Liquidity and the Cost of Fuel
February 12, 2020
5 minute read – Liquidity is still tight for many institutions, and is likely to continue to remain an important issue going forward. If you imagine your institution’s lending machine as a jet airplane, liquidity could represent the fuel needed to keep your institution’s engines running. And when it comes to fuel, the type really matters, not just from an earnings perspective, but from a risk perspective as well.
Liquidity Costs and ALM Modeling
The source of liquidity can materially impact earnings as well as your institution’s risk profile. In Example A, a $600M institution evaluated several different what-ifs scenarios. Each what-if tested about 5% of assets, or a $30M shift in funding. Note that additional transfers from lower cost funding was included in the scenarios that evaluated CD strategies. Like many places, this institution has seen transfers increasing and wanted to make sure that was factored in.
If reducing interest rate risk is the key driver, then adding longer-term borrowings was the most favorable option in a +300 rate change.
If ROA is the key driver across a narrow band of rates (+/-100bps), then funding loan growth through the run-off of less profitable assets created the most favorable results. Working through a process that identifies key decision drivers, then testing various options helps create clarity before decisions are made.
Going a step further, it’s important that decision-makers not only understand the risk/return, but also are looking at these decisions holistically, making sure other relevant operational and strategic questions are being answered.
For example, if borrowings were utilized, how does this impact the amount of available credit remaining and would you still have sufficient lines of credit in the event of an unexpected liquidity event? If you are looking to sell assets, are those loans or investments used as collateral to secure lines of credit? Liquidity risk management conducted in siloes can stifle opportunity and blindside managements and boards.
Thinking Strategically About your Fuel
Another long-term liquidity consideration is where future deposits will come from? Having to rely on “hot money” such as CDs can be an expensive and rate sensitive source of funding. Consider:
- What are your sources of new customers? If many of your new customers are coming through the indirect channel, how likely are they to bring deposits?
- What types of deposit accounts are new customers bringing to the institution? Is it Savings, Checking, CDs? The type of funding can make a material difference in terms of cost, potential risks, and how sticky they may be.
- What is the age of your existing and new customers? If much of your growth is coming from younger people, for example, less than 25 years old, they may not bring much liquidity to the table.
- In addition, who holds your deposits today?
In Example B, customers in their 60s, 70s and 80s represent about 22% of this institution’s total customer base. However, their average deposit balances represent 62% of total deposits. You can follow the red line in the graph to compare average deposit balances between the older customers and someone under 30. In fact, for this institution it would take about 27 customers under 30 to replace 1 over the age of 60. If you take that analysis a step further, what could it look like if 100 customers over the age of 60 left over the course of a year? It would take 2,700 customers under 30 to replace that funding! Consider what the operational and strategic implications of that could be.
Using Data to Tackle Problems and Uncover Opportunities
This institution had concerns given what the demographic data revealed, and chose to tackle this challenge through a multifaceted approach. One of the actions was to analyze where and why their largest savers moved their money, either within the institution or somewhere else.
With that data they were able to find some ways to retain and re-engage some of the customers who are providing much of the institution’s fuel/liquidity.
They also looked at how new customers were acquired. Process improvement helped drive a faster and more efficient onboarding and service process, which allowed the institution to become a more attractive choice to people across all age groups. This in turn has helped to add some larger balance customers while beginning to fill out the pipeline of younger people who could become savers down the road.
What Else is on the Horizon?
Consumer preferences continue to evolve. However, there is no reason that financial institutions can’t become as strong at deposit gathering as they have been at making loans. For some institutions it may take a shift in mindset, and a willingness to prioritize deposit acquisition as a strategic initiative.
In addition, creating reliable sources of funding in this environment requires organizational focus and alignment from key stakeholders. This means that everyone from the CEO to the front line staff buy in to the importance of acquiring and maintaining reliable funding. Finally, as outlined above, the effective utilization of customer data, trends, and behavior patterns can help create a clearer picture of liquidity challenges and opportunities.