Liquidity Drought

by Kenneth Cline

As bank profitability is squeezed, many institutions are rediscovering the importance of core deposits.

It might be called the "hidden crisis" of banking. Although a shrinking deposit base doesn't grab headlines, like a rash of bad loans, it can significantly deplete an institution's profitability over time. And banks are definitely feeling the pinch right now as they're forced to pay higher rates to recoup core funding.

Bankers and analysts interviewed by Bank Administration Institute and First Manhattan Consulting Group "unanimously confirmed that pricing pressure on liability spreads and fees is the largest potential threat to retail profitability over the next three to five years," says a forthcoming report, which focuses on the top 50 banks. Separately, an American Bankers Association survey released earlier this year found that the gap between deposit growth and loan demand poses a "full-fledged crisis" for community banks.

The issue revolves around core deposits, which consist of checking, savings and money market accounts. These funds are supplied by an institution's core customer base, as opposed to wholesale deposits that are acquired in the commercial money markets from customers strictly interested in high rates. The percentage of U.S. banks able to fund at least two-thirds of total assets with core deposits fell from 95% to 75% between 1992 and 2000, according to the Office of the Comptroller of the Currency.

Why does this matter? Because the profitability of most financial institutions rests mainly on the net interest spread, or the difference between what banks pay depositors for their funds and what they earn by loaning that money back out. Wholesale deposits are generally more expensive than core deposits, which pinches the spread — and they are more likely to flee an institution that runs into trouble.

Most large banks were able to ignore the erosion of core deposits during the '90s as they grew fee income and achieved merger efficiencies. Now that fee income has plateaued and much of the industry has been consolidated, depositor neglect has come back to haunt. Tightening net interest margins driven by deposit pricing pressures will soon emerge as a "prevailing trend," warned Credit Suisse First Boston analyst Susan L. Roth in a February report, reducing bank earning power by between 7% and 15%.

The Federal Reserve Board's program of easing interest rates is currently alleviating some of that pressure, as is the flight of investor funds from a plunging stock market. But the long-term problem remains: eroding core deposits means eroding profitability. BAI/First Manhattan estimates that nearly 90% of consumer profits from a typical retail bank stems from the spread produced by these funds and their associated fees. "If you give up on deposit-gathering, you're out of the banking business," says Vernon W. Hill 2d, chairman and president of Commerce Bancorp, Cherry Hill, N.J.

Some bankers take a defeatist attitude and assume these funds will inevitably migrate to Wall Street. They focus on streamlining the branch system and building their in-house mutual funds/asset management businesses. This model is often combined with an acquisition strategy based on the premise that the best way to gain new retail customers is to buy them. To boost noninterest income, institutions also milk their retail base by imposing a plethora of "nuisance" fees, such as account overdraft penalties.

The flaw in this approach is that once the string of acquisitions has run its course, an institution ends up with no organic deposit growth. And if a bank is not growing deposits, it's probably not growing customers, which suggests that this business model is not likely to endure.

Encouragingly, a few select banks have proven that it's still possible to achieve healthy deposit growth. These include Commerce Bancorp; TCF Financial Corp., Minneapolis; Fifth Third Bancorp, Cincinnati, Ohio; U.S. Bancorp (formerly Firstar Corp.), Minneapolis; and Compass Bancshares, Birmingham, Ala. Commerce Bancorp, for example, has seen deposits grow at a compound annual rate of 22% over the past five years, compared with an industry average of 4%.

The approaches vary. Some institutions emphasize convenience (Commerce Bancorp and TCF); some emphasize service (U.S. Bancorp); and some get by with effective marketing and pricing promotions (Fifth Third and Compass Bancshares).

Though tactics differ, these players share one overriding strategic vision — they believe in the fundamental importance of core deposits and are willing to devote significant resources to that side of the business. When the formula works — and it's admittedly not a sure bet — the expenses associated with depositor outreach activities are less than the interest rate differential incurred when a bank goes to the wholesale market for funds. Plus, such activities help build valuable customer relationships.

Unglamorous though it may be, the lowly checking account is a vital link to other product relationships. Based on consumer surveys conducted by BAI and Cambridge Group last fall, there's a 94% probability that a consumer will maintain at least one additional product relationship with his or her checking provider. "You don't get a chance to sell somebody a mutual fund or an annuity unless they're in the bank. And the reason they're in the bank is the deposit account," says TCF Financial CEO William Cooper.

The question, however, is whether a strategy of what might be termed extreme depositor care can be successfully extended to the industry at large.

Deposit Exodus

The erosion of core deposits in banking is nothing new, dating back at least to the deregulation of interest rates in the 1970s. But the mutual funds boom of the '90s certainly exacerbated the trend of disintermediation. The lucrative returns provided by a soaring stock market proved irresistible to many people who formerly kept a greater proportion of their wealth in basic deposit instruments.

The damage: by 1999, core deposits made up only 11% of the $23 trillion of consumer and small business assets, compared with 21% of an $11 trillion total in 1993, according to the BAI/First Manhattan study.

That's not to say the traditional deposit-gathering business is dead or dying. Regulated financial institutions have actually continued growing total deposits by about 4% annually, the study found, from $3.5 trillion in 1993 to $4.5 trillion in 1999. Checking and savings accounts contributed half that growth; time deposits the rest.

Researchers found that most of the progress was achieved by smaller banks, defined as those with less than $15 billion in total deposits or fewer than 300 branches. By contrast, the very largest institutions managed a paltry annual growth rate of less than 1%, after adjusting for the impact of mergers.

Community banks, despite their comparatively better performance, are still apprehensive about eroding deposits. They are more dependent upon the liability spread and fees than the larger banks, which tend to be more diversified.

