The long-awaited Federal Reserve easing cycle started with a 50 basis point cut at the September policy meeting. Chairman Jerome Powell asked observers to view the “50 basis point move today as a commitment to us not falling behind.” Did the “us” — the Federal Open Market Committee — finally grant bankers their wish?
Well, maybe. Or maybe not.
Let’s not forget that back in July 2021, Powell remarked that inflation was “transitory.” By the fall, he acknowledged that the word was no longer appropriate. Clearly, a lot can change quickly.
While the recently updated FOMC “Dot Plot” indicates the direction of future rates, the pace and degree to which the FOMC reduces rates are fodder for great debate.
Might the FOMC thread the needle and orchestrate the desired “soft landing”? Or will history repeat itself with a recession as it did the last two times the FOMC started an easing cycle with the “outsized” 50 basis point cut (2001 & 2007)?
What happens from here is anyone’s guess.
For most community banks, an easing cycle from the Federal Reserve is a welcome development.
The consensus is that falling short-term market interest rates will alleviate funding cost pressures and, ultimately, expand margins.
But there is way more to the story than what the above statement might indicate.
Admittedly, pressures on funding costs might abate. However, as we move forward the behavioral characteristics of the remainder of the balance sheet will rely on a more nuanced set of circumstances.
Accordingly, financial institutions must quickly pivot their balance sheet strategy as the FOMC (presumably) embarks on an easing cycle.
But first a qualifier: I would recommend taking a step back to fully understand what goes into the models that project your earnings levels. Are the assumptions still relevant? Are the stress scenarios pertinent, given market expectations? Do you really understand what the model is telling you — or not telling you?
At a minimum, before considering any of the forthcoming strategies in this article, the executive management team must thoroughly comprehend all facets of the models driving decision-making. There is no “one-size-fits-all” approach.
Several key themes require immediate attention from most institutions.
1. The Outlook for CD Pricing Demands Data-Driven Strategy
Having a data-driven strategy is critical. Often, bankers get caught waiting for their competition to make the first move. It’s a game of “liars poker” where no one wants to blink first. But is that the right approach?
Probably not.
Instead, institutions should leverage empirical data to support strategy, as opposed to simply pricing products to the “irrational” competition in local markets.
The reality is that a few disgruntled rate shoppers should not drive deposit strategy when the preponderance of the deposit base is acting differently. A data-driven strategy helps eliminate bias from pricing by creating parameters based on fact, not emotion.
Retention costs might be lower than you think. Certificate of deposit rates, which were commonly offered at 5% (or above), were already reduced prior to the FOMC September rate decision (see the table below). In fact, many institutions find that they are successfully retaining deposits even as they reduce rates below competition. At this point, do you really need to be at the “top of the market” to retain customers? Especially for those customers who might have rolled their former promotional CD with your bank multiple times through this cycle. (The table and later charts about CD rates and non-maturity deposits come from the universe of banks participating in the Deposits360°® database.)
Cross-Institution Deposit Rates Summary, August 2024
Source: Darling Consulting Group
Furthermore, institutions should re-think the terms they are offering, considering the market’s future expectations for interest rates. Allowing for faster rollover at lower rates may be beneficial in a falling rate environment, as it provides flexibility and lowers overall costs.
Consider the alternatives: Clearly, liquidity was the central concern for most financial institutions throughout the recent rising rate cycle. Fortunately, it appears as if the rate at which deposits were leaving the industry has slowed significantly.
For some, deposits may even be growing again (albeit slightly).
While many welcome this stabilization, the cost of retail liquidity remains elevated. Therefore, balance sheet managers should evaluate all options within the wholesale markets. And wholesale/brokered CD rates have quickly moved lower over the past several weeks. Given the continued inversion in the yield curve, some may opt to layer in some intermediate-term funding onto their balance sheet if the proper conditions exist within their business.
Read more: As Rates Decline, Deposit Costs Must Decline Also, Right? Think Again.
2. Will All Those Non-Maturity Balances Return?
Human behavior tends to repeat in rate cycles among bankers and consumers. Specifically, in 2007, the average community bank had a 60%/40% mix between non-maturity deposits (NMD) and CDs. That same ratio (pre-pandemic) had moved as high as 85% NMDs /15% CDs. (NMDs are deposits where the customer is free to withdraw their deposit at any time since there is no defined contractual maturity date.)
Perhaps the assumption of CDs universally migrating back into NMDs during this falling rate environment might be overestimated and that CD levels may, in fact, remain higher.
