That was then…this is now.

The concluding wave of the longest business cycle in US history has brought changes for financial institutions when it comes to liquidity.  Just less than 12 months ago, the economy was moving along fine with low unemployment, growing productivity, strong consumer spending and overall business growth.  The community financial industry looked equally strong with attractive net interest margins and growing loan demand.  Funding future growth was becoming a key focus area for management as well as regulators.

Recently, we have seen a 180-degree turn in both the economy, interest rates and health of community financial institutions’ liquidity positions.  The economy began showing signs of slowing in early 2020 and came to an abrupt stop following the COVID-19 outbreak.  GDP dropped precipitously in the first half of the year with unemployment rate reaching a post World War II high by April.  The Fed urgently responded with various monetary policy measures pushing Fed Funds, Treasury and mortgage rates to record lows.  At the same time, several rounds of stimulus programs flooded financial institutions with extra cash.

First, let us explore how and why financial institutions were surprised by the changes in liquidity position and how these changes have impacted profitability.  Then we will discuss various solutions institutions should consider now to reduce excess on balance sheet liquidity and to focus on strategies to improve profitability.

Short-term Cash Management

If you are like most financial institutions, funds management is getting a bit more attention lately.  There are two reasons for this increased attention:

1. Low rates.  Zero Fed Funds rate policy has anchored the yield curve, and the Fed’s messaging/Fed Dot Plot indicate low rates will remain for an extended timeframe.  Consequently, institutions with excess liquidity invested overnight are experiencing cash drag and margin compression.
   
   
2. Liquidity Flood.  Cash has been accumulating at an alarming rate.  Financial institutions are getting both expected and unexpected cashflow from a variety of sources:
   
   A. Resurgence of Deposits.  A combination of Federal CARES Act stimulus programs, PPP funds on deposit, and reduced discretionary spending have swelled deposit balances for most institutions.  With ongoing discussions of additional stimulus programs and potential for further government restrictions on economic activity with COVID case counts rising, deposit growth may continue. 
   
   B. Loan Prepayments/Demand.  Many loan officers remain busy, but many project flat to declining loan footings through year-end.  Much of the loan activity likely stems from a surge in residential mortgage refinancing and increasing rate modification requests from prime commercial borrowers.  In fact, new non-PPP commercial loan demand has fallen below original projections with the slower economy and increased competition for a shrinking amount of high-quality loans.  If you can’t lend excess liquidity, you have to invest it.
   
   C. Expected PPP loan forgiveness.  Mechanics of the process are still being finalized.  However, institutions that self-funded PPP loans should prepare for reduced loan balances and increased cash resulting from SBA forgiveness.
   
   D. Prepayments and Bond Calls in the Investment Portfolio.  Increased prepayment activity has occurred during most of the year.  With mortgage rates likely to dip lower, prepayment speeds are not likely to decrease any time soon. Call options exercisable in the next several months are another source of reinvestment cash flow. 
   

Declining Net Interest Margins

1. Overnight Cash.  Fed Funds rate is down 225 bps in just over a year, which can be a significant hit to earnings for institutions carrying excess liquidity in cash.
   
   
2. Loan Portfolio.  Institutions are facing loan yield pressure from rate competition for new loans, existing adjustable and variable rate loans repricing lower, and rate modification requests from current customers.
   
   
3. Investment Portfolio.  Yields are being impacted by cash flow reinvestment in in a lower yield environment.  Portfolios with higher allocations in callable agencies and residential mortgage-related products are seeing faster yield compression due to increased call and prepayment activity.  Staying too short on the curve is also hurting returns due to tighter spreads and sub-optimal relative value.
   
   
4. Funding Cost.  Non-maturity deposits remain close to historical lows; however, time deposits will take more time to recycle and realize cost of fund reductions.
   

Taylor Advisors Take

Staying in cash is most expensive it has been since 2009-2015 timeframe when Fed Funds Rate stayed at 0.25%.  Therefore, the importance of liquidity planning should be getting attention from management teams as it can be very costly.  Once an appropriate level of overnight liquidity has been determined, what are some of the options a financial institution should consider to help reduce the excess cash?

1. High cost wholesale borrowing on the books.  Analyze prepayment penalties and borrowing terms to evaluate whether to pre-pay high cost funding is economically feasible.  Often, the economic incentive to pre-pay has been eliminated with stiff prepayment penalties.  As an alternative, think about investing the cash flow in short- to mid-term securities to defease high cost borrowings.
   
   
2. Deposit pricing.  Aggressively price CDs downward in line with wholesale funding alternatives to move rate sensitive non-core deposits off of the balance sheet.
   
   
3. Invest. Customize an investment strategy that fits your asset/liability profile.  Consider pre-investing cash flow while taking steps to reduce optionality in your balance sheet.
   

Liquidity assessment and management is the linchpin for risk and earnings management.  As interest rates and balance sheets change, so should your strategy/plan.  Taylor Advisors helps executives by providing strategies and tools to effectively measure, manage and stress test liquidity.  Here are additional resources if you would like to read a liquidity success story or ask us a question about your liquidity process and how we might be of some help.