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"Your model's gap report doesn't match my call report"

I usually respond to this (quietly and to myself)...AAUGH!  (My favorite Charlie Brown quote.)

Anybody that's read my prior posts on the subject of the gap report will know my opinion.  As a tool for measuring interest rate risk, the gap report just doesn't cut it.

We do however still show a base-case gap report in our result set.  We don't use it to measure the bank's interest rate risk.  We don't even collect peer statistics on the one-year cumulative gap.  We don't because there are too many weaknesses in the measurement.

We run an income simulation which models the future principal and interest flows generated by the bank's balance sheet.  These flows include contractual maturities, repricings, amortizing principal payments, principal prepayments, and calls.  All of these flows impact the overall timing and ultimate earnings power of a portfolio; therefore we show these flows on our base-case gap report.  On a "traditional" gap report banks usually report the entire principal balance at either final maturity or next reprice date.  But doing so ignores usually significant principal flows (again: amortizing flows, prepaying flows, calls).

That's the difference, and that's why, "our model's gap report will never match your call report."

There is an interesting little comment buried deep in the FFIEC's instructions for filling out the call report.  On page RC-B-12 (page 115 in the PDF) and on page RC-C-23 (page 151 in the PDF) the regulators address this issue of amortizing payments and prepayments:

 

That's government speak for, "If you have the data to show amortizing payments (or prepayments) you may adjust the call report data."  Most bank's never do this, but it would greatly improve the gap data (for what it's worth.)

Three reasons why your model is "wrong"

It's that time again.  We've finished the bulk of our model processing and banks are reading and re-reading our reports in preparation for their ALCO and board meetings.  With the recent dramatic decline in rates community banks are watching their margins very closely.  How is the drop in rates impacting their margin?  What did the model say would happen when rates fell?  Upon asking these questions quite a few of our bank clients called to tell us that our model is "wrong".  It didn't predict the (often negative) changes in margin that they are now experiencing.  What's the problem?

It's almost certainly NOT that our cash flow engines have all the sudden gone haywire.  I feel reasonably confident that after 30+ years in the business, we have some pretty solid technology.  What's more likely is that there were assumptions made that were not appropriate.  Net Interest Earnings at Risk is calculated by first creating a forecast; and then measuring the change in that forecast after shocking rates up and down.  If the forecast assumptions aren't reasonable, the results probably won't be either.

Here are the top three reasons the model has been "wrong" when forecasting net interest earnings at risk:

1) You are still looking at traditional gap as a measure of interest rate risk
As I've mentioned many times in the past, gap is usually very inadequate for measuring IRR exposure because it fails to capture optionality.  A bank that appears liability sensitive may see its gap profile change with a sharp rate decline.  What if, for example, the bank has a large portfolio of callable bonds.  These bonds at first appear to be longer-term fixed rate bonds.  As rates fall significantly (as they have recently)  these bonds begin to call making the bank less liability sensitive and more asset sensitive. 

Stop looking at gap as a measure of interest rate risk.  Instead look at your net interest earnings at risk measurement. 

2) Your core deposit betas don't reflect your pricing behavior
How much will you change your core deposit (NOW, Savings, and Money Market) pricing when the Fed changes rates?  If the Fed moves 50 basis points will you only move your pricing 10 basis points?  If so your beta factor is 20%  (10 divided by 50).  You might have a different factor for rates down versus rates up.  Bankers love to say that they'll lag deposit rates when the Fed tightens, and that they'll move swiftly when rates fall.  On average I'd say that most of our clients use a beta factor of 50%; if the Fed lowers 100bp, they'll move their core rates down 50bp.  Guess what's happened over the past 4 months?  Core rates haven't fallen all that much.  Meaning that the model was projecting much lower core deposit costs than actually occurred. 

During each ALCO meeting you should have a realistic discussion about how you would change your core deposit rates if market rates moved.  Change your modeling parameters accordingly.

3) You changed your funding mix
Net interest margin can change because of changes in Rate, Volume, Mix, or Timing.   Most interest rate risk models only measure the impact of rate changes.  Not because they can't measure the impact of changes in Volume, Mix, or Timing, many can (including A/L BENCHMARKS).  It's just that most of the time forecasts don't significantly change volume, mix or timing.  Many rely on a flat balance sheet forecast.  One problem with this is that in the last five years banks have seen much slower deposit growth rates than in the past.  If your forecast shows 5% growth in loans and a corresponding 5% growth in deposits, and the 5% deposit growth doesn't materialize, your alternative source of funding is probably more expensive (thereby squeezing margin).

Discuss more realistic expectations of core deposit growth.  Understand the cost of your alternative funding.

