US banks use excess liquidity to shrink CDs, borrowings

Banks have taken advantage of the excess liquidity on their balance sheets to decrease their reliance on higher-cost deposits and borrowings, a trend likely to continue as deposits remain plentiful.

The nearly 20% year-over-year deposit growth and lackluster loan growth throughout 2020 has left most banks with excess cash on their balance sheets. The industry's loan-to-deposit ratio has fallen to below 65% for the first time in 30 years, putting pressure on net interest margins. In the third quarter, though, banks took advantage of the surge in deposits into the system and reduced their reliance on higher-cost CDs and borrowings for funding.

CDs decreased 10.7% across the industry in the third quarter, falling to 9.7% of total deposits from 10.9% in the second quarter. Borrowings decreased even more, plunging 19.5% from the linked quarter to 1.6% of liabilities from 2.0% as a number of banks sought to extinguish the funding early.

Banks of all sizes have reduced the concentration of CDs and borrowings among their funding bases, but the declines have been far smaller among small banks. CDs at community banks — institutions with assets below $10 billion — dropped in the third quarter, but the decline was less than 5%. That is less than half the rate of decline experienced among larger institutions, which had far smaller concentrations of CDs heading into the period.

Still, a number of community banks reported significant declines in CDs in the third quarter. Among the top 10 institutions with at least $3 billion in assets reporting the largest decrease in CD balances, five institutions had less than $10 billion in assets.

Meanwhile, some institutions reported increases in CD balances in the third quarter, and many remained heavily reliant on CDs for funding. Among the top 10 institutions with at least $3 billion in assets reporting the largest increases in CD balances, the products made up more than 40% of four institutions' deposit base.

While smaller banks have higher concentrations of CDs, those institutions could shrink the deposits more notably in the coming quarters as they seem more likely than their larger counterparts to lower rates on the products even further. Across the industry, the average rate on one-year CDs fell 64 basis points to 0.33% between Jan. 3, 2020, and Jan. 8, 2021. Of the decline, 52%, or 33 basis points of the decrease, occurred during the first quarter of 2020 between Jan. 3 and March 27.

Small banks, institutions with assets between $3 billion and $10 billion, have lowered rates on one-year CDs by 60 basis points since Jan. 3, 2020.

The pace of decline in CDs has slowed considerably in the last three months, with the average rate on one-year CD rates falling just 5 basis points between Oct. 2, 2020, and Jan. 11, 2021. Small banks had decreased the average rate on one-year CDs the least during that period, lowering the rate by 3 basis points.

Any future decline in CDs will be less substantial since rates are now below the levels recorded late in 2015. At that point, the fed funds target rate had been pegged near the zero bound for close to seven years, allowing banks to steadily lower their deposit rates.

Still, the levels of liquidity in the banking system in recent months remain unprecedented and appear to have not been fleeting. Many banks debated how sticky deposits would be since unprecedented government stimulus, funds from the Paycheck Protection Program and historically high savings rates have driven the surge in funds.

Fed data show that deposits appear to have grown further through the fourth quarter. The Fed's H.8 release, which tracks commercial bank balances, shows that deposits jumped 21% between Jan. 1 and Dec. 30, 2020, up modestly from the end of the third quarter.

As Congress has passed additional stimulus and allocated more dollars for the PPP, and deposits have held steady, more banks likely will seek to reduce CDs and borrowings even further. Such actions to reduce overall funding costs offer institutions a way to mitigate the pressure they face on earning-asset yields, stemming from the low interest rate environment.