Navigating the New Liquidity Landscape

In the aftermath of the pandemic and the financial disruptions that followed, U.S. banks are grappling with new challenges with managing liquidity, adding deposits, funding mixes and regulatory requirements that are shifting in unprecedented ways. Recent economic changes have impacted and reshaped how banks approach balance sheets, particularly when it comes to their liabilities.

A surge in government stimulus, coupled with the collapse of prominent banks like Silicon Valley Bank and Signature Bank, contributed to a sudden shift in the liquidity environment that financial institutions must now navigate.

Pandemic-Related Deposit Surge
Before the pandemic, U.S. bank deposits grew at a steady 7% annual rate. Government stimulus measures and reduced consumer spending during the pandemic led to a spike in deposits. Bank deposits grew by 22.2% in 2020 and by 10% the following year. By the end of 2023, balances had fallen by about 4.6% from a peak in early 2022.

Since mid-2023, deposit growth has resumed, but at a slower pace with a 1.7% annualized growth rate — raising questions about whether this is a temporary anomaly or a new long-term trend.

Bank Failures and Regulatory Response
The financial landscape is riddled with warning signs that point towards potential liquidity issues for banks. An inverted yield curve from July 2022 to September 2024, historically a precursor to economic downturns, suggests that short-term funding costs could remain elevated despite recent rate cuts, squeezing profit margins. Compounded by a shrinking M2 money supply and investment portfolios with unrealized losses, banks face challenges in lending and maintaining liquidity. Soaring consumer and student loan debts, along with vulnerabilities in the commercial real estate sector, further threaten banks with higher default rates and potential write-downs. Businesses, strained by mounting debt and surging energy costs, are at risk of missing loan repayments, exacerbating banks’ liquidity concerns.

This confluence of factors paints a concerning picture of the future solvency within the banking industry. The failures of SVB and Signature were fueled in part by liquidity pressures, as they faced sudden withdrawals and insufficient reserves. Federal regulators intervened, guaranteeing access to all deposits and introducing the Bank Term Funding Program to meet short-term liquidity needs. The measures helped stabilize the banking system, but many institutions still grapple with shifting depositor behavior and evolving liquidity needs.

Shift in Deposit Mix
The mix of deposit types has also undergone significant change. Noninterest-bearing deposits surged during the pandemic as customers sought liquidity. According to data from the Federal Deposit Insurance Corp. these deposits, which represented 30% of domestic deposits in mid-2022, have since fallen to 22% as depositors pursue interest-bearing accounts.

Interest-bearing deposits account for 78% of all U.S. deposits, up from 70% in 2022. A shift from noninterest-bearing checking accounts to higher-yielding options was particularly pronounced after SVB’s collapse.Banks are also seeing a resurgence in retail time deposits, such as certificates of deposit. While CDs represented just 2% of deposits in early 2021, by mid-2024, that figure had risen to 10%, indicating a renewed appetite for fixed-term investments in the current rate environment.

Data-Driven Liquidity Management Becomes Essential
Banks are increasingly turning to data-driven strategies to manage liquidity. Regulators require financial institutions to maintain cash reserves of 10% to 15% but meeting these requirements while optimizing balance sheets requires careful analysis and forecasting.

Banks can use real-time data and predictive analytics to better forecast shifts in deposit flows, loan demand and funding costs. This allows them to make more-informed decisions about their liquidity strategies, ensuring they have enough cash on hand to meet withdrawals without holding excessive reserves that could otherwise be used for more-profitable investments.

Data is critical for managing the sources and uses of cash across a bank’s operations. Banks can analyze trends in consumer behavior and market conditions to optimize their liquidity positions, reducing the risk of a liquidity crunch while maintaining competitive lending practices.

Net Interest Margin Still Key for Profitability
Despite changing dynamics, the net interest margin remains the primary driver of bank profitability, accounting for 80% to 90%  of total revenues.

Banks are focusing on managing both sides of their balance sheets to optimize yield on earning assets and keep their cost of funds low. Proactively managing liquidity through better data analysis lets banks reduce funding costs, providing them with more flexibility in their lending operations. Institutions that excel at managing their cost of funds can remain more competitive in the loan market, offering borrowers more-attractive rates.

Looking Ahead
As banks adapt to a post-pandemic world, the key to success lies in balancing liquidity, profitability and compliance. How well banks manage liquidity could determine their ability to remain competitive and weather any future financial storms. As the economy evolves, one thing is clear: In the new liquidity landscape, data isn’t just important — it’s essential.