No one has the crystal ball on when the next recession will begin, how long it will last, and how severe it will be. However, given the recent decline in inflation levels due to the Fed’s aggressive tightening cycle, it does feel as if we are getting closer to the peak in interest rates and closer to the end of the current economic cycle. Whether this current Fed tightening cycle ends in a recession or a soft landing, the Fed’s latest Dot Plot points to a path for lower interest rates in the future. Balance sheet managers and ALCOs should never try to time the peak of interest rates. Rather, they should best prepare the balance sheet for the next recession and/or falling interest rates. Here are some considerations for preparing the balance sheet for the next recession: • Interest Rate Risk — Whether the current tightening cycle ends in a recession or a soft landing, there is a high likelihood for some level of lower rates in the future. Utilizing your Interest Rate Risk Model to identify any exposures to falling interest rates is critical. Managing your asset sensitivity and asset duration through effective investment selection and strategy is key. Being reactive is not a strategy. • Credit Risk — Asset quality problems of some magnitude accompany recessions. Ensure current loan pricing and structure is appropriate given the deal and current environment. Avoid chasing loan demand late in the cycle by tightening credit underwriting standards. • Liquidity — Historically, during recessions and falling rate scenarios, deposit levels increase, and liquidity levels grow. Ensure your assets are fully deployed to optimize your earning asset mix while keeping a cushion of unencumbered liquid assets. Lastly, every institution should have ample contingent liquidity sources for those unforeseen liquidity events and needs. • Stress Testing — Stress testing should be done on a regular basis. It is important to consider higher impact, lower probability scenarios when creating stress scenarios. Stress testing can be conducted on various aspects of the institution, including on capital, liquidity and interest rate risk. “How can we better prepare for a possible recession?” I encourage you to put this question as an agenda item for your next ALCO meeting. Every institution’s balance sheet and risk profile are unique. There is no one-size-fits-all strategy, but being proactive and having a plan (as well as contingency plans) is essential. Dale Sheller is an Associate Partner in the Financial Strategies Group at The Baker Group. He joined the firm in 2015 after spending six years as a bank examiner with the Federal Deposit Insurance Corporation. Sheller holds a bachelor’s degree in finance and a master’s degree in business administration from Oklahoma State University. He works with clients on investment portfolio strategies, interest rate risk management, liquidity risk management and regulatory issues. Sheller regularly speaks at educational seminars nationwide and serves as a faculty member for multiple banking schools. Contact Dale at (800) 937-2257 or dsheller@gobaker.com. 29 West Virginia Banker
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