Here at CenterState Bank, we specialize in Florida. Now, Florida has a lot of things going for it, but it has at least two major things going against it. One is an unspoken rule that if you own a bar or restaurant with an open-air patio, you have to have some guy impersonating Jimmy Buffett on a stool wearing a flowered shirt singing for tips. These guys are everywhere, and if you live here, it gets old. The other major drawback is that hunting for the highest rate on your deposits is a national pastime only eclipsed by baseball and trying to stay out of sinkholes.
Our state is tied with Nebraska as having the fifth highest cost of funds and most sensitive deposit customers. Everyone, and especially their mother, wants a higher rate on their deposit balances. This is why we not only find ourselves subconsciously humming Margaritaville but constantly worried about our cost of funds. At 0.19%, we rank in the top 15% of all banks and struggle to maintain that position- especially in light of the new challenge banks face.
Things Are Different
In the last several weeks, the palpable (and tangible) changes in the market have sent many banks scrambling to restructure their deposit strategy for 2017. Higher rates, higher growth expectations, and more attractive investment alternatives have forced banks to relook at their assumptions and their approach for the next year. Some banks are rolling out new products, some are taking another look at pricing, some are changing their customer segment focus and still others are altering their strategy altogether. In this article, we look at the challenges that banks face in keeping ahold of these so-called “surge balances,” quantify the impact going forward and then look at various tactics that banks are using. At the end of this article, we also offer to train our models on any bank that is interested in seeing how their bank’s cost of funds, margins, and ROE may be impacted by rates and deposit balance sensitivity.
The Reality of Surge Balances
After 2008, banking saw an unprecedented amount of new funds flow into our deposit system as households and corporations moved funds out of equities and other investments and into cash. Since then, deposits have continued to build (graphic below) and now, some banks, such as JP Morgan, are preparing for the fact that we could lose $1 trillion from the banking system.
We are starting to see signs of this, as for the past two months, we have seen a change in customer sentiment and a higher than normal outflow of deposits. Other banks report the same. Fixed income managers, such as DoubleLine reported $1.4B of outflow from their main bond fund, the third largest withdrawal since 2003. Only the taper-tantrum months of September and December of 2013 saw more money leaving their complex. Thomson Reuters Lipper is a macro-fund group that we monitor for advanced signs of money movement, and their last report shows net outflows of $17.5B with their money market mutual funds. We are not sure the extent that balances could run off, but we are confident that we have seen the nadir of the cost of funds trend as illustrated below.
From here, we could not only see higher rates, but balances run off as well resulting in a sharp increase in the cost of funds for banks.
Cost of Funds Projections
Banks can regress their historical cost of funds correlation on the futures market to understand what their lag or time sensitivity is to higher rates and to see what funding is expected to do. Here, you can see what the forward curve looks like for our cost of funds here at CenterState Bank.
As can be seen, we lag the market by about six months, but even with one of the lowest cost of funds in the industry and one of the lowest sensitivities we are still expected to feel the brunt of higher rates and more interest rate sensitive deposits.
Impact On Net Interest Margin
Of course, the extent that rising rates and interest rate sensitive deposits hurt your bank is largely driven by two factors: A) The rate sensitivity of your customers, and B) The structure of your balance sheet. Banks that have been training their customers with rate or have gone after rate-sensitive customers such as municipalities will find their deposit base is highly reactive to rates. Further, banks with rate sensitive products such as certificate of deposits, high yield money market accounts or high-interest checking will find that their bank’s beta or correlation to interest rates approaches 100%.
Add to a high deposit beta an asset structure that is interest rate sensitive due to longer term fixed rate loans, a high duration investment portfolio and loans off a Prime index, and the bank’s interest rate sensitivity will manifest itself into lower net interest margins.
By way of example, at CenterState, we have been as careful as we can on how we structure both deposits and loans and even our net interest margin is expected to decrease due to higher rates (below). This is the exact opposite of what many bankers, analyst, and pundits expect. Many assume that higher interest rates will translate into higher profits and, unfortunately, it is not as simple as that. Few are taking into account balance sheet structure, customer composition, and product design.
Putting This Into Action
If you would like to see what a forward-looking view of your bank looks like, drop us an email and we would be happy to run your historic correlation to interest rate changes, regress that against future rates and then look at how your loans and deposits will perform together over the next several years.
In Part II, later this week, we will look at a couple of examples of banks that came up with creative solutions to mitigate some of this interest rate risk and help keep potential surge balances from leaving the bank. Until then, we will leave you with some bad Jimmy Buffet lyrics sung by one of those faux-Buffetts that only serves to further drive up our cost of funds…
"I've got quarters in my loafers tryin' to fight inflation when it only used to take a cent. Sometimes I wish I was back in my crash-pad days, 'fore I knew what cash flow meant."
Submitted by Chris Nichols on December 05, 2016