QT is the Federal Reserve's strategy to reduce its balance sheet, and it's far from innocuous. It has a direct impact on our industry, and we need to understand why.

The Fed reduces its balance sheet by letting mature securities roll off without reinvesting the proceeds. When this happens, the money essentially leaves the economy and the banking system permanently. In essence, QT is a deposit-destroying machine!

So far, QT has already caused massive damage, with the industry losing $1 trillion, or 6% of total deposits, in just 14 months. If this trend continues, we could see another $1 trillion disappearing over the next 24 months.

For community banks, this means that growing your core deposits is becoming increasingly challenging. Large banks will feel the initial hit, but they will eventually come after regional banks, and the ripple effect will reach even smaller institutions.

But the competition doesn't stop there. Money market funds and our own government are also vying for your deposits. With China and the Fed out of the treasury market, your deposit customers are becoming a prime target.

The bottom line: liquidity issues in the banking system are far from over. Even if the Fed is done hiking the fed funds rate, competition driven by QT will increase funding costs.

So, don't rely solely on the FHLB or your line at the FRB to bail you out. Liquidity risk is about fear and confidence.

Now that you understand the basics of QT, you're probably wondering, "What do we do about it?" Here are some steps you can take to mitigate QT's impact and position yourself for success:

1. Cleanse Your Balance Sheet: Liquidate underwater securities as much as your capital allows, using the proceeds to redeem expensive liabilities instead of borrowing at high rates.
2. Set Your Guardrails: Define internal limits that prevent risks from spiraling out of control. Craft these limits intelligently to guide you through these challenging times. Consider housing these limits in a Capital Plan.
3. Stress Test Your Liquidity: Properly assess your liquidity risk to build a smart contingency plan. Prioritize on-balance liquidity and limit off-balance sheet funding gaps realistically and within compliance limits.

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For more information or to schedule and exploratory call contact Patti Casaleggio - pcasaleggio@invictusgrp.com

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Invictus Group assists financial institutions with writing capital plans, stress testing, and both identifying and quantifying limits and triggers for key ratios which are customized to the bank.  For more information on these services, please contact Patti Casaleggio at pcasaleggio@invictusgrp.com.