30 MARCH / APRIL 2020 Fate has earned its reputation. 2019 may best be remembered as the year when things that weren’t supposed to happen, happened anyway. The world’s major economies weren’t supposed to have spiraled downward, but they did. Bond yields were not supposed to have fallen, but that’s what happens when growth decelerates. The Fed was not supposed to have reversed monetary policy and cut rates, but that happened … three times. The presence of these conditions would be less significant were it not for the fact that most community banks had been readying their balance sheets for rising interest rates ever since the end of the Great Recession almost 11 years ago. And who could blame them? Since the beginning of the current growth cycle in mid-2009, regulatory authorities of all ilk have been loudly and repeatedly sounding the alarm of higher interest rates couched in their concern that this inexorable fate would harm earnings and impair capital. Risk, though, is tricky. Its genesis does not typically spring from what is expected. Rather, it comes from the unexpected things that sneak up on us. As a result, most community banks are well prepared for rising rates, a condition that doesn’t exist, but less prepared for low and falling rates, circa 2019. Preparing a bank’s risk profile for only one environmental condition is the perfect strategy to employ, as long as one’s prescience is also perfect. But managing interest rate risk and/or an investment portfolio should not be about outguessing the market. Nor should it be about trying to get ahead of the Fed or making bets based upon economic forecasts that are less reliable than astrological ones. What if a bank could make itself indifferent to Don’t Hitch Your Strategy To a rate forecast interest rates? What if earnings projections could be made to be consistent across a wide spectrum of interest rate backgrounds? What if risk managers prepared their balance sheets for more than one outcome? Accomplishing these ideals sounds great as a concept, but in practice very few institutions ever reach the promised land of interest rate indifference. One reason for this may just be the nature of human nature. Most people tend to think their beliefs and perceptions about the universe, including interest rates, are the correct ones. If they didn’t believe this, they would have different beliefs. Self-belief is a good thing, but so is self-awareness. Managing risk for multiple outcomes requires at least a tacit admission that one’s view of the future might be wrong. Such an epiphany can suggest behavior that may seem to go against the grain. The Boy Who Cried ‘Bear!’ In 2009 the winter edition of the Supervisory Insights publication of the Federal Deposit Insurance Corp. contained a piece titled “Nowhere to Go but Up: Managing Interest Rate Risk in a Low-Rate Environment.” It was filled with cautionary encouragement for banks to make preparations for higher market rates – not at all unreasonable given that short-term rates were barely hovering above zero. But also back then, 10-year Treasuries were yielding close to 4%, and the nominal yield of the bond buyer 20-year general obligation muni index was around 4.25%. Needless to say, those risk managers who were only managing for a single outcome, the one defined by higher rates, avoided such things. The “smart” money stayed short, because that’s what smart money does when it knows rates have nowhere to go but up. As a result, many “smart” portfolio managers missed Lester Murray Associate PartnerFinancial Strategies Group The Baker Group lester@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. DIRECTORS / SENIOR MANAGEMENT
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