You say you can’t beat deposits off with a stick? You consider your investments in fed funds sold to be a non-earning asset? So why are we talking about growing core funding?
In banking, loans have outgrown deposits 13 out of the last 18 years. The five exception years were 2008–2010 (Great Recession) and 2001–2002 (9/11). In summary, during healthy economic times, loans outgrow deposits — and they will again when we emerge from our current economic funk. When loans outgrow deposits in the industry, financial institutions have three choices in funding the growth mismatch: (1) securitize and sell excess loan production into the secondary markets, (2) fund excess loan growth out of the investment portfolio or (3) fund the excess loan growth with non-core funding.
Things will be a bit different this economic recovery because (1) the securitization markets have shrunk to a vestige of their former selves, (2) regulators are demanding increased asset-based liquidity and (3) they are also asking institutions to reduce their reliance on non-core funding. On a macro-economic level (banking industry), I am not sure what regulators are asking for works in the reality of a healthy economy. But your examiner will be examining you, not the industry.
This means competition for deposits will be fierce when the economy recovers, loan demand lifts off and excess liquidity is burned out of bank balance sheets. Of course, anyone can raise all the deposit funding they need by paying high rates. Don’t believe me? Try throwing an ad in the paper next week for a 3 percent unrestricted 12-month CD. Far more challenging will be to raise all the funding you need while effectively managing your cost of funds.
Managing funding costs will be a big issue in the next rising rate environment as many of you have placed floors under variable rate commercial and home equity loans. For the first 200 bps of rate rise, yields on these loans will not move. Your cost to fund them will.
It is crucial to have a core funding plan in place to deal with rising rates, especially for the first 200 bps of rate rise. Effective segmentation strategies that separate rate sensitive from non-rate sensitive funds will be an important cost management component of your core funding strategy.
Let’s use an example. Say you have $100 million of MMDAs currently priced at an all-in cost (including servicing) of 1 percent. Market rates increase 200 bps. You find that you need to raise your MMDA rates by 75 percent of the change or 150 bps in order to hold onto the $100 million. Your results will mirror those in Strategy 1 of Figure 1 (Click here for larger chart.). At an all-in cost of 2.5 percent, annual all-in cost of the $100 million will be $2.5 million.
On the other hand, you might raise the rates on existing money markets by 30 percent of the change in market rates to an all-in cost of 1.6 percent. At the same time you introduce a new premium MMDA account at an all-in cost of 2.5 percent. That strategy is shown as Strategy 2 of Figure 1. Assuming 50 percent of existing balances (the non-rate sensitive portion) stick in the existing MMDA service line, your weighted all-in cost moves to 2.05 percent, saving $450,000 per year.
But what if the rise in rates is accompanied by increased loan demand, causing you to target MMDA growth of $10 million to $110 million? You find that in order to grow MMDAs by 10 percent, you need to raise MMDA all in-costs by 90 percent of the change in market rates. If you increase rates on the existing account (Figure 2, Strategy 1), your all-in cost will be 2.8 percent with an annual expense of $3.08 million. (Click here for a larger chart of Figure 2.) On the other hand, you could raise rates on the existing money market account by 30 percent of the change and peg your new premium account at 2.8 percent (Figure 2, Strategy 2). Assuming 50 percent cannibalization to the new MMDA account and $10 million in growth, the weighted annual all-in cost will be 2.255 percent, and the expense will be $2.48 million, a savings of $600,000.
These are simple examples that incorporate a number of institution-specific assumptions. Your strategies may be significantly more sophisticated than the above two examples and will incorporate institution-specific assumptions on pricing response in your competitive environment and on the extent to which your strategy causes cannibalization. On the other hand, the concepts illustrated in these examples apply to CD strategies (specials), checking strategies (rewards checking) and many other strategies where segmentation is used to control funding costs while growing deposits.
Based on the concepts illustrated in Figures 1 and 2, let me make the following recommendations for dealing with the coming rising rate environment.
The time to start working on your core funding strategies is now. Your strategies are highly likely to involve one or more new product introductions. You do not want to find yourself in a rising rate environment unprepared.
Analysis like that in Figures 1 and 2 is helpful in that it compares two alternative strategies you are considering. You will never get decision-making information like this out of your accounting systems or ALM model as in the real world you will only implement one of the two strategies.
If you are concerned about the validity of assumptions like the cannibalization assumptions in the above two examples, test the results across a range of potential customer responses. Then ask yourself, “How well do I feel about the results across the range?”
You are always better off competing with a new CD special in a rising rate environment than competing with standard-term CDs.
You are also always better off competing with a new premium non-maturity deposit account than paying up on existing non-maturity deposit accounts in a rising rate environment.
If you want the greatest bang for your segmentation buck, focus on non-maturity deposit account segmentation strategies. They affect costs on 100 percent of your balances immediately. In addition, you are likely to see less cannibalization with non-maturity deposit strategies as a larger percentage of your non-maturity account customer base is non-rate sensitive.
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