New A/L strategy: "get those deposits!" The tricky yield curve and rising rates have banks looking at their asset/liability strategies. But some "power tools" aren't being used right--or at all.

When you strip away all the extraneous concerns about structure, branches, ATMs, websites, and staff, a bank is a very simple engine. George Darling, a veteran assetliability management expert, has been preaching so for years.

The key to understanding the banking engine, says Darling,

Which is why, when asked how banks could best adapt to the rising rate environment and the "bear flattening yield curve," as some call it, his answer didn't involve models, charts, or graphs. His advice came to a single word: Sales.

Sales? That's right, but first it helps to understand the challenge.

Changing focus in changing times

The current rate picture has banks trying many different things to cope with a major shift: some new, some rethought, and some outside the box. How well they all will do is still to be determined, though some experts have concerns.

The long period of low rates put much of the industry into a mindset that required some hurried rethinking when things began to change. The runup in interest rates, and the shape of the yield curve today--short-term interest rates rising in response to Federal Reserve machinations, but long-term rates staying put or even dipping--is challenging.

"We're seeing a nonparallel yield curve and that's bad news for most banks," says Ed Dietzler, first senior vice-president-capital markets at $2.9 billion-assets Yardville (N.J.) National Bank.

Yardville National, fortunately for it, is not among the majority, Dietzler says. For some time, the bank built its ALCO planning around an anticipated 5% upward shift in short-term rates, and it engaged in a "rebalancing of the tires," so to speak, detailed later. The bank went into the recent cycle with a positive gap, so it benefited from the rise in rates in the beginning, says Dietzler. "At this point we are pretty much gap neutral."

Turning the ship

"Yes, you're talking about a quintupling of rates" over a short term, says John P. "Jay" Brew, head of the consulting firm BNK Advisory Group, Bethlehem, Pa. But Brew notes that in spite of the speed of the change in rates and the yield curve, the resulting margin squeeze isn't a new invention.

"But bankers always go into a tizzy," says Brew. Those in that state may remain there a while longer, says Brew, because even if the Fed is done raising rates, there are lags in the system. Banks can expect to see cost of funds continue to rise for about six months after the final hike.

Much hinges on the percentage of deposits that CDs represent, Brew notes. "It's a 'turning the battleship' matter," he explains. The more CDs a bank relies on, the bigger the battleship, and the longer the turn takes. (He calls the heaviest CD addicts "aircraft carriers," and the lightest "PT boats.")

Surprisingly, after the lessons of the past decades, some banks fell into funding short and lending long, as interest in residential real estate lending picked up, and not all of it for the secondary market. "A lot of banks have been looking 'thriftier'," says Darling, referring not to frugality, but to the deadly funding-lending mix of the classical savings industry.

Even now, many banks find themselves having to pay more for interest-bearing deposits in order to maintain liquidity. A growing number find themselves coming to a decision point: Continue growing at a higher cost, or find a way to remain where they are, or even shrink a bit, with improved profitability.

More than two-thirds of the industry currently faces declining liquidity and increasing exposure to rates rising on the short end, and it is increasingly difficult, in the current environment, to entice savers to go long themselves.

Thus, "the squeeze is on for most banks out there," says Darling. Deposit rates are rising, while loan rates aren't rising at all, or at the same pace, depending on the market, loan type, competition, and other factors.

And this brings us back to sales.

Loan officers, get the deposits!

Sales is not a word that comes up often in ALCO meetings. Darling thinks it should.

"All of the sudden, many commercial banks have gotten religion about telling their lenders to get the deposits, too," says William J. McGuire, president and CEO at McGuire Performance Solutions, Scottsdale, Ariz.

It's not often that technical specialists like Darling and McGuire are heard to argue for getting away from number-crunching. For decades, Darling explains, business lenders were just that, lenders. Much lip service was paid to "relationship banking," but at the end of the day, the road to success was making loans.

"If a banker wants to have a bad day," suggests Steve Simpson, "he should go back and look at the rates on business loans approved over the last quarter." Simpson, director of product development for Sheshunoff Management Services, LP, Austin, Texas, says the banker will find that credit rates were cut in exchange for deposits. But often, as it turns out, the deposits never materialized and the preferential rates remained.

Indeed, Simpson suggests that CEOs might find out that a great many "unadvertised specials" are being offered and accepted. In the absence of formal pricing models, which few banks have, he says, loan officers may be giving away margin when the bank can least afford doing so.

"Banks have to reduce pricing from the hip," says Simpson.

Darling says that in smarter shops the focus is being put squarely on demand deposits. (He estimates this makes up about 10% of the industry.) The traditional preference for loans is being turned on its head and business officers are not only being encouraged, but paid, to concentrate more energies on deposit gathering, especially demand deposits. Darling says that one client is actually offering three times the incentive pay for demand deposits as for credit. Simpson says he has a client that actually has the lender's spouse come in to hear, with the lender, the incentive scheme. The client wants push for deposits to come from the home front, too.

Why such a strong emphasis on DDA? It's simply a matter of numbers. Demand deposits are free, with the exception of processing costs, assessment credits, marketing costs and such. The higher rates go, the more valuable they grow.

"You never mark a DDA account dollar to market," quips Darling, but maybe bankers should think that way.

"Rebalancing the tires"

Of course, there's much more that a bank can do besides turning people loose to sell checking accounts. Much involves tinkering around the balance sheet, albeit in a deliberate fashion.

