Regulations, politics and Fed exit timeline changes keep pressure on banks, but there is a silver lining.
There is little hope that the threshold for banks subjected to the most stringent regulation and supervision (or other forms of relief) will be adjusted anytime soon. At least this was the conclusion reached at the Bank Treasurers’ Peer Group’s 11th Annual Meeting in May 2015. Moreover, the return to a positive, normal rate environment more favorable to the business of banking, by all accounts, is to be delayed at least until the end of the year. Meanwhile, larger banks in the group are looking to integrate liquidity, or “horizontal” stress-testing and resolution planning into their CCAR process, while banks below the $50B threshold continue to refine their DFAST frameworks for the downward cascade of regulators’ liquidity mandates. This presents the silver lining amidst all this stress: banks are having to optimize financial management in a way that might not otherwise occur. This optimization will pay dividends when regulatory pressure eases and the rate environment returns to “normal.”
Key Highlights
1) A friendlier regulatory and supervisory environment not likely soon. While there is some bipartisan appetite to reform bank regulation, especially for community banks, the political reality makes it unlikely. While the Fed can dial back some on its own, banks are still creating too many negative headlines to make regulators feel comfortable enough to do so.
2) Banks and their investors are focused on interest-rate sensitivity. Banks face challenges boiling down a multitude of variables into a single beta number for the interest rate sensitivity of key assets, liabilities and net interest income. Investors, without much information publicly disclosed, thus are even more challenged to determine which banks will see net interest income (NII) rise more than their peers.
3) Limitations on the asset side further focus treasurers on deposits. Looking at rate-sensitivity betas, with analysis by Morgan Stanley’s bank CIO, showed the limitations on boosting NII performance on the asset side under various rate scenarios as opposed to lowering betas on the liability side. This underscores the importance of deposit studies and internal historical data to arrive at best guesses on how deposit balances will be impacted by interest rates and how flow of funds dynamics will be altered by regulation going forward.
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Evolving Investor Perception of Banks with Rate-Rise Expectations
Betsy Graseck, who heads large-cap bank and asset manager coverage for Morgan Stanley, walked the group through her team’s efforts to help investors understand banks’ sensitivity to interest rates ahead of the rate hike. One way they are doing this is by modeling banks’ rate sensitivity on NII and the EPS impact of incremental NII for banks they cover using public disclosures. The goal is to help investors forecast NII and the EPS impact to see which banks will perform best as rates rise.
The difficulty in creating a model is that banks don’t disclose or provide enough guidance publicly. Among the information deficits that pose modeling challenges are company-run sensitivities based on static balance sheets, differences in loan re-pricing speeds, limited color on hedging impacts and competitive dynamics that are difficult to capture. Unfortunately, earnings calls help little; and because commentary tends to vary from quarter to quarter, there is limited commentary given on supporting calculations and the long-term view is not captured.
Accordingly, the interpretation used in creating Morgan Stanley’s model is more art than science. Indeed, all external modelers are left to their own best guesses on the speed and form of the coming rate rise (as is everyone), the re-pricing frequency of interest-earning assets and liabilities, NIB deposit run-off, the re-pricing and new growth spread, as well as tax rates.
Finally, bank investors, like bank treasurers, need to understand that rates are a fickle thing, and an environment with NIM compression, which can always appear unexpectedly, means they may need to lose revenue in order to sustain the business until rates move again.
A Friendlier Regulatory and Supervisory Environment Not Likely Soon
Banks are straining under current regulations, but given the current US political jockeying, there is little relief in sight on the regulatory front. While there is some prospect for legislative changes targeting community banks under $1bn, there is little likelihood that banks larger than this will see much relief. For starters, Dodd-Frank is one of President Obama’s signature legislative efforts and he is not going to be receptive to reopening it. Given Hillary Clinton’s desire to keep Elizabeth Warren out of the presidential race, she is also not going to be supportive of reforming Dodd-Frank, and this will prevent a bipartisan consensus before the next election. While the Fed may also be somewhat disingenuous in saying that it cannot make changes without legislative action, by saying this it is signaling its unwillingness to act on its own.
