Around Halloween, perhaps to scare all of the bankers out there, the Federal Reserve dropped rates again, this time by 25 basis points to a range of 1.5% to 1.75%. The widely expected move was the third such drop in as many months. With little wiggle-room remaining this looks like the last drop for a while, but f we were to ask a Magic 8 Ball, the answer that would likely bubble to the surface would be: “Reply hazy.”
Based on Chairman Powell’s signals, and if we use the past to predict the future, odds are we’re done for now. In both 1995 and 1998 the Fed dropped rates three times in an effort to encourage continued expansion and economic health, and Powell has been quoted as saying that this trifecta of drops has been done “in that same spirit.”
However, Fed vice chair Richard Clarida said in October that it’s going to be handled on a “meeting-by-meeting basis,” and that there is no preset course for monetary policy.
So, what does this mean for financial institutions? We thought this would be a good time to reiterate our guidance to Financial Institutions on the impact of rate drops.
The impact of lower rates on FIs
The most immediate impact will be for banks that have a significant portfolio of variable rate (prime-based) loans. These institutions are anticipating consumer pressure to offer rate concessions on fixed-rate loans. If not, the threat of an abundance of other institutions and non-traditional lending sources is growing. In the worst-case scenario, banks may see an exodus of customers seeking a lender that can offer them a lower rate.
On the deposit side, smaller banks may be less likely to lower deposit rates, with liquidity a major concern. Despite customer pressure, many banks were slow to raise deposit rates and would be reluctant to do so now. They cannot afford to lose deposits and will not be inclined to lower deposit rates to offset the rate decrease.
Who will take the hit?
Rate cuts hit all banks. But big banks can go to the bond market and institutional lenders to borrow inexpensively. Small banks and credit unions don’t have that luxury. Smaller institutions must rely on deposits or borrowings from the Federal Home Loan Bank, but this is limited by the size of the institution. The bottom line is that the market for good loans and for the retention of deposits is competitive. Any rate decrease will make the situation even more complicated for small financial institutions.
Some banks are beginning to hedge against rate decreases. But there are risks inherent in this strategy. While hedging may mitigate the impact of rate declines, this typically requires a sacrifice in overall earnings.
Rate-exposed institutions may be stuck with a higher Cost of Funds
Tighter liquidity, competition for deposits and market indicators have increased the Cost of Funds. Many banks are stuck with this higher cost for as long as rates keep falling.
Liquidity is tightening for many institutions. After the great recession, many institutions held off on increasing deposit rates, even while the target Fed Funds rate increased, thanks to deposit-heavy customers and low loan demand. But in mid-2018, loan demand finally picked up. This decreased liquidity levels and triggered competition for deposits. Cash-poor institutions had nowhere to go but up.
Banks that reacted too late to this liquidity crunch were forced to offer CD specials at higher rates to generate the funds they needed. Many institutions offered higher rates on longer-term CDs to protect against the future rate increases forecast at the time. Unfortunately, this turned out to be a trap. Banks that gambled on higher-rate CDs are stuck with those higher costs.
Managing rates is a long-term game
The latest rate cut shows why managing your Net Interest Margin requires a long-term strategy instead of betting on the Fed’s next move. Consider the past Federal Open Market Committee actions and predictions, as well as market indicators. Between September and December 2018, all indications were for continued increases, and the market showed no concern about inflation. The Fed, and the markets, only began indicating 2019 rate cuts in March. By April, the Fed was forecasting a rate cut in September. In August, we were adjusting to the first cut in a decade, and here we are in November with two more.
The moral of the story? It’s not enough to simply react to the Fed and the market. Institutions acting on the basis of forecasts, actions and market activity over the past year will live with the consequences for a while — as we’ll explore below. Institutions that maintained a long-term strategy, and who have clear insights into their performance, are much better positioned to ride out whatever the Fed, and the market, does next.
How can we help?
Banker’s Dashboard is a powerful tool that allows bankers to track their Net Interest Margin over time — in real time — using margin reports.
The Forecasting module provides a streamlined way for users to run complex “what if” scenarios to account for any interest rate adjustments. And if your bank intends to absorb some of the rate cut, Forecasts can give crucial insight into the impact of that too.
Dashboard also houses a CD Repricing module. This tool will provide visibility into what’s maturing at any time, and allows you to better forecast the impact of rate changes.
If you’re currently using Dashboard and wondering how to harness the reporting and analytics to help guide your institution through the storm, we’re on hand to help. Or, if you’re interested in a tool that can provide this level of in-depth insight on the fly, contact us today. The Banker’s Dashboard team includes seasoned CPAs and even a former bank CFO. Deluxe can help your institution leverage the latest technology to optimize your bank’s performance, whatever the weather.