Deposits Are a Hot Topic in Today’s Environment11.20.2017
Liquidity management and forecasting has become of heightened concern among management teams and regulators. And with good reason, as financial institutions of all sizes, shapes and location are taking a harder look at member deposit rates, balances and overall funding costs in this gradually rising rate environment. While most have yet to observe meaningful change in local deposit behavior (both rate paid and balance), the threat is real and could be brought to life by a variety of factors.
Each credit union should take steps now to ensure it is prepared from a liquidity perspective.
Member deposit growth is an essential strategic component for credit unions, but recognize that changing environments can hamper access to cost effective and core deposits. As such, a best practice ALCO process monitors the measurement and management of all forms of operating and contingency liquidity – not just access to deposits through members. The first liquidity component is typically on-balance sheet liquidity or what is often referred to as “liquid assets.” This consists primarily of excess cash, investment CDs and government back securities (MBS, treasury and agency bonds), which are available for collateral purposes. Recent examination feedback highlights a renewed focus on the importance and sufficiency of this number. Examiners are looking to ensure credit unions could withstand potential deposit outflow scenarios and that they have access to the most pure form of liquidity – cash and investments.
Revisit your ability to access funding through the FHLB. The FHLB will accept your loans held in portfolio as collateral while allowing you to keep bonds available for other liquidity purposes. Many credit unions have been strategically holding additional residential mortgages in portfolio and/or growing member business loans but have failed to “beef up” their ability to borrow at the FHLB despite their larger asset base and pool of loans that could be pledged. Ensure that this outlet for funding is not only established, but is sufficient for any future funding needs. For example, a temporary outflow of deposits due to rate shoppers eventually having more alternatives.
Ensure All Parties Are on Board
Board members are volunteers that do not eat, breathe and sleep banking. Additionally, many credit unions have made an effort to bring in new board talent since the 2007 financial crisis. As such each credit union must provide ongoing “re-education” on timely industry issues and potential strategies. Liquidity measurement and management should be an educational priority for 2017 and a discussion on funding alternatives should be a vital component for those that have not been utilizing wholesale funding or non-member deposits for several years…or longer. These funding alternatives are a key component to the liquidity process at many high-performing credit unions, so ensure that your board has an understanding of and comfort level with all forms of liquidity and that policy tolerances are set appropriately.
Quantify and Discuss the Risk and Return Dynamics of Increasing Member Deposit Rates
Moving from one annual hike by the FOMC in 2016 to potentially three hikes this year has l been the main culprit for heightened concern around deposits. There appear to be two camps: those with a real need to grow deposits and those with a feeling that they should. If the liquidity profile of your credit union is strong, lagging deposit rates may be the appropriate strategy. If liquidity is or is projected to become tight, deposit retention and/or growth strategies are likely appropriate. It is critical to understand the cost/benefit associated with either strategy.
Each credit union has assumptions for how rates paid on its deposit base are projected to move as market rates increase (the correlation is referred to as a beta). Usually, the non-maturity deposit betas/assumed rate movements are appropriately supported by historical pricing and product strategies at the credit union in prior rate cycles. The current challenge with utilizing credit union-specific data in isolation is twofold: 1) the last rising rate cycle was over a decade ago (2004 to 2006) and the credit union atmosphere has changed significantly in the meantime; and 2) the FOMC is currently moving at a glacial pace (1.00% over the past two years and projecting only 0.75% per year going forward).
There is significant variation in assumed betas across the industry. However, to date most credit unions have not increased “posted or rack rates” on non-maturity deposit accounts. This has resulted in additional income in the form of cost savings – for most the annualized number is quite meaningful when taking the total balance of non-maturity deposits and multiplying by the assumed beta for these deposits. Said another way, the FOMC has increased short-term rates four times beginning in December of 2015 and the strategy of lagging deposit rates has produced a benefit to earnings and capital that interest rate risk models likely did not capture.
Additionally, examine the cost associated with increasing rates paid on various deposit products with each future 25bp hike. What is the return for the credit union associated with unilaterally increasing rates – goodwill with members? What is more likely to be noticed and valued by your members – a 5bp increase in the rate paid on their share account or additional technology, products and infrastructure? Note that the reality for many credit unions is that their balance sheets are structured such that the next several rate hikes by the FOMC produce very little benefit to net interest income and earnings and therefore capital, even with a strategy to hold firm on deposit rates.
These items should be considered at each credit union, regardless of its liquidity profile and determined need for deposits. Remember that while credit unions do not have shareholders actively watching their earnings and capital and holding management accountable, credit unions do have elevated regulatory capital minimums and requirements and also do not have readily available access to capital outside of their own earnings.
Deposit Strategies Should Be Based on a Credit Union’s Individual Risk Position—Not a Competitor’s
The analysis above can be eye opening at ALCO meetings and helps facilitate meaningful strategic discussions of deposit product and pricing strategy going forward. As a result, many credit unions are shifting away from increasing posted rates on all product types as they may have done in prior rising rate cycles. Instead they are refocusing deposit strategies to incorporate the total member relationship and allowing for rate “bumps” if the member has a variety of relationships with the credit union as opposed to a CD only depositor (likely a non-core deposit). Credit unions are also capitalizing on opportunities to expand the total relationship (grow balances, cross sell existing members and strengthen ties to the credit union) by offering deposit products that incent more than just a one-time deposit event. Other strategies often include demographic or geographic expansion through a targeted product set or tier pricing. Having access to your credit union’s data has become critical to analyzing your current customer base and to be able to devise strategies to expand these relationships.
Before jumping to the conclusion that your deposit rates need to increase or that you should be offering long term CD specials, review your existing access to funding, look at your earnings and capital at risk under a variety of rate scenarios and run the cost/benefit analysis. Each credit union’s realistic forecast for net new loan growth should feed into determining liquidity needs, but be conscious of the yields on loans in your market when discussing deposit retention and/or growth strategies. For many, loans yields are flat to down…not just mortgage rates, but member business loans and consumer loans as well. Also recognize that there is insufficient spread to cover overhead and keep the lights on at your credit union if you are growing CDs at a cost of 2% and funding indirect auto loan growth with an effective yield in the 3% range.
The existing challenges in today’s environment are powerful and so far unyielding: pressure on asset yields, a very gradual rising interest rate cycle with a flat yield curve and economic uncertainty. Add in the potential for escalating deposit costs…ugh. It is critical to break down silos and fully analyze all strategies – not just deposit strategies – relative to your overall risk position. Click here for more on deposit analysis.
Keri Crooks is managing director for DCG, a consulting firm that specializes in asset liability management for financial institutions.