Solving Liquidity Challenges With the Secondary Market

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

Banks are facing various challenges this year, emphasizing the need to focus on the basics of their liquidity strategies as operating pressure mounts. 

Banks that resist increasing the interest rates on their deposits — usually in an attempt to preserve their profit margins or maintain their overall cost structure — risk their customers moving their funds to other entities willing to pay a higher interest rate. This creates a liquidity shortage for banks. 

The liquidity squeeze many are feeling today is primarily influenced by three factors: commercial real estate exposure, competition from fintechs and the rapid increase in interest rates.

CRE Pressures Mount
Some banks, those with a high concentration of CRE loans,  are feeling post-pandemic portfolio tensions. The Covid-19 pandemic changed where and how people work, which threatens the performance of office or retail loans that are no longer needed or utilized. 

For regional and community banks, which have a larger CRE exposure as a percentage of total assets than national banks, the situation is worse. Research shows that CRE represents 12.5% of aggregate loan portfolios for all U.S. banks with over $100 billion in assets but 38% of loans for banks with less than $10 billion in assets. This tension has led banks to tighten standards on new loans and reassess existing ones, which only stresses prudent liquidity measures and reaffirms how important portfolio diversification is in mitigating liquidity risk. 

Competition from Nonbanks
The steady rise of fintech companies and nonregulated financial entities has contributed to an increasingly competitive market. These entities, which operate with fewer restrictions than traditional banks, can often offer higher interest rates on deposits.

The Fed Effect
Between March 2022 and July 2023, the Federal Reserve raised its benchmark federal funds rate from near zero to between 5.25% and 5.50%. This increase was the fastest in 40 years, caused by the highest inflation seen in that same time frame. The rise in rates significantly impacted how banks retain and attract deposits, with many losing deposits while trying to manage the same size of loans as before the increase.

The Pressure Lever
Banks are turning to third-party participants within the secondary market to alleviate liquidity pressure and avoid volatile liabilities such as brokered deposits or Federal Home Loan Bank advances. 

For instance, in the past, if an agricultural customer needed a $1 million loan to buy a piece of agricultural real estate, the bank would book the loan with an in-house rate and assume the credit and liquidity risk. Those same customers have seen rates increase by 400 basis points because of the Fed’s increases and have started to request shorter-term, adjustable loan rates, which can come with higher credit risk for the bank.

But banks have another option instead of just taking on the credit and liquidity risk of loans with shorter-term rates, especially if they’re also experiencing tension across their portfolio. They can utilize the secondary market. 

The secondary market, which often serves as a behind-the-scenes partner, can be an effective alternative for banks by allowing them to sell the loan to a third party while keeping the customer, growing the relationship and obtaining financial solutions for their borrowers. 

The secondary market shifted in recent years from serving solely as an interest rate risk management tool to a liquidity risk management tool for banks. 

The Path Forward
As customer needs and expectations evolve, the strategies that banks deploy to maintain those relationships and ensure a steady stream of deposits also need to evolve.  

Banks do not need to navigate today’s liquidity pressures or the evolving marketplace alone. Finding the right partner with the right resources and knowledge base can help them navigate both short- and long-term portfolio challenges.