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08/09/2017

Strategic Responses to the Rising Rates Environment

Barry Adcock August 9th, 2017

Air travelers largely fall into two categories: those who pay attention to the safety instructions and mentally plan how they’ll respond in different emergency scenarios, and those who ignore the flight attendant and just keep doing whatever they were doing before the safety announcements began.

The current rising rates environment is like a plane full of bankers stuck listening to a repeating loop of safety warnings. The financial institutions that will succeed in weathering whatever the Fed decides to do next are the ones running through all the possible scenarios and planning how they will respond to each eventuality. Those that keep doing what they’ve been doing all along, or that limit their outcome planning, will struggle to sustain profitability.

Interest rate insights

In our webinar, “Strategic Responses to the Rising Rates Environment,” industry thought leaders Orlando Hanselman, managing director of Alligator’s Overhead Strategy and Risk Advisors; Eli Mullis, CFO of WB&T BankShares; and Mike Summer, director of product management at Deluxe Corporation explored what banks will need to do in order to continue thriving regardless of the Fed’s next move.

The air travel analogy is the brainchild of Orlando Hanselman, who opened the webinar by talking about how he assesses risk and plans for every emergency scenario whenever he buckles into an airplane seat. In order to remain profitable, Orlando points out, banks will need to plan for “certainty of uncertainty as well as the likely continued Fed tightening.”

Flat yield curve, uncertain future

The Fed’s actions have flattened the yield curve, impacting heavily on short-term bond yields, while longer-dated bond yields remain lower. Multiple factors are contributing to the uncertainty that banks currently face, Orlando explains:

  • The unemployment rate is approaching the Fed’s target of 4.5 percent.
  • Inflation is approaching the target rate of 2 percent — the key pivot point for the Fed determining its future monetary policy.
  • It’s probable the Fed will increase rates again in December and thrice more in 2018.
  • The Fed has said it intends to begin reducing its balance sheet in 2017 to cull its portfolio of Treasury and mortgage bonds.

Of course, these factors raise concerns that the yield curve could invert; very recently the three-month U.S. Treasury rate exceeded the six-month rate by five basis points, possibly foreshadowing a more meaningful inversion in the future.

“From here, rates will either rise, remain the same or fall,” Orlando continues. “From here, the yield curve will either remain flat, invert, normalize or steepen.”

Banks are at a crossroads, wondering where they should go from here. To prepare for the certainly uncertain rising rates environment, banks should focus on two key actions: scenario planning and stress testing.

Scenario planning

Scenario planning can help banks develop strategies to optimize profitability in virtually any environment, including a rising rates environment. By changing multiple assumptions within varying scenarios, such as recession, stagflation or a 6 percent mortgage rate, banks can assess how every eventuality may affect all balance sheet, cash flow and income items.

Although not every scenario is probable, anything is possible. Effective scenario planning requires banks to assess their current status, refine their performance goals and then model strategies to achieve those goals in any and every possible eventuality. It’s a simple approach to net-interest margin that Eli Mullis says works for his organization.

“If you were to ask us, ‘Are you going to be happy if rates rise or if rates fall?’ the answer we strive for is basically, ‘It doesn’t matter to us,’ ” he says. “We’re going to be happy because we’re going to get the margin we want, whether it goes up or down. We reach and take opportunities where we can, but we’re not going to stretch or give up long-term viability.”

Banks need to apply scenario planning to understand what could happen to their bond portfolios, liquidity and cash flow given myriad “what-if” situations.

  • Bond portfolio — Examine cash flows. Evaluate a one-year time frame for a short-term view, then consider the duration of the entire portfolio to assess its marketability. If a liquidity crunch occurs, will you be able to sell the bond portfolio and not cause substantial disruption in your income stream?
  • Liquidity — Calculate liquidity through multiple what-if scenarios. Review liquidity and interest rate risk, and update your contingency liquidity plan.
  • Cash flow — Frequently evaluate cash flows, both forecasted and under various stress tests. Review cash flow weekly or daily in more volatile conditions.

Stress testing

Stress testing takes the scenario planning concept a step further, changing one assumption or variable at a time within a given scenario, and then measuring precisely the exact impact that one change will have.

Banks must diagnose with comprehensive stress testing as well as multiple scenario planning.

What’s next from the Fed?

In late July, the Fed decided to leave rates unchanged for now and will soon begin reducing its U.S. Treasury bond holdings and mortgage-backed securities, Reuters reported.

The Fed last raised interest rates by a quarter point in late June, and the Fed has consistently said that it believes the U.S. economy will continue growing and the risk of recession is low, The Associated Press reported.

How the Fed’s actions will affect the economy and the banking industry will depend on multiple factors, the complexity of which makes Orlando’s “certainty of uncertainty” seem even more … well, certain! Many Deluxe clients are relying on Banker’s Dashboard to help them plan for whatever happens with interest rates and the industry in the future. Real-time access to critical data can help banks make smart decisions for their future.