Deposit profitability as key to branch profitability

Deposit spreads have been the bane of banks in recent years but that could change if interest rates continue to rise. Here’s why bankers should pay more attention to their deposit balances going forward:

In the summer of 2006, the Federal Reserve ended a two-year binge raising the Fed Funds Rate, which had soared from 1% to 5.25% during the period. There it would stay until the early signs of the Great Recession reared its ugly head. Starting mid-2007, Fed Funds declined precipitously from its’ 2006 peak. By the end of 2008, it ranged between zero and twenty-five basis points, where it would stay for seven long years.

During this time of historically low rates, the fate of branch profitability lay in the lurch, driven by the spread decline in deposit products. According to our profitability peer database, fully absorbed branch pre-tax profits as a percent of branch deposits declined 123% between the end of 2006 to today’s abysmal -0.22%. Direct branch pre-tax profits, which only takes into account direct branch operating expenses, declined 63% during that period to 0.89%. Branch-originated products drove the decline. Retail non-interest checking and interest checking pre-tax profits fell 48% and 74%, respectively, during that period. Money market account profitability declined 98% and savings account pre-tax profits fell 101%.

Deposits spreads were crushed. You typically can’t lower rates below zero. Unless you are Japan.

Spreads were not the only culprit. Flush with the success of automatic overdraft privilege, branch fee income as a percent of deposits stood at 0.58% during the second quarter of 2007. Today, it’s only 0.42%, driven by large scale declines in retail checking fees, which stood at 4.95% of product balances in the second quarter 2007 and is now at 2.05%. Regulation and customer behavior were the likely reason for the decline.

It has been a difficult time for branch bankers.

Bankers React

What has been their reaction to this challenge? According to FDIC data, in the ten years prior to 2006, loan growth outpaced deposit growth, 108% versus 92% respectively. To fund loan pipelines, bankers were comfortable luring higher priced deposits because of the favorable loan-to-deposit spread. This grew the relative proportion of hot money.

Fast forward to 2006-2015, when deposit growth outpaced loan growth, 61% versus 19%. This left banks awash in liquidity, wondering what to do with the bundles of cash in their vaults. So the natural reaction was to stop chasing hot money. Let rate shoppers leave for greener pastures and normalize the mix of deposits. Bankers felt pretty good about their relative amount of core deposits during this period of historically low rates.

The next thing bankers did to improve branch profitability was to grow average deposits per branch. And grow they did. When the Fed stopped raising the Fed Funds rate in 2006, average deposits per branch was $45 million according to our peer database. Today, average deposits per branch total around $63 million, a 40% increase. Nationwide, branches grew to over $100 million in deposits, on average. This is skewed based on very large branches of the very large banks. For community banks, this branch deposit growth was not enough to offset the decline in spread and fee income. Total income (spread plus fees) as a percent of deposits decreased from 3.50% to 2.03%. You do the math. Growing average branch deposit size has not bridged the gap.

In comes the focus on expenses. The decline in branch transactions has been well-publicized so it’s normal for bankers to reduce staff to reduce the relative expenses within the branch and therefore increase branch profitability. Not so, according to my firm’s peer database. In the fourth quarter of 2006, direct branch expenses as a percent of deposits was 1.16%, compared with 1.18% today. And, as mentioned above, average deposits per branch grew during that period! So, nominal branch expenses actually increased.

At our firm, we review FDIC data on number of branches and read press releases of banks that are consolidating them. This seemingly anomalous data about increasing branch expenses tells me that branch consolidations are concentrated in the largest banks and community banks have not yet caught the bug. It also tells me that changes in branch hours and staffing have not yet caught on, even though evidence is mounting that community banks don’t need as many branches, lobby hours or staff members within those branches to serve customers.

