The answer to this question is a general yes! Readers of my weekly investment column, "In the Red Room, Jay Brew Investment Sage", have heard me recommending extending duration for some time. I believe that interest rates will fall. The 10-year UST has dropped from the 5.2% level to approximately 4.6%, and I believe it can decline further. But can you extend with your current balance sheet?
One concern is how an extension strategy can impact your asset/liability position. Extension strategies should be modeled by shocking your economic value of equity (EVE) up and down 200 basis points. These shocks will determine the impact to the overall bank. If you extend duration on a planned amount of assets, will you still remain within policy?
As we have moved through this question with bankers, many questions come up. One is policy parameters. We see policy parameters that are archaic. Many of the parameters were put in place years ago and are unrealistic. Many parameters were borrowed from "stock" policies and have no relationship to the bank's situation. For instance, consider a bank that has a higher-than-average EVE ratio because of a high equity-to-assets ratio and loads of core deposits. This bank has more flexibility to have more EVE volatility, if the board chooses. This compares to a bank with light equity-to-assets and significant "hot" money. This bank may have to have fairly tight EVE parameters to remain "well" capitalized. For this type of bank, an extension strategy might sound good in theory, but the reality could limit or negate implementation.
Another question is how realistic your EVE calculations are modeled. I have been giving gifts of millions of dollars as I visit banks! It is a sad reality but many models run in a bank or outsourced do not estimate EVE in a realistic way. You might say we have the best software or we spend a ton of money on modeling, but your EVE model still may be unrealistic in its output.
For example, I met with a very capable CFO who does his own modeling. I suggested that the bank's balance sheet appeared to have the flexibility to extend duration. The CFO believed he needed to stay short to comply with EVE policies. As we walked through the bank's EVE model, it became apparent that it was undervaluing its balance sheet. In fact, its EVE ratio was less than its book equity-to-asset ratio! What this was saying is that no value has ever been created in this bank's history! By adjusting its EVE value, the CFO realized that its balance sheet had significant flexibility and he could extend duration significantly and still remain within policy guidelines. That was my gift of over $10 million to this bank!
I believe that it is in every bank's interest to be assured that EVE is being estimated realistically so that earnings are not being left on the table. BNK has the passion to be the best of breed in asset/liability management. Our knowledgeable staff, the BNKBa/lance team, can give you consulting, model validation, policy reviews, outsourced modeling, and core deposit studies that will give your bank confidence that you are getting best-of-breed EVE information.