Too Much Of A Good Thing?

The banking industry is drowning in liquidity.

Deposits stuffed into the nation’s banking vaults are overflowing-a record $9.5 trillion as of the fourth quarter. Normally, this would be a good thing. It just so happens that retail banking has rarely been this unprofitable.

Banking has been hit with the oxymoron of this age: lots of deposits but little way to make use of them. Few consumers or businesses are clamoring for loans, and interest rates are so low that there is little money to be made in lending. Net interest margins, the profit margin for the banking industry’s basic function of making loans, have reached lows not seen in decades. New regulations are cutting into fee-income tied to deposit accounts, such as overdraft fees and debit interchange charges. Meanwhile, banks have a huge network of branches throughout the country to service those low-earning deposits, so the profitability of retail banking hasn’t been this abysmal in a long time.

“The profitability of deposits is lower than it’s been in decades,” says Jim McCormick, the president and founder of First Manhattan Consulting Group in New York, who has three decades of experience as a consultant to the industry.

New York-based Novantas LLC, a management consulting firm that specializes in financial services, estimates that the retail side of banking has lost more than $60 billion in annual revenue since 2006, mostly as a result of the low interest rate environment but also because of regulatory changes that reduced fee income from debit cards and overdrafts.

Long the cornerstone of banking, deposits are the source of low-cost funding that few other types of businesses on the planet have. But with slow to no loan growth, investors and analysts are placing increased pressure on banks to do something about the deposit side of banking. Some analysts and consultants are suggesting banks run off unprofitable deposit relationships and close branches.

But many of the nation’s largest banks are pursuing a more nuanced version: Grow core deposits, beef up cross selling to consumers and businesses, invest in technology and redesign stores. San Francisco-based Wells Fargo & Co. has found success with cross selling. Columbus, Ohio-based Huntington Bancshares is shifting its funding mix to more core deposits. Charlotte, North Carolina-based Bank of America Corp. is closing branches but also is investing in mobile technology and image-enabled automated teller machines (ATMs) as transactions inside the branch dwindle. New York-based JPMorgan Chase & Co. is redesigning branches so they are smaller. All of those banks are answering, in their own way, the question of what to do about deposits.

Still, some analysts and consultants are questioning whether the industry needs to do more. In a note to investors last December, Atlanta-based broker/dealer FIG Partners’ Director of Research Chris Marinac asked an intriguing question: Why keep growing deposits? He thinks deposits are the lifeblood of banking, but growing deposits requires capital to support balance sheet expansion, so growth is not without a cost. “Hence, we see the next one or two years (perhaps longer) as a period where [b]anks refuse new deposits unless there are real revenues attached,” Marinac writes.

It was a bold prediction to make. Many of the biggest banks in the country have no intention of “refusing” deposits. If those deposits aren’t now profitable, they will be in the future, and driving one’s customers away is never a good idea, or so the thinking goes.

“Our view is a deposit is a recognition of a relationship,” says Todd Maclin, chairman of Chase, the consumer, small business and credit card arm of the $2.4-trillion asset JPMorgan Chase. “It is our belief these spreads will widen out as the economy improves down the road.”

Like JPMorgan Chase, the $1.4-trillion asset Wells Fargo has a fondness for deposits. “Why would we turn away deposits from our customers?” said John Stumpf, the chief executive officer of Wells Fargo, on a conference call with investors in January. The growing level of deposits “is a good, not a bad,” he said.

Still, the profitability of those deposits in a low interest rate environment has been falling. Wells Fargo’s net interest margin fell in the fourth quarter from 3.89 percent a year ago to 3.56 percent in the fourth quarter of 2012.

Analysts expect those margins to remain under pressure for at least the next year or two. Net interest margins fell to an average of 3.32 percent in the fourth quarter of 2012 from 3.43 percent the previous quarter for all banks and thrifts insured by the Federal Deposit Insurance Corp. (FDIC). The average from 2002 to 2012 was 3.56 percent. The Federal Reserve is keeping interest rates low in an effort to support the U.S. economy, and in December, the central bank said it expected to keep the key federal funds rate near zero as long as unemployment remains above 6.5 percent and inflation doesn’t climb past 2.5 percent. Many economists think that economic scenario will last until 2015 or 2016.

Loans on bank books from earlier years are up for renewal and are re-pricing at lower rates. Pricing for commercial and industrial loans is very low and competition is tough in that market, says Mary Beth Sullivan, managing partner at Washington, D.C.-based Capital Performance Group. As of February, the average short-term rate for business loans was 5.3 percent, the lowest since the start of the financial crisis, according to a survey of the National Federation of Independent Business.

