Don't Let Current Liquidity Be “the Tail that Wags the Dog!”

last updated on Wednesday, November 4, 2020 in Strategies

In September of 2020, we co-hosted a webinar with Darling Consulting Group entitled "Don't Let Current Liquidity Be 'the Tail that Wags the Dog!'”. This article, authored by Darling's Mark Haberland, recaps many of the topics covered in that webinar. (Request the recording and slides below)

It goes without saying that we are living in an unprecedented time, and the impact of COVID-19 is felt daily, both personally and professionally. While many of the business challenges we face are not new, the pandemic has certainly impacted the lenses through which all financial institutions must view and manage the core tenets of balance sheet risk management: liquidity, interest rate, and capital risks.

At times like these when uncertainty is accentuated, important decisions are too often made with an inappropriate focus on the short-term, rather than an eye on the future. Now is not the time to look for easy answers, a “quick fix,” or to do what “everybody else” is doing. Remember, there is no “rewind button,” and the long‐term impact of suboptimal decisions made today can be very difficult to overcome.

We entered 2020 expecting liquidity to be an issue that required our attention; however, concerns about the accelerating trends towards tightening industry liquidity were quickly replaced with anxieties about what to do with too much pandemic driven current liquidity. This reality was the catalyst for us partnering with our friends at the Federal Home Loan Bank of Des Moines to present a webinar at the end of September entitled, “Don’t Let Current Liquidity Be the Tail that Wags the Dog!’” The following highlights some of the key issues and strategies discussed during that webinar.

Importance of First Setting the Liquidity Management Stage

Our live survey reflected that 77% of the webinar attendees felt their liquidity management process needed improvement, and over 40% felt that the liquidity conversation needed to be more of a focus at ALCO. We were not surprised, and this was the reason we opened the webinar by reviewing the key elements of successful total liquidity management. Ensuring clear and meaningful liquidity analysis and discussion should be at the core of strategy conversations during ALCO meetings. It is imperative for setting the stage for effective balance sheet strategy.

In an environment where margin pressure is significant and the potential for elevated credit losses are mounting, expectations for net loan growth have dampened greatly for most institutions. Notwithstanding increased current on‐balance sheet liquidity, this highly uncertain environment elevates meaningful total operating and contingency liquidity management to an even more critical level of importance. And to make matters more challenging, consider the degree to which the unprecedented 2020 deposit surge continues to remain idling in cash equivalents with less than attractive opportunities to deploy. It is no surprise that the greatest concern among 73% of those who attended the webinar was the uncertainty of net deposit inflows and the excess cash on the balance sheet.

The pandemic has brought many issues to the forefront for ALCOs and boards today, and attendee financial institutions clearly stated that their key focus is on:

  • Deposit “surge” and uncertainty,
  • Cash buildup on the balance sheet, and
  • Taking effective action at ALCO

Deposit Uncertainty

The second quarter saw significant deposit growth throughout the industry, and it is not uncommon for the cost of these deposits that are currently residing in cash to exceed equivalent wholesale funding costs. For example, our Deposits360°® analytics suggests that the average MMDA rate is more than twice the current equivalent wholesale level. Now is the time to test the resiliency of your deposit base and your value proposition.

We are seeing financial institutions bringing deposit rates to historical lows and learning how inelastic deposits have become in this current environment. They are quickly realizing that the best risk‐return decision regarding current excess liquidity is to let it first be the catalyst for testing the resiliency of deposits, especially those for which rates exceed overnight investment returns. We believe an important related activity to cost of funds management is revisiting your current fee structures and policies, in general and relative to competition. Also, make sure you revisit your ECR (earnings credit rate) and the rates you pay on customer repos.

Also, to provide greater flexibility at lowering prospective CD costs, consider incenting depositors short by inverting and flattening your CD curve. If you are in need of longer‐term funding, CD strategies are inferior in many ways relative to accomplishing funding extensions with the use of basic derivatives, such as interest rate swaps and caps.

Cash Buildup on Balance Sheet

As mentioned earlier, many bankers are looking for the “quick fix” or easy answer to alleviate the significant buildup in cash and enhance yields, but doing so can result in unintended consequences. Out of habit, or in response to the multitude of emails in your inbox informing of “the perfect opportunity,” many will turn by default to bonds in search of higher returns in a market where security yields are at historic lows and uncertainties (risks) may very well be at all-time highs.

