How To Calculate The Interest Sensitivity Of People, Products, Branches And Technology

Last week we had a meeting that few banks have. It was a rarity for us, but it was eye-opening for all that attended. It brought an important clarity about the future, a clarity that would be helpful for any bank to achieve, no matter what their size. This meeting was an asset-liability committee meeting (ALCO) of sorts, but it was also strategic. As we have written about before, a good meeting starts with a good question and the question before the group of ALCO practitioners and Regional Presidents was, “What is the interest rate sensitivity of our people, products, branches and technology?”

The Implications Of That Question

In ALCO, you discuss and plan around the duration, convexity, liquidity and general risk of your lending, investment and liability portion of your balance sheet. This analysis is largely centered around how interest rate movement will impact your balance sheet and income statement. If you are an advanced ALCO team, you probably also discuss how pricing and marketing impact volume and how this would change over different interest rate cycles. This is where you get a dynamic ALCO model. If you are an expert level team, then you also calculate the interest sensitivity of fee income lines to arrive at a duration and convexity of those revenue streams. This gives you a holistic, dynamic ALCO model. However, this is likely where your discussion stops. At least ours used to.

This could be a mistake as how you handle the rest of your bank has profound implications for your future and one could argue is equally and even more important for your future than the rest of the discussions. Understanding the interest sensitivity of staffing, brick & mortar and other inputs helps answers vital questions about a longer time horizon. This forces your bank to be more proactive about its legacy.  

The Duration Of People

Staffing is the easiest to understand. It is likely that your branch staffing model is trimmed for speed right now without too much excess capacity. With net interest margins heading below 3%, there is little room to keep people standing around on the teller line, for example. But, wait, think through that point.

If rates do stay down and deposit activity is low, you want your tellers to be selling. That means you probably want to rotate to the universal banker model faster and train your staff to handle sales, account opening and customer support. You might also conclude that you need to cut staffing level to compensate for lower net interest margin. While we want to focus on people in this discussion, you might also decide to reduce your branch footprint, make greater use of mobile and interactive teller technology, roll out new products and incorporate other changes to your infrastructure and/or pricing strategy. These moves will presumably lower your interest expense, hold costs neutral, reduce your interest rate sensitivity   of your deposits and increase fee income.

As you create a financial model on the above scenario, you then can figure out a ballpark return on equity (ROE). By understanding the duration of your people in a low and flat interest rate environment you got to the conclusion that your prospective ROE is likely greater than your current ROE.  

Now Add An Interest Rate Shock

Let’s take the above scenario and calculate what would occur if short-term rates go up 1%, as the forward curve predicts. Here, you might conclude that your surge balances are going to leave your bank and you are going to need more staff to handle the additional transactions and items processing. If you are like most banks, you are likely about 90% correlated to interest rates so you only achieve a 0.10% increase in your margin. Unfortunately, if you are like most banks, a majority of your assets are fixed (or fixed on floors) so your net impact is negative. Add to compressing margins your higher staff costs and most banks would have to conclude they better find a way to restructure their branch model and increase the use of technology to lower expenses in order to just keep profits where they are today.

Alternatively, if you think the economy is stronger than expected and rates go up faster than the forward curve expects, then you might forecast your margins will increase and that your deposits are now valued at more of a premium. This might have you adding branches and staff as your return would increase on both.

Conclusion

As can be seen in just one scenario on the chart above, the effective duration, or interest rate sensitivity for branches and people can exceed the impact of interest rate changes to loans, investments and deposits. Thinking through how you would add or subtract to your physical and digital infrastructure forces you to think about business planning on a longer-term time horizon.

For us, the path forward became clearer. We noticed that we would be making the same asset allocation, product, technology, investment and staffing decisions in the majority of the scenarios. More importantly, we were able to quantify the impact of those decisions and how important they were to our long-term performance. These realizations lead to better decisions.

It doesn’t matter if you are a $100mm sized bank or a $100B sized bank, joining ALCO and strategic planning together at this granular of a level sets up your bank to be more proactive in their decisions. Give these exercises a try at your next ALCO meeting and see if does not provide you clarity on your future.

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CenterState Bank is a $5B community bank in Florida experimenting their way on a journey to be a $10B top performing institution. CenterState has one of the largest correspondent bank networks in the banking industry and makes its data, policies, vendor analysis, products and thoughts available to any institution that wants to take the journey with us.