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  • Writer's pictureJeff Reynolds

The Scenario Nobody Talks About

The Scenario Nobody Talks About

In the asset/liability management business, we spend a lot of time running “what ifs.” These are scenarios that make us think, analyze risk return trade-offs, and build game plans to reduce the risk of major fluctuations in net interest margin and overall earnings. Odds are the worst scenario is one that ALCOs look at each quarter: falling rates.


From the Editor

What goes up must come down

As we reach the halfway mark in 2022, it’s truly remarkable how much interest rates have increased. The FOMC has increased rates by 150bps to date, and the 10YR UST has essentially doubled. And it certainly feels like market sentiment is that they will continue to rise.

Sometimes, we should remind ourselves that interest rates move BOTH up and down. While it’s hard to focus on a falling rate scenario with the magnitude of this year’s projected FOMC rate increases, one doesn’t have to look far to see heightening recession probabilities and the specter of lower interest rates.

Accordingly, now is the time to understand how your institution will respond to a potential downturn in economic conditions and interest rates. In this month’s Bulletin, DCG Managing Director Jeff Reynolds explores some of the key considerations for a falling rate scenario.

It doesn’t cost anything to ask questions, and there is no better time than now to orchestrate a “soft” landing for your institution’s balance sheet.

Vin Clevenger, Managing Director


With the Federal Reserve dot plot showing the target rate moving up a lot more rapidly than communicated just months ago and inflation pressure on everyone’s mind, why spend a lot of time thinking about rates going down? Well, this rising rate cycle may behave very differently than past cycles and that could make falling rates more problematic than ever before.

Federal Reserve Summary of Economic Projections

Federal Reserve Dot Plot

Federal Reserve dot plot showing the target rate moving up

The Pandemic Throws a Curveball at Historical Falling Rate Risk Perspectives

FDIC data shows that banks are far more “deposit rich” and liquid than ever before. In the rising rate cycles of 1999 and 2004, banks with $1-$10 billion in assets had loan-to-deposit ratios that hovered around 95%, and borrowings-to-assets were near 20%. Unsurprisingly, the cost of funds moved up precipitously as the Fed raised rates.

During the “Great Recession,” we experienced the “Great Reset” of loan-to-deposit ratios. When the credit markets froze and loan growth ceased for many, banks continued to see deposit balances grow. This reduced the average loan-to-deposit ratio for that $1 to $10 billion peer group from roughly 96% in 2007 to approximately 80% in 2012.

Loan/Deposit Ratio vs. Fed Funds Rate

Not surprisingly, institutions began to put liquidity to work in loans as the credit markets improved, and loan-to-deposits climbed to 88.6% by the end of 2018. A slower movement in funding costs was evident as banks were less aggressive in growing deposits in favor of bleeding off bond cashflow to fuel accelerating loan demand, and as they benefited from less pressure from variable rate wholesale funding costs (borrowings-to-assets fell from 16% to 9.5% in that time).

At the end of 2021, those same ratios reside at just over 73% and 3.5% for the same peer group.

In the News: Hostage Situation at the Bank

Today, bankers bemoan sluggish fixed coupon lending rates despite a meaningful selloff on the 5-year and 10-year points of the treasury curve. The 5-year point (important pricing reference for many commercial loans and investment purchase categories) increased from roughly 0.35% at the beginning of 2021 to 3.14% by mid-June 2022.

However, commercial real estate lending rates have not moved accordingly.

This is perplexing, because in the many conversations I have with banks and credit unions, I have yet to find one that is not in favor of higher origination rates. But because of this liquidity overhang in the current market, most are bracing for the equivalent of a prolonged situation in which the institution is held “hostage” to intense lending competition.

What might break the hostage free? Risk-adjusted returns in liquid assets must push loan pricing committees into a corner, or loan to deposit ratios normalize. For argument’s sake, let’s assume that means 85% vs. 73%.

All These Deposits Have to Go Somewhere… Right?

If your deposit levels jumped meaningfully over the past two years, have you broken that growth down and done a risk assessment?

