DEPOSITS ARE DESTINY

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Liquidity remains top of mind for most of our credit union clients. Last year surely tested even the most sophisticated liquidity plans. And those whose funding strategies were less thought out and more reliant on a single source were exposed to stiff competition in securing funding from members and non-members alike.

The maxim “demography is destiny” is commonly attributed to the French philosopher Auguste Comte. While many doubt that the so-called 'father of sociology' actually uttered the phrase, the observation remains as relevant today as it was in the early 19th century. In the post-COVID era, work-from-home arrangements, improvements in technology and the changing ethic of the American worker have combined to give the phrase particular resonance. Today, in the credit union world, however, there is an even more important trend than the demographic shifts that are reshaping our nation’s power centers.

As we enter 2024, the average credit union is confronting the reality that “deposits are destiny.” The primary role of financial institutions, like credit unions, is to take in funds — called deposits — from those with money and lend them to those who need funds. In fact, the country’s credit unions might be best understood as a network of intermediaries between depositors (who lend money to the credit union) and borrowers (to whom the credit union lends money). Historically, retail savings and deposits have represented the most stable and typically cheapest form of funding for a credit union. A steady, reliable stream of these deposits is crucial for most credit unions in generating revenue. The more money a customer deposits, the more money a credit union is able to lend and derive interest on those loans.

With the competition for customer deposits as fierce as at any time in recent memory, a set of factors suggest that credit unions should remain laser focused on their deposit gathering for the foreseeable future. Each of the drivers behind the difficult deposit gathering environment is discussed briefly below:

THE UNWIND OF PANDEMIC RELATED DISTORTIONS

First, the stimulus-driven deposit growth of the pandemic era has simply evaporated. Worse, the inflation resulting from the period’s excessive money printing has forced many Americans to draw deeper into savings to support day-to-day expenses. This reality has depleted the checking and savings accounts of many Americans, frustrating the deposit retention efforts at even the country’s best run financial institutions.

INTEREST RATE POLICY

At the same time, the cost of funds has risen dramatically, with the Federal Reserve’s efforts to raise interest rates to fend off inflation.

As a result, customers are more discerning about the rates they are earning on the cash they leave at financial institutions. This phenomenon can be observed in the overall mix of deposits at the country’s credit unions. Like their community bank counterparts, U.S. credit unions have seen a significant rise in certificates of deposits (CDs) concentrations, surpassing pre-pandemic levels in the third quarter of 2023. At credit unions, member CDs climbed from $248 billion (Q4 2021) to $483 billion (Q4 2023) over the past two years.

This growth in CDs is attributed to customers moving their deposits into higher interest-paying accounts, a shift directly influenced by the Federal Reserve's interest rate hikes. Financial institutions are also adjusting their funding strategies, turning to brokered deposits and Federal Home Loan Bank (FHLB) advances to fill the gap created by organic deposit flight.

The competitive environment has led many institutions to continue to offer higher rates on CDs to retain core deposits. Offering high-yield deposit accounts to keep up, however, is a strategy that risks cannibalizing lower-cost deposits from existing customers. To mitigate those risks, financial institutions often tailor “CD specials” to target new rather than existing customers to avoid cannibalization. There has also been a focus on cross-selling lower-yielding products, such as checking accounts, to customers with high-yield savings accounts.

The industry’s weighted average and median cost of funds — calculated as total interest expense as a percentage of average interest-bearing liabilities and average non-interest-bearing deposits — were 1.59% and 0.76%, respectively, as of YE 2023. These measures are up 13 and 11 basis points quarter over quarter, and 101 and 49 basis points year over year, according to Callahan data.

AVAILABLE-FOR-SALE SECURITIES RELATED LOSSES

At the same time as deposit gathering remains challenged, the increases in interest rates over the last two years have pushed the bond portfolios at credit unions deeper underwater. As unrealized losses have mounted in the available-for-sale securities portfolios, which continue to hold the majority of bonds that credit unions own (and must be marked to market on a quarterly basis), some market observers have expressed concern that institutions might begin to sell securities at a loss to meet their liquidity needs. Thus far, credit unions have hesitated to sell underwater bonds, even for restructuring purposes, opting to struggle to fill their liquidity needs elsewhere instead. As funding costs stabilize and the underwater bonds move closer to maturity, many hope that these effects will continue to wane.

At the end of Q4 2023, credit unions held Available-for-Sale securities with a $321 billion historical value and a $291 billion market value. This compares with Q4 2022 levels of $358 billion and $321 billion, respectively.

INCREASED COMPETITION

In recent years, credit unions have also had to withstand deposit gathering competition from outside traditional financial depositories. A recent report from the U.S. Department of Treasury highlighted this rather new phenomenon:

“Technology has facilitated the growth of digital deposits, reducing the need for physical branch locations for deposit accumulation. Taking advantage of these new capabilities, some new entrant non-bank firms – namely, neobanks – are offering digital-only deposit accounts through relationships with [Insured Depository Institutions]. New entrant non-bank firms are serving as the consumer-facing front-end for digital-only deposit accounts. These firms facilitate the opening and maintenance of consumer accounts – designed to provide FDIC insurance to the non-bank firm’s customers – held at third-party IDIs. Additionally, some consumers hold balances in accounts on new entrant non-bank payments companies’ platforms in a similar manner to how consumers hold balances in a traditional deposit account.”[1]

PROPOSED REGULATORY CHANGES

Finally, additional liquidity pressure might be on the horizon, with proposed changes in the regulatory landscape. For many credit unions, the FHLB system has offered a welcome and reliable source of borrowings, cushioning the twin stresses of mark-to-market losses and deposit flight. With plans being considered to limit the FHLB borrowings of depository institutions, however, we are encouraging our clients to ensure that their other sources of liquidity are available and can be tapped as needed.

THE BOTTOM LINE

As credit unions continue to fight for relevance, in large measure, their fate will be tied to their ability to raise deposits reliably and at reasonable cost. We do not see this pressure abating any time soon.