Choosing the Right Funding Strategy

CHOOSING THE RIGHT FUNDING STRATEGY

Written By: Matt Pieniazek President, Darling Consulting Group Table of Contents

 Introduction...... 1

● Regulators taking note...... 1

● Good business sense & best practices...... 1

 Considerations when choosing an alternative funding source...... 2

● Interest rate risk...... 2

 Collateral management is key...... 3

● Role of reciprocal deposits...... 3

● Role of FHLB...... 3

● Reciprocal vs. FHLB...... 3

● Customer repos...... 4

● Contingency liquidity management & stress testing...... 4

 Conclusion...... 5

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expanded ability to support credit and growth needs of local communities. needs of local and growth support credit ability to expanded prudent liquidity management; prudent of funds; cost manage effectively ability to risk; and rate interest in managing flexibility

and each can have a different impact on not only a bank’s bottom line, but also its overall balance overall line, but also its bottom on not only a bank’s impact a different have and each can seamless than others. more are some sources reality, risk position. In sheet reciprocal deposits from using deposit placement services such as Promontory Interfinancial Interfinancial services using deposit placement such as Promontory deposits from reciprocal offer to enable financial institutions that or ICS, and CDARS), Cash Sweep, (e.g. Insured Network equally, created are not all funding sources $250,000. Of course, eligibility beyond FDIC insurance Funding options should include FHLB advances, brokered deposits, repurchase agreements, and and agreements, repurchase deposits, brokered should include FHLB advances, Funding options Best practices clearly include a delineation of the role for and prudent utilization of alternative alternative of utilization for and prudent role of the clearly include a delineation practices Best well. this as guidance confirms Regulatory funding sources.     Having a well-defined funding gameplan and supporting policies is a necessity for all banks, for all banks, supporting policies is a necessity gameplan and funding a well-defined Having as: such number of fronts, business sense on a good It makes size. of asset regardless Good business sense & best practices Good business sense & best Similarly, banks that complement their traditional deposit strategy with a quiver of appropriate of appropriate with a quiver strategy deposit their traditional complement that banks Similarly, costs, funding overall in managing their successful be more will undoubtedly funding alternatives environment. the rate of regardless includes an appropriate role for wholesale funding and alternative deposits. wholesale funding and alternative for role includes an appropriate contingency funding plans. With that in mind, developing and defending a meaningful contingency contingency a meaningful and defending developing in mind, With that funding plans. contingency that strategy funding well-defined in futility without a liquidity policy and plan is an exercise uncertainties. This has resulted in liquidity management becoming a key area of concern with of area key a becoming in liquidity management resulted has This uncertainties. for under the microscope liquidity are with strong banks Even community. the regulatory of bank robustness and efficacy to the shifting frequently with the focus liquidity management, Prospects for elevated deposit competition have also clearly captured the attention of bank attention the captured clearly also have deposit competition elevated for Prospects environment and economic rate interest of current the degree especially given regulators, Survey, 4th Quarter 2018, February 2019) 2018, February 4th Quarter Survey, note taking Regulators coming year as competition for deposits is expected to increase. This sentiment was confirmed in confirmed was This sentiment to increase. expected is for deposits as competition year coming Network Interfinancial Promontory by conducted recently a survey deposit pricing discipline. However, and notwithstanding a Fed that appears to be on hold, angst be on hold, angst to appears that a Fed and notwithstanding However, deposit pricing discipline. the over could escalate and balance pressures deposit pricing concerns that given is accelerating How effectively a bank manages its cost of funds plays a big role in determining its financial its determining role in a big of funds plays cost its manages a bank effectively How thus successful been quite have banks most Fortunately, value. its and, ultimately, performance risen, due primarily to have rates as interest of funding costs on the reins in pulling back far Introduction Choosing the Right Funding Strategy Funding Right the Choosing 2 DCG • CHOOSING THE RIGHT FUNDING STRATEGY targeting larger relationships using ICSand CDARS to drive deposits into bank-preferred deposit In terms ofattracting meaningful balances into desired products, wesee banks successfully as acomplement to traditional deposit gathering initiatives. FHLB advances isanotherexample ofimportant tactical advantages wholesale funds can provide base ofbankbalancesheets. Also, the abilityto embedderivatives suchasinterest rate caps into the option) isanimportant consideration formanaging prepayment risks embeddedintheasset Keep inmindthat theavailability ofcallable brokered CDandFHLBstructures (where bankowns structure andrelated needs. structures can provide broader flexibility dependinguponabank’s particular balancesheet oriented markets. Whilebrokered depositsare aviablesolution,theFHLB’s array ofadvance looking to extend funding maturities, willbemuchmore successful if executed inthewholesale- Accordingly, interest rate riskdriven fundingdecisions, especiallyfor liabilitysensitive banks 3) 2) 1) basic realities: interest rate riskpositionthrough local market deposit strategies. It comes down to oneofthree For example, itisvery difficult foraninstitution toquickly effect anymeaningful change in its Interest rate risk influence incremental funding decisions. ready accessto adiversified set offunding structures/alternatives isimportant andthus can interest rate riskshouldalsobeanimportant consideration. When managinginterest rate risk, traditional depositgrowth challenges orotherliquidity related management variables. However, When bankers consider andevaluate fundingalternatives, they are typically responding to      marginal fundingstrategies withoutadditionalimportant considerations. Theseinclude: source. Obviously, relative cost (orprice)isalways a variable. Butpriceshouldnotbethedriver of A numberofkey businessissuesshouldbeconsidered whenselectingaparticularfunding Considerations WhenChoosinganAlternative FundingSource long ortoo shortfor thecustomer’s liking). Customers are notinterested CDspecialthat iseithertoo (e.g. inwhat thebankis“selling” alternatives); and/or The rate neededto bepaidto attract depositsis too expensive (particularly relative toother they needinareasonable timeperiod,if at all; Banks can’t drive enoughvolume oftheparticulartypeand/or term structures offunding interest rate riskmanagement objectives. current mixoffundingandlevels (includingconcentrations) relative topolicylimits;and equivalents—another accelerating focal point inbank exams); level of“on (unencumbered marketable balancesheet liquidity” securitiesand cash available collateral levels, bothsecuritiesandloans; outlook for loanvs. depositgrowth; DCG •CHOOSING THE RIGHT FUNDING STRATEGY 3 The primary disadvantage of FHLB LOCs vs. insured cash sweeps is that they are liquidity neutral liquidity neutral are they is that sweeps cash insured vs. of FHLB LOCs The primary disadvantage liquidity a net produces product while the sweep security collateral), for loan collateral (exchange FHLB vs. Reciprocal lieu of pledging securities for public funds. LOCs have a common benefit with reciprocal deposits reciprocal with common benefit a LOCs have for public funds. lieu of pledging securities security collateral. don’t require they in that Role of FHLB Role also We have funding quiver. should also be included in a bank’s (LOCs) of Credit FHLB Letters credit) in of letters or municipal LOCs (MULOC, FHLB utilize to successfully banks many influenced customer repo funding strategies can be a game changer. changer. be a game can funding strategies repo customer interest rate risk position and materially improve their liquidity flexibility by freeing up collateral collateral freeing up by flexibility their liquidity improve risk position and materially rate interest management balance sheet overall by to be driven management portfolio enables investment that public funds and service an ICS-type into needs. Incorporating than collateral needs, rather One way to mitigate this, or any collateral challenge, is with a reciprocal cash sweep product. product. sweep cash reciprocal is with a challenge, collateral any this, or mitigate to One way their change completely banks helped numerous we have the ICS program utilizing example, For deposits of reciprocal Role liquidity benefit and the creation of interest rate risk that is unnecessary and readily avoidable. In readily is unnecessary and risk that rate interest of and the creation liquidity benefit of being instead that, activities a series of security leveraging into locked the bank becomes effect, (repo). deposit surrogates public funds and/or funded by are borrowings, funded by to buy securities to meet the collateral requirements for that funding, and the simultaneous quest funding, quest for that and the simultaneous requirements collateral the to meet buy securities to no in this has resulted Unfortunately, funding costs. of the related yield in excess a reasonable for rate interest their liability sensitive how banks numerous to demonstrated have we the years, Over the need from emanates It strategy. repo by their public deposit and/or largely is driven risk profile context of both liquidity and interest rate risk management, it is insightful to take a quick look at a quick look take to insightful it is risk management, rate of both liquidity and interest context is being pledged. security collateral whereby strategies repo public funds and customer common To illustrate how alternative funding sources differ in their impact on collateral management, and management, collateral on in their impact differ funding sources alternative how illustrate To in the favorably can be augmented strategies retail-oriented existing how also demonstrate to including retail-oriented deposit strategies, can have notably different impacts on this collateral collateral impacts on this different notably have can strategies, deposit including retail-oriented reservoir. when it comes to a bank’s reservoir of investment and loan collateral: using it judiciously for using it judiciously for and loan collateral: of investment reservoir a bank’s to when it comes Funding decisions, contingencies. for availability while ensuring appropriate purposes, operating Collateral Management Is Key Management Collateral dichotomy of an interesting the management necessitates strategy funding Choosing the right ICS and CDARS. ICS and Since most reciprocal deposits are no longer considered brokered under federal law (subject to to (subject law under federal brokered considered no longer deposits are reciprocal Since most servicestheir use of deposit such as increase to expect banks we or 20% of liabilities), of $5B, cap structures with rate concessions readily accepted by customers in exchange for the FDIC insurance insurance the FDIC for in exchange customers by accepted readily concessions with rate structures benefit. 4 DCG • CHOOSING THE RIGHT FUNDING STRATEGY management processes. of theserealities andincorporate that knowledge into theirliquidity stress testing and related Reciprocal depositsfall in-between thesetwo. Clearly, banks must document theirunderstanding (rarely involves non-renewal ofoutstanding advances, buthaspotential for curtailment of new). (entails immediate curtailment andrequired non-renewals ofexisting) thanitis for FHLB advances provider backingaway dueto itsown policy. issuefor Thisisamuchbigger brokered deposits falling(e.g. below well capitalized andassumingnoFDICwaiver) orbecause ofthefunding curtail accessto fundingoreven require repayment, eitherbecause ofregulatory restrictions However, regardless offundingsource, banks must understand thecircumstances that could for banks even instressful bankingindustry environments. loan and security collateral, and the FHLB System has a history of being a reliable source of funding and FHLB)letters ofcredit. FHLBproducts have theadvantage ofbeing able to shift between collateral levels andthuscan increase stress-testing resiliency vs. collateralized borrowings (repos collateral availability iskey. Reciprocal depositprograms donotimpact eithersecurityorloan When itcomes to contingency liquiditymanagement and stress testing, total securityandloan Contingency liquiditymanagement & stress testing sweep products are more conducive to abroader array ofbalancesizes. customer repurchase agreements are typically reserved for larger balancerelationships, while cash banks substitute insured cash sweeps for repurchase agreements. Another consideration isthat tracking andcan result inothercollateral management activities.That is why we are seeingmany dislike, even thoughthisisintended to protect them.They alsonecessitate collateral market value downsides for boththebankandcustomer. Repos require dailyremittances, whichcustomers sensitive deposits.Onedrawback isthat repurchase agreements come withsomeadministrative funding alternative and continue tobeusedquite effectively at many banks to capture rate Notwithstanding itscollateral requirements, customer repurchase agreements are animportant Customer repos can alsopositively impactfranchise valuation metrics forpublicbanks. customer monies are lower classifiedasdeposits,whichnotonlyhelps theloan/deposit ratio, but Another relative benefit of products like ICSand CDARS vs. reposorotherborrowings isthat the banks that are insearch offunding. one-way programs suchastheICSOne-Way to Sellservice temporarily shift excess deposits to noted that banks can create an offbalancesheet liquidity reserve (andearn fee income) by using levels ofonbalancesheet liquidity, whichisanaccelerating area of regulatory focus. Itshouldbe Importantly, asinsured cash sweeps andLOCs free upsecuritycollateral, they alsoresult inhigher which lowers theeffective cost ofFHLB credit. alternatives isthedividend received onthe stock purchase required to supportsuchactivities, collateral related, animportant consideration when comparing FHLBcredit products withother advantage can sway between LOCs andICS-type products dependingoncircumstances. Whilenot benefit (no collateral required). In general, related costs are comparable; however, theall-in cost DCG •CHOOSING THE RIGHT FUNDING STRATEGY 5

