The Path to Deposit Growth

Wil Daly once flew A4 attack jets in the U.S. Marine Corps, so he`s no stranger to danger. But two years ago, when the chief marketing officer for Fifth Third Bancorp rolled out free checking, a lot of experienced bankers would have said that he was on a suicide mission. Fifth Third had previously acquired two thrifts that offered free checking, and Daly had spent considerable time studying the product. Most bankers dislike free checking because they don`t want to give up the monthly service charges, but Daly was betting that a flood of new balances would make up for the lost income many times over. The gamble was a smashing success: Free checking helped the Cincinnati-based regional bank grow its core deposits nearly 11% last yearu00e2u20ac”well above the national growth rate.

Fifth Third`s experience is unusual because when the effect of mergers is factored out, core deposit growth has been modest at best for commercial banks in recent years. Core depositsu00e2u20ac”certificates of deposits and checking, savings, and money-market accountsu00e2u20ac”are the primary drivers of retail bank profitability, yet many bankers are fatalistic about their seeming inability to grow deposit balances. “I think they have just come to accept whatever the market will give them in terms of deposit growth,” says Chuck Kim, an executive vice president who runs the retail operation at Kansas City, Missouri-based Commerce Bancshares. According to the Federal Deposit Insurance Corp., core deposit growth from 1996 through 2000 averaged about 5%, while loan growth averaged 8%. By comparison, core deposits grew 7.5% in 2000, to nearly $2.9 trillion, largely because they were the primary beneficiaries of stock market volatility and the sharp decline in many industries` equity values. But loan volume similarly grew in 2000, at a rate of 9.3%, which means that many banks had to rely on more expensive sources of funding, such as Federal Home Loan Bank advances and brokered deposits. These stopgap measures, while necessary, cut into banks` net-interest margins.

The largest banks have had the greatest difficulty growing their deposits. New York City-based First Manhattan Consulting Group recently completed an extensive study of retail banking for the Bank Administration Institute in Chicago and estimates that when the effects of acquisitions and divestitures are factored out, the 30 largest bank holding companies grew deposits by less than 1% over the past six years. First Manhattan further estimates that banks and thrifts below the top 30 grew their deposits on average about 4% a year over the same period. As a group, large banks also tend to have the lowest concentration of core deposits as a percentage of total deposits and borrowings. One explanation is that many large banks generally have sizable capital markets, commercial lending, and commercial finance operations that are too big to be funded with core deposits alone. But their low growth rates also seem to imply that large banks are not giving their retail customers what they want. “As a group, they have a less attractive value proposition than the smaller banks,” says First Manhattan president Jim McCormick. In a ranking of the 50 largest publicly owned U.S. banks (see p. 37), Burlington, Vermont-based Chittenden Corp. had the highest percentage (90.07%) of core deposits to total deposits and borrowings at year-end 2000, according to SNL Securities, a Charlottesville, Virginia-based research firm. Small banks dominated the upper end of the ranking, although Pittsburgh-based PNC Financial Services Groupu00e2u20ac”with $69.8 billion in assetsu00e2u20ac”finished an impressive 34th.

There are several reasons why all banks have had a difficult time attracting deposits. A roaring bull market through much of the 1990s tilted the playing field toward the mutual fund and brokerage industries and made it difficult for banks to retain their depositors. Likewise, dramatic consolidation throughout the industry had a deleterious effect on service quality. Nor did a large number of banks do themselves any favors when they aggressively raised fees on a variety of consumer products and tried to direct traffic away from their branches to lower-cost distribution channels.

The First Manhattan study shows that deposit-related fees rose 33% in the last six years. This may have sustained the profitability of many banks throughout much of the 1990s, but it alienated consumers even further. Given these self-inflicted wounds and the industry`s mediocre performance at growing deposits, one thinks of the late, great Casey Stengel who surveyed the hapless 1962 New York Mets during their first season and wondered aloud, “Can`t anyone here play this game?” Indeed, some can. A number of banks have succeeded in generating high concentrations of low-cost core deposits despite stiff competition from the stock market and savvy nonbank competitors like Fidelity Investors, Charles Schwab, and Merrill Lynch & Co. Interviews with strong performers reveal that while there are different strategic models for generating high levels of core deposits, those institutions that do it well have three things in common. First, they focus intensely on their customers and strive to give them consistently good experiences.

