Banks that can successfully defend or capture lower cost funding will better weather current industry pressures – outperforming and even thriving in a tough environment.
Stable core deposits have always mattered to banks. Providing durable, low cost funding and a gateway to loyal customers, core deposits are prominent in the mix of performance levers that includes loans, fees, margins and efficiency.
Coupled with new liquidity regulation, the stagnant environment for revenues and profits has further boosted the importance of sticky deposits — so much so that for traditional bank intermediation, this precious commodity has become the single greatest determinant of profitable growth. The deposit business — if it can successfully hold or acquire the right deposits — is a lifeline at a time when institutions are suffering margin compression, losing fee income and liquidity options to regulation, and traversing a distribution minefield as digital migration accelerates.
In turn, core funding has become a battleground. Forced by regulators to implement LCR requirements early on, the four largest U.S. banking companies have dramatically regrouped around core deposits following the financial crisis. Looking at their loan to core deposit ratio (loans strictly compared with transaction, MMDA and savings balances), the big four went from 119% in 2011 to just 97% in 2015, both by growing core deposits and trimming undesirable lending. With their vast branch networks and marketing clout, the nationals are excelling in retail customer acquisition and consolidation of commercial core balances, and will continue to claw for core funding.
Meanwhile regional banks are worried about funding for further loan growth. While they have grown core deposits slightly faster than loans in recent years, regional bank holding companies are also beginning to turn to brokered deposits, which collectively rose by 22% in 2014 and 31% in 2015. Without a course correction, they are going to run afoul of regulatory liquidity guidelines and veer into hollow loan growth, with incremental revenues increasingly chewed up by rising funding costs.
The situation is forcing a shakeup in bank balance sheet management. Traditionally, banks could set stretch goals for loan growth and leave the deposit and treasury teams to figure out how to raise the necessary deposits or other funding. In corporate planning and bank balance sheet management going forward, incremental returns from loan expansion must be balanced against the incremental cost and availability of core funding, with the latter often governing the former. Getting there will require:
Improved forecasting. Today’s deposit projections are based on a loose blend of: 1) pressure from the lending side; 2) projections based on historical trends; and 3) modeling of deposit promotional yields and deposit stickiness by product category. The extra edge will come from a comprehensive understanding of potential formation of long-lived balances, based on customer behaviors, profiles and segment potential.
New metrics. Which customers have deposits that are truly sticky, and which do not? Segment-based metrics on deposit retention and potential have direct implications for how longer-lived deposits are valued across the bank.
Business line management. Deposit-gathering businesses — consumer, small business and commercial — must rethink strategies and tactics to emphasize stable core deposit funding. Analytic banks will develop customer-specific offers that preserve/augment high-balance accounts, and refine deposit acquisition as well.
Industry profitability has yet to return to pre-crisis norms — and will not any time soon.
Before the economic collapse at the end of 2007, the collective return on assets of FDIC-insured depository institutions ranged from 120 to 140 basis points. Since then ROAs have hovered around 100 bp, breaking 110 bp only once in 2012. Similarly, pre-crisis returns on equity were in the 12% to 15% range, but have not exceeded 10% post-crisis. Assets have grown by 23% to $16 trillion in the past eight years, but revenues have dragged over most of that time.
Ominously, the lack of profitability reflects the ailing state of core intermediation — the fundamental middleman role of banks to gather deposits and turn them into loans. Among FDIC institutions, our models indicate an ROE of only 7% to 8% for the lending side in 2015, and 5% to 7% for the deposit-gathering side (deposits suffering relatively more from prolonged lower rates). Comparing these low returns with equity hurdle rates, the industry does not appear to covering its cost of capital.
In considering ways to revive core intermediation, most banks face a set of difficult options — which will continue until industry overcapacity rights itself through a substantial reduction in the number of banks.
Lend beyond core funding. For a period of years prior to the recession, the collective industry ratio of loans to core deposits soared at stratospheric levels, 150% to 180% for FDIC banks. Loan rates were high, as was economic confidence, regulation was far less onerous, and core deposits were viewed as one of many funding sources. Paying more for deposits and funding made sense and yielded better returns — pre-crash.
It is unlikely that banks will outrace core funding like that again. Regulation is one reason. The four national banks already have gone through a wrenching transition, and large regional banks are next in line for enforcement of tougher liquidity standards prescribed under Basel III. And the crisis-scarred regulatory community will be monitoring liquidity profiles and practices among all categories of banks.
