THRIVING IN A RISING RATE ENVIRONMENT Reward Checking Is Your Best Weapon Against Interest Rate Risk By Jeremy Foster, CFO, Kasasa Published January 2016
SUMMARY Interest rates have recently become a major concern for U.S. financial institutions for the first time since the Great Recession. The FDIC has highlighted interest rate risk as a major concern given prevailing low net interest margins and widespread mismatches between asset and funding maturities. 1 While rates will likely rise slowly over a long period of time, many institutions remain sensitive to even small increases. Complicating this is the fact that the traditional solutions to rising rates, such as certificates of deposit (CDs) or long-term borrowings, mainly provide protection against short-term, rapid rate increases; as a result, they're an expensive and unwieldy solution for the most likely scenario facing financial institutions in the United States. Our research indicates that reward-based checking accounts are an effective weapon against margin compression. This may seem counterintuitive at first glance given their high-yield payouts, but a closer look at their cost structure reveals the advantages of these accounts: 1. The low-rate environment places current reward account rates at a premium in consumers eyes, so those rates will not need to increase at the same pace as the Fed rates. 2. Reward accounts aren t as expensive as they initially appear nationwide reward accounts provided a median 52% discount on cost of funds (COF) in 2015. 2 3. As rates rise, the actual dollar value for loaned out funds increases for financial institutions but so does the institution s COF. This makes the COF discount reward checking accounts offer even more valuable in a rising rates environment. 4. Reward account product designs are highly flexible and can be customized to meet individual institutions need for funds. Additionally, unlike CDs, reward account rates can be raised or lowered across the account holder base at any time. Federal Open Market Committee's Projection Of Interest Rates 5% 4% 3% 2% 1% 0% -1% Source: The Federal Reserve 2015 2016 2017 2018 In The Long Run A member s vote 1
BACKGROUND In December 2015, the Fed raised rates for the first time in nearly a decade. CEOs and CFOs at community banks and credit unions have increased their focus on interest rate risk as a result a shift from the focus on credit risk that consumed much of the past eight years. It could even be argued that those who haven t shifted some of their credit risk focus towards interest rate risk are managing yesterday s risk instead of tomorrow s. Reward Checking Is Your Best Weapon Against Interest Rate Risk Adding to the complexity, many of the traditional tools institutions use for measuring and managing the risk are inappropriate for today s unique environment. Adding to Rate-shock the complexity, approaches many of the focusing traditional one tools two institutions years out use may for dramatically measuring and underestimate managing the the risk long-term are risk of margin compression inappropriate a gradual for recovery. today s unique Exacerbating environment. the situation Rate-shock is the approaches fact that recent focusing cycles one of to aggressive two years out mortgage may dramatically refinancing suggest that underestimate the long-term risk of margin compression in a gradual recovery. Exacerbating the situation is the fact those relying on history to calculate the duration of mortgages or mortgage backed securities may underestimate how long they may be that recent cycles of aggressive mortgage refinancing suggest that those relying on history to calculate the duration of operating with mortgages very low or yields. mortgage backed securities may underestimate how long they may be operating with very low yields in their portfolio. These and a dozen other potentially flawed assumptions could lead a community financial institution (CFI) to take the wrong approach to liabilities management. These and a dozen Seeking other mid-term, potentially rate-sensitive flawed assumptions instruments could like lead certificates a community of deposit financial may institution have worked (CFI) to in take other eras, but today s unprecedented the wrong circumstances approach call to liabilities for growing management. core deposits. Seeking Taking mid-term, a closer rate-sensitive look the instruments advantages like of certificates high-yield of reward deposit checking accounts (CDs) may have worked in other eras, but today s unprecedented circumstances call for growing core deposits. Which and their unique COF discount becomes that much more important. is why that closer look at the advantages of high-yield reward checking accounts and their unique cost of funds discount is that much more important. Diagram A MAY 2004 AUGUST 2006 May 2004 was the last time exceptionally low short-term interest rates increased dramatically. The yield curve quickly started to flatten, eventually inverting by August 2006. DECEMBER 2012 DECEMBER 2013 Here we see a snapshot at year-end 2012 and 2013, illustrating the changes on the long end of the yield curve. Source: StockCharts.com Source: StockCharts.com 2
