Lock Your Front Door 

*This article was published in Bank Director magazine’s third quarter 2024 issue.

Conventional wisdom has long held that bank failures are the result of liquidity crises, which are the byproduct of credit issues. That logic remains true, and if credit weakens in 2024 or 2025, it could play out again. However, 2023 reminded us that acute liquidity stress can also arise from interest rate risk troubles. 

Last year, two bank failures — Silicon Valley Bank and First Republic Bank — dominated the national media. While interest rate risk wrecked both balance sheets, liquidity issues closed their doors. Stories about those failures sounded like an animal invasion: A grizzly bear shows up in a tranquil neighborhood, bashes in the front door of a beautiful home and ravages everything inside. 

In response, almost every management team examined if they were prepared for a similar invasion, devoting time and energy toward identifying how they could access liquidity after that risk had already become an acute problem. To be clear, this type of preparation is prudent, but an important, simple and preventative preparation is being missed that protects the bank like locking the front door each night protects a home. 

Too many banks are leaving the front door unlocked by actively choosing deposits and other liabilities at rates between 5.25% and 5.50%, with short-term or non-maturity profiles. In some cases, banks are offering above 5.50% in the desperate search for so-called core deposits.

A Lot of Unlocked Doors
We have been tracking data from S&P Global Market Intelligence on liabilities since the great remix started in late 2022. For banks between $500 million to $5 billion in assets, the amount of total contractual funding (CDs or term borrowings) maturing or repricing within the next 12 months has expanded from 69% at the end of the third quarter 2022, to 80% at the end of the first quarter 2024. The amount has almost doubled, increasing from $217 billion to $424 billion. 

Banks could choose different structures for the contractual maturity of those liabilities, but they are increasingly choosing shorter terms. This is concerning. 

Let’s examine the first quarter 2024 as an example. At that time, executives could choose five-year contractual liabilities with a fixed rate and the discretion to call that fixed rate at any time after six months. Those contracts don’t require collateral and are fixed in one direction (up) while effectively floating in the other (down). The starting coupon ranged between 5.15% and 5.25%, with an all-in cost between 5.30% and 5.40%. If called prior to maturity, the unamortized discount could increase the cost to up to 5.80%, depending on when the bank exercises the right to call.

Instead of selecting the structure described above, many banks choose maturities under 12 months. These shorter liabilities carry coupons between 5.25% and 5.50%, or in some cases over 5.50% in the quest for core deposits.  Not only will this coupon float higher if rates rise, but the balance must be continuously rolled over — leaving the deadbolt open to liquidity risk.  

By choosing better structures and securing the deadbolt, institutions can set up the ability to increase earnings while simultaneously decreasing potential interest rate and liquidity risk.  

Be Smarter in the Great Rollover
As the massive balances of short-term liabilities mature through 2024, many institutions will simply replace them with similar short-term liabilities. Meanwhile, an option is available that could create greater opportunity and help reduce risk.

If we do not change our thinking as an industry, we are:  

• Leaving the front door unlocked, increasing exposure to potential liquidity stress.
• Setting ourselves up to be price takers — rather than price setters — in the competitive battle for retail, or core, deposits.
• Truncating the menu of assets we can comfortably own on the opposite side of the balance sheet.

Since March of 2023, our industry has worked hard to prepare for the unlikely event of acute liquidity stress. Sadly, most of us are leaving our first line of defense unlocked, increasing the risk of negative outcomes if the liquidity grizzly ever shows at our front door. 

Performance Trust has been advising community banks for 30 years and is a registered broker/dealer, member of FINRA/SIPC. This is intended for educational and informational purposes only and is not intended to be legal, tax, financial, or accounting advice or a recommended course of action in any given situation. This is not an offer or solicitation to purchase or sell securities. The information is subject to change without notice.