Publications & Resources
January/February 2009
Focus: Funding & Liquidity
Managing Liquidity in a Volatile Rate Environment
By Jeremy D. Taylor
Interest rate volatility is associated with the kind of
unstable macroeconomic conditions that have plagued the
In this environment, low-cost core deposits have become
even more valuable. Banks are competing not just with each other but also with
non-banks to attract and retain deposit funding. In previous rate cycles,
depositors have typically been less concerned with shopping around when rates
have fallen to current levels. But due to bank creditworthiness concerns and
related systemic issues, those dynamics have played out differently this time
around. Most banks are seeing stagnant or declining core deposit balances – even
lagging behind sluggish loan growth. To fund assets, therefore, as well as to
bolster available or contingent liquidity in a punitive market, banks are having
to place greater reliance on wholesale funding sources. FDIC data shows average
loan/deposit ratios for banks less than $1 billion in assets creeping up to 88%
from 78% four years ago.
Not only does wholesale funding represent higher-cost sources, but most of them
– FHLB and correspondent lines, Fed Funds purchased, repos, et al. – are also
generally the fastest to re-price as market rates (such as the Fed Funds rate)
change. That's fine in the falling rate environment of the past year, but
obviously not as we look beyond the current malaise to the next cyclical upswing
in rates – however far off that may be. And just as importantly, it introduces
an unwanted channel for further uncertainty and period-to-period variability in
bottom-line performance at a time when there are other such channels already
working overtime.
So, what's a banker to do? One fundamental problem, best avoided, is sustained
asset growth even as deposit growth eases. The loan/deposit ratio may seem like
only a crude measure of liquidity, but it remains a powerful one – and the 100%
ratio a meaningful threshold. As deposit growth stutters, therefore, don't
expect (and incent) your lenders to go full-bore. It's not just that a weaker
economy should signal rising credit-risk concerns. It's also the higher pricing
required to justify rising cost of funds if deposits aren't coming in to fund
the new assets. If you needed more reason to scrutinize new deals in a weakening
(and falling-rate) economy, there it is.
Pay attention to the interest rate risk (IRR) profile and how it's changing. IRR
is the product of two distinct things: a bank's asset/liability maturity
or re-pricing (mis)matching, and the degree of volatility and uncertainty in
interest rates. The greater that volatility, the stronger the case for a more
neutral, rate-insensitive balance sheet positioning. Most banks will stand to
lose as much from a 100 basis point (i.e., one percentage point) adverse rate
change as they would from the kind of credit losses that cause management and
board angst. And 100 basis point rate swings have not been extraordinary of
late.
Be mindful of rate risk when setting liability pricing strategy. This includes
not just the wholesale funding mix but also the resulting maturity
horizon. Whether it's jumbo CDs, CDARS, brokered CDs or the everyday retail
variety of CD, adjust their pricing to attract funding at the desired maturity
points. While venturing into wholesale funding at the very short end provides
both flexibility and, typically, lower pricing than longer maturities, step back
and look at the balance sheet's overall risk profile to assess whether, and how
much of, longer-term funding (e.g., longer-maturity CDs, term FHLB advances) may
be called for. While replacing lost deposits with wholesale sources can moderate
IRR by shortening the liability side to better match with typical asset-side
profile, it can also expose the bank to a less balanced asset/liability position
when deposit growth recovers – or when skittish lenders pull back their
wholesale funding.
Again, the key message is to manage asset growth very carefully in this
environment; new loans right now are likely to be much less valuable than new
deposits. There's a reason they call them “core” deposits. To the extent they're
relationship-based, they're likely to be stickier through the ups and downs of
the rate cycle. That low-cost stickiness is generally the largest source of
divergence between book value and market (or economic) value for a commercial
bank. Covet and pamper depositors now – as you do borrowers when times are
better.
Jeremy D.
Taylor is Director of Client Services for AuditOne, LLC (www.audit-one.com),
a California-based independent internal audit firm specializing in banks and
their service providers throughout the
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