Pub. 8 2018 Issue 2

14 www.azbankers.org Volatility with Institutional Deposits as a Result of Fed Action? By D. James Lutter, Co-authors: Todd Terrazas and Nolan Meehan Have you experienced institutional deposit roll off as a result of Fed action? This is a common occurrence that resonates with most financial institutions, yet it always seems to be a surprise. Understanding the factors around institutional depositors and the economic cycle can provide insight into institutional depositor behaviors. With recently renewed economic optimism, and an active Fed policy, we’re entering an environment not seen for a decade. Two years into a tightening monetary policy, we are seeing a transparent agenda of planned Fed increases occurring at an accelerated pace. In an evolving rate environment, the market will move in advance of Fed fund actions and will then find equilibrium. However, when the Fed moves at an accelerated rate, the market does not normalize between Fed actions. (See chart below) 3MO LIBOR – FED FUND A key step is to establish the relationship your institution has with each institutional depositor (i.e. are they a banking services client or just a deposit?) Once you understand the relationship, you’ll recognize the depositors’ motivation. This will help determine market influence on their deposit balances relating to your institution. The importance of understanding this dichotomy is because most institutional depositors are influenced by market movement. Being that institutional depositors, by nature, utilize short-term investments as fixed income markets begin to anticipate Fed action, competitive investment options create pressure on these types of depositors. In order to minimize volatility, it’s essential to understand this relationship and utilize a pricing model that responds accordingly to changes in the market. For example, the chart below shows the relationship between three month LIBOR and Fed Funds over the last 20 years. This chart reinforces the point that markets move in advance of Fed action, both in an upward and downward environment. 3MO LIBOR - FED FUND FOR 20Y As the intervals of movements begin to increase, the greater the pressure on institutional depositors is to seek higher-yielding short- term investment options. The longer you, as a financial situation, wait to respond, the greater the volatility you will experience in soliciting and/or maintaining institutional depositors. The chart on the next page is an example of a Fed funds based pricing strategy compared to Fed Funds plus a premium and three month LIBOR. Under the Fed Funds plus a premium model (a Fed based model utilized to mimic the market), you’ll notice there are