With short-term rates low and the yield curve steep, it is especially important for community banks to examine investment alternatives as they seek to maximize their profit potential.

Typically, most rural banks have 50% or less of their assets in loans, and 50% or more of their assets in investments. Furthermore, most banks stay short with much of their investment portfolio in order to have a closely matched one-year "gap".

The one-year gap is the difference between assets that will reprice within the next year and liabilities that also reprice within the next year.

If more assets than liabilities are repriceable, there is a positive gap. The reverse results in a liquidity-sensitive position, or a negative gap. In theory, an equal match allows a bank to maintain a constant margin regardless of changes in interest rates.

A Hypothetical Case

For simplicity's sake, let us use as an example a bank with an approximately 50% loan-to-asset ratio and investment-to-asset ratio.

Assume that this bank invests half of its investment portfolio in investments with an average five-year maturity. Also assume that other short investment maturities exactly equal the other liability maturities. The remaining liabilities (25% of total assets; 50% of investments) have an average maturity of one year.

This scenario creates a 25% negative gap (a liability sensitive position) in a one-year time frame. This would normally be unacceptable for most banks because of concern that upward rates would hurt earnings significantly and concern that regulatory bodies would be critical of such a large negative gap.

What is the effect of this 25% negative gap on current earnings?

Mix of Government Products

Before answering, I am going to assume that this particular bank would buy notes with maturities that average five years, which adds 275 basis points to the yield. This bank, however, would also add 100 basis points to that yield by the purchase of some type of safe, government derivative product.

Such products might include agency mortgage pools from Freddie Mac, Fannie Mae, or Ginnie Mae. The product might be a relatively safe collaterized mortgage obligation such as a planned amortization class or a standard CMO with low-risk characteristics and the same average maturities.

The hypothetical bank then has a 375 basis point spread (275 for a five-year average maturity and 100 for a government derivative product) over a three-month Treasury bill or Fed funds.

On one-quarter of the bank's total assets, this would amount to 94 basis points before tax. After tax, this would come to 58 basis points, using an average 38% combined federal and state tax rate.

This is an extremely significant amount considering that the median U.S. bank's after-tax earnings were approximately 0.8%, or 80 basis points, last year.

This strategy would equate to almost 75% of the median bank's net after-tax earnings. In some cases it would mean the difference between profit and loss. In other cases it could mean the difference between the bank with average earnings and a highly profitable bank.

It would be nice to be able to add this type of income without creating a negative gap. However, that may not be possible, particularly if there is inadequate demand for good loans.

Striving for Balance

Therefore a bank has a choice to make between earnings and the safety of a more evenly matched asset and liability mix.

Ideally, bankers and regulators would like to maintain a close match between repriceable assets and repriceable liabilities.

This would theoretically allow a bank to maintain a constant margin as interest rates change. In actuality, this is only true if spreads stay constant, which is questionable with constant changes in supply and demand.

Creating a negative gap does leave a bank vulnerable to higher rates. However, the alternative to that risk is lower earnings and therefore less capital, which may be a more serious risk.

The point that can be missed in this analysis by bankers and regulators is that there is some times a choice between more constant margins, and earnings and capital.

If a bank makes the choice to have a negative gap, it should consider the following items.

Dealing with Risk

First, it is necessary to have an investment policy and asset-liability management policy that clearly defines what is being done and why.

Our bank policies allow for a moderate amount of both credit and market risk. Market risk is the risk that a security will drop in value as interest rates rise. A loss of market value also means the loss of the potential to reinvest at the current yield.

We define a moderate amount of market risk as an amount that would not jeopardize capital in a worst-case scenario. In addition, our bank has adopted the definition of a "high-risk security" proposed by the Federal Financial Institutions Examination Council.

Short-Term Versus Long-Term

We have set one-year and five-year gap measurements that allow us to maintain a negative gap in the shorter period but a more matched-up position in the longer run, again in amounts that do not jeopardize capital.

Of great importance in analyzing investment risk-reward alternatives is a model that examines the effects of a wide range of interest rate changes on the portfolio.

We have developed a model which examines cash flow, yields, and market price for varying scenarios.

Impact of Interest Rates

The model looks at seven different interest-rate levels, from a drop of 1% in rates, to no change in rates, and up to an increase of 5%, in increments of 1%. In each of these seven environments, we calculate a one-year and a five-year gap.

From that data we are able to calculate the effect on earnings for changes in the interest rates. We then compare alternative investments that bring the gap to zero and calculate the effect of that decision on current earnings.

Finally, we can compare the effect on income of various interest rate environments, including the worst-case scenario of a 5% increase, with the alternative surrender of earnings that will occur through perfectly matching assets and liabilities.

Learning from the Model

Recently we were able to draw two important conclusions.

In a worst-case scenario of rates rising immediately to 5%, margins would narrow considerably but would not nearly eliminate all pre-tax operating earnings. In fact, an immediate 5% increase in rates would eliminate about one half our pre-tax operating earnings in the 12-month period with the widest negative gap.

Even though our gap improves from year one to year five, rising rates cost us the most in the second year, not the first. Therefore, the second year is the worst for earnings.

On the other hand, we found that a perfect match of assets and liabilities using one-year Treasury bills would cost current earnings, in a flat rate environment, nearly three-quarters of the loss incurred from our worst-case scenario, and almost the entire amount of the loss incurred if rates were to rise immediately by 4 percentage points.

Data for a Decision

Detailed policies and such quantifiable comparison data give a bank and its board the ability to make a decision as to whether or not to have a negative gap. It also gives a bank the documentation necessary to support that decision.

A pricing and market-analysis model takes time to compile. We have found a complete analysis needs to be done only once a year. It is extremely important to have at least one broker or bond man working with the bank in helping to compile this data.

Furthermore, it is essential to have an individual inside the organization who is very good with programming personal computers and who understands bonds and gap management.

Finally, when discussing a negative gap and the opportunity to improve the bank's yield, it is important to remember other factors that must be considered.

Capital Considerations

First, a strong bank capital-to-asset ratio of 7% or more is important if some market risk is taken. Secondly, strong asset quality or modest-to-low loan and bond classification as a percent of capital gives a bank additional flexibility.

In addition, liquidity is a very significant factor. Of prime importance is not only the ability to meet withdrawals by selling securities quickly, but also the overall profit or loss in the portfolio.

In summary, having, or creating, what appears to be a large negative gap may in fact be a prudent decision based on the risk-reward components of the yield curve and the particular circumstances of a bank.

Mr. Douglas is president of Citizens Banchasres Co., Chillicothe, Mo.