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  • Writer's pictureDarnell Canada

Those Awkward Adolescent Years

Now Is the Time to Do Our Homework on Deposits

When they are very young, children are full of joy, spirit, and promise. There are only a few things to worry about. As we sometimes say, “Life was easy when we were young and naïve to the world’s realities.”

Then…they reach middle school, and the ills of social norms and related pressures begin to dilute that joy and to the degree that a child’s struggles go unattended or ignored, may begin to also break that spirit.

For some, those early teenage years are the most stressful and challenging of their lives, a period they just as soon forget rather than recall as the start of an important period in the process of maturation and personal growth.

When I reflect on the state of the community banking industry and the stresses and challenges faced by ALCOs around the country, I can’t help but see a close likeness to those difficult adolescent years.


From the Editor

The DCG Fantasy Football league will be holding its annual draft with the NFL season fast approaching. The auction-style draft is a frenetic three hours of bidding during which team “owners” pretend to be NFL General Managers and build their roster within the confines of a salary cap.

There are several different strategies employed. Some opt for a balanced lineup. Others “lay in the weeds” and wait to allocate their salary cap on more value-oriented players. Lastly, some owners build their team via the “Studs and Duds” philosophy, hoping they can surround their marquee players with some “sleepers.”

In some ways, managing a fantasy football team is almost as predictable as managing a balance sheet. There are so many variables influencing success, and some are simply out of your control. Even the best executed strategies and tactics might not yield the desired result.

In this month’s Bulletin, DCG Managing Director Darnell Canada writes that “the wisest decision bankers can make for 2023 and likely 2024 is to remain patient and disciplined, avoiding temptations to take unwarranted risks as these economic conditions unfold.” (He actually does this in the context of a parent advising their adolescent child).

So, whether you are drawing up your 2024 budget or drafting your fantasy football roster, employing Darnell’s advice and avoiding unwarranted risks will best position your team for success this “season.”

Vinny Clevenger, Managing Director


Operating in yet another environment of what seems to be a constant string of black swan scenarios, we are now forced to navigate shocked interest rate conditions marked by a rapid and unprecedented shift in funding mix/composition, unparalleled pressures on funding costs, and highly unusual growth conditions.

Business conditions have more than a few banks and credit unions highly anxious about earnings trends, with weakening risk management metrics. It is understandable that many community bankers have thoughts of insecurities.

For example:

LIQUIDITY – “I’m not popular enough.”

After an obscene volume of cash infused into the banking system during 2020 and 2021, deposit customers are stripping balances from our industry at an unprecedented pace. Inflation has been eating into the liquid funds of both households and businesses. Post-COVID conditions have motivated people to use discretionary funds for leisure activities and luxuries. Attractive investment opportunities have migrated yield-oriented funds away from the banking sector.

As of July 2023, aggregate deposits in the system (per FRED database) are 5% lower than the April 2022 peak and it is a near certainty that at the close of 2023, industry deposit balances will experience the first year-over-year decline in over 50 years.

MARGIN and IRR – “I’m not athletic / strong enough.”

Unprecedented liquidity pressures have triggered a war for deposit balances in 2023, causing a sharp rise in funding costs. The related earnings pressure is being felt industry-wide. Data from S&P Global indicates that quarterly NIM declined by 22bps for commercial banks and 35bps for savings banks when compared to 4Q22. While asset yields are slowly rising in response to tighter monetary policy, funding costs have nearly doubled during that 6-month period for both commercial and savings banks, attributed mostly to an overwhelming shift in funding composition/mix (rather than an increase in deposit pricing levels, which continue to lag to the fed funds rate).

BALANCE SHEET STRATEGY – “I can’t do anything right.”

The traditional solution to addressing declining margins is to increase the size of the institution to help maintain or grow income. But that is more complicated today than before.

With liquidity pressures on the liability side of the balance sheet, wholesale funding ratios have increased across the industry and are nearing uncomfortable levels for many banks and credit unions. In this case, ALCOs are focusing on deposit promotions to support loan growth, potentially at their own peril.

