In looking back at a 42 year banking career, my most interesting period was the thrift crisis. Living through it was very challenging. At times I wondered whether our company and my sanity would survive. But I learned so much that has paid off for me ever since.
We’re in another similar period with this current financial crisis. As many of you look back on your banking careers, you’ll say this was the most interesting part of your career. And you may currently wonder whether your institution or your sanity will survive. Hopefully what you learn will pay off for you from this point on.
The Challenges In Front Of Us
For most of us, the greatest challenges we face in the current crisis are not behind us. They are in front of us, spread out over the next 3-5 years. You might ask, “How can you say this Farin, when some of the top economists in the country are saying the recession is over?” Of course we know that improvements in unemployment rates lag well behind recoveries from recessions. And credit losses lag behind improvements in unemployment. So those of us experiencing credit problems are likely to be dealing with their impact over at least the next two years.
But beyond the asset quality issue, our attention also needs to focus on how regulators and legislators will react to what has happened. And the news on that front is not encouraging. Here is a quick summary of the balance sheet and income statement challenges your institution is likely to face in the next few years, both directly from the financial crisis and from the regulatory and legislative change that is likely to follow.
Capital
- Capital ratios of many financial institutions (banks and credit unions) are lower now than a few years ago as a result of asset quality problems. In addition, inflow of flight to safety funds has ballooned many financial institution balance sheets, further driving down capital ratios.
- Pressure is building to increase industry capital requirements, both core and risk-based. The Treasury Financial Reform white paper, issued this summer, calls for a proposal raising capital standards to be placed in front of the industry by the end of 2009. When it emerges, I expect the proposal to place credit unions under the same capital requirements as banks. While the capital standards are yet to be revised, many institutions are already feeling pressure in safety and soundness exams to increase capital to levels well above well capitalized minimums.
- Institution reaction to increased pressure to build capital is causing many institutions to raise their management goals for both core and risk-based capital.
- Those banks that took down TARP funds are facing a point 5 years down the road when they will need to either replace those funds with another form of capital, or see a significant increase in the after-tax cost of those funds.
Liquidity
- Loans have outgrown deposits in 14 of the last 17 years. In order to fund the excess loan growth, institutions reduced the size of their investment portfolios while increasing their reliance on non-core funding.
- Asset quality problems for a significant number of institutions triggered liquidity stress events. The effect of the events combined with shift that had occurred in balance sheet composition triggered liquidity problems in a significant number of institutions.
- Driven by liquidity related failures, the recent Proposed Interagency Guidance on Liquidity and Funds Management calls for institutions to increase asset-based liquidity and reduce reliance on non-core funding.
- Flight to safety fund inflows from the stock and bond markets have increased levels of core funding while reducing demand for quality loans. Both of these factors have eased liquidity strains on many institutions over the short-term. However, as the economy turns around, flight to safety funds may flow back to the markets while quality loan demand will increase. As this happens, many institutions will face renewed liquidity challenges.
Income
- Most institutions are working their way through asset quality problems. In some cases the problem is moderate, while in others, severe. Asset quality problems provide a hit to earnings as a result of increased charge-offs and the need to increase the allowance for loan losses. That hit is likely to continue over the next 2-3 years.
- Pressure has also building in congress to reduce overdraft protection (ODP) fees. Many institutions are highly dependent on ODP income to produce an acceptable bottom line.
- The mortgage refinance boom at the bottom of the rate cycle has been producing significant fee income for institutions originating and selling in the secondary market. An uptick in rates could choke off the refinance oriented fee income.
- A decision to shift assets from loans to highly liquid marketable securities in order to react to regulatory pressures to increase asset-based liquidity would have a negative effect on yield on earning assets.
- A decision to move funding from non-core funding into core funding at the time when many other institutions are planning to do the same is likely to result in an increase in the cost of funds.
- The deferral of increased FDIC and NCUA insurance premiums into 2010 and beyond will have a negative effect on earnings in those future years. With the uncertainty relating to needs for additional assessments to deal with future failures, it is difficult to predict the significance of the future earnings impact and how many additional years over which it should be spread.
- Increases in operating expenses due to the effect of asset quality problems on collection costs, legal expenses, and asset-management costs is likely to be felt in at least 2010 and 2011 for those institutions with significant asset quality problems.
- Higher capital standards and institution goals are likely to lead to a reduction in financial leverage, with a resulting negative effect on ROE and earnings per share for stock institutions. Because ROE is the growth rate of capital for mutuals and credit unions, higher capital requirements will have an adverse effect on their ability to grow assets.
Responding to the Challenge
A set of challenges this formidable and complex can only be dealt with by effectively planning for the future in a rolling planning environment. The rolling planning environment must incorporate:
- A horizon that looks far enough into the future for your institution to have a reasonable chance of reaching your financial goals. For most of you that is at least three years and as many as five years.
- A level of aggregation that allows you to set goals for each year of the selected horizon without requiring that you get mired in chart of accounts level detail in developing the plan.
- A scope that includes the major measures of financial performance while looking at top level balance sheet composition.
