By Robert M. Lallo, managing director, Darling Consulting Group
It seems every year brings a new set of challenges to bankers, and this year is truly no exception.
There is a wide variety of predictions for interest rates and economic growth. We start 2018 at ten years and counting into one of the longest expansion cycles in U.S. history—does this mean we are due for a recession? Possibly, as some economists are predicting a flat to inverted yield curve by the end of 2018, with the U.S. ten-year between 2.0% and 2.60%. This scenario suggests that we could see recession as early as 2019.
Could the 2017 Tax Cuts and Jobs Act, combined with improved worldwide economic conditions, help our economy continue to prosper? Could the economy perhaps even expand further, driving rates even higher and maybe avoiding the flattening curve?
This is also a possibility in the eyes of some forecasters who see the U.S. ten-year rate moving as high as 5.00-6.00%.
Not only does this seem to underscore the fact that you should never “bet your bank” on a rate forecast, but that each forecast likely brings a different set of risks to the forefront. With the large range of potential outcomes, understanding the risks that each one brings to your institution is essential.
Deposit rate betas
In 2017, bankers were able to hold down deposit rates in spite of four 25 basis point Federal Reserve rate increases from December 2016 to December 2017. Historically, overall bank deposit rate changes (betas) for non-maturity deposits (NMD) have ranged between 30-50% of market rate movements.
In 2017, many banks managed these deposit rate increases to as low as 5-15%. This has allowed most banks to maintain a very low cost of funds, and stronger margins. It would appear that given the unusual benefits experienced in 2017 and further Fed rate hikes projected for the short term, there will likely be a degree of “expense recapture” as deposit rates rise in 2018.
How each bank strategically manages this period will have a great impact on the financial performance of most in 2018.
Strategic deposit management
As you might imagine, market competition will be a key element that drives the degree of deposit rate sensitivity.
One of the factors that will drive this pressure is the need for funding, particularly if a bank is under regulatory pressure for liquidity management and “overuse” of wholesale funding. This situation, particularly given the risk of costly disintermediation, emphasizes the need for strategies that minimize disturbance of the current base of deposits, where rate adjustments as warranted will need to be handled in a discreet manner.
The fact is many, if not all, banks will need to grow their deposit bases. Some are already in new markets or looking for them, while others are seeking ways to extract greater share in legacy markets. Strategies will have to be tailored accordingly.
These issues may seem complex or difficult enough. However, there are other critical factors to consider.
For example, in 2018, customers can move money more quickly and far more easily than ever before, due to technology. If the plan to manage deposit sensitivity and/or growth is the same as it was in 2004 to 2006 (the last rising rate cycle), you may be in for some surprises.
More and more banks are realizing not only the value but the necessity of being data driven when assessing deposit portfolio risk and opportunities. Understanding depositor behaviors, uncovering predictive patterns, and/or analyzing migrations and movements when specials are offered are critical to building your own bank’s deposit intelligence.
If customers are starting to siphon deposits to other institutions, how would you know?
This risk is found only in your large balance accounts. Some surprising occurrences will likely increase in 2018. Do you have the market intelligence to help develop efficient strategies to retain and even grow these deposits?
On top of these questions, some banks are realizing that they have not actually marketed a deposit product for quite some time. What marketing methods are needed for products in 2018? Again, leaning on 2006 tools for 2018 campaigns may lead to disappointment.
Get a handle on what works for your markets before it becomes crucial.
Loan growth and pricing
While overall U.S GDP improved in 2017 as compared to 2016, most bankers have seen diminished loan demand with projections for slower growth in most budgets for 2018.
With relatively scant demand, it would once again appear that customers “hold the cards” with respect to rates and terms. The current prime rate is 4.50% on a floating deal while many banks still feel that they need to be at 4.50% or 4.75% to be competitive on an A-grade credit for a 5 year/20 year term.
Just as 2017 was a year of favorable deposit beta management, it would seem that in many markets this has been offset with tighter spreads on lending. The key here is to maintain an element of pricing discipline without chasing off top quality credits needed to drive growth. There is no clear correct path other than to maintain your top credits at the best rate possible. The lack of demand makes this a challenging proposition.
