One of the most frequently asked questions that we have received from clients since March has been “What do we do with all the excess cash that we have?” Since the end of March, deposit balances at U.S. Commercial banks have increased by $1.874 trillion. That’s TRILLION, with a “T.” Unprecedented fiscal and monetary stimulus have led to nearly exponential growth in commercial bank deposits since the beginning of the year.
Source: Board of Governors of the Federal Reserve System (US). Release: H.8 Assets and Liabilities of Commercial Banks in the United States Units: Billions of U.S. Dollars, Not Seasonally Adjusted
The country-wide quarantine in March and April led to a precipitous decline in GDP for the second and third quarters of 2020. Thus, in addition to a tremendous amount of excess deposits, demand of loans (other than SBA Paycheck Protection program loans; “PPP”) has declined, leaving banks with a significant amount of excess liquidity. Increases in loan refinancing and investment portfolio paydowns have only compounded the problem. Bank liquidity ratios have increased significantly while loans-to-deposits ratios have tapered off. For many commercial banks, this excess liquidity is sitting in low-yielding overnight accounts, placing a drag on bank earnings and causing compression in net interest margins. With market interest rates near historical lows, banks are left to ponder how to put this excess liquidity to work to maintain or grow their net interest margins.
Source: S&P Global Market Intelligence, 2020
Source: S&P Global Market Intelligence, 2020
How much liquidity is actually excess?
The first step in addressing our central question is to determine how much liquidity is actually “excess liquidity.” Banks need to assess how much of their deposit growth came from economic stimulus plans and how much came from organic growth. They also need to determine how much of that deposit growth came from new accounts versus existing accounts. If a large portion of that deposit growth came from stimulus-backed new accounts, banks need to determine if those new accounts have other relationships with the bank. If not, there is a high probability that those balances will not remain on the books if the competition for deposits increases and rates begin to rise. In that case, the bank should keep that amount of cash in overnight or short-term investments. If the preponderance of that deposit growth came from existing accounts, banks need to determine if at least a portion of that growth will remain or will be drawn off. Banks should analyze monthly deposit balance trends for their most active non-maturity deposit accounts to determine what the monthly average balances were prior to March 2020 and what they became in the subsequent months. Once that data is acquired, banks should then assess whether those monthly balances will return to their pre-pandemic levels over the course of the next several months. Chances are, if a depositor has not withdrawn excess balances from various stimulus sources by now, they probably did not need the excess cash. It is in the bank’s best interest to contact that account to determine what, if anything, the depositor plans to do with those funds. This may be an opportunity to extend the duration of a bank’s deposits and “lock in” those funds.
The second step in addressing our central question is to determine how much liquidity a bank will need to cover certain contingencies. Loan forbearance has increased since the start of the pandemic as have loans past due and loan defaults. This has reduced the cash flow from loan portfolios for many banks. While loan forbearance has been declining over the past few months, the recent increase in positive COVID-19 cases and hospitalizations may lead to another reduction in economic activity and therefore an increase in loan forbearance and default. Banks should perform a thorough credit analysis of their loan portfolios to determine which loans are most likely to be problematic over the coming months. Sufficient liquidity should be set aside to address the possibility of these loans going into forbearance or default. We strongly recommend that banks use their budgeting and interest rate risk measurement programs to run stress tests to determine the impact of a reduction in loan portfolio cash flows on liquidity, earnings at risk and economic value of equity. The amount that remains after these two questions have been answered can be labeled “excess liquidity.”
Source: “Forbearances See Largest Single Week Decline Yet”; October 9, 2020, Black Knight, Inc.
Making good use of excess funds
If there are excess funds remaining after the bank has determined how much liquidity it will need to cover possible balance runoff and other contingencies, banks can use those funds in different ways to help maintain or grow their net interest margins.
- Lower your deposit rates: Getting the bank’s cost of funds down as rapidly as possible will be key to maintaining the bank’s net interest margin. With a growing number of assets repricing at lower interest rates, reducing the bank’s interest expense will be paramount. If “surge” deposit balances runoff as a result of the reduction in rates, what remains will most likely be a core deposit. Those core deposits tend to be less rate sensitive and therefore will benefit the bank’s net interest margin should market interest rates start to rise.
- Pay down or pay off your borrowings: Some of our clients have used the excess deposit balances to either pay down or pay off existing FHLB borrowings. For some, that led to a significant decline in interest expense. The unanticipated increase in non-interest income from PPP loans was then used to offset the prepayment fees issued by FHLB for early payment. Paying down the existing FHLB borrowing not only improved the banks’ current net interest margins but also positioned the banks to obtain lower costing wholesale funds in the near future.
- Invest the excess funds in the Investment Portfolio: Excess balances sitting in overnight accounts earning less than 10 bps are putting a strain on net interest margins. While many of our clients are concerned with increasing investment balances and extending investment duration in such a low rate environment, an in-depth analysis of their investment portfolio duration and overall asset duration proved that many banks can absorb this excess risk without posing a significant threat to their long-term valuation (i.e., economic value of equity). If a bank is still unsure of how much liquidity it will need over the next several months, a short ladder of investment maturities will still generate more yield than overnight investment accounts. This will, at least, slow compression in a bank’s net interest margin.
- Make more loans: While the old adage “we’ll make up on volume” seems cliché, it actually does apply to the current situation. We learned from the previous financial crisis that loan growth was key to maintaining or growing net interest margins. Even with historically low market interest rates, loans are where bank margins are made. In the current economic environment, growing the loan portfolio is easier said than done. However, with the development and distribution of a viable vaccine for COVID-19 over the coming months, the economy is expected to recover somewhat over the course of 2021. This may provide new opportunities for banks to lend excess funds to people or businesses recovering from the recession.
When considering any of these alternatives, we encourage banks to use their interest rate risk measurement systems to simulate the impact of each on liquidity, earnings and economic value. Model simulations may help you determine which alternative or mix of alternatives works best for your bank.
Looking ahead to 2021
The year 2020 has been a challenging year for banks, to say the least. The COVID-19 pandemic led to a sharp decline in the world’s economies in a very short period of time. Unprecedented fiscal and monetary stimulus have kept the world’s economies afloat as the search for a viable vaccine nears an end. This stimulus left banks flooded with excess funds and a dilemma; what do they do with it? Lending those funds will be key to economic recovery. Until the demand for loans returns, banks are left to decide how much of those funds to keep on hand and how much to deploy. In this article, we reviewed a few alternatives for banks to consider. Reducing deposit rates, paying down borrowings, investing in bonds and expanding the loan portfolio are the most viable alternatives for banks when looking for ways to enhance their asset-liability mix and improve their net interest margins.
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