“A recession is when your neighbor loses his job. A depression is when you lose yours.” - Ronald Reagan
To paraphrase President Reagan, a recession in banking is when banks face funding and cost of funds challenges. Banks, however, can replenish their liquidity. In contrast, borrowers may be experiencing a depression. At a minimum, borrowers are undergoing a liquidity crisis.
As result, for the first time in two decades, banks have leverage in negotiating rates and terms with customers. Unlike when the Federal Reserve Board had the spigot on full, banks are not being punished for maintaining excess liquidity.
The question for many banks is whether it is worthwhile to pay an incrementally higher cost of funds to meet a loan request. As always in banking, the answer to that question is partly a function of the supervisory and interest rate environment.
In late 2022 and early 2023 the handwriting was on the wall. The Federal Reserve Board knew they needed to raise interest rates to combat inflation. The Federal Reserve Board, however, delayed taking action. Perhaps the reason for their hesitancy was to await Congressional approval of President Biden’s renomination, and Congressional confirmation, of Jerome Powell. For whatever reason, the inflation genie was allowed out of the lamp.
At the same time, the prudential regulators were seeking to address the largest bank failures since the subprime mortgage meltdown. Their prescriptions are still being felt. Initially the bank regulators raised concerns about uninsured deposits. While such matters are still an issue for some banks, the bank regulators have shifted to evaluating all aspects of funding at all banks.
Bank regulators have mandated short term, six month and one-year projections with detailed assumptions regarding deposit betas, deposit decay and how funding dovetails with the strategic plan. Examiners have reevaluated contingency funding plans to first assume an asymmetrical event leads to prompt corrective action. Examiners have engaged in “land office” business in issuing liquidity and interest rate sensitivity matters requiring attention. The FDIC recently piled on to this avalanche of mandates with its ill thought out (data lacking) proposal regarding brokered deposits.
An effect of this regulatory onslaught has been to make bankers reconsider the appropriate loan-to-deposit levels and whether to stretch for the next loan. The regulatory penalties for a component-3 rating on liquidity and interest rate sensitivity (and thus on management) has resulted in bankers becoming more reluctant to make every quality loan.
As always bankers need to address the examiners transparently (and certainly not defensively). Bankers need to understand regulatory benchmarks for loan-to-deposit ratios, on balance sheet cash/highly liquid assets, liquidity and AOCI stress testing, wholesale funding, and uninsured deposits, among others. Banks need to be positioned to have sufficient liquidity and to be able to demonstrate it has addressed interest rate risk.
Then banks should turn from defense to offense. Loan-related fees should be re-examined and embedded loan subsidies should be addressed. Pricing should be based on actual rather than perceived competition.
Loans that are disfavored in the current market, such as hotel, office building, and high-end apartments should be priced up. The old rule that a good loan was priced at one percent over prime and a weak loan was one percent under should be discarded as a relic of an earlier time. Prepayment penalties should never burn off or burn down. Challenging loan types, credit arrangements or structures should lead to new pricing opportunities. The Comptroller of Currency has allowed profit participations since at least 1966. No pricing alternatives should be off the table.
Over $2 trillion of real estate loans are due to mature over the next four years. There is not sufficient liquidity in the system to provide for such assets. Again, some commercial real estate loan borrowers are experiencing a liquidity crisis. Bankers need to evaluate what loans to make at what pricing.
Boards absolutely should be part of the discussion. For most community banks, net interest margin below 3% will lead to very low profits or operating losses. Current pricing needs to address not just the relationship but needs to be made against the backdrop of legacy loans. President Obama said, “never waste a crisis.” Well, the liquidity crisis presents an opportunity for banks to realign their yields with their cost of funds.