Relieve Some of the Investment Pressures with Incremental Growth in Lending
October 28, 2021
4 minute read – As many leadership teams are in the process of building their 2022 budget, a common theme is emerging and that is an expectation for lower earnings next year. With the potential for less profit, no stone is being left unturned for important revenue generating opportunities.
One way to increase Return on Assets (ROA) is to take on additional Interest-Rate Risk (IRR) through lengthening the investment portfolio. While this can be a quick way to support earnings next year, there are a couple of challenges making longer-term investments a more difficult decision. One challenge is the dollar amount often required to achieve the desired earnings impact. To illustrate, consider a $1B financial institution that hopes to increase its ROA 5 basis points (bps). While there are many different types of investments, the team is evaluating longer-term callable bonds.
As seen in the table above, $50M of longer-term callable bonds are needed to achieve the desired 5 bp improvement in ROA. With market interest rates and investment yields still very low, a significant amount of liquidity is required for 5 bps of earnings. While liquidity may not be an immediate concern, what if in the next year the team thinks it might need that $50M for pent -up loan growth or to absorb a potential slowdown in deposit growth?
Beyond liquidity considerations, another challenge with many current investment strategies is the difficult risk versus return trade-off. In the callable bond example, the institution increases ROA 5 bps. However, the +300 bp EVE/NEV volatility increases nearly 70%, changing from -11.55% to -19.67%. In addition, the +300 bp EVE/NEV ratio decreases 0.73%.
Because of the complex investment environment, many leadership teams are turning their attention to other areas of the financial structure. They may ask, “What would we have to do in auto loans or mortgage loans to gain the same 5 basis points we are targeting with the investment portfolio?”
As seen in the table above, only $10M of auto loans and $15M of mortgage loans are required to achieve the goal of increasing ROA 5 bps. In addition, both have less IRR in a +300 bp shock. It can come as a surprise that the 30-year mortgage strategy has less IRR than the 5-year callable bond strategy, but consider the difference in dollar amount. The 30-year mortgage strategy is only $15M leaving an additional $35M in overnights serving as an on-balance sheet hedge to rising market interest rates.
With many teams continuing to sit on a lot of liquidity, it can be easy to support deploying large amounts of liquidity towards lengthening the investment portfolio. However, with a focus on loan processes, digital delivery, and pricing, perhaps such large investment decisions may not be necessary.
Longer-term investments can still play a complimentary role in increasing ROA but relieve some of the pressure of having to carry so much of the burden. While it may take time for lending to build the desired momentum or loan-to-asset to return to some semblance of normalcy, focusing on incremental victories in loans can have a better financial impact than using large amounts of liquidity to purchase investments.