Banks Are Letting Deposits Run Off, but for How Long?

In September, the CEO of Fifth Third Bancorp, Tim Spence, said something at the Barclays investor conference that might have seemed astonishing at another time. The Cincinnati, Ohio-based bank was letting $10 billion simply roll off its balance sheet in the first half of the year, an amount the CEO described as “surge” deposits.

In an age when banks are awash in liquidity, many of them are happily waving goodbye to some amount of their deposits, which appear as a liability on the balance sheet, not an asset.
Like Fifth Third, banks overall have been slow to raise interest rates on deposits, feeling no urgency to keep up with the Federal Reserve’s substantial interest rate hikes this year.

Evidence suggests that deposits have begun to leave the banking system. That may not be such a bad thing. But bank management teams should carefully assess their deposit strategies as interest rates rise, ensuring they don’t become complacent after years of near zero interest rates. “Many bankers lack meaningful, what I would call meaningful, game plans,” says Matt Pieniazek, president and CEO of Darling Consulting Group, which advises banks on balance sheet management.

In recent years, that critique hasn’t been an issue — but that could change. As of the week of Oct. 5, deposits in the banking system dipped to $17.77 trillion, down from $18.07 trillion in August, according to the Federal Reserve. Through the first half of the year, mid-sized banks with $10 billion to $60 billion in assets lost 2% to 3% of their deposits, according to Fitch Ratings Associate Director Brian Thies.

This doesn’t worry Fitch Ratings’ Managing Director for the North American banking team, Christopher Wolfe. Banks added about $9.2 trillion in deposits during the last decade, according to FDIC data. Wolfe characterizes these liquidity levels as “historic.”

“So far, we haven’t seen drastic changes in liquidity,” he says.

In other words, there’s still a lot of wiggle room for most banks. Banks can use deposits to fund loan growth, but so far, deposits far exceed loans. Loan-to-deposit ratios have been falling, reaching a historic low in recent years. The 20-year average loan-to-deposit ratio was 81%, according to Fitch Ratings. In the second quarter of 2022, it was 59.26%, according to the Federal Deposit Insurance Corp.

In September, the Federal Reserve’s Board of Governors enacted its third consecutive 75 basis point hike to fight raging inflation — bringing the fed funds target rate range to 3% to 3.25%. Banks showed no signs of matching the aggressive rate hikes. The median deposit betas, a figure that shows how sensitive banks are to rising rates, came in at 2% through June of this year, according to Thies. That’s a good thing: The longer banks can hold off on raising deposit rates while variable rate loans rise, the more profitable they become.

But competitors to traditional brick-and-mortar banks, such as online banks and broker-dealers, have been raising rates to attract deposits, Pieniazek says. Many depositors also have figured out they can get a short-term Treasury bill with a yield of about 4%. “You’re starting to see broker-dealers and money management firms … promot[e] insured CDs with 4% [rates],” he says. “The delta between what banks are paying on deposits and what’s available in the market is the widest in modern banking history.”

The question for management teams is how long will this trend last? The industry has enjoyed a steady increase in noninterest-bearing deposits over the years, which has allowed them to lower their overall funding costs. In the fourth quarter of 2019, just 13.7% of deposits were noninterest bearing; that rose to 25.8% in the second quarter of 2021, according to Fitch. There’s a certain amount of money sitting in bank coffers that hasn’t left to chase higher-yielding investments because few alternatives existed. How much of that money could leave the bank’s coffers, and when?

Pieniazek encourages bank boards and management teams to discuss how much in deposits the bank is willing to lose. And if the bank starts to see more loss than that, what’s Plan B? These aren’t easy questions to answer. “Why would you want to fly blind and see what happens?” Pieniazek asks.

What sort of deposits is the bank willing to lose? What’s the strategy for keeping core deposits, the industry term for “sticky” money that likely won’t leave the bank chasing rates? Pieniazek suggests analyzing past data to see what happened when interest rates rose and making some predictions based on that. How long will the excess liquidity stick around? Will it be a few months? A few years? He also suggests keeping track of important, large deposit relationships and deciding in what circumstances the bank will raise rates to keep those funds. And what should tellers and other bank employees say when customers start demanding higher rates?

For its part, Fifth Third has been working hard in recent years to ensure it has a solid base of core deposits and a disciplined pricing strategy that will keep rising rates from leading to drastically higher funding costs. It’s been a long time since banking has been in this predicament. It’s anyone’s guess what happens next.

Drivers of Bank Valuation, Part II: Growing Loans and Becoming More Efficient

4-10-13_CK_Lee.pngBanks are in business to drive value—for the community, for customers and for shareholders. In our previous article we explored the concept of tangible book value (TBV) and its importance as a baseline for defining shareholder value. Growing TBV inspires confidence in the bank’s relative strength among shareholders, customers and regulators. 

We recommend boards regularly assess their internal operations and take affirmative steps to ensure more of a bank’s revenue production capability turns into TBV growth. In this article, we’ll explore two critical areas that can drive greater earnings and greater growth in the bank’s value. 

Become More Efficient

It is a truism that more efficient companies are more attractive—to investors as well as potential purchasers. If it takes less to make a dollar, greater earnings result. The earnings are then available to provide shareholders a current return on investment, through dividends or to enhance capital and support future growth. Looking at the industry data, there is a direct relationship between banks’ efficiency ratios and their earnings. In the third quarter of 2012, for example, banks with efficiency ratios of 80 percent to 100 percent earned an average of 35 basis points on assets. This compares with 84 basis points on average for banks with efficiency ratios between 60 percent and 80 percent, and a whopping average of 148 basis points on assets for banks with efficiency ratios less than 60 percent. This same pattern holds true going back several years. 

The obvious benefits to earnings of running an efficient organization is certainly payback enough for the effort involved. But controlling this process within your own boardroom is preferable to having inefficiencies dealt with through pressure from third parties, whether they are disgruntled investors, analysts or regulators. This sort of pressure can result in disruptive cost-cutting that could result in the company taking a step backwards before it can move forward. Addressing efficiency on an ongoing basis can head off these challenges, drive greater shareholder value and improve the organization’s overall strength and discipline. 

Grow Loans

The current yield curve has had a painful impact on margins at smaller banks, particularly banks with lower loan-to-deposit (L/D) ratios. So, how do you drive margin in this challenging rate environment? One answer is to make loans.

The disparities within the margin data are interesting. If you look back to the third quarter of 2009, there was little disparity in average margin between banks with higher loan balances and those with lower L/D ratios. Since then, however, margins have expanded, on average, for banks with more than 50 percent L/D (driving margins well above 4 percent), while the banks with less than 50 percent suffer margins in the low 3 percent range. This incremental disparity is a key driver of the industry’s depressed earnings profile and the low valuation placed on banks with lower loan balances.

Now, the interesting question is how to grow loans? The overall economy isn’t exactly helping. But there are steps boards and management can take to improve their ability to grow loans. These include growing the overall bank to allow access to additional customers and products through a higher legal lending limit. Other options include acquiring loan portfolios through M&A, aggressively pursuing lending staff with solid track records and books of business, partnering with nearby institutions on participations, and upgrading your pursuit of loan business within the reach and scope of the bank. Like anything else in the bank, growing loans must be a priority if the board desires to drive margin and earnings, and the managers need to be held accountable in this regard, as in any other bank priority. 

In our final article on the drivers of bank valuation, we will explore the impact of size and business diversification on bank valuation.

Lee’s comments are strictly his views and opinions and do not constitute investment advice.