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Balance Sheet Resilience & Adaptation Playbook

Print Download
March 2023


BALANCE SHEET RESILIENCE & ADAPTATION PLAYBOOK

By Chris Stanley, Scott Dietz
Asset Liability Management,  Enterprise Risk,  Stress Testing

The events of last week are a reminder that the business of banking works
effectively only when bankers are aware of how much liquidity they need and when
they'll need it. Experts here at Moody's offer this 5-step playbook to asset
liability committees so they can manage risk with greater efficiency and
confidence.  

The recent failures of Silvergate Bank, Silicon Valley Bank, and Signature Bank
marked the first bank casualties following a year of rising interest rates.
While the days and weeks to come will undoubtably uncover issues specific to
these banks that could have led some to foresee this eventual outcome; bankers,
investors and even depositors are left with a lingering concern for the
stability of their own banking partners. Bank executives need to act quickly to
reassure their investors, depositors, and regulators that they have a resilient
and adaptable strategy for whatever comes next.

In a departure from the financial crisis, the issues these banks exhibited were
not credit-related in nature. The fastest rate increase in recent history
followed a period of easy money, excess deposits, and low loan demand—providing
a stark reminder to bankers that liquidity is not the same as cash, and interest
rate risk creates issues across the balance sheet. This is exemplified by the
fall in bond prices when interest rates rise. A fundamental of finance to be
sure, but one that seemingly caught British pension funds and some sizeable U.S.
banks off guard. To confront this reality, bankers will need a mix of latent
strategies and new tools that have emerged since the last rate tightening cycle
in 2004 and inflation-fighting efforts of the Volcker Fed in the 1980s.

The business of banking has always been one of borrowing short and lending long.
The experience of the last week is not an indictment of that model, but a
reminder that it works only when bankers stay conscious of how much liquidity
they need and when they’ll need it, under normal and stressed conditions alike.
Despite markets pressuring the Fed to slow rate increases, asset liability
committees should prepare for rates to go higher and stay there longer. For CEOs
and CFOs revisiting these questions under stress, we offer this playbook to
guide next steps.

1. Target Outreach to Your Deposit Base

Using current events as an opportunity for outreach with key customers is
critical for restoring stability to the system. A thoughtful understanding of
distinctions between your strategy and the current market concerns is the
starting point of this effort. Many components of the failed banks’ deposit
bases were unique—highlighting risks and opportunities that could be critical to
managing your own deposit base. In the case of SVB, only a small portion of its
deposits were insured by the FDIC. SVB and Signature’s deposit bases had
prominent geographic and industry concentrations—amplifying their sensitivity to
changes in the business environment and creating a rapid feedback loop when bank
runs began. Media reports of large cash balances for single firms also highlight
missed opportunities to extend treasury management services that could have
managed client funds more effectively and offered bankers more consistency for
liquidity planning.

2. Understand Investment Portfolio Sensitivities

Unrealized losses in securities portfolios are appropriately drawing significant
market scrutiny, but asset liability management (ALM) strategies need nuance
beyond this loss of value. A push for yield created a substantial duration gap
and cashflow mismatch for SVB—its long duration securities were much more
sensitive to rate hikes than its liabilities, leaving it unable to fund
withdrawals and with insufficient capital. To manage interest rate risk and
deploy liquidity effectively, it is important to understand your portfolio’s
duration and cash flow sensitivity to multiple rate scenarios. Resilient
strategies will include contingencies for rate increases beyond current
consensus forecasts for terminal rates, as well as the possibility that rates
remain elevated for an extended period. Analyzing duration gaps with rate shocks
can help bankers build plans for repositioning their portfolios, maintaining
resilience for unexpected cash outflows, and hedging interest rate exposures.
Recent accounting changes simplify and diversify strategies that qualify for
hedge treatment in comparison to the last rate cycle. CECL tools are an
additional advantage, as they provide a multi-scenario view of interest rates,
credit and prepayment behavior that are critical inputs to hedging strategies
and effectiveness.

