The Federal Home Loan Bank System: Lender of Next-to-Last Resort

"The FDIC recently has observed instances of liquidity stress at a small number of insured banks." So opened the Summer 2017 FDIC Supervisory Insights issue. And so went your exams.

At a recent banking conference an industry consultant said, matter of factly, that in times of stress your Federal Home Loan Bank (FHLB) borrowing capacity would dry up. Nobody challenged him, including me, by the way. But when I mentioned the comment to the attending FHLB rep, she was not particularly happy.

This has happened before. Regulators and consultants promulgate this untruth. And having heard it so much, bankers are beginning to believe it. 

This week I sat in a bank CEO's office where he complained, ranted really, about his latest exam and the regulators' perception of liquidity risk, driven by the aforementioned Supervisory Insights. He was confident in his bank's liquidity position, but felt regulators could artificially create a liquidity problem.

Their conversation goes something like this: pretend that your non-core and wholesale funding dries up, and you are unable to attract local funds via rate promotion because of our restrictions on rates paid above the national rate cap. What would you do? Prepare for that.

I recently wrote that I thought bankers would have to prepare to offer rates more in line with the market. I noted that there was a greater than 100 basis points difference between what a customer could earn on an FDIC-insured Goldman Sachs Marcus account than what they could earn in your bank's money market account. And that bankers are going to have to build the infrastructure that allows them to be closer to market.

The national average rate for a money market account at the end of last year was 0.09%. The Fed Funds Rate was 1.25%-1.50%. So, according to the FDIC rate cap "guidance", you could not exceed 84 basis points on your money market accounts at December 31, 2017 if you were under regulatory scrutiny. Sixty six basis points less than the Fed Funds rate at that time.

I monitor trends. I know loan/deposit ratios are going up, and liquidity ratios are going down (see charts). But what are the chances that your liquidity position plummets, you lose access to your

correspondent line(s), you can't attract local deposits, your municipalities withdraw, and your FHLB line "dries up", all at once? As the FHLB rep mused to me, it could happen if say, an extreme black swan event much worse than the 2007-08 financial crisis happened.

More to the point, she directed me to her FHLB's president's message on their website where he wrote: "As long as markets remain open, and a member has pledged sufficient qualifying collateral and is willing to purchase the requisite amount of capital stock, the Home Loan Bank will always continue to lend to our members to help you meet your community's needs." 

We need a smarter discussion on liquidity. Before we create an artificial liquidity crunch.

The consultant at the above mentioned conference did have some solid recommendations that I would like to share, even though he is a competitor. Pretty magnanimous of me, right?

1. Create detailed funding concentration risk analytics, that includes:

     -  Stratify funding using a liquidity matrix

     -  A deposit loyalty study (to classify what regulators consider non-core as core)

     -  Determine a local rate cap (to use vs. the federal rate cap)

2. Conduct forward looking stress tests that include realistic contingency funding strategies

3. Train board members

4. Update liquidity policy and contingency funding plan to be consistent with the above process

Are you feeling pressure internally or from regulators on liquidity?

~ Jeff

Which Bank Will Blink on Rate?

It happened. I received an e-mail this week for a 13-month CD special. The ad insisted it would make me happy. Instead, sadness. Sad that this bank thought I wouldn't notice they were front-running a likely Fed rate hike. Sad that the bank fell back on old tricks, getting customers to bite on an odd-lot CD term that will reprice at a lower rate when it matures. Sad that they got my e-mail address.

Staring down the barrel of a rate hike, and the specter of future and faster hikes, how does your institution feel about how fast you will have to reprice deposits? Because we are coming off of unprecedented times folks. Times that had the average balance of a money market account go from $47 thousand at the end of 2005, to $129 thousand today (data taken from my firm's profitability peer database). 

Why do you think that happened? And what will customers do with that money when deposit rates become more enticing?

I know your ALCO models predict what might happen. But if we dig deep, we know we don't know. That doesn't mean we can't look around us to predict pricing pressures applied by our competitors, like the bank that solicited me for the 13-month CD.

So I took a look at metrics, publicly available in Call Reports, that were indicative of a competitor's need for funding, and therefore will drive their pricing decisions.

I focused on the St. Louis MSA. Why St. Louis? I have friends that are getting married there in the next few months, and they work for one of the banks on the below list. Together. Same bank. I will defer to them on the wisdom of this. St. Louis also has a good baseball team. And they are not likely to win as many World Series as the Yankees in my lifetime.

I looked at the top 10 deposit market share banks that were not SIFIs. True, SIFIs had a 52% market share at June 30, 2016. But the below top 10 own 29%. Not an insignificant amount. And SIFIs' need for funding is much more complicated as they have greater access to the capital markets, and don't necessarily rely on drawing funds from St. Louis.

Here is the list, their St. Louis MSA market rank, in-market deposits and deposit market share at June 30, 2016.