What has declined as branches grew in size was the relative size of branch support function expenses, 1.42% as a percent of deposits in the second quarter 2006 versus 1.07% today. This is good news, as the economies-of-scale argument requires banks to spend less per branch to support IT, Deposit Operations, Executive, etc. as deposits grow. So, there are successes to be sure in reducing fully absorbed branch expenses.

What Now?

With all of these actions, what is left for bankers to do to improve their branch and deposit profits? With the Consumer Financial Protection Bureau continuously harping on overdraft fees, boosting checking fees does not appear to be the answer, although there may be hope in giving customers menu choices when building their own checking features and benefits, once the technology becomes more readily available. For now, let’s shelve fees as the savior of branch and deposit profitability.

Expense management surely looks like an opportunity to improve profits. As mentioned, the relative and nominal branch direct operating expenses increased from 2006 to present. This is counterintuitive to what we have been reading. How does a branch that costs $500,000 ($43 million times 1.16%) in annual direct expenses increase to $743,000 ($63 million times 1.18%)? In a presentation I made to bankers on this issue, the audience pointed to salary and benefits expense. I cautioned them that, although I believe there are opportunities to reduce branch staff, I don’t think salary and benefits expense would decline.

Why? Because community bank strategies are changing and will require highly capable branch staff. This will likely cost more per-employee and therefore keep salary and benefits expense steady even as size of staff declines. Taking salary and benefits off of the table in branch expense reductions reduces the positive profit impact of such an initiative.

So, what are branch bankers to do?

Consider this. When the Fed last raised rates in mid-2004 through mid-2006, branch direct pre-tax profits as a percent of deposits peaked at 1.20%. Since that time, though, regulation and customer behavior reduced the amount of fee income generated in branches through deposit products. Also, since that time, support function allocations declined, more than offsetting fee income decline. And recall that most banks improved their deposit mix from 2008 to the present.

Then, last December, the Fed raised the Fed Funds Rate 25 basis points, to 0.50%. It is doubtful, based on economic conditions and Chairman Janet Yellen’s own statements, that they will raise rates as quickly as they did 2004-2006. But they are committed to “normalizing” the Fed Funds Rate, and rate increases are likely to continue. This will cause the spreads of deposit products and therefore within branches to increase, should banks be able to maintain the deposit mix they worked so hard to improve.

Growing spreads mean growing profits. If deposit and therefore branch spreads return to where they were in 2006, and fee income and operating expenses remain the same as today, branch pre-tax profits as a percent of deposits could soar to 1.11%. And recall that this is with an average branch of $63 million, versus $45 million in 2006.

But wait! What about banks that use return on equity (ROE) to measure performance? The picture is even better. We know intuitively that loans are riskier than deposits, mostly relating to credit risk. Deposits have liquidity, operational and interest rate risk, and yes even a little credit risk. But the capital required to support a business loan is far greater than the capital required to support a business checking account if the bank allocates capital to products based on risk.

In today’s environment, the business checking account is barely breakeven. The business loan, however, has a 1.69% pre-tax profit as a percent of loan balances, and a 20.83% ROE, assuming an 8.5% capital allocation.

What if, as rates rise, the business checking account spread returns to what it was in 2006? Profits would increase to 3.15% of balances, and ROE would be a stunning 105% based on a 3% equity allocation.

I recently asked a roundtable of bankers if their loan pipelines were filling to the point where they were beginning to feel funding pressure. Half said yes, the other half said not yet. It is the beginning of that period prior to 2006 when loan growth outpaced deposit growth.

The next logical question is how long do bankers think it takes to win new core deposit relationships versus a loan? Put differently, how long does it take to get a $1 million loan, versus the 20 or so business checking accounts it would take to fund it?

Unless we want to repeat history and start getting funding from hot money, perhaps we should be filling our deposit pipeline now.

Mr. Marsico is an executive vice president of Bethlehem, Penn.-based The Kafafian Group, Inc., a strategy, profitability and advisory firm specializing in community financial institutions. He can be reached at [email protected]