Don't be lulled into thinking that dramatic shifts only happen on the short end of the curve

What kind of stress-test do you run when you model your bank's interest rate risk?  a rate shock? a rate ramp? a parallel shift? a non-parallel shift? a twist?  Which one is the best one to use?

There is a point in all of my presentations on interest rate risk when the audience really seems to chime-in.  During presentations before 2001 I would say that we use an instantaneous +/-200bp parallel shock at which point audience members would cry-out, "Are you kidding?  That's way too much!  We have a much better understanding of our economy and the interest rate environment to expect such dramatic changes."  After 2001 and the dramatic drop in Fed Funds (down more than 400bp in a year) the response was, "Are you kidding?  A stress-test of +/-200bp is way too little..."

The debate really gets going again when the Fed makes dramatic moves like the most recent 50bp and 75bp drops...minus 125bp in less than a month.  However the argument usually takes a different direction.  The pundits usually say that a stress-test that shocks short-term rates is okay, but you shouldn't use a parallel shift across all points on the curve because longer-term rates don't move as dramatically.

Think again.  Here's a look a some pretty big shifts in the 10-year treasury and the long-term conventional mortgage rate in relatively short periods of time.

From October to November 1981 the monthly average 10-year treasury moved down 176bp, from 15.15% to 13.39%.  From June to July 2003 the monthly average 10-year treasury moved up 64bp, from 3.33% to 3.98%.

From August to September 1982 the monthly average conventional mortgage rate moved down 169bp, from 16.29% to 14.61%.  From March to April 1994 the monthly average conventional mortgage rate moved up 98bp, from 7.59% to 8.57%.

New Year, same debate about fair value

Over the holidays the American Banker ran a three-part series on Fair Value.  I thought it was an interesting read.  I'm not going to parrot the article text, you can read it here (subscription required).

• Fair Value: Bumpy Road from Theory to Practice
• Fair Value: Simple Idea, Complex Path
• Fair Value: Trust Is Wild Card in Debate

Best quote of all three articles is from the managing director at Lord, Whalen LLC's Institutional Risk Analytics:

"In between when you buy something and when you sell something, valuing it may be an interesting exercise, but it may not be one that is practical...the only time you can value something dynamically is if it is traded — if you have a visible, public price. Otherwise, who wants to know?"

I agree, running all this recent market volatility through the income statement for balance sheet instruments that aren't actively traded seems silly.  If you think bank financial's are complex now, just wait until you bury "estimated fair values" in there.  What a mess that will be. 

Most naive quote from the articles is from a professor of finance at Stanford:

"Companies, of course, aren't supposed to use the new standard as a way to manage earnings — they're only supposed to use it to get a closer approximation of fair value...but accountants will sometimes be led to do what management of a bank wants them to do."

What an understatement.  Fair value is a great new tool to use to manage earnings.  It's going to give a whole new meaning to "creative accounting".  And accountants are "sometimes" led to what management wants them to do?  Please, in the real world when aren't they led by what management wants them to do?

Projected Fed Funds forecast (looks like my guess is as good as anybody's)

The FHLB of Seattle publishes a regular newsletter called What Counts.  Their 4th quarter issue features "Select Forecasts of Key Economic Statistics".  It very interesting stuff.  What caught my eye is the estimated Fed Funds Rate for 6/30/2008 and 12/31/2008.  Now I'm no economics expert, I've never claimed to be.  It looks like some reasonably well know firms on this list.  What a difference!  The difference between the high and low projection for 6/30/2008 is 125bp.  The difference between the high and low projection for 12/31/2008 is 175bp!

Printable version of data:

http://www.olsonresearch.com/BlogResources/FHLBSeattleProjFedFunds2007Q4.pdf

Passing the torch

The senior member of our Olson Research family passed-away last Saturday.  To say that Al Gardner was an integral part of this company is a bit of an understatement.  I can't remember the first time I met him since I think at the time I was only four years old.

I know that my Dad, Ron Olson, saw Al as somewhat of a father figure.  He relied on Al's counsel and advice on all things accounting and business related.  Al's input has been invaluable to our company over the years.  He became every bit a part of our family and the family business that he helped create and guide.

Al quite literally filled the role as accountant, tax-advisor, legal council, research specialist, and even product beta-tester.  We'll remember him in just about everything that we do here at Olson Research.  We've even coined the term "Al's spreadsheet" as it was his standard practice to create an excel spreadsheet (or two) to solve every business problem.

Thanks Al, for everything, even the spreadsheets ;).  We'll miss you.  Rest in peace.

