After transitioning from near-zero rates to one of the fastest rate-hiking cycles we’ve ever seen, financial institutions are now in the position of waiting for rates to fall. As we wait for the Fed’s next move, it’s important for management teams to understand how lower rates will impact their institutions’ income statements and take steps to better position themselves for the lower-rate environment likely to come.

Many Financial Institutions Funding Their Balance Sheet Short

First, let’s consider where we are now. Federal and consumer spending have been driving economic growth, despite the higher interest rates. This growth, in turn, has the markets thinking the Fed will delay rate cuts until later this year or possibly into 2025.

Funding short has not yet worked out, with funding continuing to roll at nearly the highest cost on the curve. Coupled with continued deposit migration within the bank, cost of funds is continuing to rise at many institutions.

Managing Expectations for Rate Cuts

To manage margin this year, one question to ask is if your institution will need to offer the highest interest rate in the market for deposits or one that’s “just close enough” to that rate to keep existing customers. We find that, if the rates are close enough, the incumbent tends to win because consumers don’t want to deal with the hassle of moving their money. This strategy may allow your institution to manage the upward pressure in cost of funds (COF). Additionally, management teams may consider what realistic reprieve in COF may come from the first few Fed cuts. Many institutions have not raised non-maturity account rates in line with non-bank alternatives (ex. money market mutual funds). Consequently, community banks may be reluctant to reduce rates on these accounts, as they will still be below alternate funding costs.

Investment Portfolio Conundrum

Some institutions may have decided that they’re not taking any risk by accumulating cash. However, we challenge that thought: If the Fed starts cutting rates and your institution doesn’t get a meaningful and immediate COF improvement, your institution’s earnings on that cash are going to drop immediately. And so, institutions that are asset-sensitive or holding cash today need to consider the immediate margin compression that could occur once the Fed starts cutting rates. In the meantime, locking into investments closer to cash rates today can help hold yield until the COF starts to decline. A balanced investment strategy could allow your institution to add a mix of securities that average a yield close to Fed Funds with an allocation to call-protected assets. We urge management teams to consider the trade-off of investing in only the highest yield options compared to the potential benefits of adding assets with call protection that could result in an unrealized gain when the Fed lowers rates.

Finally, it’s important to keep in mind that repeating the past is unlikely, but it’s still essential to learn from it. Understanding the choices that your institution made, and then making informed decisions is how your institution can and will put its best foot forward.

Kent Musbach is a senior vice president and Marc Gall is a senior vice president and asset/liability strategist for BOK Financial Capital Markets.

Contact BOK Financial Capital Markets at (866) 440-6514 to discuss the latest economic outlook and timely considerations. We can help guide a unique, well-conceived strategy that considers many variables and potential outcomes.