Are Your Deposits at Risk? Part 1
Several months ago, the Federal Reserve announced it was trimming its monthly bond purchases to $75 billion from $85 billion, taking the first step toward unwinding the unprecedented stimulus put in place to help the economy recover from the worst recession since the 1930s.
“Reflecting cumulative progress and an improved outlook for the job market, the committee decided today to modestly reduce the monthly pace at which it is adding to the longer-term securities on its balance sheet,” Fed Chairman Ben Bernanke said prior to his retirement, at a press conference after a meeting of the Federal Open Market Committee.
Minutes of the Fed's Dec. 17-18 policy meeting, released in March, showed many members of the policy-setting Federal Open Market Committee wanted to proceed with trimming the asset purchases.
This trimming, plus the recovering economy and the fact that rates are already very low, should drive rates up and increase the various yield curves. How will this affect your liquidity going forward?
We hear some credit union executives say, “Worry about liquidity? I have more deposits now than ever before and my loan-to-share ratio is the lowest in 20 years.” But let’s take a deeper look at your members’ behavior and see how they will react to an upward shift in rates. Perhaps we should be more concerned about your liquidity and enact tactical and strategic funding strategies that may have been just conversation to this point.
How we got here. Three main factors have led to the abundance of liquidity that you have been challenged with for the last few years.
- Accelerated cash flow speeds of assets, such as loan/mortgage-backed security prepayments and/or securities being called;
- Decreased lending activity; and
- Incoming surge balances (which we will spend the most time discussing in this article).
Surge balances come in two waves. First, whenever the economy deteriorates and/or the stock market declines, the safety of deposit insurance is a haven for both individuals and businesses. We have seen the phenomena before (see Figure 1). From the mid-’80s through the mid-’90s, a steady drawdown of deposits moved funds from Main Street to Wall Street (disintermediation). Then the opposite occurred. Deposits surged into credit unions and banks in the early 2000s (with the collapse of the dot-com bubble, a recession, and then the political uncertainty of 9/11 and other events) and again in the past four to five years.
The second surge is internal. Your CDs do not offer enough of a premium for your members to lock up their cash. So they move their funds into money market and savings accounts and wait for rates to go up. Figure 2 shows the dramatic change of the deposit structure: an increase in total deposits and the decline of CDs.
Special note: If your CD buyers have extended their terms, you may be exposed to some early withdrawal risk when CD rates rise. Unfortunately, in this historically low-rate environment, the nominal early withdrawal penalties collected will not cover the costs if members withdraw from CDs early and you have to replace them at a higher rate.
Source: American Banker
So what’s the upshot? Your CU’s liquidity would be substantially tightened in several scenarios, and we are already seeing this pattern starting.
A notable trend is that banks/credit unions are getting more aggressive in making loans. They are now viewing profitability from an opportunity cost, not from a return-on-assets (ROA) benchmark. Idle liquidity is a drag on your earnings and you have to deploy it into loans. That means if you are flush with cash, the rate on a loan only needs to beat a relative investment benchmark (and take into account the costs and risks associated with the loan) to be profitable.
In this environment, that is not a very high threshold (the current three-year treasury is at .788 percent, and the five-year treasury is at 1.520 percent as we write this. Coupled with an improving marketplace and some pent-up demand, we see loan growth picking up steam in 2014.
In regard to deposits, remember, surge balances are a two-way street. First, they arrive to you as a flight to quality, away from the risky stock market, but the opposite is also true. Some accounts have gotten noticeably smaller in 2013 as individuals draw down some bank accounts and get back into the markets. “Deposit balances in insured banks have fallen by $51 billion—a small amount relatively speaking, to be sure, but notable in that it reverses a six-year pattern,” according to Market Rates Insight.
The second surge runoff is that with an increase in long-term interest rates, we expect to see you holding the line on your non-maturity deposit rates, but increasing CD rates in response to market trends and local market competition. (CD rates have much higher betas. That is, they react faster to changing rates than core deposits).
With the increase in CD rates, we will observe the continuation and escalation of surge runoff, as a certain portion of members move their money to a CD at your credit union or with a competitor.
As we mentioned earlier, we also expect to see some of your longer-term CD buyers exercising early withdrawal options and, again, either buying a CD at your institution or going up the street.
A related liquidity/funding concern for those that have used listing services: The bulk of these deposits are funded by credit unions for terms of 6 to 24 months, so if you are depending on these resources to fund future needs, these institutions’ available liquidity will be diverted into funding their own loans and will be limited in the terms you are looking to secure in your efforts to mitigate interest-rate risk.
In all, the liquidity challenge will be somewhat different than the last cycle. The growth of loans by itself would pose modest liquidity issues; but when coupled with the lack of asset-based liquidity, it will become more challenging.
Your securities will be more under water than in the past rate cycle, because of longer terms and lower rates, which equals higher portfolio durations and a higher percentage of surge balance deposits on your balance sheet.
Based on the core deposit studies we have seen, the surge balance burn-off is estimated to be 20-30 percent, and we may once again find ourselves aggressively seeking and paying up for deposits.
What will your funding strategies be for the next one to five years? How much will you be able to lag your rate increases? Will you be able to avoid the cannibalization and repricing issues of the past? Can you fund locally? If not, how much is local vs. wholesale? What types of wholesale funding should you use?