May 2004 was the last time exceptionally low short-term interest rates increased dramatically. The yield curve quickly started to flatten, eventually inverting by August 2006. Diagram A shows a snapshot at year-end 2012 and 2013, illustrating the changes on the long end of the yield curve. MORE GRADUAL INCREASE COMPARED TO MARKET High-yield reward checking accounts are priced further out on the yield curve to entice consumers to move their existing checking account (its accompanying non-interest income coming with it) and consolidate their long-term CDs. For example, the median promotional rate for high-yield reward checking accounts in January of 2016 was comparable to the average yield offered nationally on CDs: 1.9%. Because the reward checking product is paying an attention-getting premium to compensate for the incredibly low rate environment, the promotional rate should rise more gradually than the federal funds rate. COST OF FUNDS TRUMPS PROMOTED RATE High-yield reward accounts typically promote among the highest deposit rates available to consumers. In the current rate environment, the products appear to pay premium rates making them very attractive to consumers. It is important to note, however, that the true cost of funds to an institution is dramatically lower than the promotional rate. For example, our partner Progressive Savings Bank (a $260MM institution in Tennessee) has had great success offering free Kasasa Cash checking accounts. In 2013, Progressive Savings had an advertised promotional rate of 1.98% APY. But their interest expense for those accounts was actually only 0.86%. They enjoyed a 57% COF discount versus their promotional rate. 2 This COF discount occurs for two reasons: (1) Not every account holder qualifies for the promotional rate because they didn t meet the criteria to receive it. These account holders are paid a nominal base rate, which Progressive Savings set at 0.10% APY. (2) Account holders that do qualify are paid the highest promotional rate only on balances up to a pre-determined balance cap. In our example, Progressive Savings balance cap was $15,000. When a balance exceeded this amount, the first $15,000 earned the promotional 1.98% APY and the portion of balance above $15,000 earned 0.25% APY. As such, even if an account holder qualified, a balance of $25,000 truly earned a blended APY that equaled 1.29%. The larger the balance, the lower the APY paid becomes. COF DISCOUNT INCREASES AS RATES RISE The cost of funds discount Progressive Savings Bank enjoyed closely mirrors what community financial institutions nationwide experience. Because of our nationwide network of partnerships, Kasasa has access to analytics for more than 2 million reward checking account holders at nearly 700 CFIs. Of those accounts, the median promotional rate nationwide was 1.86% in 2015, but the median cost of funds was 0.88%, a 52% COF discount, or 99 basis points. 2 Reward checking accounts are the only major deposit products that enjoy this significant COF discount, a highly beneficial advantage that is often overlooked. Even more significantly, this discount increases as rates rise. This is due in large part to the previously mentioned fact that the accounts already pay what consumers consider to be a premium rate, so there s no need to raise the promoted rate as quickly as surrounding interest rates rise. Assuming an institution keeps the same promotional rate and balance cap, and that account holders qualify at the same rate, simple math demonstrates the higher the rate, the larger the discount. A 52% COF discount on 4.00% APY would equate to 1.92% COF, a discount of 208 basis points! In comparison, a 3.67% APY CD (the average 5-year CD rate prior to the 2008 economic collapse) has a COF of exactly 3.67%. Since competing products like a CD or money market enjoy no discount, the COF savings with a reward checking account grows, in comparison, as rates rise. EASILY CUSTOMIZABLE TO FUNDING NEEDS In addition to the organic discount between the promoted rate and cost of funds, reward accounts also benefit from proactive performance analysis and product design adjustments. A slight change in product design can easily translate to a 0.5% or more decrease in actual cost of funds for that product. This savings can add up quickly with a product that typically has average balances four to five times greater than free checking. Their product design s versatility makes reward accounts easily customizable and highly capable of meeting individual institutions unique funding needs. 3