Second, higher loan-to-core-deposit ratios had a powerful influence on an institution’s cost of deposits in 2015 (Figure 1: Core Deposit Leverage vs. Deposit Interest Expense). The depressed state of risk-adjusted loan yields makes it difficult to pass along the extra costs of non-core funding to borrowers. On the horizon, the use of non-core funding is setting up aggressive banks for higher deposit betas when market interest rates rise in earnest.
Price up for loan margin. Lending is heavily competed — rate is primary focus of most loan shopping and purchasing — and lending spreads remain under intense pressure. And rarely can a bank make a practice of charging higher rates to an insulated lending base; borrowers know they have options and will eventually pursue them.
Sacrifice credit quality for volume. There is continuing evidence in Federal Reserve surveys on loosening credit conditions. Yet going down the credit spectrum is often a fool’s errand. It requires an ability to time the economy and unload speculative credit (assuming that is even possible) ahead of a downturn. How well did oil patch banks anticipate the collapse in gas prices? Presumably some investment banks are now playing the timing game in funding unsecured lending start-ups, but these are measured investments from nimbler players.
Tighten the belt. Among the most profitable intermediators are those with low efficiency ratios — below 60% or even below 55% — who have figured out how to gather deposits and lend at relatively lower cost. Scale favors the largest banks here. Keeping that advantage will require them to stay ahead of the curve in cost reduction, including branch reduction and loan origination restructuring. For those not there yet, there is a painful restructuring just to catch up.
Improving Deposit Composition
This brings us to funding. For many banks, the one best way to improve intermediation economics is to improve the composition of the deposit base — strengthen the core.
Given rate pressure on the lending side, banks with lower cost funding sources can lend at market rates and still capture superior spreads, without being tempted to degrade credit for loan yield. As a result, in regression analysis on the profitability of traditional bank intermediation, we find that funding costs have a larger impact on profitability than loan yields or non-interest revenue.
Notwithstanding the major changes in brick and mortar distribution and the rise of direct banks, core deposits remain the stickiest part of intermediation. This is especially true for deposits held for cash management purposes, where the customer’s focus is on payments as opposed to managing yields. Once opened and in active use, demand deposit accounts remain quite cumbersome to pick up and move — unlike loans, which when due are typically and easily shopped.
Only a depository institution can hold deposits and offer DDAs (though non-bank payment providers are trying to wedge themselves between the DDA and the customer). And critically, the payments account is still thought by customers to be the center of banking relationships.
To be sure, deposits are also competed, and this will intensify as local market boundaries are steadily erased by online DDA shopping and direct bank competitors. And the regulator-specified liquidity coverage ratio has placed much greater emphasis on core funding, explicitly valuing stable operating deposits over more fleeting excess deposits.
LCR is already intensifying competitive dynamics for core deposits ahead of market interest rate rises. This re-doubles the emphasis that banks must place on securing stable core funding. All the more reason for proactive banks to move now to identify and retain more stable depositors who are less likely to shop their DDAs, and to win more customers like them.
A true focus on growing core deposits will require a top-to-bottom rethink of the bank (Figure 2: Reorienting the Bank to Defensible Core Funding). In traditional budget planning, lending units are encouraged to put up stretch goals for loan growth, and deposit gathering units are more or less directed to find the funding — core or otherwise. With fast-paced loan growth, inevitably there is a heavier pursuit of price-sensitive, transitory deposit balances.
This orientation carries two major drawbacks. First, in the next rising rate environment, it will lead to substantially higher funding costs, especially if banks continue to rely on traditional broad-based promotions. Second, it can only go so far before bumping up against new regulatory boundaries.
Change of this nature needs to start at the top of the bank and work its way down to the business lines, and not the reverse. It starts with the long-term strategic planning process and extends all the way to day-to-day asset-liability meetings.
Getting the metrics right is key — beginning with understanding which customers have deposits that are truly sticky and which do not. Currently, most banks measure deposit duration by product type and vintage. But they are not taking full advantage of information on hand. Most have sufficient account-level balance and transaction information to identify deposit stickiness by customer segment as well.
A sharpened understanding of likely balance retention provides specific direction on which customers to target for what purpose. Adding wallet modeling of consumer and commercial segments will help paint a picture of customer potential (large vs. small banking wallets within segments), customer penetration and deposit stickiness.