Second, they have made the acquisition of core deposits their core strategyu00e2u20ac”and use that to drive everything else that happens in the bank. Third, they pursue their strategies with consistency and determination. “The top trait among the leaders is commitment and follow-through,” says McCormick. Despite the conventional wisdom that nonbank competitors hold a stronger hand, commercial banks can play the deposit game if they focus on the customer and stick with whatever strategic model they adopt. Nevertheless, it`s astonishing that more banks don`t focus on deposit gathering with religious zeal because of how crucial it is to the profitability of a retail operation. First Manhattan estimates that transaction and savings products yield about 275 basis points in pretax profits for every $1 of deposits.

It drops to 40 basis points for time deposits and 25 basis points for investment products like 401(k) plans and annuities. The firm also has determined that almost 90% of consumer profits at a typical retail bank come from core deposit spreads and related fees. “Deposits are still the big gorilla in the game in terms of income,” says McCormick. And the biggest gorilla of all is the simple checking account, which is both immensely profitable and often the product that is most likely to bind a customer to the bank. “Ask most bank customers who`s their primary financial provider, and it`s the one where they have their checking account,” says Daly at Fifth Third. First Manhattan estimates that the average return on equity for the majority of consumer and small-business loans is at or below a 12% hurdle rate. So why do banks aggressively push loans when deposits are more profitable? Charles Wendel, president of Financial Institutions Consulting in New York City, believes it`s because most bankers think of themselves as lenders first. He sees this phenomenon in the small-business banking area where he specializes. “Even though deposits are very important, many small-business officers remain lenders at heart,” he says. “That is what they know and prefer to sell.”

What makes this behavior even more illogical is that banks often rely on expensive, short-term sources of money to fund their loan growthu00e2u20ac”which reduces the profitability of loans even further. According to the FDIC, the industry`s net interest declined to 3.83% in the first quarter of this yearu00e2u20ac”its lowest level in 14 years. Banks have reacted to the problem of weak core deposit growth by turning to a variety of funding alternatives. The most popular option has been to make greater use of the Federal Home Loan System. “That seems to be the hot product now,” says Susan Regan, a senior analyst at Olson Research Associates, a Columbia, Maryland-based consulting firm that specializes in balance-sheet issues. To borrow from the Federal Home Loan System, a bank must join the FHL bank in its region and purchase capital stock in the institution. Banks must provide collateral for their advances, and FHL banks generally will only lend between 70% and 95% of the value of the collateral. Another alternative is brokered deposits, which are CDs that have been packaged by a third-party intermediary, often a securities firm. The FDIC says that brokered deposits grew 96.6% last yearu00e2u20ac”although half of this growth was driven by two brokerage firms, Merrill Lynch and Salomon Smith Barney, which used sweep accounts to move their customers` money into insured deposit accounts at affiliate banks. Banks must be classified as “well capitalized” under federal guidelinesu00e2u20ac”requiring 5% tier-one capital and 10% risk-based capitalu00e2u20ac”before they can make unrestricted use of brokered deposits.