Some institutions are still seeing the mix of deposits continue to skew towards higher-rate CDs from non-maturity deposits. If you believe a maturing legacy 5% CD might venture back into a 1%-2% MMDA offering at your institution, is that a fair assumption and will deposits ultimately evaporate — especially if that deposit was “new” money to your organization and has no additional relationships?
Such fair-weather friends might move their money away from your bank once promotional deposit rates are reduced/retired.
What is the plan to stem that potential outflow?
On the other hand, is now the time to “grab nickels and dimes” from the NMD base? Some institutions are testing deposit elasticity by slightly reducing the return on select accounts that demonstrate less rate-sensitive behavior patterns.
Banks should ask themselves why these same customers haven’t left already. They have had several quarters to move their money to garner a 5% return, yet their balances may still be holding steady. Has the FOMC given banks “cover” to implement minor rate reductions across deposit accounts that meet these criteria?
Read more: Connection Over Competition: How Chief Deposit Officers Plan to Win Deposits
3. What to Do About Bank Term Funding Program Usage
In the wake of the FOMC 50 basis point rate cut, banks now need to consider retiring or substituting the legacy funding from the Bank Term Funding Program (BTFP). Ironically, for those cheering for the 50 basis point cut, this effectively ended the risk-free arbitrage that so many took advantage of.
For those institutions who still have the BTFP funding, although they still have a “free put option,” the cost of short-term borrowings is now relatively comparable.
For those who recently added term wholesale borrowings or brokered deposits to their balance sheet in preparation for their BTFP paydown (those who essentially put “arbitrage on top of arbitrage”), they also now must contemplate when to unwind these transactions. The carrying cost might impact earnings.
Finally, what is your institution’s plan for the collateral that was sent over to qualify for those funds? Does it make sense to keep it with the Federal Reserve? Or should it be repatriated to another venue as collateral versus future borrowings?
Read more: Is Your Bank Ready for the Coming Rate Rush?
4. Loan Repricing — and Refinancing — Must be Anticipated
Loan prepayments loom now that rates are being reduced again. Many banks that issued loans during the past 15-18 months at higher rates face the risk of prepayment as rates decline. Today’s consumers are acutely aware that the Fed has lowered rates.
Banks should quantify their potential risk of refinance activity by stratifying recent coupon levels on originations and ensuring that lenders responsible for those relationships are equipped to handle potential discussions.
How will your lenders react to requests to waive prepayment penalties? While not always enforced, banks may derive significant financial value from appropriately designed prepayment penalties. At a minimum, the lending team should be able to identify who might come knocking on the door. Have a predetermined strategy for rewriting the loan.
Read more: How Data Can Defend Against Deposit Attrition
5. Investment Portfolio Management Comes to the Fore Again
It’s always interesting to hear bankers’ perspectives on the investment markets. For example, approximately a year ago, when the 10-year Treasury hovered around 5%, it was rare to see bankers purchasing bonds. For some, liquidity was at a premium, and others were reeling from the impact of unrealized losses on their Tangible Capital Ratios. But there were also some who just thought rates were going to go higher.
Banks often hesitate to buy bonds when the yield curve is flat or inverted, and instead opt to wait for some level of steepening. However, it can be argued that some of the best bond purchases are made when there is little or no spread between long-term bonds and short-term rates. This typically occurs when the yield curve is inverted.
Bankers must remind themselves that, as in past cycles, long-term rates tend to move ahead of short-term rates. Waiting for the perfect time to buy bonds can result in missed opportunities, especially after significant rate increases.
Whether you deem the time right or wrong to buy bonds, it’s important to establish parameters for your portfolio to ensure internal biases don’t dictate strategy.
Furthermore, most banks have utilized their investment cashflows to cover deposit outflows and/or fund loan originations over the past two years. In some cases, the size of the portfolio is well below historical levels. Has the time come to reinvest future cashflows?
What Should Banks Really Be Wishing For?
Eleanor Roosevelt once said that “It takes as much energy to wish as it does to plan.”
As we write this, the futures markets project an additional 75 basis points of rate cuts by year-end. While neither the futures markets nor the Fed Dot Plot have the best track record, balance sheet managers must be prepared for all possibilities.
What ultimately happens to interest rates is really anyone’s guess (including the above two parties). However, having honest discussions about the discussions outlined above should help bankers plan out the best approach to a rapidly changing rate environment.
About the Author:
Vincent Clevenger is a managing director at Darling Consulting Group. He advises clients on balance sheet management strategies. He serves as co-host of the firm’s On the Balance Sheet podcast.