COF – FROM THE BACKGROUND TO THE FOREFRONT

from Ohio Record- Summer 2023

PPP FRAUD: HOW FINANCIAL INSTITUTIONS CAN MITIGATE ONGOING RISK

Cost of funds (COF) along with bank funding structure is getting attention not seen in more than a decade. There are several factors at work that have led to much greater focus on both current and prospective COF. For bank balance sheet managers, this focus has come quickly after a long period of historically low COF with a downward trend. Beginning in the second half of 2022, this period of low COF swiftly reversed course. The graph below show the COF history, beginning in 2011, for a group of approximately 3,600 banks with total assets between $100 million and $30 billion as of 3/31/23. This group of banks will be used throughout to illustrate trends in bank balance sheets and COF.

COF – From the Background to the Forefront Cost of funds (COF) along with bank funding structure is getting attention not seen in more than a decade. There are several factors at work that have led to much greater focus on both current and prospective COF. For bank balance sheet managers, this focus has come quickly after a long period of historically low COF with a downward trend. Beginning in the second half of 2022, this period of low COF swiftly reversed course. The graph below show the COF history, beginning in 2011, for a group of approximately 3,600 banks with total assets between $100 million and $30 billion as of 3/31/23. This group of banks will be used throughout to illustrate trends in bank balance sheets and COF.

of increases in the Federal Funds Rate in over 30 years, raising the target rate 475 bps by the end of the 1st quarter of 2023. While the rate increases were dramatic, the impact on COF was not initially felt by most banks due to historic deposit growth related to the COVID 19 pandemic beginning in early 2020.

Source: FIDC, S&P Market Intelligence, and Bloomberg

Deposit Growth - 12/31/19 to 03/31/23

Source: FIDC and S&P Market Intelligence

Multiple factors have led to the rise in COF, but the most significant are higher market interest rates, lower level of liquidity, and deposits leaving the banking sector.

Beginning in March 2022, the Federal Open Market Committee (FOMC) began the most aggressive period of increases in the Federal Funds Rate in over 30 years, raising the target rate 475 bps by the end of the 1st quarter of 2023. While the rate increases were dramatic, the impact on COF was not initially felt by most banks due to historic deposit growth related to the COVID 19 pandemic beginning in early 2020.

Beginning in March 2022, the Federal Open Market Committee (FOMC) began the most aggressive period

Mar-20May-20Jul-20Sep-20Nov-20Jan-21Mar-21May-21Jul-21Sep-21Nov-21Jan-22Mar-22May-22Jul-22Sep-22Nov-22Jan-23Mar-23

Source: FIDC and S&P Market Intelligence

The growth in deposits led to excess liquidity which limited competition for deposits and held rates in check – banks were not paying up for deposits because they did not need additional funding. Beginning in the second half of 2022 this began to change. When deposits began to grow rapidly in early 2020, loan demand was weak and while banks did grow securities portfolios, deposits grew faster than loans and securities leaving banks with excess deposits. By the 4th quarter of 2023, this changed and cumulative growth in investment (loans and securities) outstripped the deposit growth.

Source: Federal Reserve and Bloomberg

The combination of much higher short term rates along with stress in the banking sector have made MMMFs an attractive option for depositors. With deposit volumes falling in conjunction with growth in loans and securities, wholesale funding volumes have increased which places additional upward pressure on COF.

Total Wholesale Funds 12/31/19 to 03/31/23

Source: FIDC and S&P Market Intelligence

Source: FIDC and S&P Market Intelligence and securities leaving banks with excess deposits. By the 4th quarter of 2023, this changed and cumulative growth in investment (loans and securities) outstripped the deposit growth.

Source: FIDC and S&P Market Intelligence

At the same time that the FOMC was raising the Fed Funds rate at a historically fast level and excess deposits were being absorbed by loans and securities, funds were also beginning to leave the banking system more broadly and moving to money market mutual funds (MMF) as seen in the graph below:

Source: Federal Reserve and Bloomberg

The result of these factors in combination has led to COF for the 3,600+ bank group increasing 83bps in the past two quarters, 109 bps from the historic low of 22bps, and led to the highest COF since 1.34 at the end of 2010

The direction of COF over the short-to-intermediate term will have a meaningful impact on net interest margin and profitability with the following factors likely determining the outlooks for COF:

FOMC Policy – Chair Powell and FOMC members have been steadfast in their goal to bring inflation back to 2%. While the rates market has begun pricing in reductions in the target Fed Funds Rate in the second half of 2023, the view of the FOMC seems to be that the target rate is more likely to move higher than lower over the next twelve months.

Banking Stress – The ongoing stress in the regional bank space has driven much of the migration out of bank deposits. Should the migration continue or accelerate, it will increase competition for deposits and drive COF higher.

Bank Credit Conditions – The stress in the bank space has led to tighter credit conditions and the most recent senior loan officer opinion survey pointed to decreasing loan demand. A decrease in lending

FOMC Policy

Chair Powell and FOMC members have been steadfast in their goal to bring inflation back to 2%. While the rates market has begun pricing in reductions in the target Fed Funds Rate in the second half of 2023, the view of the FOMC seems to be that the target rate is more likely to move higher than lower over the next twelve months.

Banking Stress

The ongoing stress in the regional bank space has driven much of the migration out of bank deposits. Should the migration continue or accelerate, it will increase competition for deposits and drive COF higher.

Bank Credit Conditions

The stress in the bank space has led to tighter credit conditions and the most recent senior loan officer opinion survey pointed to decreasing loan demand. A decrease in lending would alleviate liquidity pressure and competition for deposits which could slow increases or even decrease COF.

With the potential for rising COF to continue, the following are strategies for raising funds that can mitigate some of the current funding pressures and risks of higher rates:

Wholesale Funding

Borrowing from the FHLB or brokered CD market can have a higher cost at the margin, but the current inversion of the yield curve provides opportunities to lock in term funding at lower costs than current short-term rates. Additionally, by “paying up” for funding in the wholesale market rather than the deposit market, the risk of cannibalizing the deposit base is reduced.

Indexed Deposits

Indexing deposit accounts to market interest rates (i.e. SOFR and T-bills) allows banks to compete with the higher rates offered by MMFs which are going to move closely with changes in market interest rates. This can be an especially useful strategy for funding floating rate loans as the funding can be priced to the same index as the loan.

Derivatives

The inversion in the yield curve has made interest rate derivatives an attractive option for hedging short-term funding. Derivatives can be used to convert short-term funding into a longer term at a lower rate or reducing the risk of short-term rates moving higher.

Banks are facing the most strenuous funding environment since prior to the 2007-2010 financial crisis. COF will continue to be a key focus for bank managers over the short-term as liquidity remains tight, competition for deposits is fierce, and short-term market rates are still significantly higher than the average COF.

Brett Lofton, CFA Senior Vice President, Senior Portfolio Manager FHN Financial Portfolio Advisors