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In this episode, Jim and Dallas discuss rising interest rates. You'll come away with a clear understanding of the different ways rising rates will affect your bank and how you should adjust your tactics accordingly.
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Jim: Hi and welcome to the Purposeful Banker, the podcast brought to you by Precision Lender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, direct of communications at Precision Lender, and I'm joined again today by Dallas Wells, our EVP for international operations.
Today we're going to talk about rising rates, which is obviously been in the news quite a bit lately. Dallas, these means this should be a cheerful, upbeat conversation, right? I mean, rising rates are what commercial banks have been waiting for, right? This is so much better than 2013 and '14.
Dallas: I laugh because it makes me wonder if you've ever actually met any bankers. I don't know if cheerful and upbeat are the right ways of saying it.
Jim: Come on.
Dallas: No, I think so yes, rising rates is what bankers have been waiting on. In fact, if you look back at every bank earnings missed that's happened over the last eight to 10 years, just about every one of them would blame in some way the fact that we were at record low interest rates. So the summary of the problem, not that bankers aren't aware of it, but just to put it succinctly, if rates are really low, on the funding side you're kind of bound by that pesky number zero. So funding cost can only go so low, and then when other interest rates get to a record low, it squeezes all that spread between the two out of there. So asset rates go down to kind of market rates, the funding costs, which are usually lower by three or four percent are bound by zero, all the profit goes away. So that's why bankers have been kind of limiting how low rates are, and, as attachment to that maybe, low rates also meant that everyone is starved for yield. So banks, some of the competing banks, start to take dollars out of a bond portfolio, which is essentially earning nothing, and get really aggressive on loan pricing with it. So competition has also been really high. So rising rates, in theory, bankers have been hoping would help solve both of those issues.
Jim: All right. Well, you say naturally, once again, you have said something that makes me want to go off script here, but I'll save that question about whether low rates was the appropriate boogie man for bankers for a little bit later. But for right now, let's go to, you mentioned this, you're the one that opened this can of worms about bankers, so I'll go in with it. But naturally they're going to want to know a little bit about potential downside, right? Glass half empty. What's the risk here? What the potential problem, right?
So let's go to some numbers from Bank Director just came out with their 2018 Risk Survey. One of them on there, one of the questions on there was or responses was if the Federal Reserve Federal Open Market Committee raises interest rates significantly, and that's defined in the survey as a rise to one to three points over the course of I believe the year, 45% of the respondents expect to lose some deposits but they don't believe this will significantly affect the bank. So let's take that in two parts here. Going by that assumption and we've heard talk about in another three hikes in the rates this year. So going by the assumption that we do get at least a point rise in 2018, do you agree that a significant chunk of banks will lose some deposits with this rise in rates?
Dallas: Yeah. I think that's absolutely true. I think you have a depositor base in a lot of banks, I would say in most banks that is pretty starve for yield also. It wasn't just the banks that were hurting for some yield, especially kind of your classic CD customer. There was a lot of discussion early on in this rate cycle of how much this was hurting the savers in that they typically would live out of the interest on their CDs, and many of them that were starting eat into the principle of those CDs because the rates were too low. Didn't generate a big enough check every quarter. So you certainly have some sort of pint up demand there where once somebody blinks, once a bank in your market blinks and starts increasing rates, everybody will lose some depositors to those banks. So 45% expect to lose some deposits may actually be a little low, in my mind.
Jim: Well, okay. The bigger issue here is do you agree with that assessment that losing those deposits won't really have an effect?
Dallas: Well, I think that's a whole different question or maybe different answer would be a better way to put it. So won't have an effect I think is pretty surprising. So I think all banks expect there to be some shifting of deposits. There's a lot of what the regulators called at one time surge deposits, which were deposits that would typically be in more rate sensitive accounts, like a CD, that just landed in a checking account. So they landed there because why tie up your money in a five year CD for 0.5% interest? Why not just leave it in the checking account where at least it's liquid? So the idea is that some of those deposits will start to shift back to CDs, back to money market accounts, and so that's where the loss of deposits will come from is as those customers start seeking somewhere to put it, they'll probably shop around. They'll see what their existing bank has to offer, but they'll probably go somewhere else and look around too.
So those rate sensitive balances are going to go somewhere. I think what banks are saying is, "Yeah, some of those are rate sensitive dollars, we'll let it go away. We've got some excess liquidity. That's fine." But there is a line there that gets crossed where you need to hold on to some of that, especially if you keep hitting these big loan growth numbers that everybody seems to be after. You got to fund it somehow. So then to compete to either hang on to those dollars or to go get somebody else's rate sensitive depositors, you have to start to pay up for those.
So that brings in the concept of deposit betas, which actually S&P, their global market intelligence platform had a pretty interesting article on that. We'll put a link to that too about how deposit betas are starting to inch up. So a deposit beta is how much of a rate increase do you pass on to your depositors? So it's obviously much less lower than one, right? You don't pass on 100% of the rate increase, but the question is how much of it do you pass on? The S&P article talks about how that's really where we're going to start to see a divergence between the banks where we'll find out who has a loyal, stable core deposit base and who looks like they did just because a bunch of rate sensitive deposits landed in checking accounts and stayed there simply for a lack of alternative.
