What will our depositors do when rates rise?

The subject has been on the minds of bankers for years now. The continued extension of the Fed's easing policy through possibly 2016 has given us a sense of security. But this pro-longed period of low rates, burgeoning core deposits, and uncertainty about what our depositors will do next should keep us restless.

For those that rely on yield for returns, it has been a tough time. Retirees, insurance companies, and bank treasurers have found it difficult to earn money in fixed income. Some have been able to squeeze gains out of bonds as rates fluctuated downward, but the second quarter flip from an unrealized gain to an unrealized loss in bank investment portfolios brought reality home to treasurers.

I'm not certain what depositors will do when rates rise. But I analyzed what they did the last time the Fed raised Fed Funds Rates in mid 2004. On June 30, 2004, the Fed raised the Fed Funds rate from 1% to 1.25%. Over the next two years, the Fed raised rates 16 more times, ending at 5.25% on June 29, 2006 (see chart).

The last Fed action prior to the 2004 rate rise was June 2003, when the Fed Funds Rate stood at 1%. Surprisingly, bank cost of deposits at that time was 1.43%. Note that all deposit and cost of deposit data was for quarterly periods, where Fed Funds rates were on the date they were raised. But once the Fed started moving rates up, bank cost of deposits lagged the movement upward. When the Fed ended its tightening in June 2006 at 5.25%, bank cost of deposits was 2.68%, a significant spread.

What did depositors do during this period? They moved money from core accounts (all deposit accounts less time deposits and brokered deposits) to non-core, as shown in the chart below.

But not to the extent one might think. Yes, non-core deposits as a percent of total deposits grew from 32% in June 2004 to 38% in June 2006. But core deposits did not decline during that period, growing 8.3% during the two year span. But time & brokered deposits grew 48.7% during the same period.

By the time the Fed stopped tightening in the second quarter of 2006, core deposits represented. 61.8% of total deposits. Today, core deposits stand at 77.8%. So, if past is prologue, then we can anticipate that although our overall core deposit base may not decline, time deposits are sure to increase. 

This analysis reviewed what happened to FDIC insured deposits across the U.S. How that money will flow between institutions is a result of efforts made by financial institutions today to win the loyalty of customers once rates begin to rise. Will they stay with you, or go across the street? Is it in your hands, or the hands of fate?

~ Jeff

How stable are your deposits?

I am attending the Financial Managers' Society (FMS) Forum in Las Vegas this week. The Forum is chock full of education opportunities for banking finance professionals. One session caught my attention. The tandem speakers taught the audience about going "long", or at least longer, in their investment portfolio and minimizing risk.

One of the underlying assumptions in advising to "go long" was that core deposits were as stable today as they were four years ago. I challenge that thinking. Average balances per account among most core deposit categories have been growing and I think customers are parking their money waiting for greener pastures. When they arrive, what will they do with that money? I put this question to Dallas Wells, an asset-liability specialist from Asset Management Group in Kansas City. I have followed Dallas' writings on his informative blog for a while now and caught up with him at the Forum. Here is what he had to say.

What do you think will happen to core deposits once rates rise?

~ Jeff

Community Financial Institutions: Parking Lot for the Benjamins

The current market volatility has been with us for nearly three years. To resuscitate the economy, the Fed is doing everything possible to keep interest rates low through monetary policy. First dropping the Fed Funds rate to near zero, and most recently with Operation Twist designed to guide long-term rates even lower. The Euro Zone debt crisis and resulting lack of investment alternatives makes US Treasuries, as one economist put it, the "best house in a bad neighborhood".

This has kept investment options for community financial institutions at historic lows. Low loan demand further exasperates the challenge.

While investment options dwindle, FIs find themselves awash in cash. Market volatility and prolonged low bond yields is keeping investors on the sidelines. The sidelines, as it turns out, is in banks. This led to Bank of New York Mellon's decision in August to begin charging very large depositors fees for parking their money. There simply isn't any place for them to lay it off.

Community FIs are experiencing similar activity from their Main Street customers. From December 31, 2009 through June 30, 2011, deposits for all FDIC insured depositories increased 5.84%. But average deposits per money market account, according to my firm's peer database, increased 31% during that same period (see chart). Community FI customers are parking their money waiting for better, more certain times.

At first, senior managers of FIs felt good about the inflow. Loans from 2002 through 2007 generally grew faster than FIs' ability to fund them. This resulted in FIs turning to CD rate promotions, brokered CDs, and FHLB borrowings to bridge the funding gap. Deposit mixes became more expensive and less attractive.

But with loan demand at historic lows, FIs began running off their high-cost CDs and other so-called "hot money" to right-size their funding sources. This may have created a little hubris among senior managements, thinking it was the quality of their service and the value of their brand that attracted the core funding. But looking from a wider lens shows us it has been an industry phenomenon more than what any institution did on their own.

This is creating uncertainty with Treasurers across the landscape. What does the FI do with the money? How long will the money remain in the FI before migrating back to the market or the hottest CD promotion? With historically low re-investment rates, FIs are keeping the money highly liquid. FDIC insurance costs, on average, are 12 basis points on deposit balances. This, and the operating costs for maintaining the accounts, is resulting in some core deposit accounts actually being unprofitable... a highly unusual situation.

But this too shall pass. If FIs are pleased at their current mix of funding, perhaps they should take positive action to maintain it. Initiatives could include a disciplined onboarding program for new customers, and a timely calling program for existing ones. Your customers may certainly be parking their money at your FI, but they probably have money elsewhere too. If you demonstrate service beyond what they experience at their other FIs, perhaps you can win their loyalty, including their core deposit balances.

Alternatively, you could do nothing, stuff your vaults full of cash, and pray that customers stick with you. Hey, it's possible, just not probable.

What do you suggest FIs do to keep core deposit customers?

~ Jeff

Note: I will be part of a panel discussion at the Financial Managers Society (FMS) Philadelphia Chapter on Wednesday, November 9th to discuss liquidity, value, and profitability of core deposits.