Eight Steps for Banks to Stay on Top of 2023’s Volatile Market

Since our discussion with banking experts in early 2023, the industry has seen seismic shifts. Three major banks have closed, the Federal Reserve has increased interest rates four times, and all banks have fallen under increased regulatory scrutiny. As banks try to manage risk in an evolving marketplace, we checked in with with Chris Cain from Carr, Riggs & Ingram CPAs and Advisors, Lance Holladay from Renasant Bank, and Chris Mihok from Keefe, Bruyette & Woods about the changes we have seen since our January conversation and steps banks can take to stay ahead of the curve.

What issues are banks facing in this market?

• • Liquidity and capital constraints – Liquidity has historically grown 5% each year, peaking in $2.8 trillion in 2022. Now, there’s a $1.5 trillion gap between where deposits should be and where they are.
  • Interest rate fluctuations – Additional rate hikes are planned for this year, with the goal to manage inflation. These economic factors are creating a highly inverted yield curve, where mid- and long-term investments see less returns than short-term investments. And as deposit costs rise, asset yields aren’t repricing fast enough to keep up.
  • Commercial real estate downturn – A mid-size bank typically has 5% of their loan portfolio in office space, with an average loan size of $1-4 million, and office rates are now trading at 50% of their value.
  • Credit tightening – The outlook for loan growth is much lower for 2023, which could contribute to an economic downturn.
  • Lack of M&A deals – With just 1.5% of industry consolidation estimated in 2023, mergers and acquisitions, and the financing opportunities they bring, are set to hit the lowest rate on record.
  • Lower stock values - Banks used to make up about 8% of investments from major mutual funds. Now they make up 1.5-2% of mutual fund portfolios.

Many of these challenges are the result of ongoing economic uncertainty, with customers and investors staying on the sidelines to wait out market changes. What can banks do to shore up their operations as they navigate these rough waters?

1. Understand Deposit Base

With a shrinking customer base, competition for deposits has hit historic levels, even resulting in bidding wars among banks. Every bank has some sort of CD or money market special and is focused on increasing their core base of deposit clients. Banks should work to build positive, proactive relationships with their clients that include strategic engagement to understand their needs in terms of cash flow and whether they’re collateralized or uncollateralized.

2. Review Customer Makeup

All banks are trying to acquire new customers, but the types of customers are just as important as their quantity. Balancing deposits with new loan customers is critical. Maintaining relationships with significant deposit holders and creating new relationships with loan customers to obtain their deposit business are strong steps to improve a bank’s balance sheet.

3. Assess Investment Strategy

The industry is seeing deterioration in accumulated other comprehensive income, and banks need a plan to manage this long-term. It may be wise to look at your entire portfolio and consider whether investments are held-to-maturity or available-for-sale. There may also be opportunities to drop certain investments at a small loss and pick up higher yielding investments.

4. Analyze Risks Through Modeling

Many banks’ asset-liability committees are conducting comprehensive modeling to predict certain scenarios, better understand their investment portfolio, and test deposit and loan beta assumptions. It’s a good idea to run multiple models to look at situations from as many angles as possible.

Keep charge-offs in mind during modeling, especially when looking at CECL models. The industry is seeing an increase in charge-offs and not including them in modeling can impact a bank’s allowance for loan loss, which impacts its capital. This should be analyzed before the end of 2023.

5. Don’t Forget About Funding Costs

With so much of the industry focused on deposits and loans, costs of funds can be overlooked. Borrowing from the Federal Home Loan Bank (FHLB) currently sits at 5% with upward pressure. In previous rate hike cycles, about 60% of the change in Fed funds carried over to deposit rates. But only 25% of the current rate increases are reflected in today’s deposit rates, which could lead to an uphill climb on funding costs if the Federal Reserve keeps interest rates high. Banks should review the costs of deposits relative to the costs of FHLB and Fed funds.

6. Be Disciplined on Loan Pricing

Competition for customers is high and banks may want to offer specials to acquire customers. But they still need to make sure they’re getting the right returns in relation to the wholesale borrowing side. For instance, for customers choosing a bank for a one-time loan, a top-of-market rate may be more appropriate than for a client who is also bringing their deposits to the bank. Discipline around loan pricing should come from the top down – bankers and regional leaders need to keep this top of mind.

7. Reevaluate Budgets

2023 budgets were created at a very different time in the market, and many banks are re-analyzing their budgets to better understand the impact on net interest margins. Banks should carefully compare estimated to actual earnings and costs to fine tune their budgets for the rest of the year. Funding costs are putting pressure on margins, and if normalized interest rates and a regular yield curve return, banks will do well, but budgets should be reviewed with the understanding that it’s uncertain when this will happen.

8. Look for M&A Opportunities

There are some benefits to acquiring in this market. Acquisitions bring with them new deposit bases and expanded geographic markets, which add stability and reduce risk. And with the current workforce shortage, acquisitions can be a great way to find talent. It can also increase liquidity for banks to help them pay down borrowings.

Though the industry is facing challenges, banks typically outperform the average when the economy emerges from a recession. Banks are resilient, and their balance sheets are built to handle rate changes. Being proactive about understanding customers, exercising discipline and anticipating risk can help banks weather the current storm and end 2023 strong.

Please reach out to Mark Fullmer or any member of Phelps’ Business, Corporate and Securities or Finance and Lending teams with questions or for advice and guidance.