The end of the great deposit flood may soon be nigh. Since the start of the pandemic, banks have been saturated with liquidity due to a flight to safety and government stimulus. In December 2019, just before the pandemic started, total commercial bank deposits were roughly $13.3 trillion. Within a few months, by May 2020, they had jumped 16% to $15.4 trillion. By April 2022, they were over $18 trillion.
While initially beneficial, the influx of deposits is proof of the adage that you really can have too much of a good thing. Banks have been awash in liquidity without much loan demand to deploy it. But with the Federal Reserve raising rates and rate-sensitive customers beginning to pull their deposits, bankers are wondering how sticky those customers—and deposits—are going to be. Combined with geopolitical events and the fact that the pandemic remains ongoing, the future is uncertain
So what should banks be doing now and how can they best prepare no matter what happens next? On our podcast, Banking with Interest, we sat down with Scott Hildenbrand, chief balance sheet strategist at Piper Sandler, to find out the answers to those questions.
Following is our conversation, edited for length and clarity:
The Fed raised rates by 50 basis points at the last meeting and signaled it could keep moving aggressively until inflation is under control. How do you see things playing out?
The bond market appears to be pricing in ten to 12 rate hikes over the next couple years, though I doubt we’ll get that many. Bank loan activity is a signal for growth in the economy and loan-to-deposit ratios are hovering near all-time lows. I’m more concerned with how quickly rates increase. There are 50-bps hikes priced into each of the next two meetings, and it will be interesting to see what that does to banks’ balance sheets.
What's going to be the impact on deposit betas as rates rise? And does the size of the bank matter?
I think it does. Big banks rely less on spread, so I doubt they’ll have to change deposit rates much. But smaller banks do rely—heavily—on spread business. So those institutions will probably feel some pressure over the next six to 12 months. But even they have some time.
That said, I don’t believe cost of funds is driven by the Fed. It’s driven by the LTD ratios of a bank’s main competitors. It’s all supply and demand. But right now, banks are artificially large, so regardless of what their competitors do, they might just let their balance sheets shrink to a more normal size, with better capital levels.
How sticky will all this liquidity be?
It’s hard to say. The deposit landscape has changed, so we can't make assumptions based on historical trends. But depositors are starting to realize that they’re losing money by letting it sit in a bank while inflation spikes and rates head north. They want to know what they can earn from their banks. So I’m actually less concerned with depositors running out the door than I am with them shifting from non-interest DDAs into some form of money market account.
If deposits do end up leaving, should banks focus on increasing their deposit base or locking in wholesale funding?
Both. I’m a huge advocate of wholesale funding as a tool to manage interest rate risk, grow earnings, and invest back into the institution. It should be in every bank’s playbook. It also enables banks to determine which part of the curve to be on without bothering their customers.
So in a highly unpredictable world, it’s something banks can control relatively easily?
Yes, and that uncertainty is why I’m also a little bit bullish on buying bonds right now. There could be a ton of rate hikes over the next 24 months, and beyond that, the yield curve is basically flat. So a lot of bankers aren’t concerned about higher rates in two years. They’re actually concerned that rates could drop, and we have a recession. So I’d argue that banks should be buying bonds. Earning a little less now and taking on a little more interest rate risk might be a tough sell to their boards, but when you think about the lack of loan demand, it makes sense.
What other advice would you give banks?
It’s all about weaponizing your balance sheet. Banks should focus on answering three questions: What hurts? What helps? And what are we going to do about it? That’s the best way to fight market volatility.
ALCO members should start by understanding which parts of the yield curve matter most to their institutions. This will enable them to reduce exposure where necessary and design strategies around smaller moves in the shape of the curve that are more actionable. They should already know what they’re going to do with every 10-to-15 basis-point flatter or steeper, so that when the time comes, all they have to do is execute. They don’t need to write a memo or assemble a special committee to watch rates. Too many banks are reactive—they wait for rates to go higher, then add insurance to hedge against rising rates.
There’s a lot of behaviors banks can stop, too: They should stop treating all risk as interest rate risk (yield curve risk is far more important), stop treating ALCO meetings like a dentist appointment to get through as quickly and painlessly as possible, stop looking backward and start looking forward.
What are the best- and worst-case scenarios for the industry?
Best-case scenario is loan demand picking up. Some spread widening in lending would be great, because banks have time before deposit costs will go up. So banks could make a lot of money with loan growth and higher interest rates on the short end of the curve.
Worst-case scenario is the Fed hikes rates a bunch of times, LTD ratios stay where they are, and we get stuck in a world of stagflation, where things look a lot like they have over the past ten years. I’m concerned that we’ve seen the belly of the yield curve up over 100 basis points in a short period, and most banks don’t have the loan demand to capture that full interest rate move. So we’re likely going to have a slight correction on credit. In the meantime, there are no more PPP fees coming through the door. Add it all up and it could be a tough year—even with the rate increases.