The ramifications of this increased reliance on wholesale funding sources are threefold. First, because this funding is considerably more expensive than core depositsu00e2u20ac”particularly checking accountsu00e2u20ac”it has slowly eaten away at the industry`s net interest margins. And most banks today still make a majority of their profits from the spread between their cost of funds and the rates they charge on loans. Second, because their cost of funds is higher, banks with comparatively low percentages of core deposits must lend more aggressively, which generally translates to carrying a higher loan-to-deposit ratio and writing riskier loans, thus heightening their credit risk. Third, because they are relying on short-term money that reprices quickly, wholesale funds carry more interest rate risk. Institutions that borrow short and lend long are always at risk when interest rates go up. Thankfully, this is not a major problem at the moment since the Federal Reserve has cut interest rates six times this year in an effort to prevent a recession. In its examination of retail banking, First Manhattan identified several statistically significant factors that drive core deposit growth, beginning with customer-friendly pricingu00e2u20ac”which is to say higher rates and lower fees than most of their competitors. Other drivers include the proliferation of branches, the density of a bank`s nonbranch automated teller machine network, excellent service, andu00e2u20ac”the only one that individual banks do not controlu00e2u20ac”a strong regional economy. But when it comes to retail banking, no one strategy seems to be clearly superior to any other. “There is no magic bullet,” says Paul Olivier, group executive vice president at San Antonio, Texas-based Cullen/Frost Bankers.”You`ve just got to do the little things right and stick to it.” Indeed, what you do may be less important than the skill and consistency with which you do it. Fifth Third`s Daly is a fervent believer in a product so banal that many bankers seem to treat it as an afterthought. And yet he considers the basic checking account to be the linchpin for Fifth Third`s relationship with its retail banking customers, saying it`s the most inexpensive funding that his bank can find, averaging between zero and 3%. “It`s cheaper than Fed funds at 4% and a CD at 5%,” he says. “Our thrust is mix improvement,” he adds. “We`d rather get new checking than CDs.” One challenge banks grapple with when they go after retail checking accounts is differentiating their product from everyone else`s. It was for this reason that Daly wanted to take the free checking product that was being offered in the markets of the two former thrifts Fifth Third had acquired and roll it out systemwide. Bankers generally loath free checking, fearing the product will cannibalize existing accounts and cost them a bundle in lost monthly service charges. In Fifth Third`s case, however, cannibalization has been minimal. “We`ve never had a campaign that was less than 98% new money,” says Daly.

Fifth Third`s checking account balances grew 17% in 2000u00e2u20ac”excluding acquisitionsu00e2u20ac”largely because the bank focuses on it intensely. Every year it runs one savings, two commercial, and three consumer marketing campaigns a yearu00e2u20ac”called blitzesu00e2u20ac”and everyone gets involved, including Chairman and Chief Executive Officer George Schaefer. All branches have dollar and account number goalsu00e2u20ac”the minimum dollar target for new balances is 30% of their existing balances and the bank tracks each manager`s performance and posts it internally, so the peer pressure can get pretty intense. “If you don`t have a growth strategy, you can`t do any of this,” says Daly. Fifth Third has two other advantages that have helped it grow core deposits. It`s widely considered to have one of the strongest sales cultures in banking, which means it does a great job of pushing product. And it has one of the industry`s lowest cost structures, which gives it a decided pricing advantage over its major competitors. There are other stellar performers. Billing itself as “America`s Most Convenient Bank,” Cherry Hill, New Jersey-based Commerce Bancorp. may be the most prolific bank in the country when it comes to raising depositsu00e2u20ac”with a 25% average growth rate since 1996, including 25.7% in 2000. Nearly 84% of the $8.3 billion-asset company`s funding comes from core depositsu00e2u20ac”good enough to place 7th on the SNL top 100 ranking. Founded in 1973 by Vernon W. Hill II, who has an MBA from the University of Pennsylvania`s Wharton School and first made his mark in the fast food business, Commerce operates on the theory that serviceu00e2u20ac”not ratesu00e2u20ac”drives deposit growth.

