The legacy metrics of core deposits and cost of funds are top-of-mind issues for bank executives, directors, shareholders and regulators.
Bank executives are adjusting to the stress of funding banks in a highly competitive environment where consumer depositors have many more viable options than ever before. Clarity about the struggle for bank funding can be observed within the industry in terms of core deposit funding and the incremental cost of that funding.
Efforts to relieve funding pressure will often involve seeking time deposits locally, through listing services or brokered sources. Thus, the cost of a time deposit portfolio is a sound indicator of the cost of marginal retail funds for the financial institution.
On their own, low liquidity or high cost funding are potentially problematic – their combined occurrence signals reduced margin for error in funding the bank.
We have created what we call the “Pressure Gauge for Bank Funding” that combines a pair of independent ratios relating to liquidity and cost – loans/core deposits and time deposit portfolio yield/peer cost – into a single metric that measures the stress on individual banks regarding generating sufficient volumes of properly priced long-term funding.
An increasing loans/core deposits ratio indicates greater liquidity stress. As of third quarter 2019, the median loans/core deposit ratio based on data from the FDIC was 0.89.
We believe the quarterly cost of time deposits is a good proxy for the marginal cost of core deposit funds. The funding cost index is measured for each financial institution as a function of peer, so on an aggregate basis, this index will always gravitate toward 100 percent. The median cost of time deposits for 3Q 2019 was 1.91 percent, according to the FDIC data. If a particular bank’s cost of time deposits is 2.15 percent, the relative funding cost ratio for this bank would be 2.15/1.91 = 1.13.
Each metric is meaningful on its own merit. However, when assessed in tandem by multiplying these two ratios together, we observe a distribution of results that we believe provides a useful measure of funding stress. The Pressure Gauge can be used to stack-rank banks to identify how a specific bank is positioned relative to peers.
The following categories might be helpful in assessment of bank funding pain/pressure:
||Current Bank Count
|>/= 0.9 to < 1.2
|>/= 1.2 to <1.5
Studying the most recent quarterly data, we found that the cost of time deposits for banks with a Pressure Gauge reading of 0.9 ranged from 1.57 percent to 2.54 percent and their loans/core deposits ratio from 67.8 percent to 109.4 percent. At the other end of the spectrum, banks with readings of 1.5 ranged from 2.01 percent to 2.83 percent on deposit costs and their loans/core deposits ratio ranged from 100.8 percent to 143 percent.
The Pressure Gauge levels indicate that banks with a 0.9 reading are currently at the 48th percentile when measuring funding stress, while those at 1.5 are at the 91st percentile.
It is essential to recognize that minimizing loan/deposit ratios and cost of funds does not create a high-performing financial institution. In fact, high performance in banking is generally positively correlated with higher loan/core deposit ratios. Healthy banks also pay a fair interest rate that allows them to attract and retain growing volumes of deposits – driving interest expense toward zero can shrink the bank and its profits.
The Pressure Gauge is designed to call attention to instances of intensifying stress on bank funding, which among other things can allow management to anticipate the need for enhanced approaches to pricing and sales of deposit offerings. The conventional approach of merely ramping up interest rates to attract deposits in response to funding issues becomes less effective as the Pressure Gauge increases.
To find out where your bank and competitors rank, key in the FDIC certificate number or bank name into the Pressure Gauge. The system will use recent call report data to report the Pressure Gauge percentile and its components.
While all banks should be efficient and effective in attracting discretionary deposits to fund banking operations, the Pressure Gauge for Bank Funding clearly identifies the margin for error that bankers have in this regard. This new gauge gives bankers a new tool to measure, understand and communicate about their current situation, the trend over time and how they compare with peers.
Neil Stanley is founder and CEO of The CorePoint, a financial technology firm.