Jim: Alright. So then if you're that bank and you realize that your deposit betas at the wrong end on that scale, how do you react in that situation?
Dallas: Yeah. I think that's fair. Part of the ... Whenever you talk about these kinds of strategies, you have to realize that a lot of this is kind of already baked in, right? That's the account base that we have today. We may wish we had something different, but that's what we have. So what do you really supposed to do about it? This will be the really interesting part I think to watch for the industry in the coming months, it's been a long time since we've seen a true rising rate environment. You have to go back from the Fed aggressively, and I would call this now starting to aggressively increase rates, you have to go all the way back to 2004. The tricky part is is the world today versus 2004 is very different. The demographics is different and certainly the technology is different. It is much easier now to move money between different banks. We've seen some interesting data from Gartner about kind of a decreasing level of loyalty from bank customers. More bank customers have multiple accounts. So it's easy for them now to have multiple accounts and to shift money between them to wherever it is optimal to them.
So what do banks do about it? I think the old strategies may not work this time. So the old strategy was you run a CD special. It's be an odd term, so that's why you saw CD specials advertise for like ... Back then they were still a lot of times in the newspaper. 11 month or a 13 month CD. It would have a special premium rate on it. So the reason for those odd terms was it kept your balances that were already in a standard term CD from kind of automatically landing in the higher premium rate. Somebody had to actively go seek out that rate. At the end of the special term, it would convert to a 12 month CD. So it would roll over to kind of the standard product. So the idea was you pay a premium rate once to get the balances in, and then they just keep rolling over in a 12 month CD. Worked like a charm. Worked great. It was a strategy that a lot of banks used to great success.
Again, there's more information available. I don't know that those things will work as well as they used to. So there's some new ways of looking at this that I think are probably going to be more successful, and they're more about giving the customers some flexibility. So Neil Stanley, one of our ... Who's been on this podcast before. He has a company that does basically negotiated term CDs. So you can pick a term and come up with a rate for those CDs. They also do a premium transaction account that you can add money to but you can't withdraw it. So it's kind of a hybrid premium savings account. So things like that where you give customers the option to pick how they want to do an account, pick how they want to move money around within it to some degree, and then also have some flexibility about when they get that money away from you. It's going to be more about customer choice than about kind of trying to trick them into landing on your balance sheet. So I think it's going to take new strategies and some of the old tricks that we're going to blow the cobwebs off of will get put to the test. So it'll be really interesting to see how all that plays out.
Jim: All right. Well, here's another nugget from that Bank Director Survey and again it's their 2018 Risk Survey. So again, this was, just to give a little back story, this survey's taken before the actual recent rate hike, but basically, again, it was in anticipation of all this was coming. It said if rates rise significantly, 45% of the respondents say their bank will be able to reprice between 25% to 50% of their portfolio. 28% indicated that bank would be able to reprice less than 25% of its portfolio. So again, two part question here. One, do the percentages sound about right to you, and two, just because you'll be able to "be able to reprice those loans" should you?
Dallas: Yeah. So just to clarify, we're not talking about loan portfolios there. First of all, the terminology there, I think, is a tricky one, which is we'll be able to reprice your loan. So does that mean that contractually they are floating or adjustable rate loans and they will reprice up as rates go up? Or are we talking about bankers saying, "Sure. I'll be able to price up some portion of my portfolio because of the great relationships we have. They'll come to us wanting something else or we'll be able to proactively increase the rates on those." I'm not sure which way they're talking about it but I'm guessing they got some answers of kind of both there from that survey.
So do those percentages sound about right? That's one whereas we dug into bank balance sheets fairly recently, we found out that it depends. So larger banks really don't have a whole lot of long term fixed rate loans. They're share of those in their portfolios stayed about the same as it's always been. Smaller banks, so that would be smaller regionals and community banks, they really have gone out on the yield curve. So they have a lot of longer term, fixed rate loans in their portfolio of all kinds. Real estate loans, residential real estate loans. The duration of those portfolios are much longer than they used to be. So as rates are rising, those customers with fixed rate loans are very happy and the bankers are not. So at some banks, they're really probably hurting there. So repricing between 25% and 50%, that should cover most but it doesn't cover all. So I'd say yeah, the numbers sound about right, but it is very bank dependent.
Jim: Just from sort of a customer service standpoint here, even if you are, again, it's floating and that sort of thing, you have the ability to hike it up and make more money. Are there situations in which you might actually not do that? Just say, "Actually ..." Maybe without sounding a little bit too self congratulatory, make it clear to them that, "Look, we could hike this up, but we're not going to."
