet they tend to do exactly the opposite when it comes to utilizing the wholesale markets.

I think we do the same thing on the CD side. Right now, there's a lot of irrational pricing on CDs despite what the yield curve is, because we're looking down the street at what everybody else is doing. That's why earlier when we were talking about the inverted curve and pressures on margins, I suggested that banks would be well-served today to do CD specials anywhere between five months and eight to nine months at the most to manage their cost of funds and their exposure to falling rates.

Finally, Frank, what is one way companies can manage regulatory expectations while managing financial performance?

[Farone] Therein lies the epicenter, or that is the biggest challenge of outcome. From a regulatory perspective, we all know that the regulators, at the end of the day, are the insurer of the organization. From a regulator's perspective, they would love banks to have high levels of liquidity, high levels of capital, very short duration assets, because they don't lose a lot of value when rates rise. High capital, economic value of equity, minimal exposure to economic value of equity, no borrowings, fully funded with retail deposits.

The reason the banking industry works is, it's a leveraged business. It's a leveraged business. Unfortunately, that leverage is being taken out of the banking industry as regulators want more and more capital. The challenges is, particularly in this low rate environment, where the yield curves inverted, at the end of the day, how do we make money? The yield on assets, the yield on loans and investments minus my cost of goods for CPAs? The old manufacturing analogy.

What's happening? My revenues are coming down, my cost of goods or cost of funds is going up. I'm getting squeezed. And so, the big challenge now is, how do I offset that margin squeeze while at the same time ... that's the financial side, but at the same time, making sure I'm not offsides from a regulatory perspective. As I said earlier, keeping money, excess money sitting around in cash, burning a hole in our pocket. Two and a half percent for Fed funds might look pretty good right now. But if the Fed starts to cut, and that rate goes from 2.50 down to two or lower, that's going to put a big dent in our income.

All the asset yields are coming, screaming down. And for a lot of banks, they don't have as much room to bring their funding costs down. Most funding costs for a bank today, are below 1%. So, if asset yields have already come down a hundred since last October, we can't lower our funding costs a hundred. We're going to get squeezed. And what that means at the end of the day is, we have to continue to grow. And to grow moving forward, the least cost of funding at the margin, is going to be utilizing the wholesale markets.

We've got to manage financial performance, we've got to continue to grow, we've got to continue to put on long-term fixed rate assets, otherwise we're not going to have any spread. And that's where the demand is. The challenge is, how do we fund that? Most of it's going to have to be wholesale. That's the least expensive fund. That drives up borrowings. Borrowings are not the favorite thing of examiners. The most important thing we suggest to our clients is, make sure that you've got good solid policies, asset liability management policies, contingency plans.

You can tell the story when the regulators come in, what you're doing, how you're doing it, how you're managing it. Make sure you've got rock solid policies in place, contingency plans, stress testing to say what happens if worst case scenario hits? What are we going to do? Have a plan in place. This is all part of what we would consider to be a robust, comprehensive asset liability management process. It's easier said than done, but it's doable. And regulator relations are critically important. Having good policies in place, being able to explain and articulate your position is critically important.

I can tell you, when banks are being examined, the best thing they can do, the best thing they can do, before anybody takes a look at policies and ALCO packages is to sit down and be preemptive. Walk them through what you do, how you do it, your plans, your policies, etc. And I can tell you, regulator relations are critically important, and it goes a long way because otherwise, you know what? People are going to look at your ALCO packages from afar if you send them, and they have their own biases. Regulators have their own biases, let's face it.

I want to be preemptive to make sure that we get everything out on the table before they start looking through our ALCO package and making decisions on our interest rate risk our capital our funding our contingency funding. And so, again, I think it's important to have good policies in place, and then, just make sure you're able to defend your position. Have a game plan and have a backup plan.

Well Frank, thanks again for sharing this insight with our listeners today.

[Farone] My pleasure Jim, thanks so much. I appreciate being a part of this and it'll be interesting seeing where it falls between now and Sept. 17, but regardless of what happens, there are always things that we can do, and strategies to consider, regardless of any interest rate environment. I'm delighted to be able to, to share my ideas and thoughts with the PICPA.

Again, you can hear more on flattening and inverted yield curve strategies for financial institutions at PICPA's 2019 Financial Institutions Conference on Sept. 17 at Penn State Great Valley in Malvern.