It is critically important to be very clear with your investment strategy and the risks you are willing to accept (nature and extent). There is no free lunch. Also, have candid conversations about unrealized loss potential. The industry will be filled with Monday Morning Quarterbacks when the tide turns. So, revisit your investment policy. There is a reason many are adjusting their policies, including authorities, in direct response to the pandemic environment.

A useful exercise is to ask yourself: if you were not sitting on excess funds today, would you borrow at FHLB Des Moines or take down brokered CDs to fund the very same security purchase? If the answer is no, then make sure you clearly document why you are electing to extend cash into an asset you really don’t want to own.

What about loans? Assuming comfort with credit risk, consider earmarking a pool of commercial loans for 7‐10 year fixed rate terms, with disciplined use of prepayment penalties. We find that the majority of financial institutions have balance sheet capacity for additional asset duration, and many can command premium pricing for longer term structures. With few exceptions, the worst‐case outcome for financial institutions is a sustained low or lower rate environment. The economic environment likely associated with higher interest rates would be very much welcomed by the banking industry, making the opportunity cost of lower rate loans an acceptable tradeoff.

Be prepared for lower loan rates ahead and/or tighter credit spreads, and examine opportunities for getting ahead of loans coming up for repricing/maturity by rewriting the loan sooner than later.

Also, consider offering medium‐term residential mortgage products for portfolio (e.g. 10‐12 years) targeted to borrowers looking to shorten the life of their loan rather than lower their payment. And revisit your secondary market vs. portfolio strategy to ensure that you have a productive conversation regarding the future vs. current income dynamics associated with earmarking a portion of selected loan production for portfolio, and thus 2021 earnings contribution. We are having very interesting and productive conversations on this single issue alone.

Taking Effective Action at ALCO

When it comes to managing your balance sheet and related strategy development, there is no one‐size‐fits‐all strategy. You must understand your risk profile, including exposures to changes in rates, and find the right balance with your organization’s risk tolerance. There will be some institutions for which keeping excess funds parked in cash is the right decision – at least for now.

For others, extending out on the curve may be the right strategy today. It is important to remain flexible to be able to adapt to the ever‐changing environment.

If something looks too good to be true, it probably is, and don’t manage your balance sheet based on where you think rates are going; rather, listen to your balance sheet and protect against your worst‐case scenario. During 2018, when everyone was certain rates were going to continue to rise, we were talking to our clients about protecting against their worst case – falling rates. Many balance sheets were positioned to perform very well if rates rose, but had material exposure to a sustained falling rate environment, and that was the perfect time to protect against rates down (whether on‐balance sheet or by incorporating derivatives into their risk management arsenal) – and it was the best strategic decision they could have made! Similarly, institutions exposed to rising rates were able to implement strategies that protected against rising rates, while retaining the ability to simultaneously hedge against an extreme low rate environment such as the one we find ourselves in today.

For some, a similar situation exists today in that it makes sense to understand opportunities to prudently protect their balance sheet against rising rates; even when it seems as if everyone feels rates are remaining low/lower for an extended period of time.

Remember, there is no such thing as a rewind button for your ALCO.

A Final Thought

Our industry has experienced a very sudden set of changes in circumstances, including risks and opportunities. If your conversations don’t sound extremely different at your ALCO meetings, I encourage you to change that, and soon. Effective ALCOs are meaningful profit centers for their institutions. The nature and dynamics of conversations and introspective questions at ALCO matter ‐ greatly. The COVID-19 pandemic has made a challenging environment even more unpredictable. And it is more critical than ever to be proactive rather than reactive…to have a more strategic focus at ALCO, consider the alternatives at your disposal, and do what is best for your balance sheet. Maintain flexibility, understand the impact your decisions have, and don’t do something you wouldn’t do under normal circumstances if it just doesn’t feel right.

We are passionate about balance sheet management and would welcome any discussions with you or your ALCO team. If you would like to discuss the thoughts noted above or additional issues facing your institution, feel free to reach out to Mark Haberland by email at mhaberland@darlingconsulting.com or by phone at 508.237.2473 and we would be happy to share our extensive experience with you. This is a challenging and unprecedented time, and you don’t need to go through it alone.

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