You might think, let’s fire up “Farin Foresight” or some other A/L model and get to work. There is a role for an A/L model in this process, but it is not at the beginning of the process. Rather, the role an A/L model will play is in building the detail plan that takes us in the direction of achieving our annual goals — once the goals are established. We need to use a higher level capital/liquidity planning model in setting our goals. I’ll have more to say on this in a second.
You might respond, “Farin, do you really think a model can help us address all the challenges you laid in front of us earlier in this post?” The model I described won’t be able to solve the problems in the challenge. It merely provides you with a set of goals to shoot for in addressing the challenges. “OK, Farin. Aside from the model, you must have a potential solution in mind to some of the challenges. Please share your solution!”
I believe the “solution” to delivering acceptable performance while dealing with the challenges falls into three areas. Two attack the last great frontier of net interest margin management, loan and deposit pricing.
- You need to upgrade your ALCO process to focus on risk/risk and risk/return trade offs in deciding between alternative strategies you might develop to address the challenges. Anything short of an upgraded ALCO process is likely to lead to a “solution” to the above challenges that doesn’t even come close to optimizing the relationship between risk and return. In other words you’ll spend far more of your bottom line than you need to in “responding” the above challenges.
- You absolutely need a Core Funding Plan that addresses how you will grow core funding to meet your growth, liquidity, and balance sheet mix goals, while managing your cost of funds. A quality core funding plan:
a. Is made up of revisions to your deposit pricing process,
b. addresses the deposit products you need to develop,
c. provides the analysis tools to make more effective decisions, and
d. designs the segmentation strategies you will use in addressing customer constituencies you want to grow while managing funding costs. - Most of you need a much more effective loan pricing process that focuses on goals for loan growth while making sure that all loans you originate meet profitability goals. Changing capital standards as well as recent loss experiences will cause a dramatic change in the way loans will be priced in the future. Are you going to benefit from the changes or be a victim?
“OK Farin, thank you for telling us what we need to do. Now, please tell me how to get there!”
Farin Liquidity and Core Funding Workshop
Farin has a long history of delivering Consulting Workshops. “So what is a Consulting Workshop?” It is a very cost effective way of receiving consulting services in a workshop setting. The idea is:
- Bring in top level (expensive) management consultants. Supplement with other members of the Farin consulting staff.
- Bring in financial institution management teams.
- Assign a consultant to work with each team for two days. Have the consultant compile results and decisions.
- Have the top level consultants float between teams, sharing their expertise with the teams.
- Send the management team home with a plan, a set of goals, and tasks to implement.
The Farin Liquidity and Core Funding Workshop is a consulting workshop with a very specific set of objectives:
- Work with your team on developing a top level capital/liquidity plan for using a model developed specifically for that purpose. You will be allowed to take the model home with you at the end of the workshop so you can make revisions as your goals change and as the challenges evolve. The plan you develop will have the following components.
- A reconciled set of long-range financial goals for growth, earnings, capital, dividends (stock institutions), and capital actions.
- A set of annual financial goals extending up to five years into the future for capital, earnings, dividends (stock institutions), capital actions, loan growth, core funding growth, and balance sheet mix.
- A broad sense for the sources and uses of funds over the five years of the plan. This information will be useful in upgrading your liquidity policy to meet proposed interagency guidance. - Develop a complete core funding plan that incorporates changes to your process, products to be developed, pricing strategies and marketing strategies. The plan will be targeted to meet the growth goals in your capital/liquidity plan while managing your funding costs in the process.
- Conduct a review of your loan pricing process. Evaluate the effectiveness of pricing of major loan categories. Develop with some new product ideas and make recommendations as to how to effectively price your loans.
- Conduct a review of your ALCO process. Make recommendations as to how it might be revised to deal with a rapidly changing economic, competitive and regulatory environment in optimizing the relationship between risk and return.
Some have already questioned the price of the workshop – $5,000. If it was just a seminar, I would agree with your price concerns. But what is being delivered is two days of consulting that involves some of the best known experts in the industry, delivered to a very limited number of institutions. That works out to $2,500 a day for consulting, a real bargain given the normal consulting fees of some of the folks who will be helping you. Better yet, the workshop backed with a money back guarantee. If our core funding recommendations don’t deliver at least a 500% return on your workshop investment, you can have your money back!
In summary, here is what you will receive:
- Education and consulting from some of the best minds in the industry.
- A five year capital/liquidity plan.
- A five year capital/liquidity model for you to use on a continuing basis in reacting to change.
- A review of the pricing on your four most important categories of loans. Recommendations on how to implement a more effective loan pricing process.
A written comprehensive core funding plan that focuses on product offerings, new product development, marketing strategies and pricing strategies aimed at achieving your objectives.
- A number of inputs to revisions you need to make your liquidity management strategy.
- A money back guarantee.
In summary, I’ve detailed the challenges you face. And I hope I identified where you should focus in working through the challenges while achieving your financial goals. And I’ve provided information on a workshop that gets you moving solidly in the right direction. I hope to see you in Madison on December 2nd and 3rd.
