The Timing Risk of Loans and Deposits

A common challenge financial institutions often find themselves in is centered on interest rates.  I can accurately predict what will happen to interest rates—they will fluctuate!  These rate changes can cause fits for the CFO as they attempt to adequately fund the balance sheet and earn the highest amount of Net Interest Margin (NIM) as possible.

 If rates did not fluctuate, how much easier asset/liability management would be!  The marginal cost of funding would be constant with the only variations occurring with the timing of the term of the deposits or the loans.  The CFO could prop his feet up on his desk, set a standard margin, choose a index of interest rates to go by, and set prices across the institution for both loans and deposits for the best risks.  Higher rates on loans and lower ones on deposits can deviate from the best rate in order to price for the risk.  I believe if rates did not fluctuate, we may find more financial CFOs spending time on the golf course.

 But alas, fluctuations have been here since the dawn of the market and will continue into the future.  Because of that fact, wise CFOs must engage in a diligent study of the interest rate sensitivity analysis of their institution and also watch for the trends in the market as a whole in relation to how that will impact them.  In interest rate sensitivity analysis, an institution will have a positive gap, negative gap, or no gap.

 A positive gap occurs when the amount of interest earning assets exceeds the amount of interest paying liabilities.  This is beneficial to an institution in a rising rate environment.  The CU or bank would be able to move rates higher with the market on its loans while enjoying the locked in rates on the deposits for a season.  Note that a positive gap in a decreasing rate time will cause NIM to fall.

 A negative gap occurs when the amount of interest paying liabilities exceeds the amount of interest earning assets.  In this case, a declining rate environment where the liabilities are repricing at lower rates while assets remain fixed at higher rates will benefit the firm.  A rising rate environment will hurt a firm that is negatively gapped. 

 Financial institutions with no gap or a neutral gap will have an equal amount of interest earning assets and interest paying liabilities reprice at the same time.  Theoretically in this case, the NIM will remain constant.

 Mismanaging the interest rate gap can kill an institution.  Around ten years ago, as I banked in Colorado, we learned of an agricultural-focused bank in the northeast corner of the state.  That bank had a strong desire to grow and began to become quite aggressive with their Ag lending portfolio, offering terms of 90-95% financing on land and requiring very little equity or reserves from the farmers.  They also locked in interest rates on these loans for long terms.  It was not uncommon to see 10 or even 15 years on a fixed rate before the loan would reprice. 

 Soon, borrowers flocked to the bank, quicker than politicians to campaign contributors.  The bank began to experience phenomenal rates of growth.  The growth ate up all the funds they had available to lend so they turned to the Internet to acquire “hot” CD money.  They generated deposits that would reprice quicker than a lot of their heavily margined loans would.  They also had to pay higher rates to attract the money, which squeezed their NIM.

 A dip in some commodity prices coupled with a couple of dry years in that area hurt the farmers.  Those who were highly leveraged, did not survive.  This resulted in several farms from earning some interest to earning no money at all as they were transferred to the bank’s other real estate.  The 2008 crash also took its toll.

 The next whammy that hit was the loss of the hot CD money.  The deposits time came to reprice and the new rates were not as competitive as the prior ones so much of the funding left.  Other deposits were pulled out as depositors began to look at the bank’s financial position and rightly judged the bank was unsound.  A small run ensued.  The bank was insolvent and the regulators took it over.

 There are several lessons to learn here. First, uncontrollable growth funded unwisely can kill an institution.  The bank should have increased their underwriting standards to slow down the rate of growth to level that matched their ability to organically develop deposits.

 Second, risk should be priced for.  If you are going to do 90% farmland loans, a practice I would strongly advise to not enter into, you had better increase the rate to adequately compensation you for the increased cost of delinquency and default in the portfolio.

 Third, as much as possible, the duration risk in the portfolio, should be minimized.  Duration risk is the sensitivity of your NIM to a change in interest rates.  So if you locked a loan in a rate for 15 years and left it on your books, you would experience a higher amount of duration risk than if it was locked for 3 years.  The larger the duration number, the greater the interest rate should be on the credit facility.

 Duration risk can be minimized by matching the timing of repricing of assets to when liabilities reprice.  NIM usually greatest at the onset of a loan if the interest rate is fixed for a long term and it is funded by very short-term liabilities. The risk here lies that if rates rise, the wonderful NIM you enjoyed at the start will not continue.  I was with a bank once that eliminated much duration risk by requiring no loans over $1MM could have an interest rate locked for longer than a year.  If a customer wanted a locked rate, the customer would have to enter into an interest rate swap contract.  This effectively transferred the duration risk from the lender to the borrower. 

 So the next time you see your CFO ask him if he is keeping his eye on the balls, both the little white golf ball and also the funding ball of his NIM.