If deposit behaviors are examined carefully to quantify the influence of migration risk, institutions may find that their marginal cost of deposit growth can meaningfully exceed the yield levels on the loan growth in today’s marketplace. It is not uncommon to see community banking institutions with growth materializing at a negative carry, reducing the outlook for income.

Strategy decisions are complicated further given that interest rate risk profiles for most community banking institutions have become increasingly liability sensitive with growing short-term NIM exposures to additional rate hikes by the Federal Open Markets Committee (FOMC).

To address this, ALCO needs to either pay an extra premium to incentivize deposits further on the CD curve and/or tolerate even higher wholesale balances. It is important to also remember that in many cases, sustained lower rate conditions remain the worst-case scenario for NIM performance. The yield curve is more inverted than it has been since the 1980s, which raises the question: What are the actual merits of even buying protection against a rising rate scenario?

STOCK PRICES and M&A outlook – “I’m not attractive enough.”

According to the KBW bank stock index, bank valuations in July were 40% lower than the $147 peak price in January 2022. Performance was again strong in 2022, but forward earnings outlooks for 2023 and 2024 are weak due to lower margins and rising liquidity and interest rate risks. The specter of credit-related risks is also lurking and influencing how the capital markets view the banking industry. Declining market caps have many in the investment community now speculating on a new wave of mergers and acquisitions in the industry.

REGULATORS – “My parents just don’t understand.”

If it wasn’t already difficult enough trying to navigate the current environment, blanketed criticisms by examiners do not make it any easier. Liquidity is at the top of the discussion list in exams, with little sympathy for the uncontrollable and extraordinary COVID-related influences on deposit balances.

Higher interest rates have always prompted a resurgence of concerns regarding the economic value of equity models, which often conflict with earnings models.

Interestingly, despite relatively consistent ratios during the past 15 years, institutions that have not been criticized much in the post-financial crisis recovery are now being warned about loan concentrations.

While we know, like our parents, regulators are only looking out for our best interests, we don’t always see eye to eye on how to deal with life’s challenges.

“Don’t be a victim of negative self-talk. Remember, you are listening.” – Bob Proctor

With the benefit of hindsight, we now understand that during those middle school years, life wasn’t as bad as it may have seemed, and we were certainly not experiencing those adolescent struggles alone.

In this regard, we should look beyond the stressful trends we are experiencing and add some perspective by looking at absolute levels for performance and risk metrics.

  • Income trends are stressful, but levels remain solid. Although pressured, industry earnings performance is stronger than 4Q19 pre-COVID levels and pre-shock 1Q22 levels. Quarterly net income in 2Q23 call reports reflect close to an 8% annualized compounded growth rate over pre-COVID 4Q19 levels and a 15% annualized compounded growth rate over 1Q22 when the Fed embarked on its aggressive tightening policy. Although down 22bps from 4Q22 (3.38%), NIM levels for 2Q23 (3.16%) are only 4bps from pre-COVID 4Q19 (3.20%) and 72bps higher than 1Q22 (2.44%).

  • Liquidity stress is obvious and evident, but balance sheets appear adequately protected. It is important to remember that liquidity levels reached immoderate levels during the COVID period 2020-2021. While deposit sensitivities remain important to gauge, monitor, and manage, traditional industry liquidity metrics remain strong and indicate that a properly administered contingency liquidity risk management process should prevent the undue risk that victimized a few regional banks earlier this year. Loan to deposit ratios are 64% on average; 16% higher than observed pre-shock 1Q22, but they remain well below pre-COVID levels when they were on average at 72%. Deposit attrition has been high for most banks and credit unions, and, as a result, core liquid asset and wholesale funding ratios are considerably less favorable than observed during their COVID peaks. However, when compared to pre-COVID 4Q19 levels, both are still in line or better.

  • Capital strength has not been compromised. Leverage capital ratios are lower than pre-COVID levels, but it is important to remember that balance sheets ballooned during the COVID years with the deposit driven liquidity surge, evidenced by a notable decline in loan to asset ratios. If average assets were adjusted downward and normalized to the 4Q19 pre-COVID loan to asset ratio, leverage ratios today would be higher, indicating stronger support for potential hiccups in credit and asset quality.

