Up Close: FP&A in Banking | By John Hamrick | April 30, 2013
Traditionally, banks derive most of their revenue from their margin, which is the net difference between what they earn on money lent or invested (interest-earning assets) and what they pay deposits or other sources of funds (interest-bearing liabilities). Therefore, pricing, measuring and projecting that margin is of crucial concern to the financial analyst. Banks price their products to cover their operational costs and expected losses and still provide reasonable profit to the owners. An increasingly competitive market dictates the price, however. To compensate, banks manage their margin more by manipulating the mix and types of assets and liabilities on their balance sheet.
There is an additional problem of concern down the road, which is stability of rates over time. Very often there is a mismatch between the re-pricing characteristics of a bank’s interest-earning assets versus its interest-bearing liabilities. Deposits tend to be short-lived—from checking and saving accounts that can be instantly withdrawn to CDs with up to five years life—while loans tend to be longer-lived, from commercial loans of around two to three years to mortgage loans of 30 years and beyond. If rates begin to rise rapidly, banks are locked into their yield but have to pay more for the re-pricing borrowings, and the margin compresses (or may even go negative).
This problem is further compounded by the change in consumer behavior as rates change. If rates fall a sufficient amount, loan customers will increasingly take advantage of options to pay off or refinance their loans. If rates rise sufficiently, they will tend to hold onto the loans longer than normal. Bankers generally prefer a steady rate environment, since they often lose value whenever rates move up or down, sometimes losing value on old business faster than new business can replace.
In the marketplace, banks try to mitigate this interest-rate risk by offering (at lower rates) adjustable rate loans that re-price in shorter cycles, but consumers prefer fixed-rates. Banks then turn to their treasury department to find ways to offset remaining interest-rate risk through a variety of means, such as interest-rate swaps and other hedges, or selling off originated loans and buying into other investments with preferred characteristics. In many ways, issues with bank margin control are analogous to any industry dealing with commodity pricing differential, e.g., electrical energy.
FP&A and/or the bank’s treasury department, with increasing sophistication of analytical tools, closely and constantly monitors and projects the bank’s margin over a range of interest rate scenarios, to spot exposures, particularly against likely rate environments, and recommend changes in pricing, product structure, hedges or other actions to protect against margin compression. The analysis will often look at two elements, a projection of annual net interest income and a projection of net market value, over a spectrum of rate changes, up and down.
Another major concern to most banks is the quality of their earning assets. Either FP&A or the bank’s credit department, again with increasingly sophisticated analytical tools, will constantly review its portfolio of loans and borrowers to estimate the probability of default and loss. Banks make provisions for these potential losses to the income statement, and carry a reserve against loss on its balance sheet. The provisions are usually split into general reserves reflecting the nature of the loan-type and current economic/rate environment, and specific reserves that reflect new assessments of the financial health of the particular borrower.
In monitoring the health of the loan portfolio, bank analysts will look at a variety of measures, particularly the ratios of non-performing loans (for which payments are late but the loan not yet written off) to total loans and net charge-offs (loan charge-offs during a period less recoveries) to total loans. They will also consider the adequacy of the reserves by looking at ratios of loan-loss provisions and loan-loss reserves to total loans.
John Hamrick (email@example.com) is a member of the FP&A Newsletter Editorial Advisory Board. Hamrick has been a director of FP&A in community banking for over 20 years. He is co-founder of the Houston FP&A networking group and currently is an FP&A advisory consultant with Seamans & Associates, LLC.
This article appears in the May edition of FP&A.