Interest Rate Risk Must Be Actively Managed
by a Bank’s Risk-Management Plan
Patti Tobin
Community BancInsurance Services
Powered by Nicoud
Springfield, IL
Pigs get fat, hogs go to slaughter, and in banking you get bailed out when you’re deemed too big to fail.Rehashing the obscene imbalances that kept the multinationals alive in the wake of their imprudence while community banks continued to lend is a bit fatiguing by now.Nonetheless, the realities and lessons from the last crisis must be kept front of mind when setting out to manage the new risks that have emerged after cleaning up the last mess.
Community bankers have a lot of people to thank for the headwinds to their quest for profitability.Loan demand at the local level is improving, but still slack in the plow-horse economy of 2-2.5 percent growth.Interest rates can’t go lower.New regulations that ostensibly protect the consumer are costly at the top line and erode what is available to lend.Still, stakeholders and shareholders require returns. In an effort to generate profit from systemically unproductive market conditions, community banks have been adding duration to their fixed-income holdings as a viable strategy to generate returns.The FDIC has reported that the proportion of community banks holding long-term notes has grown from about 20 percent to 50 percent over the past six years.
The 30-yearbull-run in the bond market is over.Just ask Bill Gross, founder of PIMCO, the world’s largest bond trader.Gross, who has no doubt enjoyed the billions he’s personally made and his walk-on-water persona fanned by an obsequious financial media, is persona-non-grata these days.Investors are pulling out of PIMCO funds by the billions (of dollars).
Gross is an easy target, but his firm’s underperformance serves as an important reminder that there is risk—substantial risk—in fixed income, safer instruments typically used to mitigate volatility.For community banks that have added duration to their holding for the purpose of immediate profit, the question of interest-rate risk looms large and is one that must be actively managed by a banks’ internal risk-management protections.Interest rates will go up.When is anybody’s guess.But directors and officers need to consider that significant upward movements in interest rates maybe more common than they think.According to the FDIC, the overnight federal funds rate experienced an increase of 300 basis points or more over a 12-month period 15 percent of the time between 1955 and 2008.
Healthy increases in interest rates will be good for loan income, so long as the increases don’t shock demand further.But bonds with longer duration will be sensitive to any increase in rates, let alone a sharp increase.This is the conundrum.Community banks have been put in the extremely difficult situation of having to add duration knowing that interest rates have nowhere to go but up.This is counter-intuitive—shorter duration instruments have less exposure to an increase in rates.But the need to generate return for a bank’s overall profitability has required the assumption of such risk.
We are no doubt preaching to the choir of bank officers in our association.The nuances of bond markets are better known to the officers we serve at Community BancInsurance Services than they are to us.The question of situational awareness relative to interest rate risk is likely more relevant for a bank’s board of directors.No multinational or rapacious Wall-Street bank can serve our communities as efficiently, as thoroughly and as carefully as the community banks that are the organic life source of the towns and regions they have been a part of for generations.And board members are vital to a community bank’s value proposition.Local expertise, local relationships, industry familiarity in core sectors like farming and transportation give bank officers needed insight as to where to best deploy assets.For all of the expertise board members bring, they can be, and often are, poorly acquainted with the internal workings of the banks they advise.The vagaries of the bond markets and duration and interest rate risk are probably foreign to many of our industry’s board members.
That is a problem.A bank’s board of directors has ultimate responsibility for setting risk-appetite parameters and overseeing the appropriate controls.Many board members bring little familiarity with interest-rate risk management from their expertise outside of banking.The D&O liability services offeredby Community BancInsurance Services protect bank officers and directors against prospective interest-rate risk liabilities.As with all risk management, the key to protection is to know what liabilities may arise before they do.
The tools for education do exist. For example, the Federal Reserve offers a Bank Director’s Desktop. It’s a good example of the proactive steps directors can take to ensure the right questions are asked, and that the decisions on risk appetite are properly decentralized throughout a bank’s internal and external leadership.
That’s good news, but only if those tools are utilized.
To learn more, contact Patti Tobin, FI Specialist with Community BancInsurance Services at 800-982-6564.Community BancInsurance Services, powered by Nicoud Insurance, is a CBSC Preferred Provider.