Pub. 8 2020 Issue 4

12 The Community Banker www.mibonline.org By Scott Hildenbrand, Managing Director Head of Balance Sheet Analysis and Strategy, Head of Piper Sandler Hedging Services TACTICS FOR NAVIGATING TECTONIC SHIFTS IN LIQUIDITY Guest Article T his year has presented bank management teams with many issues to juggle, many of which seemingly pull in opposing di- rections, and most of which were not firmly on the radar to start the year. Such was life in 2020. Some banks’ primary concerns stem from the fact that the industry has seen a shift in liquidity. Balance sheets are flush with deposits relative to recent periods, while securi- ties holdings have come down relative to assets. The build-in balance sheet liquidity has come in the form of cash, with an unusually high 7.6% of assets held in cash and equivalents as of June 30. This drastic change in the liquidity picture is best encapsulated by the Cash and Unencumbered Securities-to-Assets Ratio’s significant uptick. The ratio has surpassed the average over the past 14 years of 20.6%, steadily climbing toward the high of 24.7% last seen in 1Q13. (Source: S&P Financial, Banks and thrifts with assets between $250 million and $25 billion.) While every institution is unique, many banks have responded to the shift in liquidity by asking two questions: how does this affect the asset side? What are the options on the liability side? On the asset side, management teams wonder what to do with excess cash in a world where most bond yields are disappointingly low. Even though liquidity profiles appear strong and are trending stronger, economic uncertainty creates unpredictability in depositor behavior. As such, some institutions feel more comfortable with investments that maintain maximum flexibility in the future — sale-ability and pledge-ability —with lower yield as a tradeoff. Other institutions have looked to extend their investment portfolios further out on the curve to increase yield while mitigating tail risk by match funding with 5+ year structures at historically low rates. For instance, banks have worked with some firms to utilize their inexpensive, longer-dated funding mechanisms at attractive rates. Many corners of the banking industry are concerned that low rates, slower loan origination and excess liquidity trends are here to stay for the foreseeable future and have begun searching for loan surrogates. Allowing these banks to extend their liability portfolio’s duration at a scalable level opens the door to more asset purchase strategies. We have seen two specific asset strategies gain momentum: exploring community and regional bank subordinated debt as an investment option and analyzing how to invest in municipals without ruining their interest rate plan. As an alternative to extending the liability portfolio, some institutions have swapped fixed rate municipals to floating, thus obtaining an attractive yield with reduced duration risk and protecting Tangible Common Equity. Exploring risk/reward pro- files of earning assets is nothing new to balance sheet managers, but the environment has certainly evolved since the start of 2020. Managing excess liquidity while planning for interest rate risk man- agement has also become slightly more complicated on the liability side. How does a bank choose from the various funding options and hedging strategies available? The decision-making process must