The unprecedented economic implications of the coronavirus has led the Federal Reserve to embark on a path that even just a few short years ago would have been completely unimaginable. The moves include a drastic cut in interest rates, the provision of trillions (yes trillions) of dollars in liquidity across a broad spectrum of programs, and an unprecedented massive federal government support program. Without editorializing on the sagacity of any component of the Fed’s response, let’s unpack some potential implications for community banks.

In the 2008 financial crisis, the last time the evil black swan made its appearance, the Fed made credit and liquidity available primarily to banks. The mechanisms included Quantitative Easing, the purchase of U.S. Treasury and agency mortgage-backed securities for the Fed’s own portfolio; TARP, direct repayable investments into banks; interest rate cuts; and various other short-term credit facilities. All of these were designed to sooth the credit markets and ensure that the largest capital market in the world could function.

The Fed’s goal today is broader. While it still has the primary responsibility of ensuring that the U.S. Treasury market remains liquid, this time the Fed is also attempting to make sure that it supplements the credit responsibilities of banks by providing liquidity for short-term borrowings for large issuers. In addition to lowering rates and buying securities, the Fed is also encouraging banks to borrow from the discount window without penalty, reducing reserve requirements, and urging banks to provide credit to ensure that money gets into the hands of consumers and business. It is hoping that the large banks and brokerage firms will use some of the freed up capital to both lend to and support larger companies coming to the debt markets to raise cash.

What are the implications for community banks? We will ignore the potentially massive credit implications for now. The yield curve today is both lower and significantly flatter than it was immediately after the 2008 financial crisis. This means that NIM compression, which most banks experienced post-2008, might be even more exacerbated.

The table above shows that the 5-year and 10-year U.S. Treasury yields are 120 and 162 basis point less than during the financial crisis. While the shift away from LIBOR adds a new wrinkle, remember that corporate, commercial real estate and residential real estate are all priced off indicators based on U.S. Treasuries. Therefore, new loans booked are going to carry lower yields. Similarly, variable resets are going to be significantly lower unless creditors have put floors in place. The graph with the yield curve comparisons shows that the shorter end of the yield curve, while lower than in 2009, does not approach the decline in yield in the longer end of the curve. This suggest that liabilities will cost less but will not be able to support the decline in loan yields. That’s the implication of a flatter yield curve.

Another factor to consider is that during the last financial crisis, businesses still functioned. It was more of a financial meltdown based on bad credit underwriting. The current crisis is spread across most consumers, most small businesses, and many large businesses. That means we could see massive unemployment for a protracted period.

In the short-term, individuals and businesses may hoard cash, particularly if there is no fear of giving up interest income. (Some large banks are seeing increased deposits, however). We believe that there will be a short-lived deceptive mask of increased liquidity. However, if there is a prolonged period of unemployment, that cash will dissipate and we could see a significant liquidity crisis. This could include individuals liquidating IRAs and 401(k)s, deposits and investments that are often considered very stable.

Many community banks are used to having municipal deposits. The ebb and flow of these deposits have followed normal patterns of peaks based on tax collections and spending over the balance of the year. While the Fed can print money to support federal national programs the states and municipalities are going to run into cash flow problems almost immediately. State and municipal deposit flow can become distorted or disappear. Public entities may be rushing to market to issue tax anticipation notes and revenue anticipation notes, which would put supply pressure on the capital markets.

The Fed’s support to banks should provide confidence in the banking system. But in a time of fast-moving news, banks need to be careful of a deposit run, despite the FDIC’s reassurance to consumers.

Another area to watch is pensions—both the banks’ and their customers. Lower equity markets and lower bond yields means the unfunded portion of pension liabilities could increase, placing even more pressure on companies and banks that have defined benefit plans. On the plus side of the double-edged sword, the increase in bond prices/decrease in yield should erase most AOCI securities losses in the AFS portfolio. However, extreme volatility in the bond market will most likely continue. The chart below depicts 10-year note volatility 30 days prior to the start of 2008 financial crisis and 30 days prior to the pandemic crisis. As we can see from the 2008 scenario, it took almost 7 months for volatility to return to pre-crisis levels. While the Fed will ensure that short term rates stay low, it will be difficult to determine the duration and magnitude of the volatility at the longer end of the yield curve. If the pandemic economy returns to solid footing quickly, we can expect volatility to decrease rapidly.

Source: CBOE (Chicago Board of Options Exchange).

However, we now need to add one more factor to the equation. The stimulus plan is going to cost money. In addition to the $2.2 trillion cost of the plan itself, we can safely assume tax receipts will be down and certainly delayed as companies face losses and unemployment rises. The stimulus money will need to be borrowed, which will put enormous pressure across the Treasury curve.

People will need cash/credit, which is what both the Fed and Congress are trying to do. The risk is a timing issue. The Fed is trying to get ahead of the problem by putting out cash in amounts that would attempt to ensure that there is minimal crisis. We are in a new world. All we know is that the new environment will create additional management challenges for all community banks. To arm themselves with the best tools possible, community bank CEOs should consider stress testing their banks under a pandemic scenario.

By Leonard J. DeRoma, Invictus Group Director of Liquidity Analytics

*The Fed’s 2008 toolbox is back in play: zero interest rates (ZIRP), negative interest rates (NIRP), and quantitative easing (QE). On March 25, 1-month and 3-month Treasury bills went negative for the first time in history.