The Big Idea
Too much of a good thing
Tom O'Hara, CFA | September 9, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Loan growth and rising interest rates have both helped bank earnings lately, but not without complicating the business of managing a bank balance sheet. Lending has had the knock-on effect of tying up expensive capital, and banks have started turning toward a handful of solutions. Rising interest rates have helped drive up asset income faster than interest expense. But many banks now worry about recession and potentially lower rates and lower earnings. Banks have started taking a couple of routes to extending the duration of their assets.
Bank capital deterioration
Banks in the APS tracking group had a median decline in their Tier 1 capital ratio so far this year of 60 bp (Exhibit 1). This decline is partly attributable to strong loan growth (Exhibit 2). and while loans typically carry higher yields and drive stronger earnings, they also usually require additional capital. Banks have also taken record losses in their available-for-sale securities portfolios, which have flowed through accumulated other comprehensive income to hit capital, too. While most banks are able to ignore these hits for their T1 capital calculation, the banks’ tangible capital is still affected. Also, our tracking group includes a couple of Global Systemically Important Banks which are not allowed to ignore these AOCI adjustments in their T1 calculations, and those banks reflect T1 adjustments larger than the median.
Exhibit 1: Change in Tier 1 capital ratio year-to-date through 22Q2
Exhibit 2: Loans as a percentage of assets have increased 2.3% on average
Adequately capitalized banks must maintain a minimum total risk-based capital ratio of 8%, comprised of common equity, preferred stock (Additional Tier 1) and subordinated debt (Tier 2). Many loan types, such as commercial and industrial loans (C&I), commercial real estate and most consumer loans carry a 100% risk-weight, meaning the bank needs to hold at least 8% capital against those.
In many cases, banks have allowed their securities portfolios to run-off in order to help accommodate the growth of loans on the balance sheet (Exhibit 3). Banks often hold large positions of U.S. Treasuries and Ginnie Mae securities, both of which carry the full faith and credit of the US government and therefore are 0% risk-weight. Another large component of bank portfolios are Fannie Mae and Freddie Mac securities, carrying a 20% risk-weight, so a bank would need to only hold 1.6% capital against those (20% X 8%). The capital impact of rotating out of securities into loans is obvious.
Exhibit 3: Some of the banks with the highest loan growth also had the highest securities portfolio run-off
A simple tactical solution to this problem is to add more 0% risk-weight securities to the portfolio (Exhibit 4). This may be difficult to do if a bank is also experiencing leverage ratio issues, but assuming a bank has cash to deploy, 0% risk-weight securities present an attractive option.
Exhibit 4: Many of the banks that did add to their securities portfolios in Q2 chose to do so with 0% risk-weight bonds (change as a percentage securities portfolio)
Even for banks that saw net reductions in the size of their securities portfolios, many of them were still growing the size of their 0% risk-weight buckets (Exhibit 5), either on a relative or an absolute basis. Exhibit 5 below shows several banks with declines in their total securities portfolios, but less of a decline or even an increase in their 0% risk-weight Treasury portfolios.
Exhibit 5: Most U.S. Treasury positions increased in Q2, even with overall securities positions declining
Banks have many 0% risk-weight options available to them, and often opt for Ginnie Mae securities as they can provide roughly a 50 bps yield advantage to treasuries. Below is a menu of those options (Exhibit 6), which include Ginnie Mae CMOs, HECM floaters, SBA pools, Ginnie Mae project loans, and Ginnie 30-year pass-throughs.
In terms of market liquidity of the 0% risk-weight alternatives, the pass-through market is the largest, and pass-throughs currently also offer a relatively high yield. However, many banks may not want the longer duration given current industry preference to reduce asset sensitivity (see ‘Many banks are now reducing asset sensitivity’ section further below). Ginnie Mae project loans currently provide the highest yield of the listed options, but may not be treated as a Level 1 from a Liquidity Coverage Ratio (LCR) perspective given the smaller market size (LCR treatment is often tracked by banks on their portfolios, even if they’re not technically subject to it). Ginnie Mae CMOs provide a nice balance of solid yield, low duration and good market liquidity, and they happen to have the highest Option Adjusted Spread (OAS) of these alternatives currently.
