Why Record Deposit Growth Should Spur Funding Rebalancing

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Is there such thing as a gold lining?

In a year with seemingly constant crises, finding silver linings has been crucial in maintaining optimism and planning for a post-pandemic future. Banks have faced myriad challenges, but core deposit growth may represent a fundamental strategic advantage for profitability enhancement.

Total FDIC-insured domestic bank deposit balances increased by nearly 18%, or just under $2.6 trillion, over the first nine months of 2020. While government stimulus efforts and the Federal Reserve’s return to a zero interest rate policy are driving factors, higher levels of deposits should remain on bank balance sheets into the foreseeable future. Forward-thinking banks should be proactive in repositioning this funding to aid profitability improvement for years to come. Core deposit growth gives banks a chance to reduce exposure to higher cost non-transaction deposits, brokered deposits, repurchase agreements and borrowings. But despite this year’s massive deposit inflows, the Federal Deposit Insurance Corp. reports that other borrowed funds have only declined by 12%, or $167 billion, over the first nine months of 2020.

Higher loan-loss provisioning in 2020 has strained net income across the banking sector, reducing net operating income to levels not seen since the Great Recession. This may make the costs of funding restructuring — such as prepayment fees or relationship discounts on loan pricing — seem like exorbitant earnings constraints, representing an impediment to action. We believe this is short-sighted.

Economic weakness and macro uncertainty has tempered loan growth, and forced banks to maintain larger balances of lower-yielding liquid assets on the asset side of the balance sheet. Most community banks remain heavily reliant on net interest income to drive higher operating revenues. But net interest margin pressure has accelerated in 2020; combined with negligible core loan growth (excluding participation in the Small Business Administration’s Paycheck Protection Program), operating revenues have been stuck in neutral. As a result, return on equity and return on assets metrics have suffered.

There are three reasons why banks should judiciously adjust their funding profiles while the yield curve maintains a positive slope and before competitive factors limit alternatives.

Driving higher core deposit balances in challenging economic times through above-peer rates not only promotes growth, but engenders customer goodwill and loyalty. Banks have the luxury of growing customer deposit balances by increasing their offered interest rates, which  can be offset by reducing the reliance on higher-cost borrowings. Furthermore, assuming the Federal Reserve’s interest rate policy stays in place for several years, future opportunities will emerge to gradually adjust core deposit products’ rates. 

Funding adjustments provide the chance to rethink deposit products, loans or investments that may no longer be core to the business strategy. Liability restructuring can be the impetus for corresponding changes to the asset side of the balance sheet. Perhaps certain loan categories are no longer strategic, or investment securities have moved beyond risk parameters. Asset and liability rebalancing can refresh and refocus these efforts. 

Banks with higher core deposits as a percentage of total deposits higher tangible book value (TBV) multiples than peers. Our research at Janney shows that for all publicly traded banks, price-to-TBV multiples are 15% higher for banks with core deposit ratios above 80% compared to banks with less than 80% core deposit ratios. Better funding should also result in a higher core deposit premium, when a more-normalized M&A environment returns.

Nobody expects banks to perfectly forecast the future, but it would be a low-probability wager to assume that Fed intervention and the current interest rate policy will remain in place indefinitely. Banks that allow market forces to dictate deposit pricing and borrowings exposure without taking action are missing a huge opportunity. Making mindful funding decisions today to reduce reliance on non-core liabilities lays the groundwork for changes in future profitability and shareholder value.

The Case for Rating Community Banks Investment Grade

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investment-9-18-18.pngFor years, legacy rating agency thinking held that community banks could not be rated investment grade. They were too small, the thinking went, and therefore could not compete with scale-advantaged larger banks. Moreover, this structural deficiency likely made community banks riskier, as they were naturally subject to adverse selection in terms of loan originations.

All of this is intuitive. But it doesn’t stand up to further scrutiny.

If we consider the history of bank failures, we see that very small banks and very large banks are disproportionately represented. Meanwhile, well-run community banks, with long-standing ties to local markets, core deposit funding and well diversified risks have a long history of successfully riding out credit cycles. That piqued our interest. But we still needed to get over the hump of competitiveness. How could a community bank’s cost structure—the basis for pricing assets and liabilities—match the efficiency of the largest banks? We took a closer look.

Started with funding costs. Turns out that government guaranteed deposit funding—available to all FDIC-insured institutions, large and small, is a great equalizer. In fact, most community banks derive substantial amounts of their funding via core deposits, giving them an advantage over the largest banks that require substantial sums of more expensive market-sourced funding.

