By Jeff Reynolds, managing director, Darling Consulting Group
How times have changed!
Back in 2010, the horse was already out of the barn with respect to liquidity risk. As such, the expansion of liquidity management expectations set in “Interagency Statement on Funding and Liquidity Risk Management” was a little late in terms of making a difference. In 2009 140 banks failed, followed by 157 in 2010, and 92 in 2011.
For those without credit-induced capital issues, by then the prevailing liquidity challenge seemed to be a surplus of cash and few options to deploy it. This occurred because many banks had pulled in their horns on lending risk. Because of this liquid bond and cash holdings spiked.
Things changed in 2012 when the credit markets began to thaw for community banks and they returned to lending. Gradually, excess liquidity has been absorbed.
According to S&P Global Market Intelligence, there are just over 900 bank charters (excluding obvious special purpose charters) for institutions between $1 billion-$15 billion in assets at the end of 2012 that are still active today. Of those, 15% had loan-to-deposit ratios greater than 95% back at the end of 2012. Today, 33% are over that mark. For that entire pool of banks, the average loan-to-deposit ratio has increased from 78% to 87%.
As a result, more banks are struggling to find funding at the margin to continue to feed the loan machine. Perhaps to make sure the horse stays in the barn this time around, the regulatory community has recently placed an increased emphasis on liquidity.
Consequently, deposit gathering is once again a top agenda item for the community bank sector.
Credit spreads shrink, funding costs poised to rise
In ALCO meetings, it is common to hear how intense competitive pressures and underwriting issues like low capitalization rates are causing a lot of heartburn.
Quality assets are at a premium. This leads to lower pricing spreads, longer fixed terms, and, in some cases, banks walking away from deals. Why? They simply cannot get comfortable with the credit risk others seem not only to accept but are more than eager to book.
Many are fortunate if they have been able to price up commercial loan production by half of the amount by which market rates have moved. This has worked until recently from a margin perspective because of sticky and low funding costs. This may change in the very near future.
With short treasury rates now passing the 1.70% mark, funding at the margin through any typical wholesale or negotiated-rate deposit sources has become more expensive and thus tougher to justify with lagging loan offering rates.
While this should eventually cause a recalibration of loan pricing, it has also caused community banks to focus more intently on traditional deposit gathering efforts.
Funding concentration risk increasing
Here’s a stat for you: It is not uncommon to find that fewer than 5% of the depositors in a given community bank control as much as 40%-50% of total deposits.
Understandably, this raises some concerns when trying to establish a comfort level with strategies while managing this concentration risk.
Bank managers should be able to quickly convey that they understand this risk when asked. Stability trends, historical and current pricing strategies, and contingency plans are all items that bankers should expect to be asked about on this topic during the next exam. This is particularly true for deposit relationships that exceed 2% of total deposits.
Interestingly, doubling down on deposit concentrations has been a typical growth catalyst for many community banks; mainly because it is the easiest way to control the rise in funding costs when trying to grow.
Banks that need to get funding ratios in line have been turning with greater frequency to larger balance sources such as municipalities.
While the pricing and collateral requirements often put this funding source on par with wholesale funding, technically it shows up as a non-brokered deposit on the call report. It is available in large blocks, and pursuing it poses little chance of upsetting deposit pricing with existing retail and commercial customers because price negotiation is a one-off.
But as these avenues have become more competitive, attention has shifted to how to grow the more sluggish core deposit balances. The trick is to do so without needlessly paying up on the balances already held.
Deposit cost history: past and present
For many the pricing question really comes into play when considering growth. While many have no problem paying up to acquire new deposit relationships, they can ill afford to pay the same rate on what they already own.
This is particularly true when lenders are saying they lack pricing power on just replacing existing portfolio cash flow. History can provide some insights.
Absent the larger balance concentrations mentioned above, depositors have been surprisingly quiet to date. One of our deposit specialists recently pored through data for the current and prior rising rate cycles. The question he was trying to answer was whether historical pricing assumptions have been overly conservative, and whether they will continue to be so.
Here’s some of what he learned:
• Through the first 125 basis points of rate movement by the Federal Open Market Committee since December of 2015, the average pricing beta (correlation of deposit rates to market pricing) of interest-bearing deposits for community banks has been 8%.