Exhibit 6: Relative value – 0% risk-weight securities examples
Alternatively, to reduce risk-weighted assets, a bank might decide to sell whole loans. Banks are not typically sellers of loans, given that loans are generally more liquid when sold on a servicing-released basis, meaning that the servicing is transferred to the buyer and the seller loses the customer relationship. A bank may be able to sell loans servicing retained but liquidity will be reduced. Also, banks may need to realize an accounting loss on a sale of loans originated in the last few years, given the large sell-off in fixed income markets in 2022. But if current loan demand is putting pressure on capital, a bank likely could sell new loans without material loss, if any.
Banks could consider issuing capital instruments into the markets to increase the numerator of their capital ratios. Subordinated debt would help to increase the total capital ratio, but as a Tier 2 instrument, would not help to increase Tier 1 or Common Equity Tier 1 ratios. An issuance of common equity would help to improve all of the bank’s capital ratios, although this would be the most expensive form of capital. A bank may still decide to move forward with a stock issuance if it is able to demonstrate that the incremental loan production that the equity will support is profitable and a prudent use of shareholder capital.
For banks that would prefer not to issue traditional forms of capital for various reasons such as shareholder dilution or cost, another strategic solution that banks are exploring is a credit-linked note structure. CLNs are sometimes referred to as ‘denominator trades’, in that they improve capital ratios by reducing risk-weighted assets (the denominator in bank capital ratios). These structures can free up 60 – 85% of the capital that a bank holds against a specific loan portfolio (Exhibit 7). Depending upon how well the particular loans lend themselves to securitization, the bank may be able to achieve a favorable CLN capital structure. Market spreads also play a key role in determining the cost of such a transaction. APS recently refreshed cost of capital estimates for auto, residential mortgage and commercial mortgage loans.
Exhibit 7: Credit-linked note cost estimates
Many banks are now reducing their asset sensitivity
Asset sensitivity, where asset coupons are resetting more frequently than liability coupons, is a desirable position for banks to be in when rates are rising. Many banks, however, now believe their asset sensitivity is too high. They have reaped some of the benefit of an increasing rate environment but now may see a decline in net interest income if rates decline. Some of our clients have noted being in a similar position at the end of 2019, only to see the bond market rally before asset sensitivity could be fully addressed. Therefore, many banks are moving early, and using several different methods as described below.
Banks may position their securities portfolios to benefit from a lower rates environment:
- “We have continued to focus on adding duration and structure to the investment portfolio to provide stable and predictable cash flows”, Jamie Leonard, EVP / CFO FITB 7/21/22.
- “$50 billion investment portfolio structured to provide greater yield stability in lower rate environment”, KeyCorp Second Quarter 2022 Earnings Review 7/21/22.
This may be achieved by purchasing longer-duration 30-year pass throughs or sequential CMOs.
Banks also have different ways in which they can add duration to their loan portfolios. One method is to add structure to their loan agreements:
- We currently have over $1 billion in down-rate protection, including floors and collars [in loan contracts], which we will continue to build over the remainder of the year”, Brendon Falconer, CFO ONB 7/26/22.
Other banks are adding receive-fixed swap positions as cash flow hedges to their floating rate loan portfolios, such as C&I loans, effectively converting their coupon to fixed and adding to their duration of equity.
Banks may choose to address the duration of their liabilities. Those that rely heavily on issuing unsecured debt often issue fixed rate notes. A receive-fixed swap may be used as a fair value hedge against that liability, converting the note’s coupon from fixed to floating, which also adds to the bank’s duration of equity.
Finally, as wholesale funding returns to prevalence more generally, banks are using FHLB funding more so than they had in the previous two years and are able to incorporate longer duration features into these agreements. One is to embed a simple interest rate floor into the funding, and another is to incorporate a zero cost collar, where a cap is sold to help pay for the floor.