By Monica C. Meinert
Interest rates are on an upward trajectory, loan growth has been outpacing deposit growth for the past several years and bankers expect funding costs to increase in the months ahead.
In addition, competition around deposits is heating up, particularly as larger banks and digital bank players start to move in on community banks’ retail deposit base. “Years of excess liquidity are behind us,” notes Steve Kinner, senior managing director at Promontory Interfinancial Network, who recently spoke at the American Bankers Association’s Conference for Community Bankers in San Diego. “Depositors are open to switching banks.”
With all of these forces at play, banks should be taking the time to assess and understand their liquidity position—what they have for liquid assets, assets cash, bond collateral and so forth.
While lending growth isn’t a bad thing, bankers must ask themselves what the funding game plan is if liquidity remains under pressure. Conducting a thorough liquidity assessment to understand the bank’s liquidity position is essential—and it’s a prudent step to take from a regulatory standpoint, too. “We’ve been seeing a lot of examiner comments on liquidity management,” says Joe Kennerson, managing director at Darling Consulting Group.
“As on-balance sheet liquidity levels continue to decline, it’s going to pivot into all these strategy discussions,” he says. “How are we going to fund loan growth in 2019? What’s our deposit strategy? How aggressive are we going to have to be?”
Depending on the bank’s liquidity position, those conversations will be different.
Banks that find themselves in a comfortable position with liquid assets may want to consider keeping cash invested and taking a more defensive posture on deposits. “I see some banks out there swimming in liquidity, yet they have a CD special at 2.75 [percent]because that’s what everyone else is doing,” Kennerson says. But he cautions that that may not be a winning strategy; ultimately, the bank may end up simply cannibalizing existing funds within its own deposit base—increasing costs rather than bringing in new money.
Meanwhile, banks that are tighter on liquidity may have to be a little more offensive with their deposit strategy, and seek alternative wholesale funding methods, such as Insured Cash Sweep or CDARS—which are endorsed by ABA—or letters of credit at the Federal Home Loan Banks. “If you’re tight on liquid assets only because a lot of your bonds are being covered with sweeps or public deposits, that’s easy,” Kennerson explains. “If there are some alternative methods out there and you can insure those deposits through other avenues, that’s a good way to artificially increase your liquid assets without changing the structure of your balance sheet.”
As bankers engage in these strategy discussions, they must also factor in what’s happening in their local market. For example, the current regulatory framework—particularly the Basel III regulations and the liquidity coverage ratio—are part of what’s driving large bank competition for retail deposits, explains Promontory Interfinancial Network’s Taylor Binder.
Under the LCR, “regulators want [the largest banks in the country]to say: how much runoff do we expect for certain types of deposits?” he explains. “Public funds get a 40 percent runoff rate. Financial institution money gets a 100 percent runoff rate. So you’re seeing a lot of larger institutions that are moving away from some of these higher-runoff types of depositors, and they’re focusing on retail deposits, because those only have a 3 percent runoff rate.”
While this may be concerning to community banks—for whom retail deposits are often bread and butter—Binder adds that “it’s also creating a lot of opportunities for community banks to go after those types of clients” that the larger banks may be pushing out the door.
One tool community banks can use to take advantage of to help bring in larger clients and more efficiently fund their balance sheets are reciprocal deposits. The S. 2155 regulatory reform law changed the treatment of reciprocal deposits so that well-capitalized, well-rated banks would no longer be required to treat reciprocal deposits as brokered deposits, provided that they are less than 20 percent of a bank’s total liabilities, or $5 billion.
According to a recent Promontory study, 87 percent of banks noted that they would start using or increase their use of reciprocal deposits immediately or consider doing so in the future as a result of the law. “With reciprocal deposits, you’re able to go after larger clients in your area [and]the money stays local at your bank,” Binder says.
Given the fiercely competitive landscape and the need to fund loan demand, “you have to come up with creative ways for how you’re going to bring those deposits in,” says Rita Lowman, president of Pilot Bank in Tampa, Fla.
Last year, the bank grew its loan portfolio by 28 percent, Lowman says. The deposit side lagged behind, however—growing by about 15 percent. As part of its strategy, the bank invested in search engine optimization to ensure that when consumers in its market searched online for banking topics, Pilot Bank would be among the first businesses listed in the search results, helping the bank to reach more potential new customers.
Another creative step banks could take is to revisit their money market tier structures.
“Determine where the concentrations are within the tiers,” Kennerson advises, adding that often, “a big portion of the balances in money markets are in the one high-tier bucket,” so when the bank raises rates, they’re moving mostly high-tier balances, which could balloon their cost of money market funds.
If this is the case, banks might consider restructuring their tiers—collapsing some of the lower ones together and creating more levels on the higher end. “Now you’ve got a more balanced tier structuring so that when you do raise rates, it minimizes your cost of funds impact, and it gives you more flexibility,” he says.
Wherever the bank lands in terms of strategy, testing and monitoring liquidity is a must, says Kennerson. For community banks stress testing their balance sheets, “keep it simple, but have a good approach for the examiners.” (The FDIC’s 2017 Supervisory Insights, which focuses on liquidity risk, provides good information on how to effectively run hypothetical stress tests scenarios and build liquidity cash flow forecasts, he adds.)
Part of that approach should include the creation of a dynamic liquidity forecast—looking at loan growth and deposit growth and determining what it means for the bank’s entire liquidity inventory.
“Really [build]out that inventory and say, loan growth is outpacing deposit growth, but what do I have available for bond collateral in my coffers? What do I have for available loan collateral? What is my brokered deposit capacity? Take inventory of all the liquidity that you can get your hands on today,” Kennerson says, so that when the bank runs the stress test, it can show regulators all the different areas it can tap into.
When conducting stress tests, banks should model out three macroeconomic scenarios—mild, moderate and severe—to get a sense for what bank liquidity will do under pressure. “You want to build in a below-well-capitalized stress test,” he adds. In addition, banks can also run one or two “bank-specific” tests—for example, testing concentrations of potentially vulnerable liabilities.
Banks should be sure to run their tests within a projected time frame—not just as a “point in time analysis”—to get an idea for how things will play out over several quarters. If they find their liquidity position is tight, “build it out into a remediation scenario” that will demonstrate to regulators that there is a contingency funding plan in the event of a liquidity crunch.
From a monitoring perspective, it’s also important for banks to do their homework to understand their customer base. Kennerson recommends taking a hard look at the bank’s top customers and delving into what those relationships look like—how sticky are they? What have those account balances done recently? If they are declining, it could be an early indicator of potential attrition down the line. “If things get ugly at the bank, these high-balance customers are usually going to be the first to leave,” he cautions.
It’s also worth paying extra attention to single-source customers—those with only one account—which present a higher risk, as it’s easier for them to pick up and leave, Kennerson says. It may benefit the bank to do some direct marketing for these customers to help deepen the relationships and decrease the likelihood that they’ll leave the bank altogether.