ST. LOUIS – Risk management is critical as small banks aim to make money in a low-rate environment.

That was the view shared by Charles Evans, the Federal Reserve Bank of Chicago's president and chief executive, at a conference co-hosted by the Fed system and Conference of State Bank Supervisors. He also told community banks that they must "adjust to a new normal" where there is no end in sight to low rates.

"Community bankers are likely going to have to focus more on the asset side of the balance sheet in order to maintain their institutions' performance levels," Evans said.

Evans said he is seeing more banks employ new strategies in an effort to bolster profits. While some might be viewed as "prudent adjustments," he strongly cautioned banks to avoid reaching for yield without a "proper road map."

What should that road map look like? Evans had several suggestions.

First, bankers need to regularly run rate-sensitivity tests on their balance sheets, including the assumptions made about the duration and costs of deposits. Bankers should also continue to simulate earnings and equity performance under different rate scenarios as part of their ongoing risk management, Evans said.

"These exercises are valuable in helping institutions understand the impact of interest rate changes and other economic developments … over both the short and long run," he said.

Next, he described a hypothetical bank that was making longer-duration loans for commercial real estate. He did not discourage the strategy, but Evans urged bankers to set conservative lending limits and to conduct regular reviews of concentration risk. Liquidity targets are also a critical consideration, he said.

While it seems natural that banks would conduct sensitivity tests, doing so does not address other issues that could crop up as rates stay low, bankers said. One reason is that low rates lead to increased asset valuations, particularly with real estate, which has its own set of problems.

"I've seen cap rates on commercial properties rise to 8-10%," said Gene Rainbolt, chairman of BancFirst in Oklahoma City. "We'll be arguing about appraisals before too long."

Competitive factors are also weighing heavily on the minds of bankers.

"We don't want to go too long on investments or out 10 years on our loans," said Lyn Hayth, president and chief executive of Bank of Botetourt in Virginia. "Looking back at it, we should have done some [longer duration] loans seven years ago. Over the last seven or eight years, we've lost a lot of those loans to regional banks."

Evans' remarks, meanwhile, are the latest by regulators who seem to be closely watching CRE concentrations.

"A lower-for-longer interest rate environment does not absolve firms of interest rate risk management," he warned. "Nor does it mean we have eliminated uncertainty over future rates or other factors influencing current credit conditions."

Still, Evans stopped short of pressing bankers to conduct stress tests, which involve more than simply assessing rate risk. Right now, stress-testing is only required for banks with more than $10 billion in assets.

A focus on rate risk seems appropriate, Rainbolt said.

"We stress-test regularly, but I am much more concerned about [balance-sheet] mismatch and interest rate risk than anything else," he said.

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