By Keri M. Crooks, managing director, Darling Consulting Group
While uncertainty around the timing of the Federal Open Market Committee’s rate hike persists, we have clearly entered the zone of: on your mark, get set ... and are now waiting on “go!”
Today’s environment is still rife with global challenges and downside risks. But the U.S. economy as a whole has improved from the lows of the Great Recession. Recent FOMC language is geared towards preparing the markets for the “go” on rising short-term interest rates.
Let’s agree to disagree on the precise timing for the first upward rate movement, but subscribe to the idea that we are closer with each passing day. As such, every bank needs to proactively manage the potential liquidity challenges that may arise.
Change of mindset?
Many ALCO-related articles and discussions center on rising interest rates and the impact on future earnings, these days. By contrast, liquidity risk is receiving notably less focus.
Most bankers have, appropriately, been discussing the changes in projected earnings when rates rise, while incorporating the stress to earnings from potential deposit migration and/or paying up more than historically to retain deposits.
Best-practice ALCO practitioners take this one step further and discuss available strategies—such as loan growth or utilizing borrowings—to remedy the stress associated with this change in deposit behavior.
However, the underlying assumption that one can “grow out of it” or “replace deposit runoff with borrowings” hinges on having the liquidity flexibility to do so at a point in the future. Consider:
• Could rising interest rates negatively impact access to funding?
• What if depositors chase higher rates more so than in the last rising rate cycle—ten years ago—and at the same time loan demand accelerates?
Liquidity planning is critical. You should elevate it, and incorporate it into your ALCO discussions related to rising rate risks.
Whether your bank is still flush with cash or has strategically decreased its investment portfolio and grown loans, the following action items will better serve you when interest rates begin to creep higher:
• Look at the impact rising rates will have on the market value of your bond portfolio.
If funding is needed quickly (inside of a 30-day window) as rates are rising, one should not have to offer a high cost CD or MMDA special—nor be in a position where assets need to be sold at a loss—to bring in funds.
Most bankers recognize that they can readily utilize their bond portfolio as collateral to secure public deposits, retail repurchase agreements, and wholesale borrowings (e.g. the Federal Home Loan Bank or Federal Reserve Bank). The amount of liquidity readily accessible will be a function of the market value of the bonds utilized as collateral.
So frequent review of the market value assigned to various segments of your investment portfolio under a variety of interest rate scenarios is warranted. As an example, look at the change in collateral values if rates were to increase 200 basis points.
What impact will this have on your liquidity measures? How about relative to board-approved policy minimums?
Also, if redeploying investment cashflows is a key component of your contingency plan (or perhaps your budget) to address changes in loan and/or deposit balances as rates rise, review the projected reduction in cashflows when rates rise (driven by prepayment and/or call optionality).
Changes in value and cashflow will likely produce materially less liquidity at some point in the future.
• Increase your ability to borrow from the FHLB.
If your bank has strategically reduced the size of its investment portfolio and excess cash to fund loans and improve earnings, wholesale avenues may be required to support funding needs when rates rise.
Accessing the FHLB for funding as needed is no different than a manufacturing company that utilizes a just-in-time inventory control system.
Under this system, materials are purchased and units are produced only as needed to meet actual customer demand, making it unnecessary to have raw materials sitting idle (i.e. in cash) and not generating a return. Your ability to readily access a variety of funding sources will be critical to controlling costs and ensuring that changes to loans and deposits can be funded when rates rise.
It is time to review the percentage of your total loan portfolio that is currently pledged as collateral to your FHLB (the most readily available outlet offering a variety of funding options) and the resulting borrowing capacity.
Discuss whether or not your current borrowing capacity provides a sufficient buffer against deposit migration. If possible, refer to bank-specific volatility analysis from the last rising rate cycle as a starting point. Then, review your current borrowing capacity to your board-approved policy for accessing wholesale funding.
Ensure that your policies allow for meaningful borrowing flexibility and that you have the outlets and collateral pledged to secure it, if needed. Many banks have put their lenders on the “hot seat” to grow loans, but have fallen short on utilizing these assets for collateral and liquidity purposes.
The process of pledging additional collateral does take time. Make this part of your near-term contingency planning process.
• Update your stress testing.
The downturn beginning in 2007 and resulting bank failures, were driven by deteriorating credit quality that destroyed capital levels and earnings. Ultimately this dried up access to funding and liquidity for banks when they needed it the most.
Robust liquidity planning, policies, and stress testing allowed many banks to navigate around and even out of near failure. Subsequently, contingency liquidity planning became a best-practice approach and a regulatory requirement.
Most banks have successfully adopted contingency liquidity planning as part of their ALCO processes and have been analyzing numerous liquidity stress events and proactively discussing action plans. However, as banks approach a changing interest rate environment, they should discuss recalibration of our liquidity stress-testing scenarios.
Stress scenarios centered on deteriorating asset quality and the resulting reductions in borrowing flexibility, coupled with deposit outflows, are likely being monitored at your bank.
You may even have a stress scenario analyzing a “black swan” event, where your bank drops below well-capitalized status and liquidity access becomes increasingly limited.
Consider incorporating an additional scenario that highlights the funding pressures potentially associated with a rising interest rate scenario where funding demands arise on both sides of the balance sheet.
As a starting point, utilize the deposit volatility experienced at your bank during the last rising rate cycle. If this data is not available, select a percentage that would be considered stressful (e.g., 15% of non-maturity deposits, as an example).
Also, layer in an acceleration of loan growth. For example, consider doubling your loan growth forecast for 2015. In a rising interest rate environment where the economy improves and loan growth opportunities expand, ensuring that you do not find yourself on the sidelines due to a lack of liquidity will be critical.
Deposit landscape’s changing today
Some markets are already witnessing increased competition for deposits, creating outflows for some and pricing pressure for others. Clearly understanding the mix, relationships, account-level trends in balance and historical behaviors of your deposit base will be critical to managing your access to deposits when interest rates rise.
Recognizing that deposits are just one piece of the liquidity equation, which may become increasingly expensive, will ensure your future resilience. Allocate time now and ahead of rising rates to ensure you have strong funding flexibility and have sufficiently stressed your liquidity position.
About the author
Keri Crooks joined Darling Consulting Group in 2002. She presently consults directly with ALCO groups and boards of directors in the area of asset liability management with the goal of enhancing high-performing institutions. Additionally, Keri remains actively involved in advancing Liquidity360°, DCG’s proprietary liquidity risk management software, and is a frequent author on balance sheet management topics.