Funding the Bank

Charles Bud Koch loves core deposits, and who can blame him? Since 1996, the chairman and CEO of Cleveland-based Charter One Financial Inc. has made energizing his company`s liabilities a top priority, working overtime to market totally free checking accounts to new and existing customers. As you grow your core deposits, you`re lowering your funding costs and building relationships, he explains. That, to a large extent, is where the real value of any banking franchise lies.

It hasn`t been easy. Like many banks and thrifts, Charter One has been dealing with a funding crunch the likes of which the industry has never before seen. Across the nation, strong loan demand has run headlong into less-than-stellar (sometimes negative) deposit growth, boosting loan-to-deposit ratios and slashing the net interest margins banks have traditionally relied upon for income. Between 1992 and 1998, commercial bank assets rose at an average annual rate of 6.3%, while deposits grew at only a 3.9% annual clip, according to figures compiled by the Federal Deposit Insurance Corp.

On the surface, this doesn`t sound like a dire dilemma. Good economic times have allowed banks and thrifts to pile on loans, which is where banks make most of their money. It`s a good problem to have, because it says that earning-asset growth has been tremendous, says Michael Moran, a banking analyst for Roney Capital Markets in Detroit.

But more than a passing trend fueled by a strong economy, many observers believe that tough competition from mutual funds and other investment options will continue to sap low-cost deposit growth from banks, wreaking havoc on their traditional spread-based business and compelling financial institutions of all types to search elsewhere for profits.

Already, the average large bank garners 57% of its funding from nondeposit sources, according to the FDIC, while 75% of community banks get at least 10% of their liabilities from noncore sources-up from 42% in 1993. A 1998 study by the American Bankers Association found that about 20% of community banks expect the majority of their funding within five years to come from wholesale sources, such as Federal Home Loan Bank advances, repurchase agreements, or debt offerings.

Wholesale funds are more expensive than deposits, which cuts into net-interest margins. Indeed, in the second quarter, net interest income for all banks was 3.51%-down 18 basis points from two years earlier. When you`re funding loans with wholesale dollars, you have to realize that you`re going to be paying market rates for them, explains Koch, whose bank had a loan-to-deposit ratio of more than 100% and an interest rate spread of 3.06% at the end of the third quarter, down five basis points from nine months earlier. You`re going to have lower spreads than when you`re funding the same-yielding loan with core deposits, and that will hurt your margins.

Excessive use of nondeposit funds can also raise liquidity and interest-rate risk fears in regulators. David Hanson, an analyst for the North Carolina State Banking Commission, says his office is concerned that, in their efforts to hold spreads steady, some banks might pursue higher-yielding loans that add more risk to their portfolios. In response to such fears, regulators are more willing than ever to ask banks to slow loan growth to match deposits.

Whether the emerging funding crunch constitutes a crisis for banks or is merely another operating challenge is open to debate. Many argue that as banks continue to offer broader product menus and become more fee-oriented, spreads will matter less. Nonetheless, it raises some serious issues for bank boards.

While day-to-day funding details are usually handled by management, boards must set the tone and strategic direction for their institutions. The funding shift challenges some of the basic assumptions that directors may have about the nature of banking and raises a host of long-term technical and strategic questions: What`s the proper asset/liability mix for an institution? How large should a bank aspire to be in an era of higher funding costs? Should it bite the bullet and pay up for alternative funding, or compete harder for deposits? Or should it seek profits from places other than spreads?

At their core, questions sparked by the funding crunch are rooted in two basic, yet complicated concerns that always have fallen squarely in directors` laps: how to best use scarce capital resources and how to produce the best value for shareholders. Unlike some areas of bank management, there are no generalized answers to such questions. Each bank faces its own unique set of market and customer dynamics-and board sensibilities. This makes striking the right capital and funding strategy an exercise that`s part art, part science, rooted in business plans and knowledge of local communities.

But this much is clear: As competition continues to eat into banks` deposit growth, many will find profits squeezed as well. If their institutions are to survive in this new environment, directors must understand, in broad terms, how funding impacts their institutions` balance sheet, income statement, and business model, and then recommend comprehensive plans of action that reflect those deliberations. We`re talking about a whole new way of life-a different philosophy-for some banks, says Robert Calvert, president of Calvert Consulting in Roslyn, Georgia. A lot of banks are simply not going to be able to handle the tremendous adjustments of operating in such an environment.

Back to basics

Used to be, banking as we know it was rooted in a simple premise: People put their money in banks for safekeeping and a small bit of interest. Banks then lent those funds, making money off of the difference between interest rates they charged borrowers and what they paid depositors.

Today, of course, banking is a much more complex endeavor. A variety of loan types and sizes are found on the typical financial institution`s asset ledger, and most banks maintain sizeable securities portfolios to provide stability, modest income, and collateral for borrowing.

