By Kent Musbach, senior vice president, and Marc Gall, vice president and asset/liability strategist, at BOK Financial Capital Markets
The Fed’s about face on interest rates has left management teams searching for a silver bullet to help improve profitability in 2023. Unfortunately, this abrupt change in policy has created a lack of easy choices. Limited mortgage origination income, accelerating cost of funds and deposit pressures from perceived industry turmoil is hitting net interest margins at an accelerated rate. While we eagerly await a more “normalized” rate environment, how do we balance the desire for current earnings versus the need for solid, longer-term earnings?
Rough Out 2024 Budget
The balance sheet for many institutions is tough to maneuver quickly, so now is the time to start considering what 2024 income (or margin) is likely to be. For instance, the state median for loan yields has increased from 4.40% in March 2022 to 5.16% in June 2023. The Fed has increased short-term rates by 5.25% during roughly that same time period. Putting in the work today and having a realistic understanding of a starting point for 2024 will help your management team and board have a baseline for starting those strategic conversations.
Deposits in Focus
Liquidity and deposit balances continue to be a challenge at many institutions—which is perhaps an understatement. Between the recent bank failures that have regulators focused on liquidity management and non-deposit competition from money market mutual funds and Treasury bills, deposit balances continue to slide for many.
We’ll offer a few questions to ponder: First, if interest rates fall by 100 or even 200 bps, how much will your institution realistically be able to cut interest expense given your overall realized deposit account cost increases thus far in the cycle? Second, what will it take to win back deposits lost in the recent disintermediation of deposits to T-Bills, CDs at online brokerages and money market funds?
Loan Rates Shifting Higher
Rising cost of funds and liquidity is beginning to increase loan yields versus the cost of funds. Today, we feel community bank management teams should be pausing and asking forward-looking questions, “Are we adding the right type of assets, quality and duration structure?” and “Are we truly pricing our loans and deposits properly for the optionality our customers may have in the future?”
Understanding your true IRR position is the first step to improving go forward earning
Because we are in this historically inverted yield curve, truly understanding the overall IRR of your bank is difficult. All of the ‘normal’ rate shocks that you run are parallel rate shocks. In other words, the + or – 200bps rate shock keeps the curve inverted. We recommend running a variety of non-parallel rate shocks including a steeper yield curve, with the front end of the curve lower in rate. This is what the current forward rates are forecasting.
Is it Time to Reset The Balance Sheet?
Many publicly traded banks have taken steps to improve go forward earnings by selling low yielding securities and doing some combination of reinvesting, paying off wholesale, funding loans, and/or holding cash. To make sense, these strategies should improve overall earnings versus doing nothing. With wholesale balances increasing, pressuring liquidity and cost of funds, it may be time to consider if 2023 is the year to partially reset the balance sheet for improved future performance.
Content Sponsored by BOK Financial Capital Markets, a WBA Gold Associate Member.