How the Best Banks Manage the Balance Sheet

Throughout most of 2021, Federal Reserve Chair Jerome Powell asserted that inflationary pressures in the economy were “transitory.” Pandemic-induced shifts in consumption and supply chain snarls, he said, were responsible for pushing prices up — with the consumer price index up 7.0% year-over-year in December 2021.

In Los Angeles, executives at Preferred Bank weren’t so sure. They saw how inflation impacted the bank’s Main Street customers throughout 2020 and 2021, and they suspected it was here to stay. And, they believed, the response to bring it down would be dramatic.

“We never know the magnitude of the rate increase,” says Li Yu, chairman and CEO of the traditional commercial bank, which had $6.4 billion in assets at the end of 2022. “But we believe that [staying] asset sensitive going forward is the best protection against the higher rate environment.”

The bank avoided making fixed, lower-rate loans, which meant spending more time working with current and prospective borrowers to put together deals, passing on credits and scrutinizing underwriting. Loan officers saw their loans refinance out of the bank.

“If you lose a loan, that’s fine because we choose not to compete; that is also on me, not only on you [the loan officer],” Yu says. “The philosophy is we’re one team — [lenders] don’t feel they’re penalized for losing that loan.”

Yu says that the discipline to not compete for certain loans in this environment came from employees’ previous experience in the 2008 credit crisis or even earlier, going back to lessons from the savings and loan crisis in the 1980s. Throughout the bank, he says, employees understood and agreed that this approach would protect Preferred from a substantial rate and duration mismatch between liabilities and assets once rates began to rise in 2022.

This discipline paid off. Net income for 2022 hit $128.8 million, compared to $95.2 million in 2021. The bank’s return on average assets for 2022 was 2.08%, and its return on average equity was 21.31%. Loans still grew 14.7% over the year. Yu adds that about 85% of Preferred’s loan portfolio was floating rate at the end of the first quarter of 2023, a percentage he believes makes them one of the most asset sensitive banks in the industry.

The word “unprecedented” has been thrown around a lot in the last three years, but 2022 saw a truly unprecedented event in banking history: a more than 400 basis point increase in interest rates. It generated record net interest income for banks, but came with rising risk, costs and uncertainty. It also caused a mountain of unrealized losses in banks’ securities portfolios or other low-yielding assets, and it has pressured funding costs.

“If you’d asked any banker a couple of years ago, ‘Would we be better off in a higher rate environment?’, the answer would be unequivocally, ‘Yes,’” says Mark Fitzgibbon, managing director and head of financial services research at Piper Sandler & Co. “The problem is [that] getting from a low rate environment to a higher rate environment is painful for almost everybody, and that’s the period that we’re working through right now.”

But some banks have managed to weather this transition well and avoid the pain, and they have done so through fastidious balance sheet management. Two banks on the RankingBanking top 25 list — Los Angeles-based Preferred Bank and Wilmington, Delaware-based The Bancorp — are perennial top performers that have been profiled by Bank Director in the recent past. Both make floating rate loans with price floors, making them extremely asset sensitive as interest rates rise. They can reward depositors, producing a slightly higher cost of funds, without pressuring the margin too much. They have relatively small securities portfolios. And in a year where all banks made money, they made even more.

“When you look at institutions that do well, they have fairly diversified business models. They execute well, they have better than average rates on their asset side of the portfolio, and they’ve got good funding sources that are stable and at a relatively low cost,” says Rick Childs, a partner at Crowe LLP, speaking about banks broadly.

As rates rose in 2022, so did loan demand. Total loans and lease balances at banks increased by 8.7%, or $979.9 billion, from 2021 to 2022, according to the Federal Deposit Insurance Corp.’s fourth quarter 2022 banking profile.

“The real question [of 2021 and early 2022] was, ‘How do we get yield, and where do we find it?’” says Patrick Vernon, senior manager, advisory services at Crowe. “As we started to shift and see rates rise, it became a game of, ‘How can we redeploy our balance sheet and operationalize the capital we have to find those avenues of yield?’”

The loans banks made in 2022 were at higher rates relative to the last three years. As a result, bank net interest margins grew 82 basis points year-over-year, to 3.37%, according to the FDIC — the largest reported increase in the history of the agency’s quarterly update.

Banks making floating or variable-rate loans in 2022 “have fared better and have seen [better] yields,” Vernon says.

Balance sheet management is also crucial to The Bancorp, which had $7.9 billion in assets at the end of 2022. The Bancorp is a specialty bank that focuses on supporting financial technology companies, including facilitating payments or providing depository services for neobanks. Its business model works best under $10 billion, when the Durbin Amendment cuts into debit interchange income. Revenue growth doesn’t come from growing its asset size or adding new loans unless other loans run off; it must also consider how securities could grow its overall size.

Executives spent several years positioning the balance sheet for a rising rate environment, deploying deposits from its fintech partners into short-duration, floating-rate loans. About 70% of its loan book is variable rate, says CEO Damian Kozlowski.

The bank looks for credit niches that are dominated by funds and nonbanks to maximize its pricing power, Kozlowski says. Real estate bridge lending, which made up 36% of loans at the end of March 2023, is short duration and variable rate; banks have historically avoided these loans because they often pay off before the term ends.

The Bancorp takes “virtually no interest rate risk [nor] duration risk,” Kozlowski says. Net income for 2022 hit $130.2 million, compared to $110.7 million in 2021. Its return on average assets for 2022 was 1.85%, and its return on average equity was 20.08%.

The NIM expansion that banks enjoyed in 2022 is unlikely to continue into 2023 for most institutions. In the second half of the year, high interest rates began to noticeably impact bank funding. By the end of 2022, overall bank funding costs increased to 1.17%, according to the FDIC. Higher interest on bank deposits drove about 76% of the increase in average funding costs between the third quarter of 2022 and the fourth, the agency wrote.

