Projecting Interest Income Needs New Approach in Pandemic Economy

COVID-19 may be as contagious economically as it is medically. Community banks, whose lifeblood is interest income, have significant exposure to companies that have been hit particularly hard. They face the question of how to best react as we sail into uncharted waters.

Any forecasts made pre-COVID-19 have little to no value in the new normal. A new approach is required for projecting interest income. It requires a mindset shift for many bank CEOs as they must give their shareholders a realistic picture of future earnings prospects.

In the past, the simplest form of projecting interest income was to work on the basis of a “run rate” of previous earnings, project forward from that base at a predefined growth rate, and then assess how loan yields would be affected by changing interest rates. That simply will not work today, especially because the Federal Reserve has slashed interest rates to zero.

Don’t think this isn’t a C-Suite problem. This is a strategic, not an ALCO, challenge, and community bank CEOs must embrace it. Here are some things you may want to consider when looking to adjust your forecasts:

1. Your bank’s balance sheet is the reservoir of future earnings

Every bank’s loan portfolio is unique and has been built up over the years with different compositions of loan types. We call each bank’s unique portfolio composition its loan mix, and the timing component of when the loans were made is its loan vintage. The combination of loan mix and loan vintage will be a major determinant of a bank’s interest income and future earnings.

In a falling rate environment, as current loans mature or reprice, they will be replaced or repriced at lower rates. The maturity of the current interest rate profile is the runoff, and it is the challenge of the bank’s senior management team to protect earnings and grow shareholder value with the runoff in mind.

*Invictus Portfolio DNA report for a sample bank.

2. The best loans are often made at the worst of times

Uncertainty also means opportunity. While it’s counterintuitive, some of the best loans from a risk/reward trade-off perspective were loans originated in the depth of the 2008 Great Recession or in the early part of the recovery (circa 2009 to 2011). Banks were able to obtain disproportionate yields because of the lag between Fed rate cuts and higher credit risk premiums, and real estate appraisals already reflecting the sharp decline in real estate valuations. When thinking about cash flows, keep in mind that those businesses that qualify for loans, even in the worst of times, are like unicorns, so do not shut the door on all opportunities. It’s easy for borrowers to show you they have strong income when the economy is doing well, but how resilient is that income stream when times are tough? The point is that in tough times, the risk/reward trade-off for new loans is often the best.

3. The trade-off between volume and spread

Banks will need to make hard calls. Yes, credit risk premiums may keep loan yields from cratering, but there will be fewer borrowers who will qualify for a loan in a recession or even in a zombie economy where GDP is, say, between 0 and 1%. This means that loan volume will be a challenge. Most banks will choose to prioritize risk management over volume, irrespective of the credit risk premium. For example, you may forecast that your loan portfolio will remain flat over the next year, but that doesn’t mean your interest income will be flat. You need to know how your interest income will change, and you should have a lending philosophy tailored to the current environment that recognizes the trade-off between credit risk premiums and loan volume.

4. Value investing – hidden value in bank M&A

M&A activity has come to a virtual standstill because of the massive uncertainty created by the pandemic. However, activity is likely to pick back up again in the next 6 to 12 months as banks settle into a ‘new normal’ that is likely to be challenging, no matter how you look at it. Many banks will simply not have the stomach to go through another downturn and will likely look to exit at valuations that are more realistic than they were prior to the pandemic. Acquisitive banks need to be careful because nobody wants to acquire a loan portfolio that could blow up in their face. However, some acquisition targets will have weak earnings, but massive amounts of value hidden within their loan portfolio. Their portfolios will have attractive yields relative to organic growth alternatives and the credit risks will be either manageable or have already been largely recognized via provisions and write-downs. We can often see this through their loan vintage. The earnings are weak, not because of the quality of loans, but the quantity. The target simply does not have enough volume to create enough interest income to cover their costs and/or make enough money to justify its independence.

Some of these banks may decide that this is the time to fold. Those with good loan portfolios represent an opportunity for those with capital at disposal for an acquisition. An acquired loan portfolio starts bearing fruit from Day 1 so there is a time value effect compared with organic growth that should be taken into consideration. M&A offers opportunities for diversification, an extension of your geographic footprint, and the chance to acquire new talent. However, you need to have the right analytical toolbox at your disposal to give you the confidence and trust to make such moves in a volatile environment. As Warren Buffet once said, “Be fearful when others are greedy, and be greedy when others are fearful.”


While there are significant challenges ahead for community banks, there are also hidden opportunities for forward-looking banks when looking at how they assess strategic decisions related to their interest income.

Structurally, community bank CEOs need to be able to identify weaknesses that must be corrected and strengths that can be exploited. The question that bank management needs to ask is: “Do we have the tools and analytics to measure the impact on our bank’s performance under these scenarios so that we can identify critical issues and, following that, do we have the tools and information to evaluate corrective actions?”  In summary here are management’s choices:

  1. Do nothing and wait for the dust to settle.
  2. Try and quantify the impact on the bank under likely scenarios.
  3. Separate from the pack by analyzing and implementing strategies to counteract expected issues.

Traditional methodologies and tools barely address these issues individually and cannot address them in combination. However, the right approach will help management quantify the impact of each option (individually and together) and more importantly, help them evaluate and take corrective actions.

— Avik Ray is an Invictus Group senior advisor.