What are core deposits going to do when interest rates rise?

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Lewis Dorsey
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1 What are core deposits going to do when interest rates rise? By William J. McGuire, Ph.D. Chairman Emeritus, McGuire Performance Solutions, A MountainView Company

2 What are core deposits going to do when interest rates rise? By William J. McGuire, Ph.D.,Chairman Emeritus, McGuire Performance Solutions, A MountainView Company McGuire Performance Solutions (MPS) has been quantifying core deposit supply, repricing, and decay behaviors using an advanced statistical analysis approach since 1995, with data beginning as far back as Over the course of the assessments performed, interest rates have moved through several cycles of increase and decrease. MPS experience over those cycles provides context to answer the question of what to expect from core deposits when interest rates next rise if future behaviors are generally consistent with history. That experience further identifies potential threats to the historic consistency of behaviors. This note shares highlights of those insights. A more complete exposition will be presented at the upcoming FMS 2014 Forum in Orlando. What is the historic record of core deposit outcomes when interest rates rise? It is best to split that inquiry into two parts. The simpler answer applies to high rate paid core deposits, such as high tier MMDA s or any premium priced category. Supply and decay (average lives) will be maintained at historic levels but at the price of near indexed re-pricing. That is the way it has most always been, and there is no reason to expect otherwise in the future when interest rates rise. In fact, more transparent deposit markets (for example made possible by webbased search capabilities) will likely intensify the effect. The more complex answer applies to traditional core deposits, those with low (or zero) rate paid and limited (or no) repricing as interest rates rise. The historic record is clear that since 1998 the behaviors of such core deposits in rising interest rate environments has largely held constant. Each rate cycle had its own character, of course, influenced by the economic conditions unfolding and the unique pattern of interest rate changes, but the fundamental outcomes of stable supply and near constant decay prevailed. There is even evidence that those outcomes may be more pronounced when interest rates next rise, for example due to what appears to be an increase in the preference by consumers for stored liquidity rather than available liquidity in the form of credit. But nothing is certain, especially since financial institutions may be facing a new normal in the next rising rate period. The severity of the recent financial crisis, the weak recovery, and in particular a very long period of unprecedentedly low 2

3 interest rates and deposit rates paid do define very different conditions than those prevailing in the historic record. So tomorrow may well not be like yesterday. But it may be better or worse there are arguments for both. A number of conditions support the hypothesis that traditional core deposits will exhibit their historical normal stable supply and decay behaviors in the next period of rising interest rates. Those conditions are as follows. Limited real changes to the fundamental underlying traditional core deposit value proposition. The dominant service, convenience, and product value determinants of those core deposits have not changed by any significant degree. With those behavior drivers constant, outcomes for traditional core deposits should be consistent with those observed historically. Minimal current rate paid. The very low rates now being paid on traditional core deposits imply that upward repricing creates a token change in the dollar incentive to depositors. Current low rates paid also significantly increase the marginal cost of gaining new core deposits, a factor which should mute repricing by financial institutors. Both factors converge to suggest that changes in rate paid related traditional core deposit supply and decay behavior influences will be modest as interest rates rise. A change in consumer liquidity preference. Deposit supply patterns after the financial crisis are different from those in previous times when flight to safety was evident. In (the prior period of surge balances ) most funds logically went into high tier MMDA categories the highest yielding place to park funds until financial conditions improved. Surge balances in the most recent experience have gone much more into interest bearing checking and saving type categories. Given the minimal rates paid on those balances, the implication is that consumers now prefer greater stocks of stored checking and savings based liquidity rather than rely of the availability of liquidity through borrowing. That implies a likely large base of stable traditional core deposit funding even if interest rates rise. The need for secure retirement funds. Another area of strong growth in the aftermath of the recent financial crisis was IRA account balances. The principal protection accorded to such balances by deposit insurance offsets the low rates paid, in particular as retirement draws closer for more and more depositors. There is little reason to expect the rapid departure of such targeted funds if interest rates rise. Limited loan growth. Almost every expectation is for modest gains in future economic growth and low inflation for the foreseeable future. Such an environment is normally associated with tepid loan growth. Without a profitable use for deposit funds, financial institutions will not bid up rates 3

