The idea that now is the time to focus on liquidity and credit quality may strike some as a bit surprising. After all, bank deposits continue to grow steadily. Over the first three quarters of last year alone, total deposits grew by 7%.
What's more, the cost of funding earning assets has steadily declined since the beginning of 2001. It now stands at an almost shockingly low 1.43%. In addition, credit quality at most institutions is extremely good.
Life is sweet, right? Yes, but maybe not for long.
Chief executive officers with foresight are taking meaningful steps now to build a diversified and reliable base of lower cost funding. They are wary of weakening credit standards. The reasons are clear when you look further into the numbers.
Eroding Margins: One might expect after three years of a falling cost of funds that banks would have increased margins. This is not the case. Over most of this period net interest margins have declined. At the end of the third quarter, the most recent period for which call report data are available, net interest margins were lower than for any period since the beginning of 2000.
Why has this happened? In large part it is because money is plentiful, and as every banker knows, lending has become more competitive than ever. Banks have been cutting prices to make loans.
Most loan growth has been in mortgage loans and consumer loans. The Federal Reserve reports that in the third quarter household debt increased at a seasonally adjusted annual rate of 9%, and mortgage debt by 11.25%. Mortgage lending by banks has increased 32% since the first quarter of 2003.
The growth of corporate debt has been slower - only 5% during the third quarter. Commercial and industrial lending has been stagnant for several years.
It is not hard to see that a storm is brewing. There are both micro- and macro-economic reasons for this.
Micro issues: Weak margins, the end of the mortgage boom, and a soft C&I loan market are not the only reasons banks are under pressure. Certain costs of operations are going up. For example, in many parts of the United States, the cost of new branches is on a steep rise. Regulatory costs also continue to climb.
In addition, increased revenue opportunities are and will continue to be harder to come by. Loan pricing is under stress. Also, certain kinds of fee income will be more difficult to raise in the coming year.
In this kind of environment - where costs are rising, increased revenue is harder to come by, and a great deal of money is chasing limited lending opportunities - there is pressure to increase profitability by taking on more risk. Typically, for banks, this means increasing risk in the loan book - relaxing underwriting standards, underpricing loans, and/or permitting greater funding mismatches.
We see this happening now. Lending officers are reporting an easing of credit standards; but as we all know, it takes a couple of years for loans to age and the problems to appear. Anecdotal evidence suggests that at least some institutions are lending longer and using shorter funding at or near historically cheap rates.
In addition, some institutions may have become overly reliant on a limited number of wholesale funding sources.
Macro Issues: As if this were not enough, the U.S. economy now faces greater uncertainty. This raises a number of significant questions, one of them being whether debt markets are properly accounting for future increases in interest rates.
There is a serious chance that they are not, and that we will see a higher rate environment and much more volatility than markets are currently signaling.
As we all know, the United States is running very large budget and current-account deficits. Foreigners have been willing to lend us money, and this has helped to keep interest rates low. But how long can this last?
The President plans to propose tough budget cuts and changes to the Social Security program. These are complex matters worthy of great debate. However, Congress and the administration will have a very difficult time reaching agreement, and all the wrangling that will take place may shake the confidence of the very international investors who are financing our deficit. Terrorist attacks and the possible disruption of oil supplies could also shake foreign confidence in the U.S. economy.
There are other reasons to worry that foreign financing of our deficit is much less secure than in the past. One reason is the soft dollar and the fact that the international community has strategic and economic interest in investing elsewhere.
For example, Japanese investors may conclude that their long-term economic interests are best served by investing in the rebuilding of Asian countries hit by the tsunami; or by investing more in China. In this regard, it is interesting to note that the Japanese government's pledge for the tsunami relief effort is the largest pledge of any government.
These macro factors affect many aspects of the world economy, and among them is the likelihood that the United States will have to pay more to finance its deficit over time. Furthermore, if the dollar dropped precipitously, the Fed would be under considerable pressure to sharply boost domestic interest rates - as disruptive as that can be.
What a CEO Can Do: CEOs should be taking steps now to protect their flanks.
- Make sure that loan officers are not letting lending standards slip. Shaky loans made today are most likely to default just when the bank needs the earnings most. Banks need to price longer term loans to account fully for risk - including, of course, interest rate risk. This is especially imperative for loans that cannot be easily sold into secondary markets, such as many commercial mortgages.
Treasury operations at banks should be working to diversify funding sources and lock in stable, low-cost sources of funding. They should also consider increasing the duration of the liability side of the balance sheet, at the very least to minimize asset/liability mismatches.True, the loan-to-deposit ratio has been pretty steady since 2001, but the ratio for core deposits has increased 6.78 percentage points over that period - making it three times higher than the ratio for all deposits. This means that banks are losing low-cost, long-term stable funding and becoming more dependent on more volatile funding sources. That is just the opposite of what should be happening at most banks.
- Finally, bankers should be keeping a weather eye out for early signs of increasing volatility in the marketplace - and should have a plan ready for when the storm approaches.
