Friday, April 19, 2013 6:00 AM CT
Core deposits, the antidote to interest rate risk
By Nathan Stovall
Nathan Stovall is a senior reporter and columnist with SNL Financial. The views and opinions expressed in
this piece are those of the author and do not necessarily represent the views of SNL.
To protect against interest rate risk and increase franchise value, bankers just might have to take their
medicine and build core deposits.
Building deposits today might seem counterintuitive as banks struggle to put excess liquidity to work,
but it could be the best tool to manage against interest rate risk. And it might attract potential acquirers
further down the road. Some advisers and regulators believe banks should covet deposits more than
they do and should look to build deposit bases cheaply while they can to better prepare for when
interest rates eventually rise.
Banks have discounted deposits, watching the excess liquidity on their balance sheets eat into margins.
Through the end of 2012, banks with more than $1 billion in assets saw their net interest margins
compress to 3.28% from 3.39% in the third quarter of 2012 and 26 basis points from 3.54% at the end of
2011. Margin compression has continued in the first quarter. Sixty-five banks with more than $1 billion
in assets reported first-quarter earnings at this publication and 78% reported margin compression from
the linked quarter and 77% reported compression from a year earlier. The banks posted median margin
compression of 3 basis points from the prior quarter and 5 basis points from a year earlier, according to
SNL data.
Margin compression has occurred as existing loans get paid off — and in many cases at levels exceeding
new loan originations. New loans are being booked at lower rates as the market remains intensely
competitive, with banks scrapping for the few quality credits that exist. Occasionally, the competition
has even forced banks to offer five- to seven-year fixed-rate loans at yields that could end up
significantly underwater should rates increase by 300 basis points.
Margin pressure is only compounded by the fact that banks have looked to their securities portfolios to
bolster income, growing those books considerably over the last few years. Falling rates have led to gains
in those portfolios, but banks have realized many of those gains and now face the prospect of
reinvesting them at lower yields and taking losses when interest rates rise.
Even though securities portfolios have expanded notably, cash balances have grown nearly as much,
leaving banks with sizable amounts of excess liquidity. Many banks say they have a liquidity problem,
but one of a different kind — there is too much of it. And they seem to believe that deposits are simply
not worth much today.
This becomes clear when looking at deposit premiums paid on recent acquisitions. From the beginning
of 2012 through the end of the first quarter of 2013, the median core deposit premium was just 2.58%
on whole bank and thrift deals, with the median deposit premium on branch deals just 2.65%, according
to SNL data. Between 2005 and 2007, median core deposits premiums on whole bank deals stood at
17.05%, while deposit premiums were 7.37% on branch deals.
Banks today, at least when acquiring other institutions, do not seem to assign much value to deposits.
But such a stance could prove short-sighted. Deposits offer banks the best tool to manage against rate
risk, and a strong core deposit franchise will eventually attract the attention of acquirers.
Guggenheim Securities Director Chuck Caswell said the most valuable asset a community or regional
bank has over a rate cycle is its core deposits.
"The folks that are accumulating those can live with the little bit of margin compression and will be wellpositioned if the economy turns around," Caswell recently told SNL. "All you have to do is go back to the
early 2000s to remember what a really good deposit franchise looked like in terms of driving value and
really being a differentiating factor in terms of high-performing banks and middle-of-the-road banks."
Many banks do not seem that focused on building deposits, though, believing they have their hands on
plenty of sticky liquidity. Just how sticky those deposits are remains unclear and some would suggest
that banks need to prepare for the time when interest rates eventually rise and some customers
withdraw funds in search of higher yields.
Scott Hildenbrand, managing director at Sandler O'Neill, said at the recent SNL Community Bankers
Conference that banks need to consider the possibility that deposit outflow could occur when interest
rates rise. He said that the results of virtually every interest rate risk model show that a given bank has a
strong deposit base and the ability to fund loan growth through a rising rate environment. Banks have
simply gotten comfortable with their current and projected liquidity levels, he said.
Hildenbrand suggested that banks assume that some amount of deposits flow out of their institution
though, particularly given the tremendous growth in funds held in money market accounts that has
occurred since 2007. SNL data shows that the banking industry's overall deposit base has grown more
than 26% since the end of 2008.
Regulators are focused on the issue. Thomas Dujenski, regional director of the Atlanta region at the
FDIC, said at SNL's event that banks should be asking what will happen to not only the asset side of their
balance sheets if rates were to rise, but also the liability side of their balance sheet.
Hildenbrand gave an example of one bank's efforts to try to prepare for potential deposit outflows. He
said the institution ran two "what-if" scenarios in their interest rate risk model, assuming that 25% or
even 50% of the growth the bank experienced in money market accounts would leave the institution if
interest rates increased 300 basis points. In both cases, the bank experienced significant margin
contraction and stress on liquidity, he said.
Beyond testing for outflows, banks should ensure they hold on to their best core deposits. Jon Bruss,
CEO and managing principal at Fortress Partners Capital Management Ltd., said at the SNL event that he
believes it is "incredibly important to build a strong core deposit franchise and defend it."
Banks might be wise to look to their board to help build their deposit base. R. Lee Burrows Jr., CEO of
Bank Street Partners LLC, said that most community banks tout their local involvement and investor
base but it is hard for directors to get their friends to become loan customers and borrow money at
higher rates. Burrows said the same is not true for deposits, though.
He believes it is easy for directors to ask people they meet at a football game, a parent-teacher
association meeting or a charity event to move their checking account to their bank. He said banks, and
in particular potential sellers, would be wise to build their deposit base now. A stronger deposit base
will make those institutions more attractive to potential buyers since the "new crisis is the spread crisis"
and deposits can help protect margins in the near term and possibly lead to expansion down the road.
"Bringing in core funding can help protect that spread better than anything I can think of today,"
Burrows said.