By Kent Musbach and Marc Gall
Recent banking industry situations have refocused attention on liquidity’s importance. Rising interest rates, volatile markets, and depositor diversification are but a few of the causes for concern.
Accordingly, banks must act more strategically than ever in how they evaluate, access, and deploy liquidity when facing economic uncertainty. An overarching concern is how these strategies may change if interest rates pivot and decline, as analysts and the Treasury yield curve are forecasting for later this year.
Maximizing Available Liquidity
The first step in liquidity planning is assessing current and potential availability. With input from both the deposit and lending side, a simple sources and uses document can chart out the bank’s current position.
From there, identify current contingent sources of funding. These may include the Fed discount window, Fed Bank Term Funding Program (BFTP), Fed funds lines and the Federal Home Loan Bank. Within these sources, some may require collateralization. Consider rearranging the collateral pledged to each entity to maximize coverage.
Collateral-free options, such as brokered CDs, may merit consideration even at a slightly higher current cost to preserve other borrowing lines. Taking losses in the investment portfolio or repositioning these assets for higher income in 2023 and beyond can also be considered.
Short-Term Gain, Long-Term Pain?
The inverted yield curve presents unique challenges to managing net interest margin. In the face of falling margins, bank managers may be enticed to find ways to maximize earnings in the short term that could be detrimental to longer-term performance. This may mean adding more optionality or credit risk to the balance sheet.
Attempting to maximize earnings in this environment may lead to earnings issues if the market is correct and rates fall, resulting in a positive sloping yield curve. For example, purchasing callable agencies that would likely be called if rates fall, or making a substantial amount of floating rate loans without floors, would negatively impact margin if the market and analysts are correct about the downward direction of rates.
Within the investment portfolio, callable agencies have very high yields. While attractive for this year, should rates fall, the bond is likely called and returns cash to reinvest in a lower-rate environment. Stretching credit standards in the loan portfolio to book higher yields could also spell trouble. The inverted yield curve has traditionally forecasted a downturn in the economy. With that in mind, compromising on standards late in a credit cycle could result in unwanted troubled assets if the economy turns.
Loan Pricing Considerations
Given the stress on the banking system and the drive to have liquidity on the balance sheet, banks may be reluctant to extend credit. Banks can be pickier—and may have more pricing power than they think. In national Federal Reserve survey, large banks are tightening their lending standards and increasing credit spreads, which should reflect three types of risk—credit, optionality and liquidity — and each has value. Bank earnings are at risk when rates fall and prepayment penalties aren’t included in loans. Their choices then will be to refinance and lose income or lose the customer to a competitor.
Be sure to consider prepayment penalties, which some bankers disavow, but are actually quite common. When rates are high, the option for a customer to refinance a loan has tremendous value. Without prepayment penalties, institutions may be forgoing higher income should rates fall and the loan refinances.
Today, community bank management teams should be asking, “Are we pricing our loans and deposits properly?”
Liquidity is the lifeblood of any financial institution, but with lower interest rates an eventuality, banks must be strategic and intentional to maintain your income streams, liquidity and customer relationships.
Musbach is senior vice president and Gall is vice president and asset/liability strategist for BOK Financial Capital Markets. Content Sponsored by BOK Financial Capital Markets, a WBA Gold Associate Member.