Pub. 11 2020 Issue 2

Pub. 11 2020 I Issue 2 19 West Virginia Banker The three charts above show the potential outcome for our industry assuming a 75%, 100% and 125% magnitude of the impact from 2007-2009. While it can be tempting to “sit on the sidelines” and hope for a V-shaped recovery, we must weigh the potential negative implications from that approach if we end up being wrong. The correct strategy here is not to make a one-way bet in either direction. We can remain positioned for a quicker than expected recovery while also improving our hedge against a longer-term low rate environment like 2007- 2012. It all comes down to executable ALM management. As of 12/31/2019, the industry was carrying just under $222 billion in cash and due from balances earning roughly 1.50% on average. In just one month (March 2020), the return on that cash balance dropped to 0.05%, which equates to an annual interest income shortfall of $3.219 billion. To put it quite simply, we cannot afford to accept an income loss of that magnitude when we do not know how long the current situation could last. In fact, every day that we continue to receive 5bps instead of investing those funds, the foregone income becomes harder and harder to recover. If we assume that we can invest 50% of our cash balance as of year-end ($111 billion) at a yield of 1.10%, the foregone income from waiting in cash builds quickly. In just 6-12 months we will have already missed out on $580 million to $1.1 billion in additional interest income. To make matters worse, we ran these figures using cash balances as of year-end 2019. We all know the first quarter always tends to bring the largest deposit growth. So, if we take that into account and also apply the growth trend in cash from the last crisis (+51%), the industry could be looking at another $100 billion in cash balances near-term. That could potentially double the foregone income figures. Then we add in the potential windfall of liquidity coming from the forgiveness of PPP loans industry wide. That figure was sitting at $513 billion as of 05/16/2020. Add this all up, and it is not sustainable for earnings or capital. We fully understand that 1.10% is not the most attractive yield historically; however, income is income in this type of economic environment. If we had the opportunity to add 105bps of additional margin on just about any other asset we would jump on it. So why does the industry choose to keep additional liquid funds at 0.05% when better earning options Andrew Okolski is a senior financial strategist at The Baker Group. He works directly with clients in a broad range of areas including ALM, education, portfolio management, interest rate risk management, strategic planning, regulatory issues, and wholesale market strategies for financial institutions. Before joining the firm, he spent 15 years building and managing a financial strategies group at a New York broker/dealer. Andy holds a Bachelor of Business Administration Degree from Long Island University — C.W. Post. Contact: 800-937-2257, andyo@GoBaker.com. are available? The response to this question usually revolves around liquidity concerns in the future. Sure, I have way too much cash now, but what if loan demand picks back up? What if deposits become more competitive? It is our opinion that with proper balance sheet management you can have both. We can increase or at least protect margin and earnings through better investment and liquidity manage- ment. As for the potential liquidity worries down the road, that is where contingent liquidity comes into play through wholesale liquidity options. In fact, this is exactly why we have these lines of additional liquidity: so that we can put our cash to work at better yields and margins without worrying about funding future loan demand. It’s also important to note that the current costs to ac- cess these liquidity avenues are at historic lows as well. If we were to invest funds and then have a surprise jump in loan demand, I’m confident we would still be able to earn a healthy spread, funding it with advances or brokered deposits well below 1%. The rule of thumb is that as long as available investment yields are higher than borrowing costs, you will make more money investing your cash and borrowing to fund other liquidity needs. The next 12-18 months will likely separate those who prepared versus those who chose to wait for it to be over. Current cash balances are already at unsustainable levels, with much more likely on the way. There is still time to put together a strategic investment and liquidity management plan based on your specific balance sheet. 