Core deposit premiums have long been a barometer for measuring the quality of a target bank’s deposit portfolio. But there are challenges with using this metric to assess deposit quality. Deposits that are classified as core can vary dramatically from truly low-cost sticky deposits and can also be materially different across banks.
The distinction among deposits is becoming increasingly important as M&A heats up across the industry. Heightened competition with direct banks and other new entrants has raised the stakes in deposit gathering and a growing number of providers are using rate to attract valuable deposits.
That makes advanced due diligence even more important for prospective buyers who must determine which deposits are really core and how much they are worth — and which deposits are likely to walk out the door when a better rate comes along.
TRENDS IN REGULATORY CORE DEPOSIT PREMIUMS
Acquisition premiums are driven by a multitude of factors, but the increased attention paid to core deposit premiums highlights the belief that core deposits are a primary driver of bank value. In fact, recent research from Novantas and the Consumer Bankers Association estimates that 70% of bank value is attributed to the “economic rent” from retail checking and low-rate, back-book savings balances.
Ultimately, the core deposit premium is a metric — just like price-to-tangible book and price-to-earnings — that can be used to compare the value of transactions.
Not surprisingly, the value of core deposits is driven in large part by interest rates. Core deposits become more valuable when rates rise because the cost of replacement funding becomes incrementally more expensive. (See Figure 1).
Core deposit premiums increased significantly in the most recent rising-rate environment, but have fallen in 2019 as rates come down.
THE CHALLENGE WITH CORE DEPOSIT PREMIUMS
The key issue with the core deposit premium metric is determining what is considered “core”. The FDIC defines core deposits as those deposits less 1) jumbo time deposits (over $250,000) and 2) brokered deposits (under $250,000).
Bankers understand, however, that a material portion of a bank’s core deposits may be just as costly and unstable as many of the deposits classified as non-core that are at risk of leaving the bank if they were to be repriced.
The difference between the regulatory definition of core and true low-cost, sticky deposits can vary significantly by both target and acquiring banks and can only be understood by analyzing the portfolio at a more granular level. This is especially true as banks pursue different growth opportunities and expand into new areas. For example, a seller may consider certain deposits as core, but potential buyers may have a different view on the value of those deposits.
Novantas recently encountered this issue in two transactions. (See Figure 2.) In both situations, Bank A and Bank B have the exact same concentration of regulatory core deposits but have a meaningfully different “adjusted” core deposit concentrations. Bank A had a notably higher concentration in non-operating corporate deposits (municipal deposits) and a greater concentration of high-rate savings and CD accounts that weren’t tied to a core checking account.
Acquirers that don’t understand these different dynamics of a potential target will risk mispricing a transaction if they rely only on comparable premiums to determine appropriate acquisition prices.
Novantas believes a three-step due diligence approach is needed in order to sufficiently answer these questions.
Buyers should complete a detailed deposit diagnostic on the target. Key types of analyses include comparison of financial performance metrics relative to other potential targets under consideration, and organic growth relative to in-market competition and underlying attractiveness of the target’s overall market.
Potential acquirers need a detailed deposit forecast of deposit balances, rates and fees. This forecast should be considered across multiple rate scenarios and include both a stand-alone and combined view that incorporates estimated impact of potential integration-related disruption.
Finally, due diligence should incorporate detailed deposit forecasts and valuation into broader valuation models, as well as benchmark deposit valuation relative to comparable deals. This will help buyers determine the amount of premium that is appropriate for core deposits.
Given the increasing scarcity of low-cost deposits for regional and community banks, protecting and growing the existing deposits is becoming increasingly important. While a more rigorous deposit due diligence approach requires investment in time and resources, a solid understanding of the underlying value of a target bank’s deposit franchise is critical to a successful M&A strategy.
Director, New York