Once I identified the community banks, my next task was to identify the financial metrics that highlighted their need for funding as rates rise, and therefore the likelihood that they would be early movers in the pricing game. Here are the metrics I used:

-  Deposit Growth minus Loan Growth (year over year)

-  Loans / Deposits

-  Securities / Assets

-  Pledged Securities / Securities

-  Time Deposits / Deposits

-  Borrowings / Assets

-  Cost of Funds

I ranked each of the above banks based on each metric, assigning the bank a "10" if they had the top rank, and a "1" if their ratios were lower. So, if UMB Bank NA had the lowest Loan / Deposit ratio, as they did, they received a "1" for that metric. If Central Bank of St. Louis had the highest Loan / Deposit ratio, as they did, they received a "10". That means that each metric received equal weight in my analysis.

I tallied all of the scores to determine which bank needed the funding the most, and were therefore most likely to be first mover in elevating rates and putting competitive pressures on other market participants. The results are below.

I predict that Midland States Bank will be the first to offer a compelling rate to raise deposits in a rising rate environment. They have a relatively small securities portfolio, high Loan / Deposit ratio, and their loans have been growing faster than their deposits, among other indicators.

Call this method the Jeff For Banks method to predict rate warriors. I can be a narcissist.

There are some tight scores immediately below Midland States, and upon looking through the data I believe Central Bank of St. Louis would be next, in spite of it having a slightly lower score than the three above it tied for second. Their Loan / Deposit ratio was 98% and their securities portfolio was similar to Midland States, at only 10% of assets. Reliance and Midwest, conversely, have securities portfolios of around 22% of assets to fund their growing loan portfolio. So the scoring system is not absolute, especially when there is clumping such as in the second through fifth ranks.

My friends' bank looks like it can sit on the sidelines during a rate war, a good position to be in. Unless they succumb to competitive pressures, and that parked money in money market accounts starts following rate around St. Louis. 

Who will blink in your markets?

~ Jeff

How stable are your deposits?

I am attending the Financial Managers' Society (FMS) Forum in Las Vegas this week. The Forum is chock full of education opportunities for banking finance professionals. One session caught my attention. The tandem speakers taught the audience about going "long", or at least longer, in their investment portfolio and minimizing risk.

One of the underlying assumptions in advising to "go long" was that core deposits were as stable today as they were four years ago. I challenge that thinking. Average balances per account among most core deposit categories have been growing and I think customers are parking their money waiting for greener pastures. When they arrive, what will they do with that money? I put this question to Dallas Wells, an asset-liability specialist from Asset Management Group in Kansas City. I have followed Dallas' writings on his informative blog for a while now and caught up with him at the Forum. Here is what he had to say.

What do you think will happen to core deposits once rates rise?

~ Jeff

Sweat the big stuff: Interest Rate Risk

I have been thinking about interest rate increases for some time now. The Fed lowered the Fed Funds rate to a target of 0 – 25 bps in December 2008. Since that time we all knew that the next move would be up, and pundits have been predicting the “when” like sportscasters predict the next champion.

Once the Fed senses economic recovery and inflation indicators start blinking red, they will move. And if past is prologue, they will move relatively quickly. Take the last time the Fed raised rates as an example. On June 29, 2004 the Fed Funds rate stood at 1%. Two years later, the rate was 5.25%. Four hundred twenty five basis points in 24 months. See the recent history of Fed Funds and Discount Rate moves here.

This should give FIs pause as they manage their balance sheet. Some banks, by strategic design, are weighed heavily in 1-4 family mortgages funded by certificates of deposit. In asset liability management (ALCO) parlance, they are funding short and lending long. This means as rates increase, their funding will become more expensive and a significant part of their assets will remain mired in historically low yields.

One such bank, a west coast financial institution with between $10-20 billion in total assets, had greater than 60% of their deposits in CD’s and over 70% of their loans in residential mortgages. Although if you had the time to dig you can figure out the bank because all information I give is public, I will keep them nameless.

In a note in their annual report, the bank reported the following structure to their balance sheet;

According to the same note, the Bank is estimated to experience the following net income impact given rate increases of 100 bps, 200 bps, and 300 bps respectively.

In other words, if the Fed raised rates 300 basis points (3%), the Bank would have $37 million less in net income. A large number, but it only represents 33% of their actual net income. But that number includes many assumptions. For example, in the bank’s 10k, they disclosed that their loan prepayment assumptions incorporate their recent portfolio experience.

Now, I’m no ALCO genius, but I have to believe that residential mortgage loan pre-payments have been up recently due to people refinancing to lower rates. When rates rise, I doubt borrowers will be knocking at the bank’s doors to trade their low rate mortgage for a new, higher rate one. By my calculation, if the Fed raised rates in Year 1 by 300 bps, and the bank had to follow suit basis point for basis point, this bank’s net income would decrease by $43 million, or 39% of their net income. Years two through six would see an additional $58 million decline. If I ran this bank, I would be concerned.

Bank risk is so compartmentalized, and asset-liability management has numerous assumptions that impact results significantly. But at the end of the day, FI senior managers need to use common sense to estimate the collective behavior of their customer base in a rising rate environment. Making strategic decisions regarding the structure of the balance sheet may result in decreased profits today but position your FI to continue serving clients needs, hedge against rising rates, and protect against declining profitability in a changing environment.

Is your balance sheet protected against rising rates? Really?

~ Jeff