Michael Benedict: Too Much of a Good Thing?

As the days grow shorter and we transition to fall, management focus frequently begins to shift from the current calendar year to the year ahead. As part of that process, it is helpful to explore the challenges and opportunities each presents.

Though much could change over the remaining months of 2024, the year to date can easily be characterized as one of relative stability when compared with the dramatic shifts we’ve experienced over the past several years. 

Balance sheet composition has largely normalized, funding costs have slowed their ascent, liquidity and credit metrics generally remain on solid footing, and industry capital continues to build at a healthy clip. 

But as other challenges have receded, profitability has stepped to the forefront. According to the FDIC quarterly bank profile, community bank net interest margin (NIM) fell 12 basis points in the first quarter of 2024, while annualized return on assets (ROA) and return on equity (ROE) were below 1% and 10%, respectively, and the proportion of banks that were unprofitable was the highest of at least the past five years. 

Finding the right balance

Strong capital levels are essential for maintaining a resilient banking system, but carrying excess capital makes it challenging to generate sufficient returns on that capital. Growth strategies may help improve ROE, but an inverted yield curve makes it difficult to generate enough spread to improve NIM or ROA. As such, strategies that both improve profitability and utilize excess capital may provide a dual benefit at a time when help is hard to come by.

Though portfolio yields have steadily moved higher over the past two years, industry averages are still well below current market rates. As such, portfolio repositioning strategies are one path available to virtually everyone that can provide the dual benefit referenced above. 

Though many banks have historically been reluctant to realize losses on security sales, the strategic rationale for doing so has rarely been stronger:

• While rate cuts are not a done deal, the Federal Reserve has held its policy rate steady for more than a year, which is typically an indication that the next move will be toward lower rates.

• Regulators have expressed support for strategies realizing losses to improve profitability.

• With benchmark Treasury rates already well below their highest level from the past 12 months, the opportunity to take advantage of 5% to 6% purchase yields could soon be a distant memory.

• Funding costs rising more rapidly than anticipated may call into question the ability to quickly lower deposit pricing if short-term rates decline in the future.

• Repositioning a portion of your portfolio today creates potential for harvesting gains if rates decline in the future (as opposed to seeing lower losses on existing positions).

Things to think through

Two key considerations come into play when evaluating portfolio repositioning strategies that take an up-front loss. 

First is the question of economic benefit: Does the strategy create more income than it consumes, and over what time frame does it do so? 

This can be evaluated in myriad ways, but the strength of bids in tax-exempt municipal bonds almost universally creates value-enhancing opportunities. This occurs because bid prices are driven by individual investors with a higher marginal tax rate than C-corp banks, creating values that exceed what is economically rational for bank investors (though this is less the case for institutions organized under subchapter S). 

Discussions become more nuanced with other asset classes, but many institutions have gotten comfortable with strategies that earn back the loss in relatively short time frames. While the definition of “relatively short” varies, we find management teams are comfortable with strategies featuring earnbacks of three years or less.

Having the hard conversations

The second consideration is the question of whether end-of-year incentive compensation is tied to reaching specific profitability targets and, if so, how recognizing losses on security sales affects your bank’s ability to achieve those targets. This is often a delicate topic, though we would generally advocate for open dialogue in pursuit of the best outcome for the bank. If such an arrangement exists, conversations generally fall into one of three categories:

1. Spending the excess. If profitability is tracking ahead of budget, strategies can be structured to move some of the current surplus into future periods without jeopardizing incentive compensation. (This is ideal.)

2. The big miss. Whether due to subdued loan growth, elevated noninterest expense or other factors, many institutions seem poised to miss budget for 2024. If you’re already going to miss, a reasonable case can be made for missing big in pursuit of more favorable outcomes over the coming years.

3. Looking ahead. Potentially the most challenging of the three, this refers to situations where the institution is otherwise on track to hit targets, but the portfolio repositioning in question would cause profitability to drop below budgeted amounts.

The third category likely requires discussing whether realized losses may be excluded from the bank’s income for incentive compensation purposes. An exception may be granted due to both the unprecedented nature of the extraordinarily low interest-rate environment in 2020–2021 and the historically rapid increase the following year. 

However, granting an exception for losses today invites further conversation about the handling of similar situations in future periods, as well as treatment of recognized gains in a different yield curve environment. 

While there is no single “right” answer to these questions, simply having the discussion can provide useful information regarding the best path forward for your institution. And from there, it’s a matter of which challenges lie ahead.