Historically, it has been a challenge for financial institutions to accurately plan for future interest rate changes. Today, however, banks are better equipped to do so due to new regulatory oversight and the Federal Reserve Bank’s guidance and qualitative assessment for rate change policy. According to the Fed, rates will most likely hold steady between 0 and 0.25 percent until 2016; even if the economy continues to stabilize and unemployment decreases. Fed Chair Janet Yellen has said the Fed is “committed to an appropriate accommodation to further stabilize the economy.”
In recent years, the Fed’s “Evans Rule” set a targeted unemployment rate of 6.5 percent as the unofficial trigger to increase interest rates. However, having now hit that number, the Fed and the Federal Open Market Committee have stated that they will be monitoring more than just the unemployment rate when considering an interest rate adjustment. As a result, the Fed’s most recent statement indicated that interest rates will hold steady in the short run, but as the economy continues to strengthen, rates will inevitably rise once again. Given this, how can financial institutions better prepare for the future interest rate changes and identify opportunities to create incremental revenue gains today?
Every financial institution is currently sitting on liquidity, whether stored in its vault, on deposit at a correspondent bank or at a Federal Reserve bank. These funds are idling with minimal return as bankers wait for safe and short-term opportunities to present themselves. In other words, they are keeping their “powder dry.” Institutions simply do not have the level of margin that they have had in the past, but by strategically looking at fixed-income opportunities, for example, banks can create their own margins by accessing illiquid funds to deploy into revenue-generating income.
Maintained reserve balances are a permanent non-liquid asset. Although these assets are included in various regulatory ratio calculations, in practical terms these reserve balances are illiquid assets for a bank. By reclassifying transactional deposits under a deposit reclassification program, banks can tap into this found liquidity and choose to make a calculated risk with the funds that does not impact the liquidity positions already amassed.
Based upon the Fed’s exit strategy from bond buying, the economy is creating opportunities now for banks to achieve gains that are better than Fed funds rates, and the quickest, most cost-effective way to increase revenue and free up capital for more customer opportunities is through a deposit reclassification program. Deposit reclassification solutions enable financial institutions to lower their reserve requirements, free up illiquidity and subsequently transform it into liquidity on a permanent, recurring basis.
By reclassifying interest and non-interest-bearing transaction accounts into two sub-accounts — a transaction and savings — for reserve computation purposes, a bank can report the majority of its transactional holdings back to the Federal Reserve as savings deposits. Money in a savings account is exempt from reserve requirement calculations, and as a result, deposit reclassification can free up these funds and transform them into liquidity; all the while maintaining minimum reserve requirements that can be satisfied with vault cash.
Valley Republic Bank implements reclassification
Bakersfield, Calif.-based Valley Republic Bank, a $400-million asset community bank, was founded more than five years ago and, according to Stephen Annis, chief financial officer, there was no need for a deposit reclassification solution early in the bank’s existence. As the bank quickly grew, however, so did its reserve requirement, which required a new approach to managing liquidity.
“The internal and organic growth we have experienced quickly increased our reserve requirement to more than $10 million,” said Annis. “A handful of our staff had experience with managing deposit reclassification at other financial institutions, and we immediately began the search for one that seamlessly integrated with our core provider.”
The search led Annis and his team to Atlanta-based CetoLogic, a provider of cash management and deposit reclassification solutions for financial institutions. “CetoLogic’s Deposit Reclassification solution will recover somewhere between $8 million - $10 million in reserve balances; enabling us to excel in our loan portfolio growth despite the industry trend of loan originations being down.” Annis continued that Valley Republic Bank’s plan for the recovered funds is to deploy them into local businesses and communities in Bakersfield and Kern County in Central California. “The deployment of our recovered funds will vastly improve our loan/deposit ratio and will subsequently improve our net interest margin and bottom line.”
First Liquidity, Then What?
Valley Republic Bank seized the opportunity and took advantage of the low-interest-rate environment to generate incremental levels of revenue. As interest rates remain low and financial institutions anticipate future change, some might be inclined to sit on their assets, simultaneously ignoring the opportunities currently available to them. Deposit reclassification solutions reclassify a portion of a bank’s transaction accounts as savings deposits to reduce reserve requirements. Because savings deposits are not subject to reserve requirements, banks are able to reclassify up to 80 percent of all transaction accounts and free up cash, which can then be re-deployed into loans and other higher-earning assets.
CFOs and investment officers are constantly mining their balance sheets looking for assets that are underperforming or holding business back. According to SNL Financial data, securities have grown to 21 percent of assets from 16.6 percent just four years ago (Q4 2009 – Q4 2013). This data indicates that financial institutions are tapping into other fixed-income sources to generate income as exposure has been reduced from government agency securities. Financial institutions that tap into their Federal Reserve positions are accessing low-cost funds for lending or investing opportunities. As interest rates rise, so does the cost of funds, making a persuasive argument to take a preemptive step to accessing liquidity while it is still cheap.
Attractive positions for liquidity — despite lower rates — continue to be via securities or bonds. While the yield on bonds fluctuates and maturity terms can be lengthy, deposit reclassification enables banks to invest in these portfolios to take advantage of higher yields with calculated risk, while still preserving their liquidity positions for short-term opportunities when rates change.
The only constant relative of interest rates and liquidity is change. By leveraging deposit reclassification solutions, banks are better situated to improve their liquidity positions, regardless of what those changes may bring.
David Austin is vice president of Atlanta-based CetoLogic, a provider of software and analytics solutions for financial institutions and retailers. For more information on CetoLogic, call 1-877-495-0687 or go to www.cetologic.com.
Copyright (c) July 2014. BankNews Media.