As U.S. Treasury bond yields worsen, the banking industry finds itself in a familiar position. Bank portfolio managers would like better yield, but regulations restrict banks from going down the credit stack or out the curve to reach for yield. Net interest margins are at all-time lows and regulations compel us to manage regulatory risk first—price, rate and repayment risks are now secondary. Banking as we know it has changed, and not necessarily for the better. But there is a silver lining.
In December 2015, the Federal Reserve raised the funds rate 25 basis points. Immediately, foreign purchasers starving for yield drove prices to new highs, resulting in yields that were lower than before the Fed increased the rate. In early 2016, several countries moved to negative rates. Should the Fed raise rates again soon, more foreign deposits will find Treasury bonds even more compelling again.
Long term, given that the U.S. national debt stands at $19.5 trillion, the U.S. Treasury can’t afford rates to be appreciably higher. The recession of 2007, the war on terror and expansion of social programs has greatly limited options. Most economists agree that the treasury debt market will remain in the lower-for-longer phase for quite some time. Ouch. So, what to do?
Lending is the first most obvious answer but regulations remain confounding. Many bankers feel as if they are only able to grow by stealing market share. Multiple banks chasing the same high quality loans exacerbate spread compression. Agency debt and mortgage-backed securities have yields basically stuck in the 1.70 percent to 1.75 percent range. Municipals remain relatively attractive, but the laborious process, small sizes, ongoing care and price sensitivity make them less compelling.
The judicious use of Bank Owned Life Insurance (BOLI) could be a winning answer. Hear me out—with crediting rates (yield) at nearly 4 percent the concept has merit. Most money center banks and many super regionals maintain BOLI holdings at maximum allowable percentages. Yields are compelling, counterparty risk is stable and price risk is minimal. Interestingly, large banks are more likely than small banks to use the maximum allowable BOLI. Community bankers sometimes forget this break is available to all banks regardless of asset size.
BOLI has a positive effect upon your efficiency ratio as it provides additional tax-free dollars for employee benefits. Since efficiency ratio equals expenses divided by revenue, every additional dollar of revenue results in an ever-larger denominator, hence the ratio shows an immediate positive impact. BOLI is purchased at par and is always held at par eliminating price risk. Given the current cheapness of the asset, BOLI can be surrendered within a year (net of taxes and penalties) and still provide a higher return than mortgage-backed securities.
BOLI can be viewed as outsourcing a portion of your portfolio. Choose a provider that only uses insurance carriers that are A+ rated or better and that employ seasoned, capable portfolio managers. In the event of an untimely loss of an insured employee, the insurance payments help the family and assist the institution to pay for costs related to replacement.
Recently, I met with the president of an $8 billion asset bank who commented, “I really thought I didn’t want to discuss my BOLI holdings. Then I realized it’s a $100 million asset on my books and I’d better get interested in how to optimize it!” We are currently completing a review of his policy holdings.
In the current market, the BOLI asset is extraordinarily cheap. It is a high yielding, low risk asset with a superb degree of price stability. Does it solve every answer? No. Will BOLI always be this cheap? No. But given recent advancements by insurance carriers and asset managers, it is a financial tool that really demands a hard look.