The liability side has changed, too-more so in practice than in thought. Despite growing evidence that suggests it should be otherwise, core deposits retain a central-some would say overly romaticized-role in most banks` funding strategies. More than merely a cheap source of funds, basic checking and savings accounts remain the key touchpoint between most financial institutions and their customers-the heart and soul of banking itself, in the words of Bert Ely, president of Ely & Co., an Alexandria, Virginia-based consulting firm. They also generate about 30% of the average bank`s income and 40% of its market capitalization, according to a recent study by First Manhattan Consulting Group.

While big banks have migrated away from their deposit dependence, about 72% of all community bank assets were funded by core deposits at the end of 1998. While a testament to the crucial role small banks play in local economies, the number masks the underlying trends. The past few decades have witnessed steady declines in deposit growth for most banks, a movement that has accelerated dramatically in the 1990s. Today, many banks-most notably the monolines and those with strong commercial lending operations, but also many regionals and community banks-are seeing loan demand outstrip deposit growth by large margins, forcing them to seek out other, higher-priced funding sources.

An analysis of FDIC numbers by Bank Director shows just how stunning the shift has been. In 1990, banks and thrifts combined held $3.62 trillion in deposits and had total net loans and leases on their books of $2.85 trillion, for a net loan-to-deposit ratio of 78.8%. By the end of 1998, the loan figure had jumped 35%, to $3.87 trillion, while deposits had increased by 20%, to $4.36 trillion. The result: a record high net loan-to-deposit ratio of 88.8% (see Figure 1). When people want to borrow money, they still go to banks, analyst Hanson explains. But when it`s time to put their money in some sort of safe investment, they have a thousand choices other than banks.

Indeed, deposits at the end of 1998 accounted for 73.5% of total bank and thrift liabilities, according to Bank Director`s analysis, versus 83.3% at the beginning of the decade. In contrast, borrowed funds made up 18.7% of the industry`s 1998 liabilities, up from 13.1% in 1990 (Figure 2).

Heady stock-market returns, combined with an ever-growing variety of investment options, are behind the shift. About 30% of the net increase in financial assets held by households in the 1980s flowed into bank deposits. In the 1990s, the figure has fallen shy of

15%. Today, bank deposits account for just 30% of the typical household`s liquid assets, compared with 38%

in 1990, according to the Federal Reserve Board. Mutual funds, in contrast, have soared, making up 22% of the average household`s liquid assets, versus just 6% at the beginning of the decade.

Competition for funds promises only to increase-from mutual funds and investment banks, to Internet-only banks and nonbank companies seeking to bypass traditional fund-raising channels by appealing directly to consumers. And banks` biggest selling point, FDIC deposit insurance, doesn`t seem to count for much with customers who haven`t even seen a recession, much less a depression.

Feeling the squeeze

The fallout of the deposit squeeze has already rippled across the industry, causing myriad banks to shift their strategies. Large banks have become adept at using sophisticated debt and equity offerings and loan securitizations to fill the funding void. They`ve also curtailed, in some cases drastically, their own low-margin correspondent lending activities to smaller banks. Large correspondent banks used to be very aggressive lenders of federal funds, says Mark Anderson, vice chairman and chief financial officer for Community First Bankshares Inc., a $6 billion holding company based in Fargo, North Dakota. But those companies are asset generators themselves, and they`re seeing their own loan growth outpace deposits. So they`re concluding it`s not profitable for them to lend [to other banks].

This, in turn, has helped push smaller banks to seek their own ways to grow deposits. Community First, for instance, has successfully pursued municipality deposits, attracting more than $500 million of such funds from small towns in recent years. Like many banks with broad geographic franchises, it uses selective pricing to attract more consumer deposits in markets where rate competition isn`t so stiff.

If you price aggressively in markets where you have very low share, it can be very effective, because you don`t have a lot to lose in terms

of cannibalizing existing spreads, says Robert Zizka, a managing vice president for First Manhattan Consulting Group in New York. Many others, such as Charter One, employ variations of totally free checking products to generate more transaction deposits from retail customers.

Those tactics may work for larger banks, but community banks-especially those in rural areas-don`t have the same options. In 1998, Piedmont Bank, a $100 million institution in Statesville, North Carolina, caught the attention of state examiners after its loan-to-deposit ratio soared above 110%. Although the situation was fairly typical for a start-up (Piedmont was launched in 1997), regulators were quick to respond. They said, u00c3″What`s your game plan to raise more funds?` recalls Chairman and CEO William Long. We said, u00c3″We`re going to push some of our deposit products more heavily.` And they said, u00c3″What`s your secondary game plan?`

In response, Piedmont lined up a $3 million line of credit with its local Home Loan Bank, but as it turned out, heavy newspaper advertising for Piedmont`s money-market accounts and CD specials generated enough deposits to soothe examiner concerns. Today, the loan-to-deposit ratio is below 80%.

