Waiting and wondering

For more than six years, short-term interest rates have hovered near zero, but that could change soon. Federal Reserve Chair Janet Yellen reaffirmed in July the central bank’s plan to  start raising interest rates before the end of the year.

If and when that happens, G. William “Billy” Beale, CEO of Richmond-based Union Bankshares Corp., which operates Union Bank, will be thrilled. In anticipation of Fed action, Union has been restructuring its balance sheet to be more asset-sensitive. Its actions have included tying more loans to floating rates, shortening the average life of its investment portfolio and emphasizing lower-cost, less reactive deposit vehicles like negotiable orders of withdrawal (NOW) and money market accounts.

“Essentially, if rates start to rise, our assets will reprice faster than our liabilities, and that would translate into improved profitability for us pretty quickly,” Beale says. “It would be a great thing.”

Unless, of course, the economy isn’t strong enough to absorb the rate hike.

“A quarter point [increase] doesn’t sound like much. A half point doesn’t sound like much,” Beale says. “But a rise in the prime rate will increase the cost of borrowing, and it could put some of our commercial customers under more stress. The question is: Will they be able to handle that increase or adjust their rents or pricing fast enough to not go into a negative cash-flow situation? That’s something we definitely worry about.”

Ups and downs
For all the hopes the banking industry has been putting on rising interest rates, an actual Fed move “will bring a lot of anxiety, in addition to great optimism, for both community and national banks,” says George Morgan, SunTrust Professor of Finance at Virginia Tech’s Pamplin College of Business.

“Everyone is expecting rates to rise, and banks that have effectively prepared will see their returns go up in the short-term,” he says. “Beyond that, though, there are a lot of scenarios that could play out, and there’s no way to predict what will happen.”

The big fear, of course, is that rising interest rates will cause the economy to weaken or even slide into recession resulting in a new round of loan defaults. Another possibility? The Federal Reserve could raise rates too quickly, effectively flattening the yield curve between short- and long-term rates and minimizing profitability for banks. The Fed also could raise rates temporarily and then drop them again, effectively hurting the same banks that the interest rate increase initially helped. And any change could create market volatility.

The last scenario, says Morgan, would play in favor of national banks that offer trading operations, M&A advisory services and other fee-based services. “Increased volatility creates more volume for those kinds of transactions, and so I think they’ll do very well in that environment,” he says.

Fortunately for smaller community banks, the Federal Reserve appears to be fully aware of the danger of moving too quickly, says Chadwick Curtis, assistant professor of economics at the University of Richmond’s Robins School of Business.

In a March speech, he notes, Yellen used the term “gradual” 13 times in describing her expected monetary policy.

“The big news is the speed at which rates are going to increase, which is likely to be a little slower than initially expected,” Curtis says. “It will probably be a quarter percent each time, and that will hopefully give everyone time to adjust, and the economy will withstand it.”

Making preparations
Most community banks have spent the last several years preparing for the possibility of both interest rate hikes and the ongoing uncertainty. Morgan notes that banks with a strategic portfolio of floating rates loans, which will reset quickly in a rate increase, and retail deposits, with rates that will rise more slowly, are sure to fare well when the Federal Reserve initially raises rates.

Reston’s John Marshall Bank is one of those banks. Its asset and liability committee intensively analyzes the interest rate gap and the potential impact interest rate changes will have on various bank operations and metrics. The committee will continue its work in earnest when the Federal Reserve finally acts.

“We try to set the mix of our loan portfolio and our deposit portfolio so it’s as closely matched as possible,” says Bill Ridenour, the bank’s president and chief administrative officer. “The way we’ve structured our assets and liabilities, we expect that when interest rates rise, it will at the very least have a neutral impact and very likely a positive impact on our earnings.”

Over the duration of the low-rate era, John Marshall Bank has controlled its expenses, managed its overhead and maintained one of the highest efficiency ratios in the industry.

“As long as you understand where your portfolio is, and you manage that interest rate risk, then an interest rate hike done in a controlled fashion will likely be very positive for banks, as long you watch what you’re doing and don’t get too far out with fixed interest rates on loans,” says Ridenour.

The fixed-interest rate loans pose a major risk, he says, “as there will continue to be a lot of competition for quality borrowers, and in a rising rate environment, those borrowers will want to get a long-term fixed rate if they possibly can.”
Danville’s American National Bank has spent the past six years restructuring for the inevitable day when rates finally start to rise. CEO Jeffrey Haley says that focus has been on “making everything as short as possible,” including commercial loans and bonds and “trying to squeeze every penny or basis point out of core deposits and vigorously lengthening our maturity of time deposits.”

Taking the long view
Michael Joyce, president and CEO of JoycePayne Partners, a financial management firm in Richmond, says that many banks have used the low-rate era to hedge their bets against future interest rate volatility by adding new sources of non-interest-rate-reliant revenue.
“They’ve done a good job of diversifying, which has stabilized their revenue streams and also allowed them to more easily comply with capital requirements,” he says.

Many smaller banks, for example, have joined national banks in putting an emphasis on fee-based wealth management services. According to data from Fiserv Intelligence Solutions published in American Banker magazine, trust income grew by 21 percent for the banking industry from 2012 to 2014 and accounted for 70 percent of wealth management income in 2014.

Leading the pack was Union Bank, which effectively doubled its trust revenue through its acquisition of Charlottesville-based Stellar One in January 2014.

Beale notes that trust income, along with other fee-generated income, such as mortgage underwriting and service charges, currently accounts for 21 percent of Union Bank’s total revenue.

“We hope to grow that to 25 percent by putting even more emphasis on mortgage and wealth management,” he says. “And it’s where we have chosen to focus a lot of our resources by adding people and trying to build out platforms so we’ll have that more stable, steady income and become less dependent on our margin.”

American National also has added variety to its income stream. The bank has had a Trust Investment Services Department in place since 1927. After the Great Recession, Haley says, the bank took steps to bolster that service, increasing assets from $531 million in 2011 to $750 million today, a 41 percent jump.

The bank also has provided merchant services and bankers insurance, emphasized debit card and debit interchange income, and eliminated fee waivers on commercial analysis and other fee-based services. Officials also have worked to cut expenses, most significantly by encouraging customers to switch from paper to electronic statements.

“We’ve dug way down and made all these little things a major strategic priority, which have all added up to a big number,” Haley says.

As a result of these preparations, Haley, like other bank officials, is guardedly optimistic. “Hopefully, all of us have our balance sheet in order, we have our expense structure in order, and then we can all benefit and the industry will have a nice pickup as rates go up in the short-term,” he says. “At the same time, I’m very concerned about the longer term: Will the Fed continue to go slow, or will rates get out of control and stifle or cut off growth? That’s the big unknown.”