Finance blog

THE FRITZ REPORT

Enigma

October 30, 2020

When most people think of the beginnings of World War II, they think of the Blitzkrieg and the overwhelming power of the German air forces and armored columns. What is less well known is the incredible underlying ability the German armed forces had of communicating encoded messages rapidly and securely across their operational sphere. This superior communication technology relied in large part on an encoding machine known simply as "The Enigma". Those of you who enjoy military history will certainly be aware of the term "The Fog of War". For those less familiar, it refers to the reality that during most wars, there is a dearth of clear and concise information as to what is going on - especially when the fighting is extremely tense. Imagine, just 70 years ago, even basic radio communications were unreliable and potentially easily compromised through eavesdropping or even mimicking. The enigma device changed all that for German commanders, who could brazenly send out communications that were "totally encoded" so that even if intercepted, they could not be unraveled by the enemy.

Or so they thought. It turns out that the Enigma code was actually first broken in 1930 by the Polish mathematician Marian Rejewski. In 1939, when it became clear the Germans were about to overwhelm the British, the Poles kindly shared the discovery with them.This ultimately led to the formation of a secret code breaking operation known as "Ultra," led by the famous (if quirky) Alan Turing. If you love this kind of stuff, I encourage you to check out a movie on the topic called "The Imitation Game (2014)".It's not the only movie highlighting the importance of breaking the code, but I really enjoyed it, and we could all use more movie ideas right now.

So, what does this mean for us?We are all in a battle right now.Margins are tight, credit is difficult, the Presidential election is next week…you get the point. It's our own kind of "Fog of War"."Fog of Banking?" The market is throwing out mixed signals and confusion at an almost unprecedented pace.

Luckily, we created our own "Ultra" some time ago, and so perhaps we have a leg-up on "cracking" whatever "codes" come our way.

We call it CIA (Client Insights and Analytics). Its members are attempting to- and often succeeding at-- breaking the code of today's banking environment. They are the perfect collection of folks to highlight my theme over the last 3 weeks, stemming from Charles Schultz' famous quote: "Life is like a ten-speed bicycle. Most of us have gears we never use." I was once again fortunate to grab the co-head of this group, Dave Salutric, and get him to explain how they are finding new, unused gears for the banking industry.

Q: How did the CIA get started - what does it mean and what is the goal of the operation?

CIA stands for Client Insights and Analytics and we exist to assist our partners at community financial institutions in framing and making what we believe are superior decisions by helping them properly evaluate risk versus reward trade-offs between alternatives ("compared to what?"). The goal is todeliver both confidence and potential outperformance. The group is comprised of individuals with a variety of different backgrounds, expertise, and specialties who can be roughly grouped into sections:

Insights;

Analytics;

Education;

Regulatory;

Asset Liability Management (ESM);

Enterprise Risk Management (PT Score); and'

Accounting (Bond Trust).

While many of these groups have historically operated independently from one another, we decided that bringing them under one umbrella would ensure interconnectivity in every decision, insight, and/or tool we deliver. Just as we encourage our community depository partners to stop operating in silos, and instead approach all of their capital allocation decisions in combination with one another, utilizing a common framework and process, we came to recognize the importance of breaking down similar barriers within our firm. We are two years into this effort, and the results so far have been tremendous. The creation of CIA has really strengthened our ability to deliver holistic advice to our clients across their entire balance sheets. Every decision they make should keep the entire institution in mind, and therefore so should all of our support to them.

Q: Your team has probably examined a great many bank and credit union balance sheets across the country in the past two years. Given the current environment, what are some of the biggest blind spots you see? What are some of the bright spots as well?

By far, one the biggest blind spots currently out there is the potential impact of performance during a possibly extended period of low rates. At Performance Trust, we've been discussing this blind spot with our clients for some time now, long before COVID-19, but the potential impact on performance is now starting to be recognized by more and more institutions. They are seeing the loan rates their customers are expecting, that their competition is offering, even that they themselves have been forced to accept. Over the last 35 years, during every previous credit cycle and accompanying decline in interest rates, financial institutions have at least benefited from dramatic reductions in their funding costs, which has always offset the pain of declining asset yields. Today, however, there is little to no room for more relief by way of funding costs, which means the only way to maintain or increase NIM would be to acquire higher yielding assets.