Piedmont was lucky. In a strong, diversified economy such as Statesville`s, loan demand and deposits often move in tandem. Elsewhere- especially in agricultural regions where loan demand has bulged even as deposits have fled to bigger markets-many banks are pricing their deposits at desperately high rates. They`ll put a rate out there for deposits that`s just out of the ballpark, and you know they`re having funding troubles, says Anderson, whose bank competes with many rural banks in the Dakotas and Nebraska. But they`d rather pay above-market rates than have any borrowing on their balance sheets.

The bad news is that even aggressive pricing and marketing techniques usually don`t produce the desired results. Despite its free-checking strategy, for instance, Charter One`s average total deposits for the third quarter were just 2% more than a year earlier, at $15 billion, even as total loans and leases surged to $18.2 billion, from $16.9 billion a year earlier, nearly an 8% increase. In response, the company increased its level of FHLB advances to $7.6 billion at the end of September, from $5.3 billion a year earlier-a pricey option, given that the average rate Charter One paid for FHLB advances was 5.10%, while the typical checking account cost it just 1.19%.

Alternative solutions

If the industry`s future will be colored by tighter funding conditions, bank managers and directors need to ask some pointed questions about their own situations. Is the gap caused by loan demand or slumping deposits? Should they pursue alternative funding, even if it is more costly and raises their risk profiles, to keep pace with loan growth? Or should they ease off on the lending side, perhaps by pricing the loans they do make higher to boost spreads?

Again, there are no general answers, only more questions. But what is true is that banks have gotten more creative in their pursuits of nondeposit funding. Some have tapped into the national CD market, using investment-bank brokers like Merrill Lynch & Co. or PaineWebber to sell three- or six-month CDs to out-of-market customers. The national CD market has become a very cost-effective funding tool for some banks, says one bank executive who uses it. Others have turned to bankers` banks or have taken to buying deposits from brokers or other institutions. Repurchase agreements, a more-cumbersome process where banks sell securities with an agreement to buy them back later, are used by some larger and mid-sized banks. And many, including Charter One, are slowly shrinking their investment portfolios, making securities a smaller part of their assets, thus freeing up more room for loans.

By far the most popular source of alternative funding, however, is the government. Fed funds remain key for banks when it comes to balancing their accounts at the end of the day. And for the medium- and longer terms, the FHLB system has emerged supreme. As of June 30, a record 4,551 banks and thrifts had outstanding advances from the nation`s 12 Home Loan Banks, compared to 3,443 on the last day of 1996, according to Bill Glavine, a spokesman for the Federal Housing Finance Board, the FHLBs` overseer. They boasted outstanding balances of $328.5 billion-more than double the $161.4 billion registered 21u00c3u01612 years earlier. Today, more than 7,100 financial institutions are members of the FHLB system, up by about 1,000 from three years ago.

Many bankers rave about the FHLBs` flexibility on rates and payment terms. Once limited to backing only mortgage loans, the FHLBs have in recent years expanded their mandates to areas such as economic development and farm lending. And because they`re government-sponsored entities, they`re able to issue debt at rates that are usually priced 25 to 50 basis points above Treasuries, passing the savings onto member banks. They alone see themselves as being in the business of lending to banks, Anderson says. That`s really their sole purpose.

Still, government funding isn`t exactly cheap. At the end of 1998, banks paid an average interest rate of 3.29% for core deposits, compared to 4.82% for Federal funds and 5.60% for FHLB advances (see Figure 3). Nor is it without risks. Regulators track such borrowings closely. If a state-chartered bank in North Carolina borrows more than 10% of its assets, for instance, it sets off some alarm bells, and we start looking at that bank pretty closely, Hanson says.

Such examinations are usually focused on trying to figure out if the [funding deficit] is being caused by real loan demand or irresponsible lending, he adds. If everything else in the bank-capital levels, asset quality, earnings-is strong, then we`re not too concerned about more borrowings. But if we start to see capital ratios decline or chargeoffs increasing, we get quite concerned.

Like many bankers, Long employed a multipronged approach when faced with liquidity troubles. In addition to marketing attractive deposit rates and opening a FHLB credit line, he capped Piedmont`s maximum loan size at $1 million, requiring that each loan over $50,000 get his personal approval. He also eliminated sweep accounts, which allowed customers to roll their money into higher-interest-rate overnight funds. We said, u00c3″OK, we`ve got a liquidity crunch. We`ve got to focus on quality deposit growth, and while want to keep lending, we want a relationship out of each of those loans.

