Bankers Face Big Balance Sheet Challenges in 2012

Balance sheet management in 2012, more than ever, will demand a balancing act.

Deposit inflows have far outpaced stagnant loan growth. A vow by the Federal Reserve Board to stifle rates through next year could further shrink already diminishing margins and add pressure on management teams to find ways to boost net interest income.

Bankers must weigh the short-term need to make loans against the long-term reality that more than a tenth of low-cost deposits will disappear as soon as better investment opportunities resurface, industry observers say.

Community banks are making progress with mortgages. Large lenders are being more cautious with underwriting, extending the time it takes to close such loans. With those bottlenecks costing big banks some business, smaller banks are eager to expand.

Cardinal Financial Corp. in McLean, Va., has hired about 50 mortgage loan officers in the past year. Bernard Clineburg, the $2.5 billion-asset company's chairman and CEO, says most are big-bank refugees who got fed up with the glacial pace of the loan process. In the third quarter, Cardinal's mortgage applications rose about 34% from a year earlier. Fee income from mortgage lending more than doubled, to $11.3 million.

"Loan officers want to work with companies that can execute," Clineburg says. "The big guys are taking [two to three] months to close loans that we're doing in 30 to 40 days."

Other small banks ramping up in mortgages include TowneBank in Suffolk, Va., which expanded into Richmond by buying a brokerage firm, and Washington Trust Bancorp in Westerly, R.I., which has opened a second mortgage office in Massachusetts.

Stephen Bessette, an executive vice president at the $3 billion-asset Washington Trust, says the company entered Massachusetts two years ago to fill a void created when nonbanks that once had roughly 70% market share in the state began closing. In its first full year, the office generated $109 million in loans, he says.

A key for growth-minded lenders is knowing when to keep the mortgages and when to sell them and collect fee income instead. A big concern is that most mortgages are for 15- to 30-year periods and, combined with historically low interest rates, carry considerable balance sheet risk.

"We've been selling a lot of residential mortgage loans because we don't like the risk on our balance sheet," says George Hermann, the president and CEO of First National Bank of Suffield in Connecticut. "In some ways, we're shooting ourselves in the foot but we want to be in the best position for a rising rate environment. We don't want long-term, low-rate loans in the portfolio."

Another concern is funding. Checking and savings accounts at U.S. banks have topped $10 trillion, as consumers remain wary of stocks. What will happen when the surplus cash goes away?

Banks must think beyond a short-term loss of yield, says Kamal Mustafa, the chairman and CEO at Invictus Consulting Group. Once customers regain faith in the economy, they will move cash into higher-yielding investments, causing major balance sheet challenges. "The new deposits are very similar to brokered funds in one characteristic: they will be flying out of the banks" when the equity markets and bond markets come back, he says.

Invictus estimates that 13% of the checking and savings accounts at U.S. banks could be considered hot money. If those funds disappear over a course of weeks or months, it would wreak havoc on bankers' assumptions about capital adequacy, return on investment and fee income.

The rates banks offer on loans and investments should be calculated only after identifying and factoring out hot deposits, Mustafa says. "Treat them as highly volatile instruments," he says.

Mustafa suggests using a simple ratio as a guideline. Start with the deposits a bank had before the recession, subtract any deposits tied to loans rolling off the books, and compare to current deposit levels. The difference between those numbers is the amount Mustafa expects will shift once customers start looking for yield again.