WesternBanker - May/June 2018

www.wib.org | WesternBanker 28 2 3 1 Net Future Value is What Matters Time’s passage is inevitable and the key ingredient of net interest income. For this reason, net future value is far more important than net present value. Yield, internal rate of return, and duration are all calculations for the present, not the future. Do you realize that if a 30-year mortgage’s duration is 5.5 years today, in twelve months, it is likely to be 5.5 years? Isn’t that a future value you want to be alert to? Assets earn money over time, and they can also evolve through time. Looking to what that asset will provide in accumulated earnings and residual value at some reasonable fu- ture date would be more telling than its nature today, which is, after all, something you already know. Finding a Common Denominator is Essential Longer cash flow instruments offer more reward, and carry more risk, than shorter cash flows. But how does one compare the risk versus reward trade-off of two unlike things? All cash flows, both before and after your selected future date, must be accounted for. These cash flows – and those of any alternatives – must be treated on the same terms in order to adequately make comparisons. In ALM, we are required to evaluate income simulation over a year or two, and EVE based on an instantaneous rate shock. The former ignores later cash flows that are already set, and the latter makes no provision for the passage of time. Did you ever won- der why it is impossible to reconcile T oday, you operate in an industry capturing, on average, 450 bps less in return on equity than it did a decade ago. Can you afford to leave any money on the table? As a banker, you make decisions of many kinds – credit, operational, marketing, and financial. In all of these areas, analyzing your options is important; suboptimal decisions can cost you money in expense, foregone earnings, or both. You can improve your decisions and capture better potential returns by adhering more closely to eight analytical principles of sound financial decision-making. Multiple Scenarios are Required There is little value in attempting to predict the future – interest rates, credit cycle timing, political outcomes – for a very simple reason: we are no good at it. World-class economists cannot success- fully predict the 10-year Treasury rate six months from now, pollsters cannot predict election results, and you don’t know which of your borrowers is going to disappoint you. Yet, thinking about the future is critical. A loan or security yield represents a single scenario for the future. So does a loan classification. What if a different future actually occurs? Would all assets and liabilities experience that difference in the same way? The principle here is to consider multiple scenarios for every decision and com- pare alternatives across this same set of scenarios to determine when and where one choice will turn out more favorably, and by how much. This goes a long way towards eliminating surprises. Once you have your choices laid out across multiple scenarios, resist the very natural desire to “average” these out- comes into a single ranking “number.” This common misstep eliminates nearly all the value you’ve gained with multiple scenarios. By Phil Nussbaum and Eric Brown, Performance Trust Are You Deciding to Make Less Money?

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