CEOs and CFOs are shifting focus from credit risk to interest rate risk – with good reason. Though viewpoints differ as to when this period of historically low rates will end, its inevitable end will put funding cost pressure on financial institutions. Averaging the forecasts of Federal Open Market Committee members suggests federal funds rates could increase to 1.13% in 2015, 2.5% in 2016, and 3.75% in the long run.
Many traditional tools used to measure and manage risk are inappropriate for today’s conditions. Recent cycles of mortgage refinancing will disrupt the ability to calculate mortgage durations based on history, causing many to underestimate how long they’ll be operating with very low yield portfolios. Similarly, rate-shock approaches focused one to two years out may not adequately account for the long-term risk of margin compression in a gradual recovery.
We are facing a unique situation that requires an out-of-the-box solution.
Cost Advantages Of Reward Checking Accounts
High-yield, reward-based checking accounts are a surprising but stable defense against margin compression for a number of reasons.
An important factor is that there is a median 52% “cost of funds discount” built into high-yield checking accounts.2 Using data compiled from more than 2 million reward checking account holders from nearly 700 community financial institutions, BancVue finds the median promotional rate was 1.98% nationwide in 2013. Yet the median cost of funds was 0.94%, leading to this 52% COF discount, or 104 basis points. The dramatic difference between true COF and the promotional rate occurs for two reasons. First, not every account holder meets the qualifications for the promotional rate, thus earning a nominal “base rate.” Additionally, account holders that do qualify are paid the highest promotional rate only on balances up to a pre-determined cap.
It is important to note that no other deposit project enjoys this COF discount. And more importantly, this discount increases as rates rise. The higher the rate, the larger the discount amount. Provided account holders qualify at the same rate, and the balance cap remains the same, a 52% COF discount on 4.00% APY would mean a 1.92% COF, or 208 basis points, compared to the 104 basis point average in 2013. Meanwhile, a 3.70% APY 3-year CD (the average prior to 2008 collapse) has an exact COF of 3.70%.
Additional factors include an opportunity for a more gradual increase compared to the market and other products. I have provided a detailed analysis and institution examples in this white paper on the rising rate environment.
Take Charge Of Your Deposit Mix
The flexibility of high-yield reward accounts to react to changing conditions makes them that much more attractive. Slight changes in product design (promotional rate, balance cap, etc.) can significantly decrease actual COF. Additionally, regardless if rates are rising, falling, or flat, these accounts generate substantially more non-interest income than CDs or even traditional checking accounts.
Some credit unions may be in a position of wanting new relationships, but not necessarily more deposits. These credit unions have the opportunity to restructure their deposit portfolio away from CDs to revenue-generating transactional accounts with a minimal increase in their overall deposit dollars.
Thus, these accounts are not only an effective hedge against margin compression due to rising rates, they are also a reliable revenue source in any environment.
Originally published on CUInsight.com, December 2014. Updated July 2018.