Industry News

What the Fed giveth, the Fed taketh away


Richard Magrann-Wells | Friday, May 26, 2017

American Banker

The unending trend toward more consolidation in the banking industry has several triggers. The slow economic recovery, combined with costs related to the digital revolution and heightened regulation, means mergers will likely continue. If the trends of the last two decades continue, half of the regional and community banks in the U.S. will be gone before today’s infants finish college.

But the next wave of mergers will also be driven, at least in part, by a less-publicized factor: the anticipated drop in available deposits over the coming years.

Since the financial crisis, easy access to liquidity for banks of all sizes — but particularly regional and community banks — has had a lot to do with the Federal Reserve’s monetary policy. Between 2009 and 2014, the Fed injected excess reserves of $2.5 trillion into the banking system to encourage lending and help jump-start the economy. Meanwhile, the long period of historically low interest rates restricted competition for deposits in the industry. A high-rate environment usually leads to banks jockeying for customers based on deposit yields — a contest typically won by the biggest banks.

But more recently, the Fed has been upfront about its plans to slowly raise rates and unwind excess reserves. In March, the Fed raised its benchmark interest rate for the second time in three months. The central bank left rates unchanged in May. But Fed Chair Janet Yellen's comments earlier this year to members of Congress were telling when she said that waiting too long to raise rates would be “unwise.” A report in May from JPMorgan Chase, according to news coverage of it, estimates that $1.5 trillion could be sucked out of the system over the next five years if the Fed follows through with recent guidance moving ahead with reversal its “quantitative easing” measures.

The Fed’s post-crisis accommodative policies led to a lower cost of funds for banks that in turn saw their deposit balances grow. But a concern is that a suddenly higher cost of funds will lead to deposit declines. Without a sudden growth in retail deposits, community and regional banks will be forced to reduce assets or seek alternative funding. The ability of community and regional banks to win deposits with slightly higher rates than larger competitors has also been complicated by the ability of retail depositors to shop for rates online. Higher yields on customer deposits could benefit the largest banks, which can afford to more aggressively market higher yields in a bid to grow their deposits.

In the past, brokered deposits had provided relief to smaller banks from shortfalls in funding. But recent regulatory guidance suggests that brokered funds would not be the resource they once were. Regulators have let their concerns be known that they view such deposits as having funded “unsound or rapid expansion of loan and investment portfolios” in the crisis, and that overuse of such funding has “contributed to bank failures and losses.” Large banks would also be better positioned than smaller institutions to make up for a loss of deposits by replacing them with other types of funding from the capital markets.

If deposits fall as predicted, banks are likely to search for merger opportunities that will broaden their deposit base. While factors like fintech competitors and increased regulatory burden may be stealing the limelight, it may be the more mundane “lack of deposit growth” that will ultimately cause more banks to look for the exit.

While many banks are considering merging or selling, a number of successful regional banks have chosen to focus on niche industries, specialized products or underbanked geographies. Whatever path is chosen, management needs to clearly articulate its strategy to remain competitive in a tightening deposit environment. Anything less than a well-considered plan for managing this oft-underestimated risk invites potential regulatory scrutiny or even shareholder action.

This article was licensed through Dow Jones Direct.

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