April 12, 2013

True Costs to Excess Cash

In this prolonged low-rate environment with excess liquidity, weak loan demand, and low coupon mortgage loans and security investments, many of our member institutions are forgoing yield and the associated interest-rate risk and maintaining higher-than-normal levels of cash reserves at the Federal Reserve, earning 25 basis points. Cash as a percentage of members’ total assets has increased by over 150 basis points over the past six years to 9.26% of total assets. Although holding excess cash at the Fed is free from credit risk, the true costs to this strategy are often not properly assessed.

An article published in June 2010 by the American Bankers Association estimated that the cost for a bank to open a transaction deposit account ranges from $150 to $200, and the yearly expense to maintain these accounts is between $250 and $300.

Let’s look at an example of an institution with $100 million in excess liquidity sitting at the Federal Reserve earning 25 basis points. We will assume the average transaction account is $10,000 (or 10,000 accounts that comprise the $100 million). Annual interest income earned from the Federal Reserve would be $250,000 on the $100 million investment. If the cost per account, per annum is $250 (statements, administrative costs, regulatory costs, technology, etc.), the non-interest expense associated with these funds would be $2.5 million, and would result in a “negative carry” of $2.25 million (see table provided). The cost to open accounts would drive the negative carry even further (account acquisitions were not included in this analysis).

Earned Income on Accounts Costs/Expenses of Accounts
Principal: $100,000,000 Number of Accounts: 10,000
Annual Yield from Federal Reserve: 0.25% Average Annual Cost per Account: $250.00
Annual Income from Federal Reserve: $250,000 Annual Account Expense: $2,500,000
Negative Carry on this Group of Accounts: $(2,250,000)

Note: example assumes an average account balance of $10,000.

Continued economic weakness and declining net interest margins (NIMs) have also inspired institutions to think more seriously about becoming fully invested, even with low coupons. In addition, several institutions are working the liability side of their balance sheets more aggressively (i.e., lowering dividend rates on shares) to reduce interest expense and fend off declining margins, unprofitability, and a shrinking capital base.

Let’s consider another scenario: a $400 million institution with a NIM of 2.87% that has 10% or $40 million of their balance sheet assets sitting in cash at 25 basis points. If the institution was able to deploy that cash in 15-year, fixed-rate first mortgages at 2.875%, they would be able to pick up an additional $1.05 million in the first year in interest income, as well as improve their NIM to 3.18%. In this scenario it’s up to an institution to decide whether the benefit of income and capital growth now outweighs the impact of spread contraction in the event of a rise in interest rates. Most members will benefit from the eventual rise in interest rates, which would boost income and mitigate the spread contraction in this scenario.

As previously mentioned, working the liability side of the balance sheet more aggressively is another way to improve NIMs. However, concerns about reducing franchise value are always a cause for “pause.” Lowering rates on shares could potentially cause an outflow of funds, but the costs of not taking any action are too high to ignore. Additional concerns may exist regarding future funding shortfalls, which may result from a fully-invested position and a declining share base. However, we have found that our members that have lowered dividend rates on their shares have had little or no impact to their core share levels. “Hot” money will almost always flow to those paying higher rates, but this type of funding is often more expensive than wholesale funds and doesn’t add to franchise value. A simple solution is managing outflows of funds through the use of Federal Home Loan Bank of New York advances. As the outflow of “hot” money occurs, consider adding longer duration advances to the balance sheet to help mitigate the interest rate risk associated with putting money to work in longer duration assets.

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This report may contain forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These statements are based upon our current expectations and speak only as of the date hereof. These statements may use forward-looking terms, such as "projected," "expects," "may," or their negatives or other variations on these terms. The Bank cautions that, by their nature, forward-looking statements involve risk or uncertainty and that actual results could differ materially from those expressed or implied in these forward-looking statements or could affect the extent to which a particular objective, projection, estimate, or prediction is realized. These forward-looking statements involve risks and uncertainties including, but not limited to, regulatory and accounting rule adjustments or requirements, changes in interest rates, changes in projected business volumes, changes in prepayment speeds on mortgage assets, the cost of our funding, changes in our membership profile, the withdrawal of one or more large members, competitive pressures, shifts in demand for our products, and general economic conditions. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.