Segment-based metrics of balance retention and expansion potential have direct implications for the valuation of longer-lived deposits across the bank. Traditional funds transfer pricing methodology looks at duration for indeterminate deposits by type and vintage. However, knowing which MMDA customers in a vintage will have larger stable balances should shift FTP crediting in favor of the longer-lived deposit balances and away from the identical but shorter-lived balances.
This level of specificity across the deposit base is as fundamental as lenders knowing which borrowers have higher FICO scores or lower prepayment propensity. Yet the industry standard is to treat all depositors of the same account type the same.
Providing different crediting rates to longer-lasting deposits by customer segment will allow banks to offer better yields to preserve and expand target relationships. In some cases it can even justify offering preferred rates for targeted acquisition of new customers who can bring large stable deposit balances.
Informed with better metrics, bank-wide balance sheet management can then be reset to focus on measuring and managing core funding growth. There will be a growing emphasis on managing balance sheet economic profit, as opposed to the raw pursuit of net income maximization.
Deposit promotions that bring in hot money with low expected duration should see lower FTP credits, while true relationship-driven deposit growth should be rewarded. Lending growth in excess of core deposit funding growth should be discouraged, once it is apparent that the marginal contribution, given high funding cost, may well not cover the cost of capital.
Deposit gathering businesses — consumer, small business and commercial — must rethink strategies and tactics in light of the increased importance of stable core deposit funding. This begins with segmentation analyses that inform differing segment treatments.
Weaning the bank off of high-cost promotional deposit campaigns is critical. In their place, analytic banks will develop customer-specific offers that preserve or augment high balance accounts, as well as new customer acquisition offers, appropriately targeted and priced based on balances brought.
Products and pricing need to rethought and re-bundled. The focus is on bringing in most or all of a customer’s deposits to the bank, and at a rate that reflects the stability and value of those deposits. Beyond that, products need to change to meet the full cash management needs of consumers — payments, deposit balances and short-term lending.
On the commercial side, it is about advancing bundled and relationship pricing for treasury management customers. On the consumer side, fundamental product redesign is called for. This will not only help to capture a more complete share of customer deposit balances, but payment-related lending as well — supporting even richer pricing for consumers yet overall profitability for the bank.
Resource allocation can also take its cue from core funding needs. The jockeying we are seeing as larger banks shed non-core commercial deposits and many banks pitch for small business and high net worth consumer deposits will only intensify.
The same applies to mergers and acquisitions. Knowing which deposits are likely to stick — and more specifically which customers have deposits that are likely to stick — refines the valuation of deposit books at target banks. The stronger the analytic knowledge about the stability of the target’s funding sources, the better the bidding and the greater the value for the acquiring entity.
Far too many bankers continue to rue the low rate environment that is now approaching eight years — waiting for rates to rise and bring back spreads and profitability. Get over it. Low rates have masked an acceleration of fundamental changes which have permanently tightened intermediation spreads that no foreseeable interest rate rise will fully restore.
Banks have tried to outrun the problem with balance sheet growth, but only a few have had any success at share gain, and with only limited profitability improvement. Most have turned to cost reduction, but at least in the short term, the primary available expense pool has been branch closures; this requires walking the fine line between cost savings through closure and retention of market share and position.
What only a few banks have been focusing on is, in our view, far more important for healthy intermediation economics: growing defensible low-cost core deposit funding. Funding has become all the more important with fundamental changes in liquidity and capital regulation that value stable core funding much more than more fleeting deposit balances, and that are stoking an arms race for core retail and commercial deposits.
Understanding customer behaviors in these deposit portfolios will unlock the insights for the smarter and better-positioned banks to secure relatively lower-cost and more stable funding. It will also create an anchor for building deeper consumer and commercial relationships.
The profitability of traditional financial intermediation will neither improve overnight nor fully recover when market interest rates rise in the coming quarters. Overcapacity and stiff competition from the national banks will continue to pressure loan spreads and bid-up deposit rates. But the banks that can successfully defend or capture lower cost funding sources will better weather the competitive pressures — outperforming and even thriving in a tough environment.
Lee Kyriacou is Head of Banking Industry Research, Gordon Goetzmann is an Executive Vice President, and Andrew Frisbie is a Managing Director in the New York office of Novantas. They can be reached at firstname.lastname@example.org, email@example.com, and firstname.lastname@example.org, respectively.