Analyzing the Economics of Wholesale Growth Strategies

Amid declining net interest margins and rising loan loss provisions, community banks are actively seeking strategies to supplement core operating earnings and to increase return on equity. Wholesale growth strategies offer potential solutions for a challenging operating environment, but these programs

Potential Benefits

A wholesale growth strategy is a coordinated borrowing and investment program with the goal of achieving a positive, stable net interest spread over time. These arrangements are commonly referred to as leverage strategies. In a typical leverage strategy, a bank borrows from a wholesale funding source, such as the repo market, and uses the proceeds of the borrowing to purchase securities with similar repricing characteristics to the liabilities. From a financial statement perspective, a leverage strategy increases total assets and total liabilities, reduces capital ratios, and boosts net interest income. Properly structured, leverage strategies can provide a number of benefits to a banks financial performance.

Increasing Return on Equity: Return on equity (ROE) is a function of two components: return on assets (ROA) and leverage. Mathematically, ROE = (net income/total assets) ? (total assets/equity capital). An increase in one or both of these factors will result in a higher ROE. However, with competitive pressures and declining interest rates conspiring to shrink profit margins, it is becoming increasingly difficult to achieve ROA growth. For institutions with excess capital, financial leverage is probably a more realistic approach to meeting ROE targets. Consider an institution with an ROA of 1.2 percent, a leverage factor of 8.3, and ROE of 10 percent. By increasing the leverage factor to 12.5 (which would result in an equity capital/total assets ratio of 8 percent) and holding ROA constant, ROE would grow from 10 percent to 15 percent.

Improving Efficiency Ratios: The efficiency ratio measures a bank's ability to generate revenue relative to its overhead expenses. A common calculation for the efficiency ratio is non-interest expense/ (net interest income + non-interest income). The lower the ratio, the more dollars of income generated per dollar of overhead expended. Leverage strategies generate net interest income while requiring minimal incremental overhead. By employing leverage, a bank can improve its operating efficiency by producing greater income from its existing overhead base.

Managing Interest Rate Risk: Leverage strategies can also be used to correct a structural mismatch between the repricing characteristics of an institutions assets and liabilities. For example, a bank with an asset-sensitive balance sheet (assets reprice more quickly than liabilities) could reduce the overall interest rate risk exposure of the institution by engaging in a liability sensitive leverage strategy. While the terms of loan and deposit products may be strongly influenced by competitive factors, bank management has complete control over the types of investments and borrowings selected for a leverage strategy. Through careful product choices, leverage strategies can be tailored to satisfy an institutions asset/liability management objectives.

Potential Risks

While leverage strategies can help an institution meet its financial performance goals, the risks of these programs must be thoroughly evaluated. Leverage strategies are sometimes incorrectly referred to as arbitrage programs. While arbitrage is defined as a riskless strategy with a guaranteed return, all leverage strategies involve some combination of interest rate risk, credit risk, and liquidity risk. In general, the greater the expected net interest spread of the strategy, the greater the associated risks. Identifying, monitoring, and managing the inherent risks are essential components of successful leverage strategies.

Under certain scenarios, the net interest spread of a leverage strategy could turn from positive to negative. Consider the simple example of a five-year fixed rate bond with a yield of 4.0 percent funded with a two-year borrowing at a cost of 2.0 percent. While the net interest spread of the strategy is 200 basis points at inception, it may vary over time due to changes in interest rates. When the borrowing matures at the end of two years, the funding will need to be replaced at current market rates. If replacement borrowing rates rise above 4.0 percent, the realized net interest spread would be negative for the remaining three years of the strategy.

Unwinding a leverage strategy prior to the final maturity of all securities and liabilities could result in realized market losses. In a rising interest rate environment, the market value of the asset side of the strategy will generally decline in value. In a declining interest rate environment, substantial prepayment penalties may be required to retire fixed rate or convertible borrowings prior to maturity.

Calculating the expected net interest spread of a leverage strategy often requires assumptions to be made. For example, if mortgage securities are used on the asset side of the strategy, the expected yield of the bonds is based on prepayment assumptions. If actual prepayment speeds differ from the initial assumptions, the yield of the securities will vary, and the net spread will fluctuate.

Since leverage strategies involve a reduction in a bank's capital ratios, these programs receive close regulatory scrutiny. A bank must demonstrate that it maintains sufficient capital to support the overall risk exposure of the institution after the effect of the leverage strategy is considered. Deploying excess capital through a leverage strategy may also limit a bank's flexibility to pursue other growth opportunities that may arise during the life of the program.

Designing the Strategy

After the potential benefits and risks have been evaluated, specific objectives and constraints should be identified. In terms of objectives, goals should be set for each of the following parameters: target net spread, net interest income, and return on equity. These objectives should be established relative to a set of constraints, including the bank's risk limits, product preferences, and time horizon.

While the bank's objectives and constraints should guide the design of the strategy, the net spreads that can be achieved for a given level of risk will largely be a function of market conditions. Yield curve shape, funding levels, and product spreads are the most significant variables that affect the net interest income of the strategy. For strategies that employ interest rate risk to achieve desired returns, steep yield curves produce more favorable risk/reward combinations. For example, the net spread between the yield on a current coupon, 15-year mortgage passthrough security and the cost of a five-year, fixed rate Federal Home Loan Bank advance was 31 basis points on June 30, 2007, a time period when the yield curve was relatively flat. As of February 29, 2008, the net differential for this same strategy had grown to 106 basis points due to a steeper yield curve and wider mortgage spreads.

Regulatory Issues

Based on my experience as a former regulator, examiners will expect banks to conduct thorough due diligence on leverage strategies prior to implementation. This due diligence process should include the following steps:

* The strategy should receive the prior approval of the ALCO or board.

* All components of the strategy should be permissible instruments under the bank's policies.

* Management should demonstrate an understanding of all securities and borrowings used in the strategy.

* A sensitivity analysis that projects the strategy's net interest income and net economic value should be prepared under a range of interest rate scenarios.

* The effect of the strategy should also be measured on the bank's overall balance sheet, income statement, and interest rate risk position.