​Case Study: Optimizing Funding Costs

Case Study: Optimizing Funding Costs 

0:00
Hi, how’s it going? My name is Tyler Buckeridge, sales and strategies specialist at the Federal Home Loan bank of Boston and in today’s case study, we are going to take a look at optimizing funding costs 
0:20
I will start by giving you an overview of what the case study will cover, first, we will do a deposit dynamics trend analysis to see what is playing out in the New England deposit landscape. Second, we will examine balance sheet impacts to see how these market forces are impacting member balance sheets, and lastly, we will look at some funding strategies that can be used to optimize funding costs.  
0:43
I would like to set the stage by looking at the relationship between the cost of interest-bearing deposits for member depositories and the daily Fed funds rate. Over the last four cycles, there has been a trend of deposit costs rising and falling more slowly than Fed funds. This low deposit beta suggests that as a funding source, your deposit book will tend to be cheap relative to Fed funds as rates rise, and expensive relative to Fed funds on the way down. While some of your ALM providers have said that you can cut deposit rates as fast or faster than the Fed without causing increased deposit runoff, this chart suggests that it is easier said than done. While some of this dynamic is caused by the repricing lag in the CD portion of your deposit books, much of it is due to consumer complacency. Prior to starting with the FHLBank of Boston, I worked in the branches of one of our depository members, and it was shocking how little awareness customers have of deposit rates and what is going on with the Fed. I would argue that for the average depository customer, there is a 12-month lag between when the Fed hikes or cuts and when the customer hears about it, realizes how it affects them, and then makes time to go to a branch or call their relationship manager and move their money.  As you opportunistically shop funding sources and set deposit pricing, this is something to keep in mind.  