Dallas: Yeah, that's where things start to get interesting, right? Is what actually happens when rates start to move? There's two parts to that. So one is on true floating rate loans. So if you got a longer term, multi-year loan that's tied to Prime or tied to Libor or whatever index, all of them are going to be pricing higher. Those loans will become more susceptible to prepayment. Meaning, they're going to go shop that, or they're going to use excess cash to pay down the balances. So they're going to start accelerating the pay downs of those. So if I got a loan at Prime and it was at 4% for a long time, and now all of a sudden it's getting more and more expensive, I may choose to use some cash that was just sitting around for a rainy day fund or whatever to start paying off that debt. I may also look for somebody else who won't expose me to those increasing rates. So those loans will just naturally be a little more at risk. So I think banks need to be aware of those. How many loans do you have like that to which borrowers, which really important relationships do we need to maybe think about or maybe proactively reach out to and make sure they're happy?
The other one is where you have shorter term loans that we tend to roll over a lot. So lines of credit or some shorter term working capital loans that get rolled over. Those things sometimes will be priced with floors or priced on fixed rates, and so they've been at a steady rate for a long time because rates have been lower. All of a sudden they're going to come back to renew that. Even if you don't change how you price it, it's just the spread over the index means that the rate goes higher. When they see that new rate on that thing, they may be unhappy. So you, again, may have some tough conversations there. So this is going to put your bankers to the test of they've kind of ridden this curve down for a long time and a lot of the conversations have been, "Hey, we booked this thing at six last year. Now it should be at five. You should refinance it." Now the conversations going to go the other way. "Hey, I was at five. Now you're telling me I should be at six. What the heck? I think I'm going to shop this." So make sure that your bankers are prepared for this as well, and make sure that you have a game plan for how those conversations should go. Don't kind of leave them hanging to guess at what those conversations should look like.
Jim: That gets to my next question. I mean, these rate hikes are exactly coming out of nowhere. I mean, there's been talk, like you said, before there'll be three hikes this year. So to what extent should banks have already been pricing say the second half of 2017 with an eye toward this and toward future hikes?
Dallas: Yeah. So couple ways of looking at that. One is seeing rate increases coming should we have been trying to kind of build that into our pricing? We're big believers in that you need to price to the yield curve. So the yield curve will guide you on how should you price a one year loan versus a three year loan, and yet, we still see bankers who try to guess at it. Well, it's a three year deal. We think rates are going to be going up over that time. So here's where we should price it. Don't try to outsmart the market. Don't try to outsmart the yield curve. That's a losing game to try to play that. So we would say for any multi-year thing don't try to guess at how many rate hikes you need to build in. Follow the yield curve. It's going to tell you the best guess of the entire market of where those things are headed.
The other part though is more what we were just talking about, of being prepared for it. This is not a surprise that rates are going up, and you shouldn't be surprised when a deal matures and the new rate on it is going to be higher. You know those things are coming. So be ready, be prepared, be proactive when you think it's necessarily. I think every bank in the world should have a list of these are the important relationships that we think are vulnerable given whatever the current circumstances are. So today's current circumstances are rising interest rates. Know who the important customers are that you need to be aware of and maybe have a specific game plan for them. So that you can be ready for when that conversation happens.
Jim: Alright. I teased this earlier when you first started off with this, but I'm curious if there is a concern at all from your standpoint or from bankers you speak to that these rising rates will, for lack of a better word, put some lipstick on a pig here or a cover of some potential warts that have been out there that maybe now the can will get kicked down the road or things will kind of get glossed over because now things are okay because rates are rising. Is there concern that now banks won't be forced to deal with some structural and directional strategies that maybe they should maybe still be dealing with?
Dallas: Yeah. I think there was a margin squeeze that went from annoying to uncomfortable to really painful, and so this is the relief from some of that. So what you see is kind of the glorious early days of a change in the rate cycle where rates go higher. What I mean by glorious is that loans start to price higher, all the assets start to move up pretty quickly and banks can drag their feet on increasing the cost of their funding. So that's why you've seen banks be very stubborn about deposit rates. So you have this period where loans reprice higher, new loans on the books are priced higher, funding stays where it's at, and so you get this kind of natural positive impact on net interest margins. You've seen that on banks everywhere. The industry as a whole saw a big jumps in that interest margin.
So I think you're right in that right now it's easy. The margins just show up on the bottom line. I think part of what the S&P article points out is that now that the deposit rates are starting to move and they're moving in just about every market that we see, that we look at. They're starting to move, which means now you're going to start to differentiate between winners and losers. So there's going to be some banks that continue to expand those margins and they're going to have the right strategies and they're going to react to the things that are different this time better than everyone else. Then you're going to have the banks that find out that they don't have all that loyal of a deposit base, and that those customers that were just looking for an excuse to move, well, here's their excuse. There's finally a rate to go down the street for. So I think you'll see a clear differentiation between winners and losers, and so yeah, I think there's this temporary period where everybody looks like a hero and some of those are going to start to be exposed pretty soon.
Jim: Alright. Well, that'll do it for this week's show. If you want to listen to more podcast or check out more of our content, you can visit our resource page at PrecisionLender.com or you can just head over to our homepage to learn more about the company behind the content. Finally, if you like what you've been hearing, make sure to subscribe to the feed on iTunes, SoundCloud, Google Play or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this has been Jim Young for Dallas Wells and you've been listening to The Purposeful Banker.
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