A McQueen Financial Advisors White Paper

Financial Advisors

The Impact of a Flatter Yield Curve on
Liquidity and Spread

By: Jim Craven

Loan growth is improving. Deposit costs are higher. Liquidity is tight. These are common phrases we hear daily. Large and small financial institutions across the country are simultaneously dealing with all three. This is a recent phenomenon, which has accelerated over the past several quarters. It all started slowly as the Federal Reserve began raising short-term interest rates in response to an improving economy. Loans began to grow slowly, then came on strong more recently. Short-term interest rates have increased faster than long-term rates, and the yield curve is very flat. Over the long term, a flatter yield curve is not favorable for financial institution earnings. Impressive loan growth has caused a fierce battle for core deposits, resulting in higher funding costs and liquidity stress.


We are very fortunate to have significant records spanning several years which we use to identify trends. Our records include a variety of statistics such as deposit costs and asset yields for all of our clients across the country. We also gain valuable insight during hundreds of conference calls and on-site visits. The data used for this analysis is sourced from various-sized clients in 27 states. Often, we find size or geographic related trends. This time, we did not find a significant difference in location or institution size. The trends mentioned here are happening across the country at large and small financial institutions.

The Challenge in Attracting and Retaining Low Cost Deposits

As the economy improves, financial institutions have enjoyed moderate to strong loan growth. On the surface, this may seem like a favorable reversal after many years of anemic loan growth. However, in many cases growth has happened much faster than anticipated. In addition, loan growth is more broad-based than in the past, fueled by improving economic conditions, local advertising, indirect lending or participation loans. Industry-wide loan growth has resulted in more demand for deposits and higher deposit costs. In nearly every market, we see upward pressure on deposit rates, often without the ability or willingness to raise loan rates. In some markets, we see an unsustainable pattern of lower loan rates and higher deposit costs. We are faced with a perfect storm accompanied by a flatter yield curve and increased need for deposits. In this environment, building and maintaining a favorable spread can be challenging. The situation is more pronounced where markets are saturated with financial institutions. Across the country, the loan to deposit exceeds 90% at 35% of banks and at 17% of credit unions. That’s nearly 3,000 financial institutions! You may be one of them. If not, you very likely compete for deposits with one or more. This makes it very challenging to attract and retain low-cost deposits.

The Impact on Margin and Liquidity

Margins are starting to compress because deposit costs are rising faster than loan yields. We anticipate additional downward margin pressure, brought on by competition for deposits and a potentially flatter yield curve. Many institutions are borrowing for the first time in years because the combination of strong loan growth and deposit run-off has caused a liquidity squeeze. Even institutions with loan-to-deposit ratios in the range of 75% are borrowing because investment portfolio maturities have not kept pace with loan growth and deposit runoff. If needed, borrowing will be much more expensive than in the past. Borrowing costs are 3 to 5 times higher than local deposit rates. Intermediate-term borrowing rates are in the range of 3.25% to 3.50%, compared less than 1% for core local deposits.

MFA Recommendations

These are unprecedented times which require us to consider action that has not been necessary for several years. We encourage you to raise loan rates now and evaluate the incremental benefit of adding new loans funded by borrowing. Net loan rates (after charge-off expense) are around 5.00% or less. When evaluating new opportunities, compare loan rates to the cost of new borrowing, rather than your total cost of funds. In doing so, we see that loan growth funded with borrowing will result in spreads of 1.50% or less. It is also important to seek lending opportunities that will boost deposits. Participation loans, indirect lending, and out-of-market loans do not result in new deposits and may impact the ability to lend locally. In a worst-case scenario, it may be necessary to curtail local lending, simply because local deposits cannot keep pace with non-core loan growth. Facing uncertain liquidity needs, we also suggest maintaining a cushion of liquid investments that could be quickly sold or pledged. Lastly, a review of contingency liquidity policies and plans is recommended.

Jim Craven is Vice President of McQueen Financial Advisors.