According to the recent ABA study, 66% of 1,034 community bank respondents in 49 states said deposit growth failed to keep pace with loan demand last year, compared with 48% in 1999 and only 39% in 1998. Nearly 68% of respondents said they are lifting deposit interest rates to attract more funds, up from 42% and 24% respectively in 1999 and 1998.

To be sure, small banks got a bit of relief in the fourth quarter. The Federal Deposit Insurance Corp. reported a sudden surge in deposits, apparently occurring as investors diverted funds from the stock market. It's not clear whether this is a lasting trend, however.

Large banks, with their sophisticated treasury functions, are better able to fund loan growth from wholesale sources, such as commercial paper, brokered deposits and Federal Home Loan Bank advances. According to the FDIC, only 39% of the funding at banks with assets of more than $10 billion comes from core deposits, compared with 73% at banks with assets of less than $100 million.

Non-core deposits work well enough when times are good. But what happens when recessionary conditions put financial institutions under strain? During the nation's last banking crisis, in the early '90s, a loss of liquidity pushed several institutions into federal receivership, and countless other institutions became paralyzed while dealing with funding issues. The First Manhattan researchers recently reported that "contingency liquidity," which measures the backup funds available to banks in a crisis, fell to a negative 2% from a positive 8% between 1992 and last year's third quarter.

Street Corner Battle

Without question, banks will sorely miss their core deposits if current economic troubles lead to a recession or financial crisis. But even if such a worst-case scenario doesn't materialize, the industry still needs to focus on its deposit problem. The reason: profitability is under strain.

During the '90s, banks relied heavily on noninterest income to boost the bottom line, much of that coming from fees tacked on to retail accounts. After two decades of steady growth, noninterest income as a percentage of industry assets fell to 2.55% last year, down from 2.64% in 1999, according to the OCC. Meanwhile, the slowing economy has sparked a surge in problem loans, which forces banks to cut back on lending and drain earnings to bolster loan-loss reserves.

In this harsher environment, deposits take on a renewed importance. "There will be an aggressive fight for deposit market share," predicts consultant Donald B. Taylor, president of FISI-Madison Financial in Nashville. Already, leaders in deposit growth are getting a lot more press and analytical attention.

What traits distinguish these over-achievers? The BAI/First Manhattan study identifies five statistically significant factors. They are: high service levels; net growth in physical branch locations; dense ATM networks; "customer-friendly" pricing, i.e., relatively higher rates and lower fees; and economic growth within the institution's geographic territory.

Economic growth is obviously outside an institution's control. But the other factors point to a customer value proposition that includes some combination of service, convenience (large numbers of branches and ATMs), and marketing (attractive products).

More subjectively, there's a strategic mindset in these institutions that elevates deposit-gathering to a priority, as opposed to an afterthought. "Some people view deposits as a mundane business," says Fifth Third executive vice president and retail chief Robert P. Niehaus. That attitude must change.

Small institutions such as Commerce Bancorp ($8 billion of assets) and TCF ($11 billion) have the luxury of focusing top management's attention directly on deposit-gathering. Hill, for example, gets involved in every detail of Commerce Bancorp's retail operation, from branch design and furnishings to the installation of coin-counting machines. Hill's strategy is expensive and critically depends on additional factors, such as high equity leverage and low credit quality problems, for strong profitability.

But even larger institutions can take the necessary care. Fifth Third saw deposits surge after it hired an executive (Wil Daly, currently chief marketing officer) expressly for that purpose in 1995. The $46 billion-asset company sustains the momentum by launching new sales campaigns on a quarterly basis. Branch employees are incented to sell products such as the Totally Free checking account, which is linked to overdraft protection and a debit card, and managers closely monitor the results.

"It's fighting the banking wars street corner by street corner," Niehaus says.

Branch Reappraisal

One byproduct of banking's reappraisal of deposits may be a renewed appreciation for branches. During the consolidation/cost-cutting whirlwind of the '90s, large banks particularly tended to view their brick-and-mortar networks as expensive encumbrances. At the extreme, outlets were "rationalized" to the clear detriment of service.

So how have Commerce Bancorp and TCF sustained aggressive de novo branching programs in an America widely perceived to be over-branched? Commerce Bancorp builds about 30 full-service branches a year. TCF, a thrift that mostly expands through supermarkets, has opened more than 150 in-store facilities in the past three years. "You get a lot of new customers when you open new stores," Cooper says. "It's the classic retailers' strategy."

So voluminous is the stream of new checking and savings accounts that deposit growth has far outstripped loan growth at the two institutions. They end up putting a lot of securities on their balance sheets, but with a low cost-of-funds they can still make money on bond investments and low-risk loans.

Of course, one can legitimately question whether any top-50 bank would be able to emulate this strategy. Most of them are under such intense pressure to boost earnings by cutting expenses that an expensive de novo branching program might be out of the question. It's also unclear whether multiple banks in a given market could attempt this strategy without ruining the economics for everybody.

There are other ways to regain retail depositors, however. First Manhattan vice president Gordon Goetzmann suggests that larger banks "redouble their efforts on service," for example. He points to U.S. Bancorp (actually Firstar, its predecessor organization) as an institution that has enshrined high-quality service as a way of life — and attracted core deposits as a result.

The key is to restore basic deposit-gathering as a core competency and accord it the necessary attention and resources. As the BAI/First Manhattan study points out, the liability spread and the fees associated with transaction and savings accounts provide the banking industry with 51% of its revenues and two-thirds of its profits.

Customers must also be viewed in a new light — as sales opportunities to be cultivated rather than as service "abusers" who deserve to be loaded down with fees. One way or another, these customers must be offered a differentiated value proposition. That value can be based on convenience, service or rate, but people must have a clear reason to pick your bank over the others. As Commerce Bancorp's Hill says, "You have to stand for something."

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

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