Banks also are struggling to put good loans on the books at all. Loan growth for the industry was 2.96 percent in the fourth quarter from a year prior, while banks with less than $10 billion in assets grew loans by only 1.27 percent in the year, according to SNL Financial, a research firm in Charlottesville, Virginia. So analysts and consultants are beginning to nudge banks to think about turning away some deposits, cutting branches and improving the profitability of the branches they do have. Fred Cannon, executive vice president and head of North American research for Keefe, Bruyette & Woods, thinks the profitability of a small branch, with maybe $50 million in deposits, has sunk from 1.67 percent return on assets in 2006 to barely breaking even today.

Cannon predicts more branch closures and bank acquisitions in 2013 as a result of the “deterioration of branch economics.” And he sees banks already running off deposits, including pricing certificates of deposit (CDs) so low that nobody would want them.

McCormick suggests banks look at their deposit mix and decide which deposits are worthwhile and profitable. “It’s not all about deposits being unattractive,” he says. “It’s about being more selective and deciding which categories of deposits are still precarious and which are not.”

He suggests banks evaluate and in some cases reduce some categories of deposits-municipal deposits, for example, that may require the bank pledge securities as collateral, so they’re costly to the bank. “Banks should focus on checking and other core deposits from consumers and small businesses that have attractive cross-sell potential,” McCormick says. “The checking account is essential to success.”

One bank that has refocused its funding mix on the checking account is Huntington Bancshares. “That’s the primary relationship a consumer has with a bank,” says Stephen Steinour, the president, chairman and CEO of the $56-billion asset bank.

To draw customers in, Steinour took an approach that flew in the face of what other banks were doing in getting rid of free checking accounts. The bank launched Asterisk-Free Checking in 2011, a free checking account with few restrictions. There was no minimum balance, no requirement for an electronic transfer or direct deposit. Nothing. The bank also has been offering customers a 24-hour grace period for overdrafts. Instead of charging an overdraft fee, the bank will notify customers by text or email of the overdraft and give them 24 hours to make a deposit and avoid a fee.

When other banks were drawing ire for overdraft policies and new fees on checking accounts in response to the reduced profitability of those accounts, Huntington was going in the other direction. “We called it fair play banking,” Steinour says. “It’s a lens we use to look at all our fees and our products for our customers.”

The bank lost $30 million in annual overdraft revenue as a result. But it grew core deposits 9 percent each year, by $2.9 billion in 2009 and $3.1 billion in 2010. Non-interest bearing deposits grew from 14 percent of total deposits in 2008 to roughly 28 percent in 2012.

The shift in deposit funding has helped reduce the cost of Huntington’s retail banking operation. Huntington’s net interest margins rose slightly in 2012 compared to 2011, by 3 basis points to 3.41 percent, based on a 29 basis point decline in total deposit costs offset by a 24 basis point decline in yield on earning assets. As of the fourth quarter, Huntington had a profit of $167.3 million and return on average assets of 1.19 percent.

There is no plan to decrease the branch count. Instead, the bank is investing in technology to make the branch more profitable. It has plans to make 450 of its 800 ATMs image-enabled by the end of the year. That encourages people to make deposits by taking a picture of the deposit, providing some assurance to the depositor of the record of the transaction. It also will launch a smart phone application this year that will let users make a deposit with their phones.

“We’re not trying to force people out of our branches,” Steinour says. “Any channel they use, we want it to be the best.”

Bank of America has been on the forefront of using technology to service multiple channels and reduce branch traffic. It was the first to convert its entire ATM fleet to image-enabled deposits, in 2009. More than half of Bank of America’s deposits are now made by ATM.

It has seen branch traffic fall by at least 30 percent in the last four years, says Robert Aulebach, the Bank of America retail distribution planning and execution executive for consumer and small business banking. The bank has a popular online banking platform and introduced a mobile deposit application last fall. Bank of America is now seeing 100,000 checks deposited on mobile devices per day, Aulebach says. There are more than 12 million active mobile banking customers at Bank of America, and Aulebach predicts mobile banking will overtake online banking this year in terms of transactions. “Consumer behavior has changed tremendously,” he says.

Meanwhile, the bank announced plans last year to close 13 percent of its branch network, or 750 branches during the next three years. Nancy Bush, an independent stock analyst and contributing editor for SNL Financial, approves of that approach. “These were tiny branches in tiny towns,” she says.

The biggest banks are the products of a consolidation wave that gained strength in the 1990s and continued up to the financial crisis. “If we come up with a less branch intensive industry, we will be way ahead of the game.”

Still, Wells Fargo and other big banks have announced no plans to cut branches like Bank of America has. Stumpf says new customers pick a bank based on proximity to their homes, so having lots of branches is important to acquiring new customers.