A MAJOR COMPETITIVE ADVANTAGE A CFI with a deposit mix that includes a sizeable reward checking base has a major competitive advantage over those that do not. Diagram B illustrates how reward checking combats interest rate risk by reducing the margin compression more traditional deposit products will lead to as rates rise. A focus on short-term risk mitigation can lead you to believe that CDs will help mitigate longer-term interest rate risk, but we believe that s simply not true over the long haul. Diagram B demonstrates how, as rates rise steadily over a period of time, the 2-year CD rate eventually rises as well, with a sharp jump once it resets. Diagram B 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Federal Funds Rate Kasasa Checking Promotional Rate Kasasa Checking COF 2-Year CD COF Money Market COF 0.0% Year 0 Year 2 Year 4 Year 6 This graph illustrates the cost of funds of an individual CD as it re-prices. If we were to plot a CD deposit mix as a whole (accounting for new CDs opened each month) the picture would look even worse for CDs, with the yellow line above the blue line for even more of the duration. In contrast, the reward checking COF not only combats margin compression, it improves the institution s interest margin as rates rise over an extended period, since the COF discount grows with the overall environment. While a reward checking portfolio may re-price more quickly than CDs for short time horizons, in the long run a reward checking portfolio will actually result in widening margins as rates rise. While this chart uses a hypothesized rate increase trend, it demonstrates the effects we can expect. It starts with rate data at the end of 2013, and the various products are plotted over time as they typically react to the federal funds rate. These relationships will generally hold true whether the yield curve rises or if the yield curve flattens. Regardless of your particular appetite for credit risk or ability to deploy funds into assets, any COF below the federal funds rate represents an essentially risk-free return (lower interest paid on accounts than earned on overnight loans to other institutions). Because non-interest income is greater than marginal operating expenses for these accounts, this added income operates as yet another hedge against interest rate risk. 4
MAXIMIZING YOUR DEPOSIT MIX While many CFIs already have a reward checking program in place, the majority do not. The good news is these CFIs can benefit even if they launch such a program after rates have started rising. This is because such programs, when deployed correctly, can have an immediate impact on your deposit mix. In 2009, Bank of Weston (a $120MM community bank in Missouri), another CFI we work with, was sitting with the following deposit mix: 55% CDs, 25% savings and money markets, 20% checking accounts. Bank of Weston launched Kasasa Cash in 2010 and quickly started improving their deposit portfolio. By 2011, their deposit mix was: 20% CDs, 20% savings and money markets, 60% checking. 3 Bank of Weston realized this success without substantially increasing their overall deposit dollars. Ocean Communities FCU (a $150MM credit union in Maine) experienced similar results, shifting their deposit mix from 54% CDs prior to launching Kasasa Cash to 26% afterwards. 4 CONCLUSION When examined closely, reward checking accounts prove to be a stable, long-term defense against interest rate risk, effectively hedging against margin compression. This is a result of a few advantages: 1. The promoted rates are priced at a premium in the current low rate environment and won t rise as quickly as the rate of other products. 2. Nationwide reward accounts provided a median 52% discount on cost of funds in 2015. 2 3. The actual dollar value for loaned out funds increases as rates rise, but so does the COF, which makes reward checking accounts COF discount even more attractive in a rising rates environment. 4. Reward account product designs can be customized to meet financial institutions unique needs for funds and are a much more flexible funding source than CDs. Banks and credit unions with a deposit mix that favors highyield reward checking over traditional funding instruments like certificates of deposit have a long-term competitive advantage over those without. As rates rise, these financial institutions will benefit from stronger non-interest income, greater operational flexibility, and interest margins that widen versus peers that are dependent on rate-sensitive funding. 1 FIL-10-2016, Interest Rate Risk Videos Updated, February 3, 2016 2 Data sourced by Kasasa Analytics, utilizing data from nearly 700 community financial institutions with over 1.8 million high-yield reward checking accounts nationwide. 3 Courtesy Bank of Weston 4 Courtesy Ocean Communities Federal Credit Union 5