Pub. 10 2019 Issue 4

Winter 2019 23 West Virginia Banker the outperformance fueled by consumer and government spending, residential investment and exports. Still, the 3Q growth rate marks a material deceleration from last year’s 2.9% growth rate. Against this backdrop, the Federal Open Market Commit- tee has cut Fed Funds three times this year. This stimulus could prolong the economic cycle, which might translate into a higher demand for loans and contain credit costs near-term. However, unless the yield curve steepens ap- preciably, bank net interest margins and earnings will likely remain under pressure. In such a challenging operating environment, banks must stay vigilant and focus on the fundamentals. Best Practices for Creating Franchise Value Late in the Economic Cycle Strengthen your core. We want better banks, not just bigger banks. Specifically, focus on improving core pretax, pre-provision return on assets (core PTPP ROA; core earnings excludes nonrecurring accruals, such as securities gains or losses). Core PTPP ROA, in controlling for credit volatility and tax structures, exposes a bank’s true earnings power. We believe that at this point in the cycle focusing on return on assets (ROA) will drive a higher return on equity (ROE) over the long run. Align incentives with desired outcomes. Consider in- corporating core PTPP ROA into your short-and long-term incentive plans. Doing so creates space for forward-looking, franchise-enhancing tactics (a securities portfolio optimiza- tion, liability restructure, lease termination or branch ration- alization, to name a few). Also, make sure that the weights assigned to loan and deposit origination, fee generation and credit look-backs in your incentive plans support your objec- tives and risk tolerance. Weaponize the inverted swap curve to reduce funding costs. Recent simplifications to hedge accounting have made hedging much more viable for community banks. Var- ious off-balance sheet strategies are worth exploring due to these changes and the inverted LIBOR swap curve. One such strategy is to use a pay-fixed swap to hedge the rollover risk of short-term funding. This creates synthetic term rate protection at a meaningfully lower cost than a comparable term FHLB advance or brokered CD. This same strategy can also make prepaying above-market FHLB ad- vances economical. Unfortunately, the inversion that anchors this funding strategy is expected to evaporate over the next 12 months. The bottom line: it’s time to firm up your funding needs and put pen to paper. Create shelf space for higher funding costs through a securities portfolio optimization. Take advantage of the rally in the bond market to optimize your securities portfolio. Gain/loss neutral trades or loss trades can be tailored to enhance book yield and forward earnings. If you’re open to taking a one-time loss, since most of the unrealized loss is already housed in other comprehensive income, GAAP capital ratios should not move meaningfully, though regulatory ratios will decline. Securities portfolio optimizations can also be tailored to reduce credit risk or drive the balance sheet towards a neu- tral position (asset-sensitive institutions should think about adding duration and lockout; liability-sensitive institutions can capitalize on wider spreads for floating-rate bonds). As always, before green-lighting a strategy, assess the impact on the portfolio’s duration, credit and convexity profiles. Continued on page 24