By Jason Mork, Director, Piper Sandler & Co.

As we close the books on 2020, we have the perfect opportunity to take stock of what bank balance sheets look like, assess what has worked (and what has not) and back test risk management methodologies. After having been through shocks and a series of surprises over the past 12 months, including a global pandemic; 30 percent market crash and a recovery before the end of the following quarter; unprecedented fed intervention and government stimulus; and fears of a default wave, we found ourselves at year-end in a world awash in liquidity with markets near all-time highs. We still face uncertainty as we head into 2021 about the pandemic and where we are in the recovery as well as how it will be shaped.

It has been a unique time to work with banks, help them model both their assets and liabilities and assist with the multiple portfolios of assets they have to manage in a zero rate environment. One of the consistent themes that has been adopted by banks has been to strengthen the way balance sheet risk is managed through better asset liability modeling and a stronger ALCO process. As I consult with bank portfolio managers, one of the most common things I hear is “I let my balance sheet tell me what my portfolio needs are,” which is a great philosophy. I frequently give the same advice. However, there is an important caveat in this saying, it cannot be a single faceted philosophy and too often it is based solely on duration. While it is true your portfolio can be the easiest place to fine tune the duration of the balance sheet and manage the interest rate sensitivities, a lot can be lost when the other risks that are also key drivers of return are not considered, such as credit risk, liquidity risk and option (call) risk.

One of the inherent challenges bank portfolio managers face is that we are in a counter-cyclical business; we are frequently forced to be engaged in an activity at the exact wrong time. Today we are forced to add assets in a record low rate environment, with credit spreads near all-time lows. This is a challenging environment where tradeoffs are made between equally undesirable outcomes i.e., current earnings vs. future market value. When reviewing the current state of your balance sheet, you should ask yourself what you were doing one or two years ago in terms of portfolio management. If you are like many, you were probably not buying bonds as you let your portfolio shrink to fund loan growth. If you were like others, you may have even sold bonds to fund loan growth. If you sold bonds, were you considering the effects of the sales on the duration, credit, liquidity and call risk of your portfolio, or were you focused on funding loan growth without taking losses?

Self-review provides a great opportunity to learn from both our mistakes and our successes to plan for the future. Earlier this year, the Graduate School of Banking at Colorado (GSBC) hosted a GSBC Cares program on navigating markets amidst the pandemic. In Figure 1 below, I shared a framework with ideas on the different ways a bond portfolio could be used to hedge different balance sheet risks in different environments and introduced the concept of multiple portfolios existing within your balance sheet. While the strategies are self-evident, especially when looking backwards, execution is frequently elusive, even for those who “saw it coming.” Strategy is a function of studying and planning whereas implementation is a function of understanding markets and the features of securities.

Rates Above Neutral and Stable/Rising

  • Dollar cost average mentality (yield)

  • Extend duration, prioritize structure over yield

  • Laddering strategy

  • Goal: Protect NIM and maximize earnings (now and in the future)

Rates Approaching Neutral and Stable/Rising

  • Dollar cost average mentality (yield)

  • Ensure you have the duration you want, prioritize yield

  • Fill in holes in the ladder

  • Goal: Protect NIM and maximize future earnings

Rates Low and Stable/Rising

  • Be sensitive to prices, prioritize relative value

  • Underwrite everything (credit, structure, duration, future market value), limit unacceptable extension

  • Maintain duration at lower bound and add cash flow to key repricing years

  • Barbell strategies usually perform best

  • Goal: Protect capital and minimize future FMV losses

Rates at or Below Neutral and Falling

  • Be aware of prices rising, prioritize discounts (if available)

  • Reduce (sell) call risk

  • Move to a neutral duration

  • Need to rate shock up and down

  • Goal: Balance income and future market value

Figure 1

I once was working with a portfolio manager who wanted to engage in a trading strategy to take gains to offset a drop in interest income in the event of a sudden drop in rates. When the unforeseen event occurred, I received an excited phone call. The portfolio manager said, “let’s sell!” After reviewing their bids, they were disappointed as bids came in well below what they had hoped for. I explained that the market is illiquid, and no one wants to buy at the lows. In this example, the portfolio manager had put a good strategy into place, nailed the duration and option risk part of the trade, but they overlooked the liquidity risk and credit risk components of the trade. Their outcome was a disappointment. The post mortem of this story is they could have executed properly but were unwilling to take the lower-yielding investments that would have led to a successful trade. In short, they chose yield over structure and bought less liquid bonds that were subject to volatile credit spreads.

This is one of the reasons why GSBC hosts the annual Community Bank Investment School (CBIS). When it comes to portfolio management and executing the strategy born out of a great ALCO process, it is important to have a thorough understanding of how the assets on your balance sheet work to achieve the results you desire. GSBC’s CBIS – being offered virtually in February 2021 – gives you the basis to begin your journey to master the key asset classes you will encounter. The experts who serve as faculty are experienced market technicians who give you an unbiased and transparent view in an academic setting. We look forward to seeing you there.