3. Revisit Loan and Deposit Pricing

Deposit betas (the portion of a change in the fed funds rate that is passed on
to deposit rates) and lending spreads (lending rate minus deposit rate) are key
levers for managing liquidity and profitability in a rising rate environment.
Having enough liquidity to support lending or deposit redemptions while also
maintaining profitable margins despite rising rates is the goal. Analysis of
duration gaps—differences in the timing of cash inflows and outflows as well as
the price sensitivity of assets and liabilities is foundational to managing
interest rate risk. Understanding your own deposit attrition and betas in prior
tightening cycles is key to setting strategies for limiting deposit outflows (or
attracting the right mix of deposits in the current market’s flight to
quality)—critical for maintaining liquidity. Deposit rates follow Fed funds
rates, but betas are lower when the Fed Funds rate is rising than when it is
falling. The Fed’s current efforts raised rates faster than at any prior
tightening cycle—a distinction bankers should factor into their deposit
strategies. Building on your understanding of your deposit mix, your strategy
will need to evaluate the types of behavior you seek to encourage as conditions
change.

Maintaining margin as liabilities reprice and avoiding interest rate risk in a
fixed-rate loan portfolio during a tightening cycle requires careful management
of lending spreads. Lending spreads have widened due to uncertainty about
continued tightening by the Fed. In addition to managing interest rate risk,
opportune hedging strategies and timing could also present an opportunity to
narrow lending spreads before your competitors do—this also depends on calling
the top of the rate cycle. Either way, pricing is one of the most effective
tools for influencing behavior to transform the portfolio you have (loans and
deposits) into the one you want.

4. Enhance Customer Onboarding Capabilities

Deposit flight to yield was widely reported throughout the current rate
tightening cycle. After the recent bank failures, flight to quality is expected,
adding stress to onboarding programs. Supporting new customers and meeting their
expectations is business critical, but so is staying in compliance with the Bank
Secrecy Act, US Patriot Act, the FinCEN CDD Rule, and all know your customer
(KYC) requirements. Satisfying increasing compliance, due diligence and
monitoring requirements at scale can challenge any program. Consider evolving
your current operations – with automation and robust data – to ensure the speed
and volume of onboarding new clients will not deviate from your current risk
guidelines and regulatory obligations. The last thing you need is bad actors to
become customers because of missed steps.

5. Analyze Credit Behavior Under Multiple Scenarios

Bond portfolios were the first casualty of rising rates, but make sure your
strategy gives changes in borrower behavior appropriate consideration. Scenario
analysis is needed to understand the effects of elevated rates on both liquidity
(timing of cash flows, repricing of assets) and expected loss that may result if
rate action produces broader market deterioration or recession. Slower
prepayments and maturity risk are first-order impacts of rising rates--limiting
cash inflows and slowing asset repricing. Proactive movement on maturity risk
will be advantageous, especially in CRE where many properties are already facing
post-Pandemic market shifts. Rising rates increase maturity risk for deals with
low debt service coverage ratios (i.e., borrowers are unlikely to find
alternative financing at market rates prevailing at maturity), and loan to value
risks (Fed rate increases impact Cap rates, decreasing property values).
Second-order credit effects could stem from rate-triggered recession, or other
shifts in the market brought on by continued tightening. Wholistic consideration
of the effects elevated rates (especially for an extended period) have on other
macroeconomic variables relevant to credit in all asset classes (e.g.,
unemployment, home prices, etc.) is critical to address these broader credit
concerns.

At Moody’s Analytics, everything we do enhances decision confidence and enables
new potential in our clients' businesses. Decades of investment in credit
analytics, macroeconomic forecasting, asset liability management tools,
structured cashflow analysis, prepayments, relationship pricing and know your
customer compliance have uniquely positioned us to support you at this critical
time and into the future.

Managing risks presented by rising rates comes down to two fundamental
questions; how much cash do I need and when will I need it? While that seems
relatively simple, getting to the answer can be challenging—thinking about
answers for multiple scenarios is the key to a resilient and adaptable balance
sheet. Whether the future holds further rate increases, prolonged periods of
higher interest rates, or both, using the playbook above will provide bank
executives with the analysis they need to strengthen their balance sheet and
liquidity position.



For more information on how Moody's is helping financial institutions with
balance sheet management, please visit our ALM page to learn more about the
offering. 

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