What about operating costs? Surely, the largest banks enjoy substantial economies of scale relative to community banks. That may be true, especially in terms of being able to absorb things like the significant increases in regulatory reporting and compliance costs. What we found interesting, however, is that the efficiency ratios of community banks in many cases compare favorably to those of the larger banks. Our research came up with two explanatory considerations. First, according to the FDIC, the benefits of economies of scale are realized with as little as $100 million in assets, and second, among larger banks, the benefits of scale are typically offset by the added costs brought on by complexity and administrative friction. This serves as a reminder that, in terms of competitiveness, banking, especially small to mid-sized commercial banking, is a local scale business, not a national (or international) one.

Now, you might point out, broader and more sophisticated product offerings must tip the scale in favor of larger banks. And there must be some benefit to the substantial technology and marketing spend of the larger banks. We wouldn’t disagree. But we also believe community banks can punch back with value of their own created out of local market knowledge and relationships as well as superior responsiveness. And most small businesses really don’t demand a sophisticated product set, and marketing spend generally creates value in consumer financial services, much of which left community banking some time ago.

So, what about the risk side of the equation? Larger banks by definition will have greater spread-of-risk than community banks, where risks are more concentrated, certainly in terms of geography, and quite possibly loan type (most notably CRE). What our research found was that through cycles, community banks’ loss rates per loan type were typically better than those of larger banks. In other words, no evidence of adverse selection, and a realization that most markets in the U.S. are relatively well diversified economically.

This is not to say that all community banks are investment grade. Well-run community banks can be rated investment grade. Therein lies an essential element of our rating determination—an in-depth due diligence session with senior management. Here, we look to understand the framework and priorities for managing risk, key aspects of growth strategies, and the rationale underpinning capital and liquidity structure. This is a story sector, and the management evaluation is critical to our rating outcome.

Our research suggests that well-run community banks can compete successfully with larger banks, and generate solid fundamental performance through the cycle. We rated our first community bank in 2012, and today that figure stands at 115 and counting, testament that our approach has resonated with investors and depositors alike.

A Report Shows Amazon Is, Piece By Piece, Assembling a Bank

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amazon-7-12-18.pngIt gets clearer every day that banks have work to do if they’re going to remain at the center of their customers’ financial lives, as more and more companies, be it upstart fintech companies or well-established technology firms, seek to disrupt the traditional banking relationship.

The examples are numerous, and attract glitzy headlines, led by Amazon, which seems intent on trying its hand at banking.

A recent report from CB Insights walks through the myriad ways the ecommerce giant is positioning itself to be, what some are calling, the Bank of Amazon. It’s not there yet, and may never be, according to some analysts, but it’s certainly making a run at it.

For bankers, this is nothing new. Amazon has long been viewed as a potential threat, but it hasn’t brought widespread disruption just yet. This could soon change, however. Amazon has purportedly been in talks with JPMorgan Chase & Co. and Capital One Financial Corp. about offering a checking account-like product, the core of any banking operation. This would be on top of Amazon Cash and Prime Reload, which allow customers to move funds from a traditional bank-managed account into a digital wallet. It’s also had co-branded credit cards with JPMorgan for years.

It was announced earlier this year, moreover, that Amazon has joined JPMorgan and Berkshire Hathaway, Warren Buffett’s company, in an effort to establish a health insurance company for their employees, collectively totaling some 1.2 million people. It’s the latest grab by the companies at creating an unbreakable relationship with American consumers.

Amazon has gotten into lending, too, backed by Bank of America. All told, Amazon has already made $3 billion in loans to more than 20,000 independent retailers on its Marketplace platform. The borrowers are invited to borrow and half of them take a second loan.

And it’s not just Amazon. SoFi now plans to offer multiple depository products as well, products which it struggled to get off the ground after former cofounder Mike Cagney was ousted in the wake of a sexual harassment scandal. With a combined checking-savings account product that pays up to 1.1 percent interest, it’s only a matter of time before the creep of non-banks like SoFi threaten the core deposit products offered by banks, regardless of FDIC insurance.

Some banks, though, have been able to spot and partner with companies that offer these alternative banking options. Ally Financial, Live Oak Bank, SunTrust Banks, NBKC Bank and, yes, Amazon all invested earlier this year in Greenlight, an alternative debit card for kids that’s backed by Community Federal Savings Bank, based in Jamaica, New York, and MasterCard.

The CB Insights report suggests there’s time for banks to adjust, but community banks with limited technology budgets will be left to watch and learn, or focus their attention on depositors they know they can keep.

In a digital age, bankers should understand that no matter the size or scope of the disruptor, they still have an advantage—the financial data they have on their customers—which will continue to grow in value as technology and analytics become more sophisticated, Jim Sinegal, a senior equity analyst at Morningstar, wrote in March.

That data may be the key that allows banks to maintain a healthy bottom line, according to Deloitte’s Banking Industry Outlook for 2018: “Banks that successfully target customers through sophisticated data analytics, make compelling product offers, and deliver strong digital experiences, could gain funding advantages and see slower increases in deposit costs.”