Deposit pricing not impacted as much as banker's would like

In case you didn't see it there's an article in today's American Banker (subscription required) about how the Fed's rate cuts aren't helping margin because of sticky deposit pricing.  I've posted about this over the past several months.  Here are the related blog entries:

The rising cost of funding is the primary reason for banks' lower earnings - Nov 29, 2007

Now is a good time to adjust your core deposit modeling assumptions - Sept 21, 2007

Is there really margin relief on the horizon? - July 11, 2007

"Is this the end of less expensive deposit funding?" - May 15, 2007

The rising cost of funding is the primary reason for banks' lower earnings

If you skim through the FDIC's current Quarterly Banking Profile (QBP) you're likely to get the impression that the major cause for the drag on earnings at any bank is poor credit quality.  However, if you really want to know what's creating the earnings pinch at most banks (not just the few largest banks) you'll need to read the fine print.

First, let me address those of you saying, "are you kidding? of course poor credit quality is to blame!".  There is no doubt that rising levels of troubled loans, and the subsequent increase in provision expense has been a newsworthy contributor to the decline in earnings.  The second headline in the QBP states it quite clearly - "Loss Provisions Surge to 20-Year High", more than double the provision last year at this time, and the highest since the 2nd quarter of 1987.  So...no, I'm not blind to the credit quality issues of the day.

It's the microscopic font-size charts that follow the articles that interest me.  For most banks it's net interest margin that drives bank revenue.  For banks under $1 billion in total assets margin accounts for 70-80% of total bank revenue.  What do the performance tables in the QBP say about margin?

Table III-A shows the yield, cost, and margin for banks less than $100 million and banks $100 million to $1 billion in total assets.  In each peer group both yield and cost rose.  Cost changed by more than the change in yield, therefore margin % declined.

What's interesting about this is that both yield and cost rose in a falling-rate environment.  By the end-of-September we had a stepper yield curve and a lower fed funds rate.  Yet the movement in yield and cost seemed to move against market rates (granted the change in fed funds didn't happen until late August.) 

Yield went up?  My reaction to this is...good.  I would almost expect to see this.  If banks are indeed tightening credit standards and recognizing that they are taking more risk, they should be compensated for that risk.  In that case higher yields makes sense.  Cost went up?  This one isn't quite as easy to digest.  Aren't community bankers the first to say that when rates rise they'll drag their feet, but when rates fall they'll jump all over it?  We're talking about cost of funds so the credit quality issues of the day don't apply.  What has happened here?  There are two causes.

First, the supply of classic cheaper sources of funds continues to decline (see related post).  With loan growth setting all-time record highs, more banks (and non-banks) are competing for the same pool of deposits.  That competition is forcing banks to keep rates higher despite changes in the Fed Funds Rate and the short end of the curve.

Second, because there are fewer sources of "core" deposits banks are turning to wholesale funding sources.  Except in unique markets, wholesale funding is almost always more expense than core deposits.  A key source of wholesale funding is FHLB advances.  The 3rd-quarter 2007 QBP reports that for all banks total FHLB advances increased by 21.8% compared to 3rd quarter 2006.

Settling on an interest rate risk policy limit when you don't have a clue

With each of our clients, at one point or another, we inevitably start talking about establishing or updating ALCO policy limits for interest rate risk (IRR).  These conversations are almost always examiner motivated because a banker is rarely self-motivated to set an IRR policy limit...they only do it because they're required to.  In fact the Joint Policy Statement on IRR outlines this requirement quite clearly:

a bank's board of directors is responsible for establishing and guiding the bank’s tolerance for interest rate risk, including approving relevant risk limits...

The trouble is that very few community bank board members are familiar with interest rate risk management & measurement concepts.  They are much more comfortable talking about earnings performance targets.  They can even have reasonably meaningful discussions regarding credit quality.  That's not usually the case with interest rate risk.  It's this lack of familiarity with IRR that makes it difficult to establish and approve meaningful IRR limits.

The typical community bank board doesn't have more than two or three members that have a financial background.  Most of the time you have a doctor, a farmer, an attorney, etc.  To these folks IRR is a foreign language.  But there are some questions that board members can ask that will help them establish reasonable limits without requiring an in-depth understanding of IRR measurement.

When considering a new IRR policy limit, for example a policy limit -15% net interest earnings at risk, consider these questions:

1. What is our current (and past) measurement?
2. What are peer measurements?
3. What the rules-of-thumb?
4. What do example policies say?
5. What are the regulatory benchmarks?
6. What is our comfort level?

In future posts I'll consider each of these questions as it relates to the suggested sample limit of -15% for net interest earnings at risk.