While Tom Brown, the founder of Second Curve Capital, a hedge fund that invests in financial stocks, agrees with that assessment, he still thinks banks need to rethink their branch strategy. “My fear is that the bank CEOs are not adequately addressing the need to reduce their delivery system expenses,” he says. Brown worries that banks need to be more aggressive in reducing branches and staff to avoid becoming another Blockbuster, the movie rental chain with a brick-and-mortar distribution system. That business didn’t adjust quickly enough with changing times, Brown says. (It was nearly destroyed by the arrival of Netflix and other alternatives to brick-and-mortar stores.)

JPMorgan Chase has been trying to adjust, although it has not been cutting branches. New branch designs in 2013, at 2,800 to 3,550 square feet, are 65 to 75 percent smaller than the size of branches built last year.

The new branches reduce teller space in favor of more office and sales space for mortgage originators, wealth advisors and credit card sales, says Chase’s Maclin. It is also using technology to reduce the costs of transactions at the bank. Deposits at ATMs now account for 43 percent of all retail deposits as of the fourth quarter. That was made possible by the company’s investment in image-enabled ATMs. Meanwhile, the bank is reducing staff to cut costs, announcing plans in February to slash up to 15,000 jobs by 2014 in mortgages and consumer and community banking.

Wells Fargo is another bank that has not reduced its fleet of branches, but instead has been trying to improve the profitability of its retail banking business. The bank is well known for the success of its cross selling efforts to boost profitability. One-third of all its checking account households had a Wells Fargo credit card as of last August, according to the company. The average Wells Fargo household has six product relationships with the company, whether that’s a loan, a deposit account or a brokerage account among others.

Carrie Tolstedt, the senior executive vice president of community banking at Wells Fargo, says the bank accomplishes that by having a conversation with every person who opens an account, and periodically after that, designed to reveal their unique financial situation and needs. “There is nothing like sitting down with your customers and having a discussion about their financial priorities and then doing a customer needs assessment,” she says. Wells Fargo coaches its bankers on how to ask the right questions to uncover needs, without telling them exactly what to say.

“You look for a complete solution for your customer and explain the benefits of what you are offering,” she says.

Community banks face the same pressures as big banks such as Wells Fargo, but in some ways, on an even grander scale. They are more dependent on net interest margins for profitability because they often don’t have profitable fee income businesses such as investment banking or brokerage.

Sullivan says community banks are beginning to look at other ways to improve profits, including cross selling with incentives for customers who have multiple relationships with the bank, such as a discounted rate on a loan for customers with deposit accounts. Or they are looking to add loans by beefing up or introducing home equity lines of credit or auto lending, she says.

Community banks are looking at ways to reduce expenses at the branch level, too, including the possibility of closing branches, but they often worry about the impact on jobs and their reputations, Sullivan says. They often don’t have the technology budget of the larger banks, which sometimes keeps them from introducing mobile banking or image-enabled ATMs.

Still, the pressures on community banks are very similar to the big banks.

“That’s the dilemma management is in,” says Kerri Corn, the director of market risk at the Office of the Comptroller of the Currency. “How do you deploy [deposits] profitably? And how do you estimate their stability and future cost?”

In an effort to improve profitability, bank balance sheets have shifted toward more securities to make up for fewer loans. Securities portfolios made up 20.35 percent of bank and thrift assets in the fourth quarter, up from 16.96 percent three years ago, according to SNL Financial. Loans totaled 61.22 percent of assets in the fourth quarter, down from 67.27 percent three years ago.

Corn has noticed a slight shift in the industry’s asset mix towards commercial and industrial loans and longer term investments on the balance sheet. The concern is that banks may lock in longer duration assets in this low interest rate environment based partially on the increase in low-cost funding gained post-crisis, she says. But what happens if interest rates rise and banks end up losing some of those short-term low-cost deposits-especially if they used them to fund long-term assets? Corn suggests boards ask management questions about that potential interest rate risk: How has the balance sheet changed since the financial crisis? How has the bank changed its product offerings? How has the credit risk profile changed? How does the bank plan to make money going forward? What are the obstacles in the next few years and what is management most concerned about? What is management’s estimate of which deposits might leave the organization once interest rates rise?

The days of bank accounts flush with deposits won’t last forever. Regulators and others are encouraging banks to improve the profitability of those deposits without taking on too much risk. It’s a difficult balance.

But many banks have spent years cleaning up problem loans and assets and may now have the opportunity to refocus on improving their relationships with customers and the profitability of those relationships.

Banks are approaching margin compression in a variety of ways, but most of them are hoping to leverage the strength of core deposits.

“Only good things come from having a primary deposit relationship,” says Novantas partner Sherief Meleis. “The question is: How do you monetize that?”