  • Balance sheets may be better postured for the next rate cycle. Interest rate risk models across the industry are showing a growing level of exposure to rising rates, especially if stress testing shifts in funding mix/composition. On the other side, exposure to falling rate scenarios appears to be decreasing. This suggests that community banking institutions might be better postured to benefit from a shift in monetary policy. Particularly if the curve were to “re-steepen” as rates decline.

In short, it is easy and reasonable to have a sense of anxiety from recent balance sheet and performance trends, but if we think back to March of 2020 when the world literally shut down with economic catastrophe a concern and plausible scenario, I expect that most bankers would have been thrilled to enter a time machine to see that a 3-year outlook would reveal that earnings performance would be higher; liquidity and credit buffers stronger; and with interest rate risk models showing manageable sensitivity levels.

“If your friends jumped off a bridge, would you follow?” – Every parent

Puberty is difficult for everyone and a condition teenagers have little control over. In the same vein, bankers cannot control the economic environment they are handed. They can only control their decisions on how to navigate. In this regard, remember that while it has been two years since COVID was removed from our daily newsfeeds, its impact on our banking system is still being felt and is largely responsible for these short-term stresses.

Learn from past mistakes…

In every sustained inverted yield curve environment, we observe bankers making decisions they later regret when the economy weakens and interest rates fall. Callable agency bonds are purchased for added yield; puttable advance funding structures are employed for supposed lower cost opportunities; and the importance of punitive early exit (i.e., prepayment) covenants in loan agreements is undermined.

Additionally, it is not uncommon to witness credit exposures added to the bond portfolio without a sufficient understanding of the liquidity and cash flow characteristics under a variety of adverse economic scenarios.

Take caution and think twice if tempted to underwrite added optionality in the balance sheet and/or buy credit risk in bond sectors you wouldn’t normally consider.

Be careful of who you associate with.

While you must take local market competition into consideration, be very careful when pricing your loans and deposits. Your balance sheet posture may be different than your competition and your risk management tools may differ. Further, your competition may have a different viewpoint or standard on profitability.

Eat well, exercise, and treat your body well.

Use data and software analytics to better understand and anticipate loan and deposit behaviors. This will require an investment in skilled staff, technology, and time. However, the financial return will be exponentially greater than using gut, intuition, and history to make product and pricing decisions.

Work smarter, not harder, and remain persistent…

Should NIM pressures continue or grow, efficiency ratios will rise and, in this regard, cost control will become a growing focus in the financial planning process. The strongest performing banking institutions distinguish between pure costs and indirect costs that are tied to growth and revenue. These institutions also understand and quantify the total financial impact of decisions made in managing overhead in select areas.

“It is darkest before the dawn” – Thomas Fuller

The current banking environment is not plentiful with profitable opportunities, but rather littered with landmines we need to evade.

Banking conditions will improve eventually as the post-COVID era normalizes. The wisest decision bankers can make for 2023 – and likely 2024 – is to remain patient and disciplined, avoiding temptations to take unwarranted risks as these economic conditions unfold.

Lastly, it is important to remember that as difficult as those adolescent years were, they didn’t last forever and never do. This will be true for the banking industry.


For more insights from Darling Consulting Group, click here.



Darnell Canada is a Managing Director for Darling Consulting Group (DCG), a solutions firm that specializes in the area of asset/liability management for financial institutions. Darnell works directly with C-suite executives, helping them to understand the complexities of their balance sheet financial risks and providing guidance and unbiased advice on strategies that strengthen earnings performance. In addition to providing advice for margin improvement and risk mitigation, he helps financial institutions manage through the rigors of challenging regulatory situations.

Prior to working for DCG, Darnell was employed as a field office examiner for the FDIC in the northeast Boston region. He is a writer on various topics related to ALM and is a contributor to several professional publications. He is a speaker and active educator, who enjoys participating in a wide range of educational programs for the banking and credit union industries, including the ABA Stonier School of Banking and the Graduate School of Banking at Louisiana State University.

Darnell’s education includes a B.S. in finance from Bentley University and an M.S. in finance from the Carroll School of Management at Boston College.


© 2023 Darling Consulting Group, Inc.


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