Now Is the Time to Do Our Homework on Deposits
"Failing to prepare is preparing to fail" -John Wooden
The definition of preparation is: the action or process of making something ready for use or service or of getting ready for some occasion, test, or duty.
I approach every quarterly ALCO meeting with the concept of preparation at the top of my mind. How can I prepare my client for the challenges ahead? How can we best position the balance sheet for the next “test?"
Each quarter, I prepare for ALCO meetings with an open mind and anything but a 'one size fits all' approach.
I consider balance sheet changes, the impact of an ever-evolving macro-economic environment, market-specific dynamics, regulatory focus (past or present) and all the other variables that make each discussion unique unto itself.
But not this time! This quarter was different. This time I did have an agenda.
While my message was simple, it was also critically important. I wasn’t necessarily bringing new or groundbreaking recommendations and strategy to the table, but instead I focused on re-emphasizing many of the steps that were already starting to take place.
From the Editor
There seems to be a common thread amongst all great athletes. By most accounts they seem to practice harder than they play.
By now, it's widely known that Michael Jordan was a menace on the practice court. Tom Brady is famous for his absolute infatuation with preparation on and off the field. Even more maniacal is pitcher Max Scherzer who once required a teammate to sign a non-disclosure agreement when he asked to observe his bullpen session so no one could “apply” his training methods!
That insatiable desire to be prepared for the next game is what sets them apart. While these athletes may not be the most naturally gifted, they are the ones willing to put in the time so that when the game arrives, it’s easier than their practice sessions.
In this month’s Bulletin, DGC managing director Mike Mitchell stresses the importance of getting your organization ready for the looming deposit pricing “game.”
Specifically, the article focuses on several steps to best formulate your deposit pricing strategy as rates rise. Mike asks management teams to do their homework by “solving” for liquidity, determining the nature of pandemic-related growth, understanding how your current balance sheet composition may change, and determining deposit sensitivity.
So, the time is now for bankers to “take a few extra reps” or “run an extra sprint” to get your team ready for what may emerge as the fastest game of deposit pricing most of us have seen in our careers. Best of luck to all!
Vin Clevenger, Managing Director
Analysis of prior tightening cycles reveals that financial institutions significantly lag the Fed Funds rate for the first few rate hikes. That said, there is potential for a rapid and material change in the Fed Funds rate. It is imperative to do homework and preparation NOW, so strategy is clear and executable as monetary policy and financial conditions change.
Fed Dot Plot, December 2021
Fed Dot Plot, March 2022
In my client discussions, I emphasize five steps to properly prepare for changing conditions:
Step 1: Solve for liquidity.
The first place to start when it comes to deposit strategy is to understand your need for liquidity. Do you have excess, the right amount or not enough?
For many in the industry today, the answer is excess. With deposit growth that far outpaced loan demand in the pandemic environment, wholesale funds have been retired and investment portfolios have ballooned.
While there might be agreement on too much or too little liquidity, solving for what liquidity profile you are striving for will add clarity to eventual pricing decisions. The target you arrive upon should take into account expectations for future growth on both sides of the balance sheet as well as the variables and uncertainty that could exist on future deposit balances.
Come up with a concrete answer to when you would need the liquidity regardless of cost. Only then can you introduce the discussion and tradeoffs of whether the liquidity comes in the form of paying up to keep deposits or wholesale funds (see "Marginal Cost of Funds").
Step 2: Do your homework on the growth that has occurred.
Where has the net growth in my deposit base occurred? In what products and tiers have average balances changed? Have we experienced a shift in the mix (e.g., CD to NMD)? Each sector of deposits has been impacted differently by the pandemic. Consumers have adjusted spending and savings behavior in addition to experiencing direct fiscal stimulus. Business deposits have been impacted by the Paycheck Protection Program as well as disruptions in supply and demand. Municipalities are seeing growth due to funds distributed through the American Rescue Plan. Each has its own unique impact on both current and future liquidity expectations, so understand these factors and plan accordingly.
Could money move or shift for reasons other than rate and what is your ability to monitor and understand these dynamics real time?
If your institution has experienced a shift in mix, could that reverse and what is the impact on interest expense?
How “in tune” are you with your largest depositors? What can you do to know and understand those customers better?
Step 3: Do your homework on price sensitivity.
What have you learned from the past? Have you done post scenario analysis to understand what worked and what didn’t in prior cycles, or where the price pressure occurred? How did your pricing compare early in a rate cycle vs. later in the cycle? How did competition in your market impact your strategy? Has the competitive landscape changed (both in market and on-line)? Are there other factors on your balance sheet besides liquidity that could impact pricing strategy?
Step 4: What is different this time?
The simple answer is everything. Inflation, technology, and the size of the Fed balance sheet are just a few notable differences that come to mind.
Focusing on institutions' balance sheet composition, here is a summary of bank profiles ($1-10B) prior to the last three rising rate cycles (with similar trends observed for Credit Unions).
Loans / Deposits > 90%
Borrowings / Assets approx. 20%
Liquid Assets / Assets approx. 30%
Loans / Deposits approx. 95%
Borrowings / Assets approx. 17%
Liquid Assets / Assets approx. 26%
Loans / Deposits approx. 88%
Borrowings / Assets approx.7%
Liquid Assets / Assets approx. 24%
Loans / Deposits approx. 73%
Borrowings / Assets approx. 4%
Liquid Assets / Assets approx. 33%
How does the above impact your strategy?
What are your expectations for balance sheet composition as rates increase? Will loans revert back to historical levels? Or will higher rates influence your ability to generate new business and therefore cause less of a demand for liquidity?
Are you OK with going back to non-retail sources of liquidity as a funding mechanism for your balance sheet? If so, what are the optimal terms? Would your management team and Board be “comfortable” if borrowings also move back to levels from 1999-2007?
Now is the time to set the parameters for what your balance sheet may look like in several quarters.
Step 5: Create the plan.
How do your non-maturity deposit and CD strategies differ? Will you have defensive shelf products (non-advertised) or negotiate on a case-by-case basis or both? How are you tracking, updating, and monitoring these pricing strategies over time?
Some ALCO meetings we left with general pricing philosophies, and others with specific products or strategies ready to execute. Do your homework and be prepared. Doing the research ahead of time gives you greater confidence in pricing at each decision point along the way and believe me, the basis points begin to add up to material levels of Net Interest Income.
The good news
If you have procrastinated, there is still time to develop your game plan. With the FOMC not scheduled to meet again until May, it's highly likely most organizations will keep deposit rates relatively flat for the next several weeks. However, with the markets currently pricing in 50bps at the next meeting, we may be on the precipice of materially higher deposit rates. Having a clearly defined strategy for when the rubber finally meets the road will be critical in ensuring your organization's success in 2022.
So sharpen those pencils, ask the hard questions, and be ready to execute a plan that best fits the needs of your organization and helps you “ace” the test that is on the horizon.
Learn more about DCG's Deposits360°® solution.
ABOUT THE AUTHOR
Mike Mitchell is Managing Director at Darling Consulting Group. He leverages his passion for the asset liability management (ALM) process to maximize strategic effectiveness, manage risk, and optimize income. Advising executive teams for institutions all over the country, he provides tailored, thought leading solutions in an ever changing economic and regulatory environment.
© 2022 Darling Consulting Group, Inc.