The market crisis has brought about a new liquidity reality. With consumers moving money out of the stock market and into demand and savings accounts and decreased loan volume across the board, there’s more of an abundance of liquidity today than there’s been in prior years. As a result, banks seem to be worrying less about it. But the fact is that these types of environments are cyclical. As economic activity increases and interest rates eventually rise, core deposits are going to become more difficult to obtain. Community banks must not take their eye off the ball — they must be actively managing liquidity and diversifying their funding to prevent margin compression moving forward.
One bank that has figured out an effective strategy for liquidity management is Mercantile Bank, an Illinois-based institution with $721 million in assets. The bank takes a proactive, three-pronged approach to funding using Federal Home Loan Bank advances, brokered CDs and non-brokered CD deposits. According to Dan Cook, chief investment officer and executive vice president of Mercantile Bank, “These sources provide a complementary mix that gives us greater control and flexibility and enable us to respond to changing market conditions.”
The bank has relied on these three sources for almost 15 years, and while it has adjusted its mix of funding during that time — especially in the past 18–24 months — Cook believes that this approach will continue to stand the bank in good stead as the economy improves. Here’s why.
More Control, More Flexibility
Active liquidity management begins with knowing your funding options, both traditional and alternative, understanding when and under what conditions each source is available to the bank, and when it’s most beneficial to use them. Mercantile uses the FHLB as a reliable source for shorter-term funding needs. Cook believes that, “particularly in this day and age, with some sources being curtailed for many banks and others being placed under close examination, FHLB funding lines should be kept open to meet unforeseen liquidity needs.”
Mercantile also takes advantage of brokered CDs, although its dependence on this source has lessened during the past two years. This is primarily a result of increased regulatory scrutiny, a fallout from the liquidity crisis. However, Cook believes that there is a misperception about these wholesale funds.
“Asset quality is what really drives whether a bank survives,” Cook said. “The longer-term issue is that community banks are going to have a hard time funding a five-year fixed loan, for example, because as rates rise, so will the cost of funds. You can match funds to this loan in the wholesale market and via other non-traditional sources much easier than in your local market.”
As the third prong of the bank’s strategy, Cook relies on QwickRate’s online marketplace to raise non-brokered CD deposits directly from institutional investors and meet shorter-term (less than five years) needs. The portfolio of CDs Mercantile has built via the marketplace makes up the largest portion of the bank’s alternative funding sources, representing 16 percent of that mix.
Among its advantages, QwickRate gives the bank a quick and reliable source for funding loans, but it is also proving beneficial in terms of managing the liability side of the bank’s balance sheet. Mercantile is doing something a little differently — the bank treats these direct deposits as a portfolio, laddering the terms of the non-brokered CDs to get more flexibility and greater control in managing them. For example, by laddering the duration of its CDs, the bank can make immediate moves to offset the impact of a big loan payoff.
“If you have a $6 million loan coming due, you must find a way to get your deposits back in line. Unlike your retail deposits — which you don’t want to chase away — throwing off those liabilities [QwickRate deposits] very close to when the loan is being paid down makes it much more efficient,” said Cook.
Like any bank, Mercantile prefers to grow deposits through its local market. However, in some cases, it makes more sense and is more cost effective to raise funds directly through institutional investors — ones who are less rate sensitive and less volatile than consumer CD depositors.
Cook explained, “I use QwickRate non-brokered deposits to smooth out the gaps in maturities; this is less costly overall than fiddling with retail rates. The fact is that when you put a special on a CD, no matter how good it is, you can count on re-pricing about 30 percent of your current deposit base, which is expensive. When we offer CD rates in the QwickRate marketplace, we know that these rates will not be seen by existing local market depositors, so we can avoid re-pricing or cannibalizing our existing accounts.”
To put that into perspective, if your bank has $20 million total deposits in savings and money market accounts currently earning 0.25 percent, runs a CD special at an advertised rate of 1.25 percent for a one-year term, and experiences a 30 percent re-pricing of existing deposits, the total cost of funds for raising an additional $3 million would in fact be $60,000.
“Furthermore, using QwickRate is very easy and you don’t have to be at 25 or 30 rate positions, or you may get a ton of money very quickly — although that’s a nice problem to have. It’s easy to see why these non-brokered deposits are a core part of our funding strategy today and will be increasingly important as we manage our liquidity moving ahead,” said Cook.
Planning for the Unexpected
Banks are experiencing compressed margins right now and should expect that to be an ongoing, uphill battle. Proactive liquidity management can help banks mitigate future interest rate risk. One of the most fundamental ways to prepare the bank is to make sure that it has a well-diversified funding mix. Mercantile’s three-pronged approach enables the bank to actively manage its liquidity position while also meeting regulators’ expectations in terms of over reliance on a single funding source and preparing for the unexpected.
“As an alternative funding source, QwickRate is also a crucial part of our contingency funding plan,” said Cook. Regulators expect banks to prepare for potential risks and ensure that all of their funding sources have been fully activated and tested. Cook continued, “The online marketplace has proven to be a prudent source for attracting non-brokered CD deposits to meet our more immediate needs. It’s a key component in addressing the risk scenarios that we have documented in our contingency funding plan.”
The bottom line is that the more well-managed your liquidity polices and sources are, the greater confidence regulators will have in your overall liquidity position. Therefore, they may grant you more flexibility in terms of concentrations and utilization of funding sources.
It’s a new liquidity reality and examiners will continue to scrutinize the vulnerability of your bank’s funding strategy. It is easy to become complacent in a time when liquidity is abundant. Institutions like Mercantile Bank that take an active approach to liquidity management will be the ones to thrive. It may seem elementary, but it all comes down to being consistent, proactive and always vigilant.
Tracey C. Frederickson is a freelance writer with Critical3 Marketing.
Copyright © September 2010 BankNews Media