For instance, let's return to Yardville National. Following from its rate outlook premise (a 5% increase), management took steps to adapt to that outlook as much as possible. Longer-term CDs were marketed to grab up as much of that comparatively cheap, and stable, money, while the curve was favorable.

The bank increased its existing focus on loan types that tended to carry floating rates, and began building yield maintenance agreements into its loan contracts. This included features such as early payment penalties to discourage serial refinancing of business debt and the like. The latter step enabled the bank to engage more seriously in matched funding.

The bank also began to let its investment portfolio run off, moving into credits that could be made at adjustable rates, or held in cash to await better opportunities.

Similar shifts have been made at The Bank of Smithtown, N.Y., according to Anita Florek, chief financial officer and executive vice-president.

Much more of the $926.7 million bank's loan portfolio consists of floating rate credits. Now, approximately 80% of the loans on the books are adjustable, versus 50%-60% five years ago. This has been accomplished in part by emphasizing highly secured commercial real estate credits and also adjustable-rate home equity lines of credit. Rising deposit costs are somewhat muted by paying competitive, but not leading, rates. Only deposits over $100,000 get the top MMDA rate.

Home Loan Banks and other options

Both banks have taken steps to try to avoid cannibalizing their own deposits through new promotions. And The Bank of Smithtown has been making more use of funding obtained through the Federal Home Loan Bank of New York.

Home Loan Bank funding is an avenue more banks of all sizes are availing themselves of, according to Dennis Gibney, managing director at FinPro, Inc., a bank consulting firm based in Liberty Corner, N.J., because it enables them to lock in longer-term funding at preferential rates. Further, many Home Loan bank advance products now incorporate rate-protection features, lessening accounting challenges for bankers.

In addition, some community banks have been stepping up their use of banker's banks as a source of funding, which is available in a number of different forms from that channel.

Another mechanism some banks have been using--including some community banks--is creating online divisions that operate on the web like independent creatures. These quasi-banks have their own names, but are "DBAs." The concept is that these entities help meet the internet challenge without siphoning off the bank's own deposits.

An oldie-but-goodie for raising core deposits is premiums. "Bankers cringe," BNK's Jay Brew acknowledges, but if a bank wants to bring in cheap money, "this stuff is effective and has always been effective."

Conduit can do it?

Along these lines, the ability to sell off business loans has been steadily improving. At one time there was resistance to an organized, Freddie-Fannie clone for business credit, and there were false starts. But now the rocket scientists have gotten around some of the old hurdles.

The tool of choice today is the loan conduit, specialty finance vehicles that buy up credits from lenders for packaging into securitizations. This has been developing for some time, and has been making its way down the food chain.

Yardville National's Dietzler says these conduits, frequently organized and run by large commercial banks, represent not only a viable funding alternative for lenders, but an eager one. Organizers need credits to keep the conduits' maws filled. Dietzler, who says that Yardville National hasn't had to tap this strategy yet, says he is constantly fielding calls from correspondent banks and other firms operating the conduits, seeking product to move into their machinery.

Thus, says Dietzler, "commercial loans have become much more liquid. There's plenty of money chasing them now, and the deals are growing smaller and smaller. I've seen them done for as little as $2 or $3 million."

Models: unused octane?

A worrisome issue brought to light in the course of the research for this article is the difference seen by some between what modern interest-rate risk and asset-liability management computer models can do versus what use they are put to and how well they are understood. This feeling is not unanimous, but it raises concerns.

Most vocal is consultant George Darling who bluntly says that many banks don't have a good handle on the risks that they face in their portfolio. "It's hard to know where you are going if you don't know where you are," Darling says.

Even though the ALCO discipline is decades old, Darling says a substantial portion of his firm's income still comes from basic education for bankers and directors in this discipline.

What concerns Darling is that much of the horsepower that banks already possess in their systems and software packages goes untapped.

"You still see some banks only modeling a parallel interest-rate shift," says Darling. The fallacy is that the interest-rate curve doesn't always move in a parallel way. Today's yield curve bears that out.

"The only thing that some institutions are using their models for is 'regulatory appeasement'," continues Darling. Examiners want to see that the bank and its board have gone through such exercises. So the bank obliges by jumping through the hoops.

"I'm talking about banks that are $1 billion to $2 billion in size," not just tiny community banks, say Darling, "and I find that frightening."

And some modeling that Darling comes across is static, or simple-minded, to his thinking. Case in point: ignoring cash-flows from the investment securities. How, argues Darling, can that be treated as just an afterthought?

Clearly, "at some banks, you need more education at the management level," says Dennis Gibney of FinPro. Gibney adds that many CEOs, of necessity, history, and habit, tend to concentrate on the business-generating side of their responsibilities. For them, interest-rate-risk management is a necessary evil.

The examination check-off mentality is something that clearly disgruntles Darling. "Some examiners understand ALCO very well, and give their banks a pretty good going over," he says. Others, however, know little more than the bankers they are inspecting. A examiner who recently visited one of Darling's clients asked the bank to run a simulation showing how its portfolio would react to a market shift to a "below 0% rate."

But what worries some analysts, such as Bill McGuire, is a "perfect storm" scenario that only a bank with a firm handle on its position and its finger on the pulse of a working model, would see coming. This would be a combination of an economic slowdown, thinning margins, and stepped-up competition from internet banks. Add the possibility of falling liquidity due to a net deposit outflow and the directional influence of some eventual fall in rates, and you have what keeps McGuire awake at night.

Steve Cocheo, executive editor