Tax reform’s impact on balance sheet and muni markets
With the blended tax rate for most C corporations moving from roughly 35% down to 21%, we can be certain that for most net income will increase. (Many will have initial one-time charges as one effect of the new tax law.)
There are a number of other specific issues with S corporations that reinforce the notion that there is not a “one answer fits all” solution. With respect to the S-corp group, it may prove wise to take one’s time and get the right answer for your institution before making a hasty election to change before the annual March deadline. Once a bank’s status is changed, there is a lockout period for changing back.
Another side effect of the 2017 tax reform is the obvious reduction in tax benefit on municipal bonds.
The “knee jerk” reaction of many is to sell these assets because the effective yield is less than it was last year. The real question should be: If I sell these assets, what am I going to replace them with and at what yield?
In many cases, the new adjusted effective yields are still higher than most other investments available. Further, experts following the municipal offerings have indicated that the prices of municipals will not change greatly from levels prior to the tax reform due to continued high demand on the personal side.
Evaluate your position on a case-by-case basis. For those still buying municipal bonds, there may be some good inventories coming online in future months from those who decide to significantly adjust or liquidate their positions.
Regulatory concerns over liquidity/contingency liquidity
If you are FDIC regulated and had an exam in the past nine months, you have likely seen a far greater focus on your on-balance sheet liquidity position, particularly if it has been trending downward and/or your use of wholesale funding has been trending upward.
FDIC statistics show that the loan-to-asset ratios are approaching levels that approximate those before the crisis in 2008. In general, this indicates that banks are relying less on non-credit dependent liquidity (liquidity eligible investments) in favor of funding loans.
This doesn’t necessarily mean you should not manage your balance sheet to an efficient position if you are comfortable with your risk profile. What is does mean is that you should make sure that your contingency funding plans and cash flow analysis are fairly inclusive, stressful, and robust in order to demonstrate to your regulator that you have the risk in hand.
Expect exam conversations in this area to be far more in-depth—and be prepared to explain your position!
Insurance against rising rates
With even the most pessimistic forecasts for 2018 calling for further Fed rate increases, many banks will be looking at extending funding to protect against higher rates. In general, this appears to an easy call, particularly if you have a liability-sensitive position in your current (static) or forecasted balance sheet (i.e. with growth).
However, there are a number of considerations that are well worth analyzing before you select your “insurance” against rising rates:
• Pace of rate increases. We note that many banks have far less exposure to an up 100 basis points scenario, as compared to those scenarios forecasting rate increases of up 200 over the first 12 months. Most economic forecasts seem to indicate the likelihood of up 100 on the short end or less. How does this impact your exposure?
• Exposure to rates down. In this cycle, we have seen short-term rates move up 125 basis points over a gradual/extended period. As noted earlier, most banks have been able to hold back on deposit rate increases. If rates (and deposit rates in response) do not go up materially before a recession, there is far less benefit to rates down 100 from this point than banks experienced in 2008 (when funding costs were much higher).
Many banks seem to overlook the exposure to a rate decline. We are not suggesting that you ignore your concerns about a rate increase, but keep your options as flexible as possible.
Purchasing interest rate caps and callable brokered CDs may prove to be advantageous structures to control exposure to rate increases, while maintaining the benefit of overall rate declines (i.e. not locking into long-term funding that may prove costly in a recession).
Dealing with the challenges
While 2018 looks to provide many challenges in an increasingly uncertain rate and economic environment, it will be crucial to understand the greatest risks to your bank’s balance sheet and performance.
With this in mind, develop and implement the strategies that best fit the mix of risk mitigation and performance goals that make sense for your institution.
About the author
Robert Lallo has an extensive 25-year background in community banking. Prior to joining Darling Consulting Group, he served as executive vice-president and CFO for a publicly traded savings bank as well as several years as an audit manager at a worldwide public accounting firm.