Deposits have flooded into the banking system, leaving bank managers with questions about the stability of the liquidity and few attractive options to put the cash to work.

Bank managers find themselves in a difficult situation where they are questioning how much of the 20% year-over-year growth in deposits is short term, boosted by the historically high consumer savings rates and Paycheck Protection Program borrowers parking cash intended for use at a later date. At the same time, bank margins have decreased substantially as interest rates have plunged to record lows and loan balances have actually shrunk when excluding PPP lending.

Scott Hildenbrand, head of balance sheet analysis and strategy in the financial services group at Piper Sandler Cos., said in the latest "Street Talk" podcast that banks have more cash today than they probably ever expected.

"The amount of inflow of liquidity into the industry is unprecedented," Hildenbrand said in the episode. He said banks need to think hard about what their optimal level of liquidity is, and rethink their asset allocation and put excess funds to work. That would likely come through investments in securities portfolios, given the lack of loan demand in the market.

"It's incredibly expensive to sit and earn 8 to 10 basis points in cash right now," Hildenbrand said. "Sitting there in cash and telling me you're conservative is an oxymoron. That means you have all your chips on the table and you think rates are going up tomorrow pretty quickly to offset those 10 basis points versus those 125 basis points in yield."

While punitive to sit in cash, where yields today are lower than the banking industry's cost of funds, many bank managers kept their powder dry in the second quarter, nearly doubling the amount of cash they have parked in interest-bearing balances due, deposits at other banks.

Hildenbrand said that too many members of asset/liability committees and bank boards do not have a true liquidity target. He said if he asked 16 different bank CEO across the country how they measure liquidity, he would probably get 19 different answers.

Hildenbrand recommended that banks take a multipronged approach to examine liquidity and determine what they can withstand. He said some banks are carving out deposits tied to PPP because they expect those will be short term in nature. Still, predicting the direction of the balances could prove difficult.

He encouraged institutions to look at the number of new deposit accounts opened versus the overall growth in deposit balances this year. He noted that anyone who has made the effort to open a new account likely has more purpose than a commercial or even retail depositor, whose balances might have ballooned simply because they are building a safety net out of an abundance of caution.

"Both are increasing my deposit base, but tell me different stories," Hildenbrand said.

The adviser further suggested that banks should look at their loan-to-deposit ratios and the level of cash and unencumbered securities as a percentage of assets. He said institutions should look at those metrics over the last 10 to 15 years and see how they have compared to their top-10 competitors over that time frame.

"We can't go to the asset side without understanding the length, the time and the understanding of who is really leaving their money with me and why," Hildenbrand said. "It's not perfect, but it's a decent way to start thinking about how to allocate the asset side."

He has encouraged some banks to carve out a small portion of the bond portfolio for purchases of subordinated debt issued by community banks given the absence of loan demand today. Issuance activity in the bank sub-debt market has continued at a healthy pace, with institutions offering investors yields of 4.5% to 5%. Those purchases should be selective but could offer banks a bridge until loan demand returns, Hildenbrand said. He noted that banks pursuing those investments are not adding credit risk, just replacing it given the lack of loan demand.

More broadly, he encouraged banks to look at their interest rate position and consider what their balance sheet is "screaming for me to take."

"There is a little bit of an obsession with keeping your bond portfolio short at all times," Hildenbrand said. "I think, quite frankly, adding duration at times when people think I'm crazy, may make the most sense for that institution because it's a hedge against rates not going up fast enough."