Bank Customers Lose Real Money

You worked hard, saved money, and reduced or eliminated debt. You've been conservative, preferring the stability and security of bank deposits versus the gyrations of the market. Now, after forty years of toil and delayed gratification, you're ready for retirement.

If this were 2006, things would be good. The Fed Funds Rate stood at 5.25%, and inflation in check at 2.5%. This means you could get roughly 2.75% real interest from your bank savings account. Your money grew.

Then, boom, the 2008 financial crisis. The Fed immediately dropped Fed Funds to a range of 0% - 0.25%. And at that time, inflation was nearly zero (0.1%), so your real interest was still positive. And since it was a financial crisis, no worries. Things would recover. And thankfully since you were nearing retirement your home wasn't leveraged to the hilt and then some. Sure, your home value declined, but what does that mean to someone with little to no mortgage and isn't in the market to sell? 

Heck, maybe there'll be a reassessment and your real estate taxes will go down.

Taxes go down? See that. I made a funny.

Retiree: That's Not So Funny

To the retiree that prefers the safe haven of FDIC insured deposits held at the local bank that lends it out locally, this is a serious issue. If we use the Fed Funds rate as a proxy for what a saver earns at their bank, the chart below is alarming. 

Source: US Inflation Rate by Year: 1929 - 2023 (thebalance.com)

Things looked good as we entered the 21st century. Sure inflation was relatively high, at least above the Fed's target rate of 2%, at 3.4%. But the Fed Funds rate, as proxy for savings, was 6.5%, a full 3.1% real return. (Note: I checked a few of our strategic planning peer groups to see their cost of deposits at June 30, 2021. One peer average was 36 basis points and the other 37. Although this is higher than the current top guideline of Fed Funds rate of 25 basis points, I feel comfortable using it as a proxy for bank savings rates. Eleven basis points difference to the peer median... c'mon.)

If a saver put $1,000 in a bank savings account on January 1, 2009, less than one month after the Fed dropped the Fed Funds rate to 0%-0.25%, and kept it in that savings account, they would have $1,091 at the end of 2020. That same $1,000, invested in the S&P 500 Index for the same period, would be worth $4,318.

Worse, in 14 of the 21 years from 2000 through 2020, the inflation rate has been higher than the Fed Funds rate. Meaning keeping your money in cash, or at your bank, caused a decrease in your depositors' buying power. 

This caused savers to flee to higher earning assets, driving up the value of those assets. This phenomenon, combined with the Fed increasing its balance sheet from $1 trillion to near $9 trillion since the financial crisis, has kept bond yields low and their prices high. Forcing savers into equities, which has driven markets up. I can't imagine those that seek a safe haven will go into crypto currencies. But never say never.

This is a great environment for borrowers and spenders. Not so much for savers and those that avoid leverage. 

What Say You, Mr. Powell?

And I'm not so sure policy makers have the savers' best interests in mind. The current inflation rate at this writing was 5.3%, well above the Fed's 2% target. Yet they continue to signal that they will keep the Fed Funds rate where it is until 2023. The two Board Governor hawks that are calling to do it sooner are leaving. 

It benefits the federal government to keep rates artificially low because we have $28T of debt to service. That's with a "T". I'm hopeful the Fed makes decisions to promote maximum employment, stable prices, and moderate long-term interest rates. And ignores politician's calls to continue to print money to keep bond yields low so they can keep swiping the national credit card.

But I'm becoming increasingly skeptical that the Fed is remaining faithful to its mission. So as an industry, we might have to solve for the diminishing value of our customers' deposits. It could be part of our higher purpose (Increase economic well-being of savers).

If you have thoughts on solutions, I would love to hear them.

~ Jeff

Please consider reading my book: Squared Away-How Can Bankers Succeed as Economic First Responders. 

Ten percent of author royalties go to K9sForWarriors.org, who work to bring down the suicide rate among our veterans. 

Kindle

Paperback

Hardcover

Thank you!

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

What will our depositors do when rates rise?

The subject has been on the minds of bankers for years now. The continued extension of the Fed's easing policy through possibly 2016 has given us a sense of security. But this pro-longed period of low rates, burgeoning core deposits, and uncertainty about what our depositors will do next should keep us restless.

For those that rely on yield for returns, it has been a tough time. Retirees, insurance companies, and bank treasurers have found it difficult to earn money in fixed income. Some have been able to squeeze gains out of bonds as rates fluctuated downward, but the second quarter flip from an unrealized gain to an unrealized loss in bank investment portfolios brought reality home to treasurers.

I'm not certain what depositors will do when rates rise. But I analyzed what they did the last time the Fed raised Fed Funds Rates in mid 2004. On June 30, 2004, the Fed raised the Fed Funds rate from 1% to 1.25%. Over the next two years, the Fed raised rates 16 more times, ending at 5.25% on June 29, 2006 (see chart).

The last Fed action prior to the 2004 rate rise was June 2003, when the Fed Funds Rate stood at 1%. Surprisingly, bank cost of deposits at that time was 1.43%. Note that all deposit and cost of deposit data was for quarterly periods, where Fed Funds rates were on the date they were raised. But once the Fed started moving rates up, bank cost of deposits lagged the movement upward. When the Fed ended its tightening in June 2006 at 5.25%, bank cost of deposits was 2.68%, a significant spread.

What did depositors do during this period? They moved money from core accounts (all deposit accounts less time deposits and brokered deposits) to non-core, as shown in the chart below.

But not to the extent one might think. Yes, non-core deposits as a percent of total deposits grew from 32% in June 2004 to 38% in June 2006. But core deposits did not decline during that period, growing 8.3% during the two year span. But time & brokered deposits grew 48.7% during the same period.

By the time the Fed stopped tightening in the second quarter of 2006, core deposits represented. 61.8% of total deposits. Today, core deposits stand at 77.8%. So, if past is prologue, then we can anticipate that although our overall core deposit base may not decline, time deposits are sure to increase. 

This analysis reviewed what happened to FDIC insured deposits across the U.S. How that money will flow between institutions is a result of efforts made by financial institutions today to win the loyalty of customers once rates begin to rise. Will they stay with you, or go across the street? Is it in your hands, or the hands of fate?

~ 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