Such funding challenges have made liability management a serious operational challenge, and could pose a threat to the long-term survival of some institutions. Under pressure from investors to produce double-digit returns, many bank boards are realizing that as their net interest margins continue to shrink, they won`t be able to stay in business, Calvert says. They don`t want to sell, but they don`t have much choice. Others could be inspired to pay premiums for banks with strong deposit balances. A lot of the acquisitions we see today are more about balance sheets than cost takeouts, Zizka says, citing the erstwhile NationsBank Corp.`s acquisition of Barnett Banks in deposit-rich Florida as an example.

Boards intent on seeing their institutions survive must sometimes reconsider exactly how they are going to fuel profitability. Depending on the personality and character of the institution, the solutions can be either invigorating or daunting.

Calvert, for instance, advises many of his client banks to radically adjust their strategies and corporate sales cultures in the face of tough funding, with an eye to a future where fees may soon produce more than half of some banks` revenues. I tell them, u00c3″Quit worrying about net interest margins, because that game is dead,` he says. Worry about fee income and controlling your operating expenses instead.

The spread appeal

While many institutions have boosted fees substantially in recent years, even successful fee generators aren`t willing to give up on spreads. Soaring fee incomes and expense reductions powered Community First to record earnings in the third quarter, despite a 1.5% decline in interest income. Still, Anderson says his board remains committed to lending.

To some extent, bank managers may be able to offset the higher interest costs of wholesale funding by improving efficiency through greater management of overhead expenses and increases in noninterest income, wrote Allen Puwalski, a senior financial analyst for the FDIC, in a recent report. But most banks, he added, won`t be able to fully compensate for margin losses with fee income.

Ely agrees, asserting that spread-based businesses will be crucial to bank profitability for the foreseeable future. But, he adds, banks must price to meet demand, raising loan rates or cutting deposit rates to boost the bottom line-much like a junkyard does. If you`re a junkyard operator, you don`t care what the price is that you`re selling stuff for, as long as you can buy it with enough spread. Banking is the same way: The key thing is figuring out how to maintain your spreads, Ely says. If you raise your [loan] rates, not only do you reduce your loan demand, but you have more interest margin to buy deposits with.

That sounds logical. But bankers such as Piedmont`s Long fret that they`d lose good relationships with creditworthy customers by simply pricing loans higher. And on the deposit end, Zizka notes that many acquirers have lost customer relationships by the thousands after slashing deposit rates to make acquisitions look more profitable in the short run.

Capital management: the directors` role

Many bank boards are focusing more on the asset side of the balance sheet, shrinking the amount of low-yielding securities in their investment portfolios in an effort to strike a more-profitable balance in their day-to-day operations. In theory, this frees up more capital to back loans. But a smaller base of investments also reduces the amount of collateral available to pledge for borrowings, and with today`s rising interest rates, many banks are reluctant to sell their bond holdings at a loss.

In the end, striking the proper asset/liability mix in an era of tighter funding falls under the banner of capital management. Would a bank with a $1 billion in loans balanced by $100 million in equity, $500 million in deposits, and $400 million in other funds be better off with $70 million in equity, no borrowed funds and around $600 million in loans? Perhaps. But bear in mind that shrinking the balance sheet in response to funding challenges could impact not only how a bank serves its customers, but how it measures performance. Lower loan and equity levels, for instance, will likely result in higher returns on equity, but lower returns on assets.

Conversely, a bank could borrow more, hoping to produce profits via its lending operations. But here, too, tough decisions must be made. If it will cost 53u00c3u01614% to raise the next $1 million in funding, and that money can be lent at 10%, then borrowing could prove a shrewd move. If, on the other hand, the bank will only get 61u00c3u01612% for the loans made with that money, then the incremental gain probably doesn`t justify the move-even if it means saying no to a valued customer.

This is meaty stuff, especially for small-bank directors who aren`t necessarily finance experts. In trying to strike the delicate balance between capital, funding, loans, customer relationships, and shareholder value, directors must be conversant in the costs of funding, the dynamics of their own local lending markets, their customers` prospects, and their own vision of how large and vital their bank should be.

Consultants and investment banks can help boards make such calculations, but after that, it`s up to directors and management to trust their own instincts which, for the time being at least, seems destined to result in less change than some experts say is needed.

For whatever challenges confront banks on the funding side, most boards and managements remain wedded-and rightly so-to the notion that banking is, at its core, about lending, and that profits should be rooted in the spread. Getting them to give up that idea in exchange for fees generated by the sales of insurance or investment products sounds as anathema to most bankers as asking them to sell hamburgers or auto parts.

We, as an industry, are going to have to live with lower spreads, Koch says. If that`s the way the world is going to be, then you need to be more efficient-spend less money-to drop the same amount of money to the bottom line. Are banks and their boards up to the challenge? Stay tuned. The coming years seem poised to produce the answer. |BD|