Independent Banker - June 2018 - 23

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push deposit rates up much less than in previous
periods. This is because the competition from
money market mutual funds has been minimal,
as the assets that these funds could invest in had
become much more constrained since the last
financial crisis.
Further hikes in the fed funds rate will likely
create increasing pressure on raising deposit
rates. In the fourth quarter of 2017, U.S. banks
passed along 40 percent of the hike in the fed
funds rate. Since the U.S. corporate tax rate was
We are approaching
an inflection point,
when lagging deposit
rates is no longer
reasonable and
rounding up asset yields
is becoming critical.
lowered earlier this year, banks have likely begun
to pass along somewhere between 60 percent and
80 percent of the most recent 25-basis-point hike
in the fed funds rate to their customers. Once the
fed funds rate eventually surpasses 2 percent,
any incremental rise will likely be passed along to
customers in full.
How phase II benefits can help
In order to offset rising deposit costs, banks can
take advantage of what we call " phase II benefits "
from this rising-interest-rate environment, rolling
securities and longer-term loan yields higher
while the cost of net free funds remains zero. In
order to mitigate the natural increase in deposit
rates at this point in the rate cycle, it has become
more critical to manage loan origination pricing
higher and look for higher-yielding securities to
replace the lower-yielding existing portfolios.
For the first time in a decade, it will become
important to manage asset yields higher to offset
the incremental cost of higher rate funding. Currently,
bank securities portfolios average about a
2.5 percent yield, while current market security
yields range from 3 to 4 percent, depending on
the needed duration of the incremental securities
purchased. This gap will naturally close as maturities
in the securities portfolio are reinvested.
Moreover, banks can choose to recognize losses
and restructure their portfolios to higher yields
instantly if a bank has the incremental capital
to deploy. This strategy can improve returns by
deploying excess capital that can enhance securities
portfolio yields, generating higher returns on
tangible common equity.
Additionally, many community banks have
high loan-to-deposit ratios, which place a higher
premium on growing deposits to fund the upcoming
incremental loan growth. For these banks,
loan officers should be conditioned to raise loan
origination pricing equivalent to the rise in the
market rate for securities and wholesale borrowing
sources. This will naturally lessen loan
growth and ease the pressure on creating deposit
growth in this tough environment.
Focus on deposit pricing
We are approaching an inflection point for
community banks, when lagging deposit rates
is no longer reasonable and rounding up asset
yields is becoming critical.
To make the most of this new environment,
community bank managements should develop
a deposit pricing plan that enables their banks
to get something in return for the higher rates
offered to their customers.
Quick stat
24
months
The time it took
the Fed this
cycle to make a
100-basis-point
rise in the fed
funds rate
Two options are to offer higher CD rates with
three- to five-year maturities to get longer duration
funding, or to make sure higher money
market rates are offered to customers who are
expanding their relationship with the bank.
On the asset side of the balance sheet, community
bank managements should refine their loan
pricing skills to ensure they continue to receive
compensation for assuming this credit risk, and
to maximize the opportunity to restructure securities
portfolios to the current higher-yielding
market rates.
By preparing for this shift in the market, we
believe community banks can continue to expand
net interest margins and net interest income.
independentbanker.org Q 23
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Independent Banker - June 2018

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