Public Funds are the easier segment of the deposit landscape to predict. They will spend it. Many stimulus funds came with a requirement that funds are in fact spent in a certain timeframe for certain purposes.

Retail consumer money may get eaten up by inflation pressures, increased availability of in-demand goods as supply chains thaw, and increased spending on things such as travel as COVID restrictions ease. Commercial deposits may ebb for similar reasons and as companies manage cash more actively rather than draw on borrowing lines as Prime moves up with the Fed.

But will the money leave the financial system? If one were to analyze the money supply and bank deposits, one would notice that there is a direct relationship between those two metrics. It’s hard to see periods where the money supply ever decreases.

This adds a lot of credibility to the hypothesis that deposits in aggregate will not recede even though balances may change hands. If you have not already built some “what ifs” and threat analyses around the change of hands issue, you should do so quickly.

The good news is that deposit rate increases have yet to significantly materialize (although this is likely to change in the VERY near future) in this rising rate cycle. The bad news is that if a falling rate cycle happens soon, little if any relief on funding costs will be there for the taking.

Risk Return of Lending vs. Investments

What is the worst deal your loan committee has reviewed in the last month? An example: a 10-year fixed / 25-year amortization, non-recourse, non-owner occupied, 85% LTV on a strip mall currently 75% leased out to “ok” tenants, at 3.75%.

Why would someone approve that loan versus buying a par issue 30-year MBS with a yield north of 4.00%, 20% risk weight, and similar duration? If the answer is that “you can’t cross-sell a bond,” I’d ask for the tracking sheet that shows how loan customers over the past year have been cross-sold other services.

Back to the Future

Let’s turn the clock forward a year and examine two possible scenarios:

  1. The first is that geo-political risks wane greatly across the globe. Mid-term elections are behind us and were non-eventful. The Fed has increased rates, reduced the size of its balance sheet, and inflation is showing signs of abating. The cost of energy has moderated. All that and GDP growth has been stable or improved. It is likely the Fed will continue to increase rates.

  2. Something else.

If you answered “1,” you buy what appears to be the “soft landing” hypothesis.

The fear for me is there are so many things that must go right for “1” to happen, that I begin to discount the probability of it happening. And then I begin to build in higher probabilities of “2” involving a recession and falling rates. And if it is “2,” is there more upside or downside risk for you?

It Does Not Cost a Lot to Start Asking the Right Questions Now

Unlike the 2020 recession, I doubt the next one will end a month after it starts. I doubt the government can afford another massive bail out of the economy, and there will be consequences that remind us that credit risk is still a thing. I also believe strongly that if this happens in the next two years, there will not have been enough time to price up loans, leaving less runway to ride asset yields back down. As for the cost of funds, there will not have been enough time to see them rise to a point where there is meaningful cost of funds relief to be had.

How badly would this hurt your institution? The best time to ask what you might do is now, and not when it in fact starts. Here are a few questions to consider:

  • If there is a flight to quality that overwhelms institutions with more cash and no place to put it amidst falling bond yields, how happy are you with how you have your liquidity position today?

  • If rates fall 100bps along the 5-year to 10-year points of the yield curve, how much would you see materialize in bond portfolio gains that you could use to offset credit losses?

  • How much shorter would your loan and investment portfolios be if rates fell 100bps? Looking at that, how might you reposition them today?

  • When the expectation is that rates rise, the cost of falling rate hedges get less expensive. Are there any that you should begin to track pricing on and set execution goals around?

  • If managing the cost of funds could be problematic for you, does that make you think differently about extending funding duration today?

  • If you (like me) feel that credit risk is in fact “still a thing,” how well prepared are you for it? How would you work through it if the unemployment rate jumps, property vacancies climb, and property values fall?

You likely have some time to do this, but with each day that passes happily living in the world of “Scenario 1,” you do not need to go to Las Vegas to determine the odds of “Scenario 2” have increased. Use that time wisely and make well-informed decisions today.


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Jeff Reynolds is a Managing Director at Darling Consulting Group. 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.


© 2022 Darling Consulting Group, Inc.


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