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Throughout the first half of 2022, many institutions have seen liquidity tighten due to increased loan demand and slower deposit growth. This has caused depository leaders to look for alternative ways to fund their balance sheet growth.
The first step in liquidity management is determining the appropriate level of on-balance sheet liquidity necessary for daily business functions. One critical ratio to utilize is the Liquidity Coverage Ratio, which measures the institution’s ability to meet short-term financial obligations given current liquid assets. The calculation is measured as High-Quality Liquid Assets, which are assets that can quickly and easily be converted into cash, divided by the net cash outflow over the next 30 days. Typically, 100% is the minimum requirement for this ratio, and many manage to 125%. Since High-Quality Liquid Assets includes not just cash accounts but also the stored liquidity in a high-quality investment portfolio, you may be surprised by how little cash you need on hand for day-to-day liquidity management at a target threshold of 100-125%.
Consider Potential Funding Sources Carefully
After assessing the liquidity position and determining if cash is needed, it’s important to closely evaluate the cost of each funding source and choose the cheapest option. Many institutions identify their primary core liquidity source as deposit funding raised via strategies such as deposit pricing specials or core deposit rate changes, or sales from their securities portfolio. However, other non-deposit funding sources like the FHLB or capital markets alternatives, such as repurchase agreements and Agency MBS dollar rolls, should also be considered as strategic funding solutions and not simply reserved for unanticipated liquidity needs.
Should You Raise Deposit Rates?
Raising deposit rates to thwart deposit runoff and/or promote growth is typically one of the first choices for financial institutions but can be costly. The marginal cost to save or grow deposits can be very high since the institution must reprice the entire existing base to a higher rate intended to attract or retain a smaller percentage of overall funding. Take for example this scenario: Institution A has $100MM in interest bearing DDA balances paying a rate of 5 basis points. In order to gain $5mm in new deposits, they raise the rate to 15 basis points. The actual cost of the new funding includes the $100k cost of increasing the rate on the existing accounts by 10 basis points plus the interest expense of $7.5k on new balances, which equates to a total marginal funding cost of 2.15% for $5mm in deposit growth. This is the cost that should be compared to alternative funding sources when determining the most cost-effective liquidity option.
Should You Sell Investments?
The other primary way we have seen institutions raise liquidity so far in 2022 is through asset sales, primarily from the investment portfolio. One of the main benefits of raising liquidity through asset sales is it does not add additional leverage to the balance sheet. Unfortunately, throughout 2022 interest rates and spreads have risen substantially and, with market volatility at historically high levels, unrealized losses in available for sale securities portfolios have increased. This can make some asset sales hard to stomach because the institution is realizing the loss and eroding capital. Another pitfall with increased market volatility is wider bid/ask spreads, making selling investments typically one of the more expensive options for liquidity.
However, selling assets at an accounting loss is not inherently bad if they are reinvested into wider spreading assets. One way to evaluate if it makes sense to realize the loss is to use a breakeven analysis comparing the loss of the investment sale to the market yield on the new asset added. This will highlight how long it will take for the institution to earn their way out of the loss position. Similar to the marginal cost of funds analysis for deposits, when selling securities to meet a liquidity need, the market yield of the securities sold becomes the effective funding rate that is compared against other funding options.
Borrowing to Meet Marginal Liquidity Needs
Assuming adequate leverage capital, utilizing wholesale and term funding to meet marginal liquidity needs should also be considered. Examples include FHLB advances, repurchase (repo) agreements, Agency MBS dollar rolls, and brokered deposits. All of these are non-core funding sources that should be evaluated in a similar manner, attempting to minimize the cost of the funding relative to a consistent market benchmark (i.e., 5-year FHLB borrowing vs a 5-year pay-fixed swap or 5-yr Treasury).
One unique strategy is the use of CD specials in attempt to retain existing core deposits at risk of leaving. This approach could also be a more targeted alternative to the broad-based increase of deposit rates discussed above yet introduces the additional risk of deposit cannibalization if “new money only” parameters are not established. Regardless, any CD specials targeting new funds should be evaluated in a similar spread-based framework as the other wholesale funding options listed above.
Are You Pricing that Loan Correctly?
When evaluating the cost of varying funding sources, it is equally important to evaluate the asset being funded. Since there is a finite amount of room on the balance sheet to add assets, if an institution is selling one asset to fund another, it is crucial to understand the opportunity cost of the swap. For example, let’s say institution A is running an auto loan special at 4% to help increase loan demand. To fund the loan growth, they need to sell investments and choose floating securities with a current market yield of 2.39% to limit the realized loss at sale. Solely looking at the two yields, it appears that the auto loan is the better option and is an appropriate swap. However, it is important to look at both assets in a Risk-Adjusted Return on Capital (RAROC) framework (Exhibit 2).
This accounts for the elements of risk associated within each asset and allows for a more even comparison. For example, the auto loan has a higher market value sensitivity to changes in interest rates (aka. duration) and increased exposure to credit risk, whereas the monthly-floating agency investment has minimal exposure to either of these risks. When looking at the two assets in a risk-adjusted framework, assuming 25 basis points for servicing and credit costs and 100 basis points in dealer fees on the auto loan, the auto loan has a return on equity (ROE) of 4.13% while the floating investment has an ROE of 27.66%. When accounting for all risk-based costs and the capital requirements of each asset type, there is a greater economic benefit to keeping the floater than swapping it for the auto loan.
Will You Be Able to Sell that Loan In the Future?
In the previous example, not only does the auto loan generate a lower ROE, but it’s also more difficult to liquidate in the event of a liquidity crisis since it was mispriced to market requirements for risk-adjusted compensation. If loans added to the balance sheet are not priced accurately to market expectations, they are more difficult to sell and could incur greater accounting losses.
One common mistake which results in this scenario is basing asset pricing off your institution’s current cost of funds rather than marginal market funding costs. Pricing loans using a market cost of funds typically creates a stronger liquidity and profitability profile no matter whether you end up holding or selling the loan. This also allows the institution to fund the balance sheet with wholesale or term funding if there is room to add leverage and still earn a spread.
As we assess paths to increase liquidity, it’s imperative to critically evaluate the funding sources, choose the cheapest option, and ensure there is a spread to the asset being funded. Consistent use of a well-tuned pricing model is a strong complement to a modernized liquidity management approach, helping to generate stronger financial performance and a healthier balance sheet.
ALM First’s team of experienced professionals is here to assist with liquidity management, asset pricing and all aspects of your balance sheet strategy. Contact us today to discuss your institution’s financial performance goals in more detail.
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