2:01
Another notable trend in member deposit books has been the flow of funds out of lower-cost DDA and savings products and into CD and money market accounts. This remixing of deposits has led to CDs and share certificates representing a much higher percentage of total member deposits and has been a significant driver of the higher deposit costs we have seen during this cycle. On the left side of the slide, we see that over the last two years, CDs have gone from about 14% to 22.5% of total bank deposits, and Certificates have gone from 14% to 28% of credit union deposits. Alongside that trend, we have also seen a shortening of average term deposit tenor. Looking at the pie charts on the right, we see that, over the last two years, CDs shorter than one year have gone from 75% of bank CDs to 91%, and share certificates shorter than a year have gone from 58% to 87% of credit union certificates. While I am sure I am not revealing any secrets here, this was due to depositories moving from a normalized CD curve to offering eye-watering five-month CD specials and fewer competitive offerings of longer term. What these two trends suggest is that when rates rise, not only do we have to consider the higher rates to be paid on deposits, but also the extent to which deposit remixing and term shortening can reduce overall duration on the liability side and result in diminished liquidity.  
3:26
Now, I would like to transition and take a look at how these deposit book dynamics are impacting member balance sheets. As I just mentioned, we need to look beyond the sticker price to see the true balance sheet impact of offering deposit specials. A significant consideration for any ALCO thinking about offering a deposit special is the extent to which that special may cannibalize deposits from your existing lower-cost offerings. In the scenario on this slide, we have a depository with 2% existing cost of funds who is considering offering either a three-month deposit special at 4% or taking down a three-month classic advance at 4.53%. While the choice may seem obvious at first glance, if just 33% of the deposits you bring into the three-month CD special come from your existing 2% deposit base, the marginal cost of the CD special is 5%! This is because to raise these new deposits, you must not only pay the 4% rate on the new CD special funds, but you are also now paying 4% instead of 2% on every deposit that has been cannibalized. What that speaks to is how the lower your existing cost of funds is, the more destructive deposit cannibalization actually is, so saying “I can afford to raise new funds with this above-market CD special because my existing cost of funds is really low” does not really make a whole lot of sense.  
4:42
Now, I would like to take a look at the marginal cost of a CD special at various levels of deposit cannibalization. This kind of analysis is valuable because I think the question that should be asked in ALCO when you are considering a deposit special is, “what is the breakeven cannibalization rate where the special being considered will cost the same as an advance, and do we anticipate our cannibalization rate to be lower or higher?” If you anticipate a higher rate, it is at minimum worth considering using an advance to raise the new funds you need. In this example, at an institution with 2% cost of funds the breakeven rate between a three-month CD special at 4% and a three-month-classic advance at 4.53% is just 20% deposit cannibalization. Of note is how devastating the higher levels of deposit cannibalization are at 30% cannibalization, the CD special costs 85 basis points more than sticker price and at 50%, the marginal cost is 6%, 200 basis points over the 4% sticker price.  
5:43
While you need to worry about the hidden but higher marginal cost when thinking about offering a deposit special, with FHLBank Boston advances you get the benefit of an all-in cost that is lower than sticker price. This is because non-overnight advances require a purchase of FHLBank Boston stock equivalent to 4% of the advance and overnight advances require a 3% purchase. FHLBank Boston pays a dividend on our stock, which was 8.41% as of the third quarter of 2024. The dividend reduces the all-in cost of a three-month Classic Advance to 5.27%, a 25.9-basis-point discount from the posted rate of 5.53%. I used the rate from July 1st, 2024, here so that we could look at an example using our posted real dividend rate and not a hypothetical scenario. However, please note that the dividend rate and methodology is subject to change and is at the discretion of the Board.  
6:35
In light of what we know about deposit cannibalization and marginal cost of funds, I think it makes sense to offer a more normalized rate curve in your CD book and focus on rewarding your high-quality, full-relationship customers instead of going above market to retain rate shoppers. You can still have CD and money market specials and negotiate rates but think about keeping your rates just high enough to retain your quality customers who have checking and loan relationships. Let the rate shoppers walk and then backfill with advance funding that compliments your balance sheet needs. By doing so you actually improve the overall quality and stickiness of your deposit book while reducing funding costs. So, let’s take a look at some flexible funding solutions. Not only do all our advance products offer term liquidity protection, they also have features to match your economic outlook or anticipated future funding needs. If you expect a higher for longer environment, you could use a fixed rate advance like the classic advance or member option advance to protect funding costs, regardless of what the rates do. If you anticipate more Fed easing than the yield curve currently implies, take down one of our SOFR-indexed advances to benefit from rate cuts as they happen. With CDs and money markets, your customer holds the option to call their funds back, but with the Member option advance and callable SOFR indexed advance, you hold the option to cancel the advance at preset intervals, meaning if loan demand is lower than expected you retain the flexibility to put back the funds. So not only can you add funds without causing deposit cannibalization, puttable advances allow you to reduce funding just as painlessly.   
8:14
Now, let's take a look at some scenarios to see how using FHLBank Boston advance funding solutions compares to offering deposit specials. In this scenario, we are adding new funding using a three-year Member-Option Advance with a one-year lockout at 5% compared to a one-year CD special at 4%, assuming 2% existing deposit cost. At 20% cannibalization, the marginal cost of the CD special is 4.5%, and at 50%, it is 6%. This scenario uses rates from January 2nd, 2025, and looks forward 12 months.  
8:49
If you can raise new money in a one-year CD special at 4% without seeing deposit cannibalization, that is the way to go. But if you anticipate even a slight level of deposit cannibalization, it is worth weighing the benefits of utilizing the three-year member option advance with a one-year lockout. This advance gives you the option to put back funding after one year if say, loan growth was to drop off, but it still provides three years of liquidity and rate protection. Now, we would all like to raise funds with three-year CDs at a reasonable rate and with sufficient penalty to offset or limit the risk of customers breaking those CDs early, but how much luck have you had doing that over the last few years? At 33% cannibalization, the one-year 4% CD special has the same marginal cost as the 5%-member option advance, and that is before including the dividend discount, which brings the all-in cost of the advance to 4.78%. And keep in mind this is not black and white, you could use advance funding to raise some of funds you need, which may allow you to raise the rest while offering a lower rate and experiencing less deposit cannibalization. 
9:56
In this second scenario, we look at the balance sheet impacts of adding new funding using a 12-month SOFR-Indexed Advance with a day-one rate of 4.57%, which is SOFR plus 24 basis points, compared to a SOFR minus 50-basis-point money market special, assuming 2% existing deposit cost. The scenario assumes two rate cuts in 2025, one in May and one at the October meeting, and uses January 2nd, 2025, advance rates. Even though the money market day one rate is 3.83% and it will end the year at 3.33%, at just 15% cannibalization the marginal cost of the money market special is 3.93%, and at 50% it is 5.28%. While it may seem like cheat code to go out and raise funds with a money market special because you can lower the rate as the Fed cuts, it can be quite costly to see your existing deposits, many of which were in sub 2% money markets, take advantage of the new money market special.  
10:55
If you see rates dropping this year and want to add funding that will allow you to benefit from Fed easing, take down a SOFR-index advance to add funding that gets cheaper as the Fed cuts rates and also gets you a full year of liquidity. The breakeven cost is at just 31% cannibalization, and that is before including the 22-basis point dividend discount, which brings the all-in cost of the advance over one year to 4.16%. If you are considering whether or not to offer a deposit special or are just curious how cannibalization and marginal cost of funds might be impacting your balance sheet, give myself or your relationship manager a call or send us an email, and we will be happy to do some analysis, put together some scenarios, or do whatever will be most helpful for you. We have tools and calculators that allow us to see what a deposit special’s marginal cost is or would be and can show you the overall balance sheet impacts of using various mixes of deposits and advances to meet your funding needs. My contact info is on the following slide. Thank you for tuning in and please don’t hesitate to reach out with any questions or comments.