Katie Kuehner-Hebert
Katie Kuehner-Hebert Jan 3, 2012

Coping with the Deposit Surplus

What to do with all those deposits? It’s a problem banks of all sizes are wrestling with in this curiously sluggish economy. Even though interest rates are at near-record lows, banks are flush with deposits that they can’t lend out profitably since loan demand remains stagnant. Those super-low interest rates keep bond rates unattractive as well.

“The real challenge is being stuck in a low interest rate environment because it compresses your net interest margin,” says David W. Miller, executive vice president of consumer banking at First Tennessee Bank, the banking unit of the $25.6 billion-asset First Horizon National Corp. in Memphis. “As rates drop, eventually most deposits are at a cost approaching zero and if loan yields keep dropping, you have no way to reduce the cost of deposits and it squeezes your margins. So being really disciplined about pricing on the deposit side is going to be a continued focus of the industry.”

One way some banks are handling this challenge is by focusing on the core relationships that deposits bring, in the expectation that those relationships will pay off when good times return.

Relationship Deposits

St. Louis-based Enterprise Bank & Trust, for example, reported 6% loan growth in last year's third quarter while deposits rose 23%, says chief operating officer Chuck Leuck. Even so, the $3.4 billion-asset Enterprise is actively pursing core deposits in its St. Louis, Kansas City and Phoenix markets, focusing on industries that are deposit-rich, such as insurance agencies, payroll companies, municipalities and medical practices, Leuck says.

"We are trying to put the hook on the relationship through Treasury services, online banking, Automated Clearing House (ACH), lockbox and other types of products -- things that add velcro to the relationship," he says. "When deposits rates are so low, it's cost-effective for us to bring in core deposits now. The benefit will be realized as the economy moves into a normal rate environment sometime in the future. Having a concentration in demand deposit accounts (DDAs) will be good as these types of balances become more expensive to acquire."

However, Enterprise is trying to reduce the amount of certificates of deposit (CDs) on its books, in the expectation that customers won't mind paying nominal penalties for early withdrawal if rates rise and they can get better terms elsewhere. "There truly is no incentive for banks to go long term with a CD portfolio unless you put on outrageous early-withdrawal penalties that most clients won't tolerate," Leuck says.

Frost Bank in San Antonio, which has experienced deposit growth just under 10% over the last two years while loan growth has been flat, has been depositing its cash with the Federal Reserve and investing in securities, such those issued by the Permanent School Fund of the State of Texas, which insures Texas’ school bonds, according to says Phil Green, chief financial officer of the bank and its parent, the $19.5 billion-asset Cullen/Frost Bankers Inc. Lately, Frost has slowed its buying of the longer-term securities to mitigate for a possible rise in interest rates and started buying short-term investments such as Treasury notes, which have two- to five-year maturities, Green says.

Even with sluggish loan growth, Frost does not want to reduce deposits, particularly since nearly 40% of them are in noninterest-bearing demand accounts. “To us, deposits are representative of a relationship, and reducing deposits would be antithetical to what we do,” Green says. “Our overall cost of funds in the third quarter on average was about 14 basis points. So even if we didn’t buy securities or lend money, by putting our money in our Federal Reserve account, which pays 25 basis points, we’d still break even or make a little money, even after adding seven to eight basis points for FDIC insurance expense.”

In Warsaw, Ind., Lake City Bank’s deposit growth, 6.7% at September 30, 2011, was slightly above its 5.3% loan growth, says Kevin Deardorff, executive vice president of retail at the bank, a unit of the $2.8 billion-asset Lakeland Financial Corp. The bank recently entered Indianapolis and, to attract new customers, is offering a rewards checking account product that pays 2.51% in monthly interest if customers conduct eight debit transactions per month, have an electronic deposit or automatic draft every month and get their monthly statements electronically.

“We’re aggressive on core deposits because we want to capture market share, both in deposits and loans,” Deardorff says. “This is a differentiator for us, and so we’re offering this product in all of our markets.” With the excess deposits, Lake City is paying back borrowed funds. At the end of the third quarter, its Federal Home Loan Bank notes decreased 62% from a year earlier.

“We’re not investing any of the deposits because we’re trying to build more liquidity,” he says. “When the economy was much stronger and we were making a lot of loans and not getting as much deposits, our lack of liquidity was a bit of a concern from the regulators’ standpoint. That’s when we relied more on borrowed funds. Now we have improved liquidity but the downside is that the reward checking product and lower loan growth has put pressure on margins.”

Lake City has offers “rate-riser” CD products that give customers the opportunity to change their rate once during the term. “We attract more people who like the flexibility, yet most tend not to exercise it, which means we’re getting more deposits at the lower cost,” Deardorff says. “Our cost of funds is a little higher than it would be if we purchased brokered deposits. We could probably maintain margins by using brokered CDs, but doing that doesn’t gain us any market share.”

Not all banks are suffering with sluggish loan growth; agricultural lenders, in fact, are enjoying boom times. First Bank of Berne, a heavy ag lender in Indiana, reporter stronger growth in loans (4%) than deposits (2%) in the third quarter, resulting in a 100% loan-to-deposit ratio, says Kent Liechty president and chief executive officer of the bank and its parent, the $420 million-asset First Berne Financial Corp.

“We have loan demand, so we want deposits to fund our loans,” Liechty says. “We do some pretty heavy advertising in addition to having expectations for loan officers that as they pick up new loan relationships, deposit relationships have to come with the loan.”

Ms. Kuehner-Hebert is a contributing writer for BAI Banking Strategies based in San Diego, Calif.

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