By Jim Ropella, Consultant & Retired CFO
In the financial services industry, a lack of liquidity will harm profitability and possibly destroy your bank’s long-term outlook. Liquidity, no matter how you calculate it, can be unpredictable. We all strive to make our funding sources as reliable as possible, which is why we covet core deposits. The current economic environment has provided an onslaught of deposits and, without loan growth, an unprecedented rush of liquidity. As a leader of your financial institution, some of these situations may sound familiar to you:
- Your Board Meeting topic of discussion is the greater-than-normal amount of liquidity on your balance sheet just sitting there earning nearly nothing.
- This new and extraordinary situation of excess liquidity prompts a variety of opinions about how it came about and how long it will last, making it difficult to come to a consensus about what to do with it.
- Your liquidity debate centers on how much liquidity your institution needs and how much is too much.
- Your excess liquidity, if any, needs to be deployed safely and with purpose to maximize profitability.
If you’re experiencing one or more of these situations, a thoughtful contingency funding plan will guide you and assist you in finding a solution for your financial institution.
During my banking career, especially as the Chief Financial Officer for a community bank, I was always concerned about liquidity. You know the drill, “How are we going to fund the loan pipeline without paying too much for the deposits we need?” I don’t recall a time when my concern was the outsized amount of the liquidity on the balance sheet and trying to determine what to do with it. If you are like me, you really don’t like letting it sit in a correspondent account earning 10 basis points while your cost of funds is 25 basis points higher.
First, it’s important to better define the problem, making sure we know which problem exists. Gather the opinions of your Board members, senior staff members, and client-facing team members, each of whom may reveal how this issue came about. The answers are likely unique to your institution, based on the economic impact of the coronavirus pandemic in your footprint. Some of the explanations may include:
- Business loan demand is down. “Business is slow, and the future is uncertain, therefore for the foreseeable future I am not borrowing more money.”
- Business deposits are up. “My sales activity is up because no one is spending money on vacations and they are using their available cash to improve their home.”
- Consumer deposits are up. “It took a while, but the individual stimulus money came in and has never really left.” -or- “I was fortunate to keep my job. The future is unknown, so I am going to save more money instead of spending it or investing in the stock market.”
Likely all their comments reflect your balance sheet. No one reason is responsible for all the increase. Similarly, no one reason will account for the move back toward your new level of liquidity.
Next, I challenge you to consider the possibility that your increase may be tied to your deposit pricing. If you haven’t lost deposits due to rate competition, you just may be the financial institution everyone else is complaining about. This is the time where local independent institutions need to establish themselves as a trusted partner in their communities. Before you address the issue of too much liquidity, let me get right to the point: pay a fair rate for deposits and wave goodbye to rate shoppers. I think you will find a greater majority of your clients will work with you rather than take their money elsewhere.
Now that you have a baseline, take a critical look at your contingency funding plan. This plan should be a working document that is valuable, helping to manage through business cycles. Key components of this plan are the stress test scenarios, which should reflect the downside of the current environment. Is the liquidity necessary to survive the potential downside of the current environment? Consider adding more adverse scenarios to your liquidity stress testing, such as:
- effects due to the coronavirus pandemic
- supply chains dry up and businesses start to close their doors, increasing unemployment
- use of previously unused commercial lines of credit begin to increase
- business deposit balances decline because of cash flow problems
- consumers reduce their balances because unemployment benefits are insufficient over the long run.
Analyzing your stress scenarios helps you ensure enough liquidity and when it’s needed to decide, “What do I do with my liquidity in this situation?” Whatever the new normal ends up looking like, your analysis will help ensure the ongoing success of your financial institution.
The Bank Consulting team at First Business can help you manage excess liquidity at your bank, creating a Contingency Funding Plan that works with Asset Liability Management and your investment portfolio. Contact us to get started.Contact Us