Three bank failures and a wide range of misinformation about bank deposit outflows during 2023 have certainly diminished the value of deposits in U.S. bank stocks. The experience of Silicon Valley Bank, where 24% of the institution’s low-cost deposits left the bank in about six hours on Thursday, March 9, caused investors to reexamine how so-called “core” deposits would move all at once, after years — and decades — of calm behavior.
We at Janney assert that funding cost advantage is wide in the U.S. banking industry and supports underlying value. Interest rates have increased far more than expected in the past 18 months, with the federal funds rate rising 525 basis points from mid-March 2022 through late August 2023. Bank deposit costs and funding costs, including all borrowings, have risen about 35% of the fed funds hikes. This is the industry’s cumulative beta through the third quarter of 2023, including Janney Research’s forecast for another high rate change this quarter. There remains a wider spread between average funding costs and the fed funds rate; the same is true for average interest-bearing deposit costs versus the fed funds rate.
We studied this history from spring 1990 to summer 2023 and found the median and average spread over 33 years are both near zero (+0.13%), largely due to decades of zero interest rate policy (ZIRP) by the Federal Reserve’s Federal Open Market Committee. Today, this spread exceeds 300 basis points for the bank charters examined by Janney Research — and we expect this wide spread to remain intact for quite a while, even if Fed policy shifts lower in future quarters.
Our perspective towards bank deposits has changed: Now, value comes from the deposit and funding “cost,” rather than “account type.” The failures of three large banks this year were heavily influenced by large, concentrated deposits well in excess of the $250,000 deposit insurance threshold. This is easily understood in disclosures that banks file with both the Securities and Exchange Commission and the Federal Deposit Insurance Corp., which detail deposits per account. Less than 4% of all public banks have deposits per account that are above the FDIC’s $250,000 insurance limit.
We believe that investors used to judge banks based on their deposit type: they assigned little value, if any, to certificates of deposits or maturity-based deposits and placed extremely high value on DDA demand accounts, interest checking, savings and money market deposits. The 2023 bank failures have shifted this thinking, in our opinion, toward the underlying rate paid for all deposits. This requires a new valuation method.
Our valuation approach for bank deposits begins with a gross value from the spread between fed funds, less funding costs and multiplied by the relationship tenure across the company’s deposit base. For our analysis here, we apply a three-year minimum tenure for banks and exclude brokered funds and government/municipal accounts from the deposit base. The government and municipal funds receive a 1x multiple; brokered have zero value.
Here is where new disclosures can educate Investors on how often companies have long-standing relationships. When asked, management teams often share the length of account holders; it is quite common for a significant portion of total deposits to have relationships of five, seven and over 10 years. Then, we record fair value marks to derive a net deposit value and net deposit premium. Finally, we add back tangible book value (TBV) per share plus accumulated other comprehensive income (AOCI) per share to avoid double-counting AOCI that is already included in TBV under accounting rules.
Yes, unrealized fair value marks absolutely matter to investors and must be included. The updated deposit valuation factors all unrealized securities marks for available-for-sale and held-to-maturity portfolios, along with a separate loan mark disclosed by companies for interest rate risk that comes with having higher rates today versus the original yields on loans from 2020-21 or prior. Nearly all public banks use quarterly SEC disclosures to share their fair value loan marks; these vary primarily by the loan structure on maturity and duration, as well as fixed versus variable rate status. Remember: Loan loss reserves are already recorded for credit risk on balance sheets within a bank’s reported tangible common equity (TCE) and TBV per share. When considering the absolute loan mark, investors should not ignore the bank’s allowance or established reserve. Some investors may recalculate tangible book after removing the after-tax marks on HTM securities and loan marks — here, we suggest netting out the reserve and allowance for a holistic picture.
The bottom line for bank stocks is the importance of a stronger examination of bank deposits and funding costs, removing both unrealized securities losses and fair value discounts on the loan portfolio for interest rate risk. At the same time, there is a true deposit value to attach to underlying deposits, excluding brokered and government accounts. In our view, it is critical that directors, executives and investors properly value both sides of the balance sheet — and that our approach is worth considering in light of 2023’s industry drama.