“Funding costs went up at a faster rate than the asset repricing, because you got a lot of assets that take time to reprice and not all of your loans reprice,” Fitzgibbon says. “I think banks’ funding bases fundamentally are different; they’re much more rate sensitive than they ever have been.”

By the end of the year, the industry lost almost $500 billion in deposits.

Preferred Bank defends its deposit base by taking care of its depositors, which can generate a higher-than-peer cost of funds. But, executives argue, the bank can afford to reward relationship deposits with an attractive interest rate because of its higher asset yields. The bank’s total deposit costs for 2022 averaged 0.78%; it was 1.66% for the fourth quarter, but NIM in the same period was 4.75%.

“If you want to keep your clients happy, you don’t want to shortchange them on a long-term basis,” Yu says. “We think we are paying a little bit above average in our deposits rate, so [clients] feel their money is not being wasted and not being shortchanged.”

Maintaining adequate liquidity in 2021 and 2022 has allowed Preferred and Los Angeles-based Hanmi Financial Corp., another bank in the RankingBanking top 25, to be “on the front foot” when it comes to serving customers and meeting their credit needs, says Timothy Coffey, associate director of depository research at Janney Montgomery Scott, who covers both banks.

“That’s one of the things I think about for these two banks: the way they focus on serving their clients, they have liquidity available to do it,” he says.

At The Bancorp, the deposits that come from the fintech partnerships and prepaid cards funded more than 130 million insured small dollar accounts at the end of March 2023. Kozlowski says the bank passes on 42% of each federal funds rate increase to the fintech partner and keeps the rest for itself, creating a predictable and immediate rate of change. It keeps 100% of the rate change on its repriced assets, which lowers the overall beta. The average rate of the bank’s $6.3 billion in deposits at the end of 2022 was 82 basis points; it was 1.68% in the fourth quarter. NIM was 4.21% in the fourth quarter and 3.55% for 2022.

“That stable funding has no deposit beta; once [the fed funds change], it changes that month, but we get a loan repricing over the next three months,” he says. “That’s why our NIM explodes.”

But the biggest change for bank balance sheets in 2022 arguably wasn’t on the loan or deposit sides. It was in the securities portfolio, which is normally a reliable source of yield or liquidity. In 2022, it was neither.

As rates rose, low-yielding U.S. Treasuries that banks purchased with excess pandemic stimulus lost resale — or market — value, given the difference between the rate they paid compared to similar but newer bonds with higher interest rates. These unrealized losses totaled $620.4 billion at year-end 2022, according to the FDIC. Of that, $279.5 billion in unrealized losses on securities marked “available for sale,” or AFS, showed up as accumulated other comprehensive income, or AOCI, in bank call report data and were deducted from tangible common equity capital levels.

Executives at both Preferred and The Bancorp say their bank has minimal securities portfolios and manageable unrealized losses. Preferred’s investment securities averaged $432.8 million for 2022; its AOCI recorded a loss of $28.6 million. Taxable investment securities at The Bancorp were $855.6 million at the end of the year; its AOCI had a loss of $30 million.

Fitzgibbon says the AOCI line item was the “biggest single change to bank balance sheets in 2022.” Even with those mounting losses throughout 2022, most banks could hold these bonds without needing to sell them at their lower values for additional liquidity. But the loss of bond values contributed directly to the liquidation of La Jolla, California-based Silvergate Bank and the failure of Santa Clara, California-based Silicon Valley Bank in March 2023. The deposit runs and instability caused by Silicon Valley Bank’s failure led to two more sizable bank failures, Signature Bank in New York and San Francisco-based First Republic Bank.

It is now nearly impossible to divorce the impact of high interest rates on bank balance sheets in 2022 with what has happened in 2023. As of July 26, the federal funds rate had already increased by roughly 100 basis points — creating more pressure on banks, not less. The interest rate environment has caused near-tectonic shifts, and the environment has yet to stabilize.

Interest income, it seems, has peaked, but for many banks, interest expense is on the rise. In addition to liquidity and interest rate risk, the emergent concern in 2023 is now credit risk: How will high rates impact borrowers’ ability to repay their loans?

Kara Baldwin, an audit partner at Crowe, says elevated loan demand in 2022 was a “mixed bag” for the industry that could make growing loans in the future harder. There’s also the issue of loan structure: Banks may have made fixed rate, long duration loans in the first half of 2022 that lost their value by the end of the year as rates continued their relentless climb. The outlook for the yield of those loans in the future may be close to or below the terminal rate of the bank’s funding cost, which could still be rising. On top of that, any loan that needs to be refinanced can expect to face a higher new rate — a dynamic that continued in 2023 and could crystalize into credit risk.

“It had various, strange impacts through the year which aren’t necessarily fully understood,” Baldwin says. “There were times when lenders came to me and said, ‘We don’t even understand how another bank made this deal or why it was structured in this way.’”

In order to survive, boards and executives will need to actively manage both sides of the balance sheet, avoid getting burned on mistimed rate bets, and stay attended to the fundamental and emerging risks they face. Most banks can hope to endure this economic cycle without taking fatal losses. But some will thrive, cresting the economic waves rather than being buffeted by them.

“Banks that stick to their processes, and management teams and the board holding their bankers accountable, really shows up when you get into these periods that we just haven’t seen before,” says Coffey. “A bank that has been doing what the crowd has been doing, they’re going to move with the crowd in a downturn, right? It’s that iconic, classic approach to banking, where you do what you do best, that really stands out when we hit these periods.”

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