Commerce branchesu00e2u20ac”it has 159 in New Jersey, Pennsylvania, and Delawareu00e2u20ac”are open 7:30 a.m. to 8 p.m. Monday through Friday, 7:30 a.m. to 6 p.m. on Saturday, and, bucking tradition, 11 a.m. to 4 p.m. on Sunday. The bank also offers free checking with a minimum balance of $100 (there`s no minimum balance requirement the first year). Hill takes his inspiration from successful retail giants like Home Depot and proclaims, “We see ourselves as a retailer, not a bank.” Commerce spends lots of money on its branches because Hill believes it`s crucial to provide bank customers with a pleasing environment, and he`s always looking for ways to improve service. For example, Commerce has installed free coin counting machines in all its branches, and they attracted over half a million users last year. “It`s not about counting coins,” Hill says. “It`s about enhancing the customer experience.” Hill still owns a chain of Burger King restaurants, and he finds an analogy in that industry to explain the value of the cheap funding that core deposits provide. “It`s like Coca-Cola in the fast food business,” he says. “It`s where we make our money.” It`s a strategy that investors like as wellu00e2u20ac”two out of four analysts polled at Bank Director`s annual analyst forum named Commerce one of the best franchises in America. Cullen/Frost, a $7.7 billion bank holding company that does business throughout Texas as Frost Bank, has used a relationship management strategy to generate 81.54% of its funding from core deposits, good enough for 11th place on the SNL ranking. Last year Cullen/Frost grew its core deposits by 8.6%. “The value proposition we give is relationship,” says Paul Olivier. “We have a very robust customer intimacy program.” The bank`s best retail customers are assigned to a relationship management officer who gives them the sort of personal attention they wouldn`t typically get from larger competitors. All account activity is tracked and monitored on a centralized system that is used to manage relationships. “We`ve reorganized the bank around this activity,” says Olivier.

Cullen/Frost also plays up its position as the largest independent bank in Texasu00e2u20ac”and the only one to survive the energy lending crisis of the 1980s, when five of the state`s largest banks were taken over by out-of-state interests, including several large banks. Its slogan is “We`re from here,” and the home page of its online banking site displays a large Texas flag. In addition to being a local bank, the intent is to project an image of stability. “Our name stands out as a survivor,” Olivier says. Another bank that has built its deposit strategy around relationship management is Chittenden, a $3.7 billion bank holding company that does business through two subsidiaries in Vermont and a third in Maine and gets 40% of its core deposit funding from business accounts. The bank is not shy about asking for deposits when it provides credit, and it looks to consolidate all of a business customer`s banking relationships at Chittenden. “We aggressively ask for that relationship to be consolidated,” says Dan O`Brien, an executive vice president who runs Chittenden`s retail operations. In return, the bank gives its commercial accounts a level of service that larger competitors can`t or won`t provide. “We stay in touch with them through a team approach,” he says. O`Brien complains that “it`s getting tougher and tougher” to raise deposits, although the bank still managed to grow its core funding 5% last year, according to SNL. Even though most large banks are treading water when it comes to deposit growth, PNC Financial managed to grow its deposits 4% last year thanks to dogged determination and a three-year-old program called Choice Banking. In mid-1998, the bank, dissatisfied with its deposit growth, introduced a new set of checking and package products that combine a checking account with other options like a loan, CD, or money market account. Senior Vice President John Rees, who manages the consumer deposit business at PNC, says the bank used the new product introduction as an opportunity to call each of its 1.5 million retail customers to explain the change. “We spent a lot of time talking about the new product line,” he says. The bank also strives to match each retail customer with the best product option. Progress was slow at firstu00e2u20ac”deposit balances grew just 1% in 1998 and 2% in 1999. By last year, however, the effort had begun to pay off. “Deposits grew,” says Rees. “Revenue per household grew. And we`ve seen a tremendous improvement in retention over that time.” The product launch was followed by a new customer contact program in which PNC uses telephone calls and letters to stay in touch with its retail customers with a focus on retaining and deepening its relationship with them. “We offer an excellent value to the customer,” says Rees.

But “that [alone] is insufficient. You have to give the customer an experience that shows you`re listening to them and acting in their best interests.” PNC was successful in part because it stuck with its new retail strategy even though it took a few years for the benefits to show up on the balance sheet. Therein reveals one of the most important secrets to winning at the deposit gameu00e2u20ac”there is no secret. Strategy is less important than follow-through. Brilliance is less important than determination. “It comes down to consistency and execution,” says O`Brien at Chittenden. “It`s basic blocking and tackling.” |BD|

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