4 paid when interest rates rise in a way that might cause unexpected supply or decay responses. Increased capital mandates and deposit concentration limits. Whether imposed by regulators or demanded by financial markets, the mandate for higher tangible equity ratios will limit general balance sheet growth. That is a second limiting influence on the need to bid up rates paid, possibly disrupting supply and decay behaviors, when interest rates rise. Also a mitigating factor is that the largest of US banks are limited in adding deposit market share, taking an often potent deposit market influence at least partly off the table. But there are alternate views that may unfavorably alter the behaviors of traditional core deposit supply and decay when interest rates next rise. Those conditions are as follows. A media feeding frenzy. Deposit repricing will get significant media attention when interest rates rise. This will elevate depositor awareness of pricing and potentially cause adverse effects on deposit supply and decay outcomes. Short consumer memories. Stored liquidity and retirement prudence may be in vogue now but will those attitudes last when economic conditions improve? Any reversion to prior preferences for available liquidity through borrowings will be adverse to traditional core deposit supply and decay outcomes. The effects could be material, also, as surge balances in traditional core deposit categories associated with increased liquidity preference are large. Deployment of business DDA balances. Some of the strongest growth seen after the recent financial crisis was in business DDA balances. Initially this was related to the unlimited deposit insurance accorded such funds. But even after termination of that, balances remained unusually high. A key factor in that is business reticence to deploy funds into investments while the economy is weak. A rise in interest rates, which almost by definition signals a stronger economy, could change that quickly. Business DDA balances would then decline at an unusually quick pace. Unexpectedly high inflation. If interest rates are rising to control already rising inflation of a notable magnitude, consumer real incomes will be falling. Depositors will look at all sources of income to mitigate that, including deposit rates paid. High inflation is a key potential player it will create adverse core deposit supply and decay outcomes. A disruptive change in payment fundamentals. A recent rumor making the rounds was that Walmart was petitioning the FDIC to apply deposit insurance to stored value cards. Were that to happen, checking accounts would be seen in a new light and possibly savings accounts as well. So far 4

5 the rumor quoted is just a rumor, but the emergence of a disruptive payments technology could rapidly (and adversely) alter the behaviors of even the most traditional of core deposits. A crazy competitor. It only takes one deranged competitor to create deposit hell in a local market and there is no predicting irrational behavior. Beware of the adverse core deposit behavior influences of such situations (which fortunately in most cases only directly affect premium rate categories). On balance, this commentator is going to put more stock in the positive conditions than the negative ones. That is based on long experience and a certain amount of personal optimism. But there is a threat to financial institution deposits that I see as real, material, and ignored CD early withdrawals. As demonstrated in the recent FMS white paper Managing Interest Rate Risk - The IRR Implications of CD Early Withdrawals and Core Deposit Surge Balances, CD early withdrawals have been experienced in prior periods of rising interest rates. Exploratory statistical analyses indicate that the forecasted percentage magnitudes of such depositor actions can become significant in higher interest rate environments, creating a materially adverse impact on interest expense. This will be a surprise to many financial institution managers because CD early withdrawal behavior is rarely addressed in the IRR models validated by MPS. Words to the wise are thus to monitor all core deposit behaviors closely as interest rates rise but to also understand and prepare for CD early withdrawals. Nobody likes an adverse earnings surprise, but that especially applies to Board of Directors! Published by: Financial Managers Society, Inc. 1 North LaSalle Street, Suite 3100 Chicago, IL info@fmsinc.org (member login required) 5

Back Testing ALM Models April 17, Back Testing ALM Models: Concepts, Practice, and Compliant Business Solutions

Back Testing ALM Models April 17, Back Testing ALM Models: Concepts, Practice, and Compliant Business Solutions Back Testing ALM Models: Concepts, Practice, and Compliant Business Solutions Presented by: William J. McGuire Chairman Emeritus McGuire Performance Solutions, Inc. 16435 N. Scottsdale Rd, Ste 290 Scottsdale,