Reflections on rising rates

By Jeffrey Reynolds, Managing Director, Darling Consulting Group

Sometimes answers to tough questions can be answered best by looking within and asking the person in the mirror for advice. Sometimes it is helpful if a third party asks a few questions to help the person in the mirror through the discovery phase to answer the central question of concern.

For many bankers, a frequent question has to do with rising rates and how deposits will behave. The voice filling in for the enchanted mirror is likely the examiner in charge during your next safety and soundness exam, asking a series of questions that all begin with:

“What are you going to do…”

• “… when all these deposits you have grown since the ‘Great Recession’ leave the bank?”

• “… to withstand the margin pinch when you are forced to ‘pay up’ for liquidity?”

• “… to fund balance sheet growth when deposit competition asserts itself?”

• “… to withstand the capital hit when you are forced to sell all those bonds you invested in at a loss?”

In my recent experience, most bankers have fretted about rising rates and deposits. However, the emphasis has been focused on the margin pinch question.

Conversely, I have been finding, in meetings with clients and on the speaking circuit, that the regulatory emphasis seems to be shifting more toward liquidity.

For example, the most recent December 2014 FDIC Supervisory Insights publication features a four-part special report on interest rate risk, including “What To Expect During An Interest Rate Risk Review.” The report foreshadows what to expect in upcoming exams. Much centers on governance and policy setting, as well as deposit assumptions and interest rate risk sensitivity.

But look more closely

The opening paragraph of the governance section asks two liquidity questions tied to rising interest rates.

• “Will there be sufficient deposit funding to meet increasing loan demand?”

• “Will potentially depreciated securities need to be sold for liquidity?”

Since they have been so kind to ask these questions in advance, it is in your bank’s best interest to have developed your answers and be conversant about a rising rate funding plan before they stop by for their next visit.

Back to the mirror

What are some of the salient questions that you should be asking yourselves? Below are a few with some comments that come from performing hundreds of deposit studies for clients over the last few years:

• What is a normal growth trend? 

From 2007 to 2015, your non-maturity deposit base could well have grown 50% larger, which works out to roughly 5% annualized growth.

Does that seem right to you? As one client told me, “I have a marketing budget, growth plan, and branch expenses that will prove to examiners that not every deposit dollar in this bank is here by accident.” 

This is a good point, and one that all bankers should be prepared to back up with some trend analysis.

•  What about abnormal growth?

Did the market open up a new opportunity for your bank? 

Maybe there were failures in the area and your bank benefited. Maybe municipalities got ticked off at the area’s regional bank over pricing and fees and sought a better deal.

A break in the normal growth trend can be acceptable if you have a valid story to go with it.

If not, you have some homework to do. And sooner better than later.

• Are concentration risks prevalent?

In many banks, a small number of accounts often control a large chunk of deposit dollars. For example, with a client I just reviewed a concentration where 2% of the deposit accounts hold over 50% of the non-maturity deposit base.

Who are these people or entities? How long have they been here?  Have they bulked up on you over the last few years, or have their balances always been this high?  

The flight risk of those large depositors should be a known—and be actively managed.

Concentration risk is nothing new to bankers, but most often the industry associates it with credit risk. Recent client exams suggest that liquidity concentration review is on the rise.

Next let’s look at a few key points to frame the discussion about preparing a funding plan for rising rates.

Charting a course to the future

Once the analytical review is done, break the issue of rising-rate funding into a few quadrants for deeper consideration.

• Earnings Risk/Cost of Funds Management: What is the earnings impact if rates rise and deposit balances either shift to more expensive/rate sensitive funding options (such as wholesale borrowings) or require a greater degree of “rate glue” to keep in place?

Don’t panic. This is a only a glorified marginal cost of funds management exercise. Given reasonable assumptions, such computations almost always show that the bank is better off letting the most rate-sensitive deposit balances leave. Then seek a replacement at the margin.

• Liquidity Impact of Deposit Outflow: Before concentrating on growing, we should focus on what we have first.

 While the cost factor may be an important part of the equation when managing the deposit base as rates rise, what about liquidity considerations?

Do you have excess liquidity to burn off and, if so, in what form? If invested in bonds, would you be forced to liquidate at a loss that could adversely impact capital or could you access secured wholesale funding without having to incur a loss? How much capacity do you have to play this marginal cost of funds game before you hit a level that starts to become uncomfortable?

• How Will You Fund Growth? Odds are your budget calls for loan growth over the next few years.

If you are planning on using excess liquidity to fund this growth, how much can you afford to bleed off before you hit a floor on liquidity reserves? If the plan is to grow deposits to keep pace with loan footings, how do you plan to attract the growth? 

If rate driven product promotions are in the cards, have you built in a factor for migration of existing accounts to the higher-cost promotional accounts?

• What Is Your Contingency Plan? From a normal operational environment perspective, what happens if more deposits are at flight risk than you think? And how would you compensate? 

Importantly, what happens if you find yourself sliding into a period of systemic banking risk and/or bank specific stress?  If funding becomes difficult to come by regardless of the rate you pay, how would you manage it?

Critical: Manage to your own profile

Long before the financial crisis hit, we worked with a number of banks to help answer these questions. They were on the forefront of regulatory concern, and tasked our firm with not only asking the questions but with helping to come up with the answers to them.

We learned a critical lesson along the way: Every bank’s liquidity profile and risk is different. But each bank most likely has a scenario or two that will keep top executives up at night.

It behooves you to begin to ask the pertinent questions now and to formalize a funding game plan.

One thing seems clear based on recent vibes from the regulatory community—if you don’t ask yourself the tough questions, your regulator surely will. Best to be over-prepared heading into the next exam cycle.  

About the author

Jeff Reynolds is a managing director at Darling Consulting Group. After serving as an auditor in the insurance and banking industries, Jeff joined DCG in 1996. His analytical and managerial skills led him on a career path within DCG that culminated in his current role as Managing Director. In this capacity, Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions. Jeff is a frequent author and speaker on a variety of balance sheet management topics and has served as a guest faculty member for the ABA’s Stonier Graduate School of Banking.