[email protected] process becomes a sustainable profit center through accurate risk accurate through center profit a sustainable becomes process About the Author Along with of Darling Consulting Group. is the President Pieniazek Matt with hundreds partners DCG colleagues, of highly experienced a team management their asset/liability that ensure to nationwide of banks or 978-463-0400. assessment and the development of tailored solutions for earnings enhancement and earnings enhancement for solutions of tailored and the development assessment on balance and authors speakers frequent are He and his colleagues risk mitigation. at be reached can Matt topics. management sheet not your friend. not your and the management Educate key. is Flexibility greatly. matter and important Funding choices are polices. Time is funding philosophies and related of your the appropriateness and revisit Board, a variety of approved funding alternatives, truly forms the foundation for managing operating for managing operating foundation the forms truly funding alternatives, of approved a variety strategy. liquidity plan and contingency a resilient liquidity and establishing Liquidity management in general and stress testing in particular have become key areas of areas key become have in particular testing and stress in general Liquidity management security and loan unencumbered of both levels managing the Accordingly, focus. regulatory incorporates that strategy with a funding along management, Collateral is essential. collateral throughout a myriad of economic and interest rate cycles. rate and interest of economic a myriad throughout borrowings (e.g. FHLB advances), brokered deposits, letters of credit, and reciprocal deposits (e.g. reciprocal and credit, of letters deposits, brokered (e.g. FHLB advances), borrowings funding costs their overall manage successfully their ability to enhance will greatly ICS and CDARS) disadvantages that can ebb and flow in terms of relative importance or value at any given time. It given any at value or importance relative terms of in and flow ebb can that disadvantages at all times. available readily all of them to have it is important is why and that is situational, for role well-defined and with a prudent deposit strategy their core complement that Banks strategy incorporating a role for wholesale funding and alternative deposit products such as products deposit alternative funding and for wholesale role a incorporating strategy and has its advantages deposits, market” “local including funding source, Every reciprocals. Conclusion funding developed an appropriately have all banks that necessitate practices and best Prudence