Putting Excess Liquidity to Work in Today’s Low-Rate Environment

Dave Koch
October 28, 2020
Read Time: min

A storm of events that have defined 2020 leaves many community financial institutions today in the position where balance sheets are awash with liquidity and competitive markets are squeezing rates on good quality loans to lower-than- comfortable levels. Cash flows from maturing investments are rolling down 150 to 250 basis points from historical levels, and many loans traditionally priced over 4.0% are now breaking below the 3.0% levels.

Essentially, what I’m hearing from financial institutions is, “Help! I’m drowning in liquidity and don’t like any of the rates I see so I can put it to work!”

Where can financial institutions go to find income?

It is in times like these that institutions need to lean back on strong fundamentals of “banking” and remember that while nominal yields are down, overall profitability comes from spreads, not simply asset yields. These times are different than the early 2000s or even 2006 to 2018 when economic activity was roaring, unemployment was low and financial institution liquidity was tight. Today, while many economic sectors are faring well despite the pandemic, other factors linger, and our liquidity levels are drastically different – for now.

It’s a good time to review some fundamentals on asset selection choices, with the goal of helping improve your approach toward simply reviewing “rate” vs. pricing “risk.”

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Risk-adjusted pricing is key in deciding where to place liquidity

Let’s begin by agreeing that when assessing the “rate” on any instrument, we must remember that rates are a summation of expected returns on risk-free instruments, plus adjustments for the risks and costs associated with the different asset classes. Credit card loans carry a higher rate presumably due to larger losses on credit extensions. Mortgage loans have very low historical default rates, but given the fixed-rate and longer-term characteristics, they require a return to compensate for the time-value of money. Different investments carry higher or lower yields depending on when the cash flow is returned to the buyer, the certainty of the cash flow return, and potential losses in the underlying collateral that may pass along to the bond holder. Using this concept of risk-adjusted pricing helps in today’s times to find answers to the question of where to place liquidity so that it enhances profitability.

Rest assured, though, the same process we use today to deal with extra liquidity on hand is the exact same approach we take when liquidity is not as plentiful. In those cases, our decision rules might be modified, but the fundamentals of the process do not change.

The following section lays out a decision-making process that should be reviewed regularly and adapted as market conditions change, as they always do!

First, answer this question: Are we trying to decide what to do with the money you already have on the books, or are we trying to find ways to grow the balance sheet and going to need new funds as a result?

Let’s say we are considering a new commercial loan and our competitor is offering a 5-year fully amortizing loan at 2.50%. Sounds crazy, right?  Consider that on the day we were considering a 5-year loan at 2.50%, you could borrow money in the wholesale market for 0.57% for 5 years (for a “bullet” advance; an amortizing advance rate is 0.37%). So, assuming you had to “buy” money from a wholesale source to fund the loan, you would have a spread of 2.13% (2.50% – 0.37%) which isn’t great compared to your traditional margin.  Of course, there are many funding options to consider, but the issue is how much incremental spread do we add.

On the other hand, if what we really have is a situation where we already have the money (like many financial institutions do right now), we are paying an average cost of funds of 0.65%. In that case, the issue here is that we are investing 0.65% money today in a “cash” account at 0.05%, so we are losing 0.60% on the funds. When we add the 0.60% lost value back to the loan returns, things get a little brighter!

See, if we already have the money on the books to invest, the only real question is where can we invest the funds where we understand the risks and costs we are taking and know we are being compensated for the risks. Notice I have not yet said whether the load rate of 2.50% is a good rate for that kind of credit. We will get there, but I am simply pointing out that for every $1 of funding that we could put into a higher returning asset that is currently “losing” money relative to what we are paying for it, we must seriously look at the option of doing so.

When we look at the 2.50% 5-year loan and we compare what options we could invest in today in a “risk-free” investment, we see the following rates for Treasury investments:

Just eyeballing these rates, we might be able to earn a total rate of 0.25% in a risk-free investment of the same cash flow life as our loan.  Agency bonds which are more common in community FIs might offer us an additional 10-15 basis points and are also essentially “risk free.”

So, let’s assume a 0.35% risk-free return is possible for a 5-year amortizing set of cash flows. Now we add in the risks and costs of the loan as well as any fees. Let’s assume no fees for simplicity here. But we probably have some origination expenses to incur making the loan. There are ongoing servicing costs we would have if we made the loan vs. not making the loan. There is the potential credit risk that the borrower may not pay us back. At the end of it all, if the sum of the costs is more than the difference between the rate and the risk-free investment, then don’t make the loan. In our example above, 2.50% - 0.35% = 2.15% is the spread available to cover risk and cost.

Note that risk decisioning on the balance sheet comes into play here. If you are considering moving into an asset that has a much longer duration and you are already heavily concentrated in long-duration assets, then making a further bet may not be the best idea in total, even though the individual “loan spreads” may make sense. In that case, maybe you can make and sell the loans. Sounds like many 1-4 family mortgage portfolios today. That is an overall asset/liability management decision that requires more time and attention, so stay tuned for that.

A decision guide to reconcile low interest rates and high levels of liquidity

For now, we have a starting point to reconcile today’s low interest rates and high levels of liquidity with a more disciplined approach to pricing risk, thus ensuring we maximize earnings in times when spreads are tight.

Remember, follow the simple decision guide as a starting point in your assessment of alternative options for excess liquidity. To download the complimentary Liquidity Decision Guide, click here.

About the Author

Dave Koch

Since 1989, Dave has delivered educational programs on Asset/Liability Management and pricing topics to Federal Regulatory Agencies, national and state industry trade groups, Federal Home Loan Banks, and Corporate Credit Unions nationwide. Dave currently serves on the faculty of the Graduate School of Banking at the University of Wisconsin – Madison as well as numerous other industry schools. In addition to his speaking roles, Dave is actively involved with Abrigo clients consulting with them on capital planning, loan & deposit pricing, and other ALM concerns in an effort to make the ALCO processes more effective. Abrigo and Dave are committed to helping the community financial industry develop workable strategies and risk management processes to improve financial performance, regulatory compliance and overall solutions to their business challenges.

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