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By Kevin G. Martin, Vice President, Member Financial Strategies Manager

January 23, 2008

If the terrible jobs number of January 4 is any indication, 2008 could turn out to be a difficult year for the U.S. economy and for the financial services industry in particular. In a recent speech, Ben Bernanke stated that “the outlook for real activity in 2008 has worsened,” and many analysts now expect the Fed to continue to cut the its benchmark rate to three percent or lower by the summer. If the U.S. economy does slip into recession, management of the region’s financial institutions will have to maneuver cautiously through the difficult times ahead.

Net interest margins of FDIC-insured institutions, steadily declining since 1992, were 3.36 percent in the third quarter of 2007, up from 3.34 percent in the second. Margins remain near 17-year lows. For smaller institutions that have not been able to diversify their revenue sources as much as larger institutions, net interest income is the primary source of profitability. Since net interest income is dependent on the size of the balance sheet and the spread between asset yields and the cost of funding those assets, balance sheet growth is essential for the continued profitability of these smaller financial institutions.

Deposit growth at FDIC-insured institutions with total assets of less than $1 billion has averaged only 2.1 percent over the last seven years, indicating that these institutions are not even retaining the dividends paid to depositors. Competition for deposits remains fierce in many markets, and many institutions continue to offer CD specials well in excess of both the federal funds target rate and FHLB Boston advance rates for similar terms. It appears to be another challenging year for deposit generation in 2008.

Given this backdrop, what can your ALCO do to squeeze a few more basis points out of the net interest margin?

• The committee must realize that wholesale funding will play a larger role in funding than ever before. Review your liquidity policy for ratios that hamper your decision-making abilities. Ensure that your liquidity policy gives you the flexibility you need to manage your business. Develop a plan for unanticipated liquidity events (such as the one we are currently experiencing) that will prove to regulators that you have a sound plan to address any liquidity pressure you may experience. Why put an arbitrary limit on your advances-to-assets ratio at a time when advances are priced so favorably to both retail and brokered CDs? Long-term advances for five- to 10-year maturities are now between 70 and 110 basis points of the lows they reached in June 2003. If you lengthen your funding now, you won’t have to chase CDs and cannibalize your core deposits when interest rates start heading back up, as many institutions had to do during the last tightening cycle.
• Most institutions should examine their CD rates compared to wholesale market rates rather than local competition. The Federal Reserve has lowered its benchmark rate by 100 basis points since September, and if you believe the futures market, another 50 basis point cut is almost certain on January 30. Many institutions are still offering CDs with coupons close to five percent. Members should consider lowering their CD rates, depending on their need for funding and overall liquidity position. Marginal cost of funds analysis illustrates that some retail CD strategies are costing in excess of 5.25 percent to retain non-rate sensitive money of one year and less. You could take a 20-year advance for 30 basis points less than that!   
• Check the pricing assumptions in your A/L model for other deposit accounts as well, such as Money Market, transaction, and regular savings (in addition check the pricing assumptions on your CDs in conjunction with the previous bullet point). Have you adjusted the pricing on these accounts in a down 100-basis-point rate environment as the model’s assumptions indicated you would? If you haven’t, that could be why net interest income trailed your estimates for the fourth quarter.
• During 2006 and into 2007, many members took advantage of favorable pricing of brokered CDs against advances and increased their usage of brokered CDs. That pricing advantage is no longer applicable with brokered CD rates still in the mid fours at all points on the curve. As brokered CDs mature, members could consider replacing these with advances at a significant cost savings, depending on their funding and overall liquidity position.
• Consider selling some optionality on the liability side of the sheet. HLB Option advance pricing for quarterly calls is extremely attractive at the moment. Whether you are running a short book or are looking to extend your funding, these structures currently present an opportunity to reduce the cost of funding. The cost savings associated with replacing overnight or short-term advances with HLB Option advances with lockouts between three months and one year is substantial; these rates are currently between 150 and 200 basis points below the Fed Funds rate. Members needing protection against rising interest rates can look at HLB Option advances with longer lockouts, say two to three years with final maturities of five to seven years. These are just a few of the HLB Option advance structures FHLB Boston offers. We encourage members to call the Money Desk at 800-357-FHLB (3452) with any questions or interest. Current HLB Option advance indications are available here. 
• Use your A/L model to quantify the result of any strategic change you are considering. Compare the results to the base case. It’s better to know if the strategy will work for your institution before you implement it.

These are currently some of the strategies that you can employ to manage the cost of funding your balance sheet. As the level of interest rates or the shape of the yield curve change, we will continue to bring funding ideas to you through the daily rates email and the Solutions page of our website to help you navigate these challenging times. Please call the Member Financial Strategies department at 617-292-9644 or 617-425-9452 to discuss funding strategies that will work for your institution.