• Through the first 125 basis points in the 2004-2006 tightening cycle, the beta was 9%.
• So far, we are true to form.
When asked about whether pricing assumptions should be revisited at this point, it is important to see what happens in the future and assuming the Fed continues to tighten. In the 2004-2006 cycle, the next 300 basis points saw interest bearing deposit costs increase by 183 basis points, a beta of 61%.
While many discount the prospect of an additional 300 basis points of Fed tightening in the near term, history affirms what many feel to be true when it comes to deposit pricing.
Once through the initial lag, things can start to move quickly when it comes to depositor behavior.
When will the dam burst?
Annually, DCG conducts hundreds of core deposit studies in addition to the modeling of thousands of client balance sheets for interest rate risk assessments. In talking with clients about the next 100 basis points of tightening by the Fed, the only consistent expectation is that depositors will be antsier with regard to rate demands.
But what would cause that $10,000 to $100,000 customer to wake up and shop?
The answer varies:
• One client did the math and concluded that the additional income that moving from 0.50% to 1.25% would bring is simply not worthwhile for the typical deposit customer.
• Another client surmises that even if the jump in rate they could get only results in a nominal increase in depositors’ earnings, customers will be looking for higher rates based on principle alone.
Said differently and from the customer perspective: “I have been paid nothing for a long time, and something is better than nothing.”
There is a lot of real estate between those two viewpoints. Where you are positioned between them is critical in setting the stage for how you manage 2018 deposit pricing.
Enemies at the gate
I often joke with clients by asking, “At what point do the depositors begin showing up with pitch forks and torches at night looking for rate?”
After a couple of nervous laughs, I ask, “When those customers show up, are they going to be looking to double their rate from 10 basis points to 20 basis points, or do they have a much higher expectation in mind?”
Everyone knows the answer to that one.
How you manage this is going to be key, and will often be worked into a new product strategy that can be used offensively to attract new funds. Being thoughtful and deliberate when moving down this road is imperative.
Measure twice, cut once: Planning is key
There is a mathematical concept in deposit rate management called Marginal Cost, and looking at the Marginal Cost of new money raised via a promotional campaign can be enlightening.
The math is not tough:
1. Estimate what might migrate from existing accounts to the new/promotional product offered.
2. Add the cost increase on the existing funds that shift to the new product to the cost of what you are expecting to attract for new money.
3. That is your Marginal Cost of the new money.
Simple enough. But buried in this analysis are a lot of assumptions. How much will move? From what products? How much will our campaign attract?
And asking and answering those questions is the value of the exercise.
Ask, don’t guess
It is better to ask these questions in advance before trying something based on gut instinct. If the goals are set ahead of time on all of those points, it might cause those who are planning the program to be that much more thoughtful in structuring the new product. Clients who have done this have been very pleased with the dialogue and engagement, and most feel that it optimizes the marginal cost of growth through new rate driven strategy.
The other action item many miss is the autopsy. Ask questions like these:
• What went right, what did not, and how would we go about this differently on the next campaign?
• Could dollar shifts from core savings have been lessened with a higher minimum balance on the new product?
• Did our advertising strategy flop in attracting new customers?
• Can we learn anything from the early movers on rate that can improve our management techniques for the next promotion?
The last rising rate cycle saw rates peak in 2006, and most deposit bases demonstrate an average life of 5-7 years.
What do you really know about the rising rate expectations of the customers banking with you today? Capturing and analyzing information on the fly is critical.
Ready… set… go!
Managing the rise in deposit costs, balancing growth needs for funding, and setting realistic expectations are not easy; particularly when many in your organization have never had to deal with a rising-deposit cost scenario in their careers or find their skills for doing so to be rusty.
However, funding trends and regulatory cues suggest there is a need for increased focus on how banks will manage a near-term drought in deposit gathering and what the longer-term implications are as well.
When drought season is upon us, finding liquidity at a reasonable cost is not the easiest task on the farm. This is true for bankers as it relates to deposit gathering today. Better use of data and technology-based tools will no doubt increase your chances for success.
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.