Balance sheets, Asset/Liability Management, funding, liquidity and regulation have changed: it may be time to review your strategy. But changing strategy does not mean changing your institution—adapting strategies to the changing environment can better serve customers and preserve your institution’s ability to operate on your own terms. Afterall, a tree can change its leaves without changing its roots.
Two things happened in the last few years that haven’t occurred before in the lifetime of any financial institution manager reading this article: a global pandemic and the widespread use of mobile and online banking. Both events have changed the time-tested structures and rules for managing a depository and many institutions are faced with a call to evolve.
Balance sheets have changed.
In the last few years, balance sheets suddenly became liquid during the pandemic and then suddenly illiquid as rates skyrocketed. Security portfolios ballooned and institutions were stuck with large unrealized losses while wholesale funding worked to fill the gap. So, what should change in your company’s strategy? There are two items our team at Piper Sandler hears consistently from management teams: we don’t take losses on assets, and we don’t borrow wholesale money. Both comments should be under review in this updated world.
Funding & liquidity has changed.
Core deposits were put to the test as technology allows for quick withdraws and transfers, and the ability to shop nationwide rates and open an account takes place in five minutes from your phone. What’s the solution? Own more of your options. The depositor at every institution owns the option to withdraw money any time, and, other than CDs, without penalty. Your institution can be defunded quickly unless you own more options on the funding side—this typically means term CDs, wholesale borrowings, brokered CDs, or other term funding.
Additionally, your next dollar of funding could already exist on your balance sheet in the form of a security sale. Make no mistake—realizing a loss is not the scenario a manager hopes for, however, it could be the cheapest form of funding. Selling low yielding securities for liquidity allows you to reinvest in current, higher rates. Waiting for rates to come down so the losses are smaller means your reinvestment yield will also be lower. Companies executing loss-trades get their cash back in higher rate environments and can lock in new assets with those higher rates. Bear in mind—you are taking the loss either way—through a one-time realized loss on sale, or through your margin every day you own the securities. Choosing to take the loss when reinvestment rates are higher will support future earnings and provide cheaper liquidity.
Asset/Liability sensitivity has changed.
Historical rates left room to make money on spread. The last five quarters have squeezed the space between asset yields and funding costs, regardless of your A/L sensitivity. All the asset sensitive institutions turned out to be liability sensitive as deposit costs skyrocketed. So, are you asset or liability sensitive? The answer: neither and both—you’re just sensitive. Every rate move, up or down, impacts your institution, and whether you model asset or liability sensitive misses the point that protecting against volatility in both directions, is the only way to reduce broad sensitivity. A neutral A/L profile reduces overall sensitivity in both directions and mitigates overall volatility. Interest rate swaps allow managers to adjust their sensitivity and remove volatility and these swaps can be applied in either direction, depending on which side is overly sensitive.
Regulation has changed.
The failure of Silicon Valley Bank and others made waves in the regulatory community. Regulators have reacted and are now requiring more sources of funding, more testing of funding sources, and more policies and procedures to back it all up. Regulated institutions need to examine their options and be sure the results are varied and multitudinous. Telling a regulator that you fund with deposits doesn’t cut it; you must have many funding sources, policies for those sources, and ways to demonstrate testing of those sources. This includes collateral preparedness for the FHLB and Fed, and knowledge on how to issue brokered CDs. Some partner with Fin Tech deposit gathers or online listing services—all new sources should be explored—the regulators will be looking for them.
With all these changes to traditional depository activities, it’s time for managers to look at their institution and decide if they are ready for a new standard. Change can be good. Afterall, the most expensive words in business are “that’s the way we’ve always done it.”
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Ryan Smith is Managing Director at Piper Sandler in the Financial Services Group.