Key Takeaways
1) It doesn’t pay to be an itty-bitty SIFI. Banks that are just over the line for additional regulatory and supervisory burdens have it the worst. Thus, when growing via acquisition or organically, banks must do it so that they get well across the line. Better to have the business size and scale to support the required infrastructure. Accordingly, banks would be unlikely to engage in M&A that took them just beyond the existing thresholds (e.g., $10bn and $50bn in total assets). On the flip-side, few banks will want to move up to the highest rungs of the Global Systemically Important Financial Institutions (G-SIFI)—subjecting them to additional capital buffers ad regulatory supervision. This will make it difficult for the largest banks to find ready buyers for any of their major pieces.
2) Pendulum is stuck on hardline supervision. Usually tougher enforcement and supervision swings back the other way, but the pendulum appears to be stuck. One reason is that regulators are still looking over their shoulders in response to criticism that they did not do enough leading into the financial crisis. There have also been too many issues post-crisis (the London Whale, Libor and FX fixing, AML violations, etc.) to convince them that banks are deserving of being cut some slack. The pendulum will not be able to swing back until these headline risks start to recede.
3) Regulators should be careful not to go too far with criminal penalties. In response to the question of how far regulators will go to enforce the rules, one regulatory expert noted that he sometimes worries that they will go too far. Criminal enforcement against banks will not be a good thing, he noted, especially regarding the impact it will have on the already poor public perception of banks and government support for the banking system.
4) The wave of new regulation coming on line is slowing. The good news is that the long list of regulatory rules that have yet to be finalized has grown shorter, so banks will start to see a shift from understanding wave after wave of new rules to figuring out how to comply with them more efficiently.
Outlook
While the firehose of new rules may be slowing, the desired let-up by regulators on supervision and enforcement stringency looks unlikely, keeping banks outside their comfort zone for now. What’s needed is a period of relative quiet, where banks are not in the headlines for wrongdoing.
Fed Exit: When and How?
Morgan Stanley’s Senior US Economist Ted Wieseman shared his views on the Fed exit, including when it would start and how it might proceed.
The slipping economic growth numbers from Q4 2014 through Q1 2015, largely driven by the impact of falling energy prices and the rising dollar (and that the Fed was seeking to move in the opposite direction to some 30 central banks that had cut rates in intervening months) pushed back the timeline to December (September at the earliest). The Fed will move off zero when labor picks up and the negative growth impacts of energy and the dollar subside. Wage growth, productivity, and related inflation expectations will also affect the Fed’s timeline.
This time around, the Fed will be cognizant of real rates, which may rise on their own, without a nominal rate rise. Deflation risk fears mean the Fed wants to see real rates come up and the curve be upward sloping. A 25-50bps hike is expected to get the rise off zero started. But the Fed is ready to do what it takes to get rates off the floor and even unleash the full reverse repurchase agreement (RRP) facility and further displace repo markets if it is really needed.
Ultimately, the Fed will default to US considerations to get US rates off the zero floor. If the rest of the world then decides to pursue QE forever, the US interest-rate curve will be in for a rocky ride, and the normalization of US rates may not proceed as the market expects (which is already lower than what the Fed is saying it will target for 2017).
Asset Duration and Deposit Betas with Change Expectations
John Ryan, chief investment officer for the Morgan Stanley Bank (MSBNA), shared his views on how banks might think about positioning their balance sheets to maximize net interest margin (NIM) from a rate rise, or a normalization of US rates. His general hypothesis is that most banks will have greater success trying to adjust the betas on their deposits via pricing powers (which is something banks control on the liability side) as opposed to timing the market or selecting investment assets that will perform better with a rate rise (where banks have less control on the asset side).
To help prove his point, Mr. Ryan showed the expected performance of a mechanical tractor, or typical laddering of investments in three- or five-year assets, in a forward curve, 50bps-up or 50bps- down shock scenario vs. a decision to delay the target investment decision for six months. He then compared this performance to that of reducing the beta on liabilities from 0.5 to 0.4 under the same scenarios. This presentation framework resonated with the bank treasurers as much as the information presented.
Key Takeaways
1) The impact of delaying investment (or market timing) is only good in the up-50bps shock scenario. With three-year assets, it represents a $2.17mn improvement in NII per billion in the up-50bps scenario, but is 2.36mn worse in the down-50bps scenario. With five-year assets, it was $2.08mn better in the up scenario vs. $2.21mn worse in the down (see tables below).
2) Lowering liability betas performs better under all scenarios. Not only would a reduction in betas from 0.5 to 0.4 create positive NII in all three scenarios, but it significantly outperforms the delayed investment decision outcomes (see tables below).