That need for higher yielding assets can lead to a second blind spot. This step alone can have profound implications for basic capital allocation strategies for CEOs. Absent a disciplined decision making framework and thorough process that quantifies all risks in conjunction with each other, such decisions could create even bigger issues down the road for financial institutions.

While recognizing these blind spots may feel unsettling, the great thing is that it's not too late to "hop in the DeLorean" as my teammate Brian Leibfried likes to say, and find quality sustainable earnings strategies at levels similar to those available in 2019 - when many were passing on them. If we could go back in time, knowing what we know today, what would we have done differently? For many, given the right decision framework, we have an opportunity to do exactly that!

Before making any knee-jerk decisions, be sure to establish a disciplined process under which you evaluate potential opportunities, across multiple scenarios, quantify all cash flows, and compare them to alternative choices, before committing to any strategy. Evaluating all strategies on a Level Playing Field and in the context of your entire institution can help you fully understand how some strategies can help limit the broad risk exposures you may carry. Stay disciplined! Institutions need to more effectively allocate capital and optimize every income opportunity available. Every institution is different, so there is no one size fits all strategy. Understand your risk exposures and your potential for loss under an extreme stress scenario, but also evaluate the expenses of various options to help protect against that outcome. Having an understanding of your risks, and perhaps having options to adjust those risks, can greatly enhance your ability to effectively allocate your capital.

Q: What are you most excited about moving forward?

Finance of Banking

We are constantly innovating and applying our analytical principles to all aspects of banking. There is never a dull day in the (virtual) office as we are always debating, analyzing, discussing, building new tools, and generating new insights. In previous weeks of your blog, Kurt, both Daryle and Bart touched on many different tools that are either available for use today, or are on the near horizon. I won't dive into all the details now. While I am excited about all of that, what I am more excited about is that all of these tools are being created to address one or more challenges on our path to creating quality sustainable earnings. Maybe more importantly, each of these tools are being designed to tie in with all the others, so they can be used in combination to help you conclude what the best use of capital is to achieve your institution's goals while staying within your institution's particular constraints. Appropriate confidence is a key principle of any good decision, so as problems get more complicated, it's critical you do not overlook any potential positive reverberations in- or negative ricochets against -- other components of your institution's success.

Another item I am extremely excited about is that, given the virtual environment, we are finding new and unique ways to educate our partners at financial institutions. Our Marketing team, along with our Education team, have put on some amazing educational events over these last six months since we went virtual. While we were disappointed that we had to cancel both instances of our planned Advanced Course this year, we quickly began working on delivering content built for a virtual world, and were delighted that over 900 attendees were able to spend 3 days with us from the comfort of their homes (or offices). Due to the overwhelming demand for this event, we've decided to offer a second chance for those who missed it to attend the Advanced Course in Mid-November. Along with that, we have been able to offer a more frequent virtual version of our Principles of Performance program, which has sold out every month since we took it virtual! At this 3-day program, attendees receive an educational experience that teaches the core principles of managing asset and liability decisions across the entire balance sheet. In today's environment, these principles are more critical than ever.

We are also finding unique ways to interact with clients and their teams in virtual strategy sessions that are proving to be a timelier service than we had ever been able to provide in the "old world". Education is at the foundation of everything we do, and we are adapting and evolving how we deliver that to ensure an experience that is equal to or better than what you've come to expect from us.

Q. How can those wanting to learn what CIA can do specifically for their institution do so?

Feel free to reach out to me, or my teammate Brian Leibfried, and we'd be more than happy to discuss a hands-on plan for anyone who's motivated to create compelling results in the face of this difficult environment. As mentioned above, we are continuing to evolve and adapt to this virtual environment, and we can offer new and unique ways to partner with you to discuss, educate and strategize for not only today, but also for a better future in the longer term.

I want to thank David for taking the time to answer my questions - and also for covering these difficult topics. While I was still riding my One Speed Bicycle, back in the 90s*, I never had to worry about all of these myriad topics. Banking has changed more in the last 2 years than in the previous 20 years combined. Can any of you guess the last time someone won the yellow jersey in the Tour De France riding a 1 speed bike? Neither can I! But I do know it could not be done today.

Final, final thought: I am planning on homemade chili-dogs this week. Please send me any tips, advice, or secret recipes.

*Editor's Note: Kurt has kids born in the 90s, so it seems more likely his one-speed days were more like the 70s. Along with his leisure suit.


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