by McQueen Financial Advisors

The Federal Reserve Bank has significantly raised interest rates in a decisive move to combat inflation. These moves have resulted in lower investment values and decreased market liquidity. The timing of a pivot point and lower rates is unknown, although it is widely believed that the Fed will start cutting the Fed Funds rate sometime in mid to late 2024. Our client discussions frequently revolve around shifts in consumer behavior, increased charge-offs, declining investment values and liquidity stress. These issues have also prompted heightened attention from regulators and examiners. We would like to share our experience and suggest some action steps that can be taken now.

Field Experience
Our advisors regularly receive feedback from clients nationwide regarding their stress points, concerns, and examiner comments. Additionally, we assess unrealized portfolio losses, liquidity stress, and interest rate risk for hundreds of clients, providing us with a distinctive industry-wide viewpoint. We have observed a definitive change that began in 2022 and has persisted, with liquidity being affected by several factors:

• Unrealized Portfolio Losses: An influx of deposits, following pandemic-related stimulus programs, led to substantial growth in investment portfolios. Our recommendation was to keep portfolios short. However, many institutions invested in longer-term securities with maturities of 5 years or more. As interest rates rose dramatically, bond values have turned negative. The Federal Reserve has indicated a commitment to maintaining current rates until inflation is controlled. Inflation has been slowly trending towards the Fed’s target rate of 2.00%.  
• Deposit Run-Off: Throughout 2022 and most of 2023, industry-wide deposit balances declined for the first time in years. Total deposits have declined for 6 consecutive quarters. In the most recent 2 quarters, Interest-bearing deposits increased, while noninterest-bearing deposits fell.
• Loan Demand: Some of our clients have experienced significant loan demand. Industry-wide, loan growth has been positive for several quarters and is widely distributed across all major segments. 
• Borrowing: Financial institutions under liquidity stress are likely to resort to wholesale funding before selling securities at a loss. Borrowing has become increasingly prevalent, even among institutions with moderate loan-to-deposit ratios.
• Core Deposit Funding Costs: Core nonmaturity deposits are the primary funding source for many financial institutions. When interest rates are extremely low, term deposits usually account for less than 10% of total funding. However, as interest rates climbed in 2022, depositors began moving from money market accounts to CDs. This drives up funding costs but doesn’t always bring in new money. Initially, most of our clients did not raise deposit rates significantly in response to the Federal Reserve's rate increases. However, as rates continued to climb, almost all clients raised their non-maturity deposit rates and CD rates. For most clients, overall funding costs have doubled over the past 2 years.

Higher Rates & Margin
There is a widespread belief that when the Federal Reserve raises rates, margins will also increase. This theory suggests that deposits at financial institutions are "sticky" and maintained for reasons other than interest rates, such as convenience, direct deposit, borrowing relationships, or ease of bill pay. Historically, it has not been necessary to match an increase in the Federal Funds rate to retain local core deposits. We witnessed ample evidence of this in 2022, when most of our clients increased nonmaturity deposit rates by little or nothing in response to a 400-basis point rise in the Fed Funds rate. Concurrently, investment and loan yields increased, resulting in higher margins. However, while this correlation may hold true for certain market cycles and institutions, it is too simplistic and may overlook more complex conditions that exist now.

The Incremental Cost of Borrowing
Financial institutions with a moderate or high loan-to-deposit ratio are increasingly finding themselves in a borrowing position due to a combination of factors, such as simultaneous loan growth and deposit run-off. In the past, institutions would sell investments to fund loan growth, but now it is more common to borrow instead of selling bonds at a loss. Borrowing costs are high across the board and it is no longer feasible to borrow short and lend long, as the spread is inadequate.

Impact of Borrowing to Fund Loan Growth
Let's consider a hypothetical scenario to illustrate the impact of borrowing to fund loan growth. Imagine there's an institution looking to expand its loan portfolio annually by 10%. To achieve this, the institution borrows funds at a rate that is approximately 2.00% less than the loan rate, but often double the rate of their current cost of funds. Using our 24/7 On Demand ALM Simulation Tool, we can quickly gauge the impact of this strategy. The purpose of this simulation is to highlight the potential benefits and risks associated with borrowing for the sole purpose of growth. While the simulation would have a modest positive impact on the bottom line, it's essential to acknowledge the inherent risk involved in this strategy. Some of the new loans may not perform well or could result in losses. Depending on the type of loans, the institution may need to set aside a CECL reserve to account for potential losses, which can be significant.

Institution Size & Deposit Type
The discussion thus far has centered on financial institutions experiencing loan growth, deposit run-off, or unrealized losses in their investment portfolios. In many instances, all three factors are present. However, smaller institutions with higher concentrations of core local deposits and slower loan growth are more likely to avoid costly borrowing. On the other hand, larger institutions, particularly those that traditionally borrow, have already experienced a steep increase in funding costs. In some cases, funding costs rose rapidly, catching many off-guard since it was not anticipated that the Federal Reserve would raise rates as quickly.

Action Items
For many years, liquidity stress was not a top concern. Recently, the need for liquidity has been changing, and the cost of funding is on the rise, particularly for institutions that need to borrow. To address these challenges, we recommend the following action items as funding needs change over time.

We suggest the following:

• Discuss and carefully balance the potential benefits of loan growth with the cost of funding that growth.
• It's important to thoroughly consider all options, including the option of slower loan growth, as it may be a more prudent strategy in some cases.
• Review the true yield and costs of indirect loan programs and loan participation. These programs allow institutions to diversify their loan portfolios, potentially increasing overall profitability. However, these programs also come with potential risks. Institutions must thoroughly evaluate the creditworthiness of the borrowers and the potential risks associated with the loans. There may also be additional costs associated with due diligence and monitoring.
• A rise in interest rates can lead to higher borrowing costs, which may decrease borrowing and slow down economic growth in the short run. However, in the long run, it may result in slower inflation and a more sustainable and stronger economy. It is important to note that during the short run, higher delinquency and charge-offs may be observed.
• Consider evaluating the costs of all available funding options, even if they have not been utilized in the past. It may be beneficial to explore options such as brokered deposits, which could potentially be a less expensive funding source.
• Carefully consider structured borrowing options and the associated interest rate risk.
• Focus on improving deposit gathering strategies to increase the availability of low-cost funding.
• Inquire about McQueen’s Liquidity Stress Testing report, which identifies ‘normal’ liquidity needs, then applies moderate and severe stress over a wide range of scenarios and time periods. This service is available on our web-app. Scenarios can be run in a matter of minutes.
• Use McQueen’s 24/7 On Demand ALM Simulator to quickly run what-if scenarios related to deposit run-off, loan growth, new borrowings or other scenarios.
• Talk to us about investment portfolio options in the current rate environment. Often, bond yields are higher than net loan yields.
• We encourage you to talk to your McQueen advisor about your specific balance sheet structure and needs.