Outlook
Mr. Ryan underscored why bank treasurers are so focused on deposit betas: they have something in their power to control that can greatly improve NIM/NII without taking the risk of second-guessing on an investment decision. He also believes that banks have more power over deposit pricing than they think. While historical correlations to higher rates suggest higher betas to some, as does the impact of LCR and NSFR, these are more than offset by the increase in supply for deposits, corresponding declines in loan-to-deposit ratios, the impact of money market–fund reform and the SLR, which will tend to lower betas. All this suggests that treasurers are right to focus on deposit studies and take a hard look at their deposit-pricing policies.
The Difficulty of a Single Beta Number
There is a level of inconsistency across banks in how they measure (deposit) beta. And the more banks drill into the question of how to measure it, the more they find it difficult to boil down the multitude of variables into one number.
The best answer might be to have a range of results, or multiple betas that take into account non-linearity with, say, a slow or fast rate change or a slow or fast up change vs. a slow or fast down. There are also regional variances and product rotation that can impact beta.
The market likes to know about bank interest-rate sensitivity, which puts disclosure in the foreground. BTPG group consensus pointed toward disclosing a range (e.g., up 200bps, down 200bps), perhaps with some caveats about regional variances and the uniqueness of the rate environment. Fifth Third surprised a lot of people with a recent disclosure of more-than-usual detail around its base case beta for all deposit types. How many more banks follow this path?
Deposit Behavior in a Rising Rate Environment
Given the impact that changes in deposit betas can have on NII, a discussion of the results of the pre-meeting deposit-study survey was a useful follow-on. Most banks in the group have seen surge deposits grow since 2008; plus, the sentiment (55 percent) is that deposit lifespan has increased in this time due to depositors becoming more conservative and alternatives like money markets losing appeal. This, plus the uncertainty around the rate environment, means treasurers have more questions than answers on what will happen when rates rise (see sidebar, this page).
Key Takeaways
1) Surge deposits in ALM model. Despite the rise in surge deposits, only half of the group said they segregate surge deposits for the ALM model, with 72 percent of those using internal historical analysis (using 6+ years of data) to make the designation.
2) Deposit sensitivity benchmarks vary. Sixty-one percent of the group use explicit betas to capture deposit price changes relative to a benchmark (47 percent use stationary betas with the remainder mostly split on betas that vary by direction of rate change or direction and magnitude). The reference rates most frequently used are 1-month LIBOR (41 percent) or fed funds (33 percent). The betas used, for example, on non-maturity deposits in an up 200bps scenario ranged on average from .24 for the least responsive category to .65 on average for the most responsive. MMDA betas in the same scenario ranged on average from .43 to .73 betas.
3) Monthly run-off most common erosion measure. Monthly run-offs are the most common method of modelling deposit erosion (61 percent), followed by a combination of such run-offs with cliff maturities (23 percent). No bank in the group said they were comfortable enough with their run-off assumptions to wire them into their fund transfer-pricing framework, however.
Outlook
The discussion regarding challenges around measuring interest-rate sensitivity, including with deposits, underscored how fascinating it will be to see what actually happens when rates rise as compared to beta-driven expectations. This is particularly true since rates will rise off of an unprecedented period of time at low levels (zero and negative in Europe), along with other equally unprecedented Quantitative Easing measures—plus regulatory changes that will alter flow-of-funds behaviors. Save your data!
CONCLUSION
While there is not much immediate hope that BTPG members will see regulators ease up on them, they continue to take advantage of the mandated stress-testing to gain a better understanding of how their banks will perform under a variety of economic and interest-ratescenarios. Their risk management, capital and liquidity planning, modeling, and funds transfer pricing is becoming that much more refined. Accordingly, banks could be in a better position to optimize their performance in ways they might not have before when rate normalization, a curve more favorable to banking business, or a best-case scenario comes about. If “normalization” also returns to the regulatory environment for banks, and banks learn to innovate with products and lines of business in sync with the new rules, then bank treasurers could see all their recent stress pay off. However, there is a real risk that the next crisis will come or that the economy tanks before members can take their new balance sheets out for a real test drive. The member bias therefore is still not to be overly optimistic. Still, if rates are off the floor by the next annual meeting, there will be reason to look up.