Mega-banks’ liquidity ratio is small bank opportunity

By Justin Bakst, managing director, Darling Consulting Group

Not all “stable” deposits are created equally.

Just ask the largest U.S. banks like State Street and J.P. Morgan Chase, who according to The Wall Street Journal forced out hundreds of billions of deposit balances in 2015.

To most bankers, this seems like a rather innocuous event, given strong liquidity metrics and today’s low interest rate environment. One might simply conclude the relationships were unprofitable or the funds were not needed.

What the more informed know: These deposits were driven out by new regulation—specifically, the Liquidity Coverage Ratio (LCR).

Understanding the LCR

The LCR was designed under Basel III as a global banking standard for large banks to meet minimum liquidity levels, and be able to survive a 30-day market crisis.

But the devil is in the details of the LCR. The definition of a deposit, specifically a “stable deposit,” has changed. Over the last year the largest international banks have begun the arduous implementation of the LCR, while most community banks have a general awareness of the regulation.

It is probable that a community bank may never have to comply with the LCR—but it is relevant to understand the potential implications.

Dissecting the fundamentals of the LCR calculation allows us to outline prospective product pricing and other trends that may trickle down to the entire industry, regardless of asset size.

LCR made simple

The objective of the ratio is to mandate that large banks have sufficient on-balance-sheet liquidity to sustain a stressful environment. LCR requires banks with assets greater than $50 billion to hold at least 100% high quality liquid assets to potential 30-day deposit outflows.

The high quality assets are primarily cash and agency grade bonds (with some exceptions) which are normally lower-yielding when compared to alternatives. LCR clearly has the potential to drive down net interest margin in these institutions.

Given this stark reality, there is a natural bias for complying institutions to want to lower the 30-day deposit outflow in order to achieve 100% coverage.

But how do these banks determine 30-day “stress” deposit outflows?

The large banks are required to assign potential runoff assumptions for all classes of deposits. Insured retail deposits with multiple relationships and/or checking accounts have significantly lower required outflow assumptions than any other deposit classes. In fact, these deposits are assigned a 3% runoff rate compared to anywhere from 40% to as much as 100% on other types of deposits.

LCR strongly favors retail checking accounts with less than $250,000 in balances with multiple relationships—the new definition of “stable” deposits. The LCR also highly penalizes non-operating commercial deposits and public/municipal deposits.

LCR implications

Conceptually, I think most would agree the LCR is a reasonable liquidity measure for larger institutions. By reserving against potential deposit outflows in times of stress the banking system can better sustain idiosyncratic or systemic liquidity risks.

However, many questions still linger. The most astute bankers are asking, how are large banks responding to the LCR? Could the response change when interest rates rise and liquidity pressures mount?  How will the consequences of the LCR impact my institution?

Increased competition for retail deposits

Recent communication from Fed officials stated that the liquidity coverage ratio will artificially drive up pricing for the rest of the industry and will result in more competition for retail deposits.

For example, JP Morgan Chase had to force out $100 billion in deposits because of the liquidity coverage ratio. Although it’s not clear what types of deposits were “forced out,” one must assume it was not retail deposits. It is not too far of a leap to expect JP Morgan and others to respond accordingly and focus deposit gathering efforts where there is the most economic bang for the buck. It’s no coincidence that a Google search of the best retail checking account lists “Chase Total Checking” account at the top with a $150 sign-up bonus with direct deposit enrollment.

In the past, many larger institutions have not relied on retail funding as a major source of liquidity. It is just not a core competency or has provided little efficiency to scale and grow. Using JP Morgan as a simplified example, the $100 billion in deposits may have most likely been a few large relationships. However, to replace these deposits with “stable” retail deposits would equate to over 400,000 relationships—and that assumes $250,000 in each relationship.

Where to focus?

As competition intensifies, banks of all sizes are working on strategies to grow their deposit base. From technology improvements to the branch of the future, new creative innovations seem to be announced on a daily basis.

But industry veterans realize that the most efficient strategy to grow the deposit base at the margin is an outright laser focus on gaining a higher share of wallet from existing customers.

There is simply a wealth of opportunity within your current base. It’s not uncommon for many retail customers to have as many as six deposit accounts spread over multiple institutions.

Bankers are asking, “How do we become the primary relationship?”

If your institution is unable to win the primary relationship, beware, for someone else will. Gaining a higher share of wallet is not only necessary to grow deposits but mandatory to protect against potential deposit attrition. So, it’s ironic that most community bank deposit strategies and marketing budgets focus on attracting new customers to the bank.

Banks that can gain greater share of wallet through best-in-class product and customer service will be winners in this new norm.

Better banking through analytics

The most sophisticated institutions are personalizing the retail banking experience through big data technology initiatives by allowing high-end services that are cost efficient. In addition, they are utilizing analytical models to predict price elasticity of depositors.

These institutions quantify all elements of the customer relationship and use this data to improve service, product, and pricing. They are using this data to communicate regularly and relevantly with their customers. This is the backbone infrastructure of gaining higher share of wallet.

At its core, analytics are helping institutions “know thy customer.”

• The hope and bias is that community banks are nimble and aware enough to already “know thy customer” without sophisticated analytics.

• The concern is “we don’t know what we don’t know,” and service/pricing opportunities are passing us by because we just don’t have the data to change or improve products.

Commercial & public fund opportunities

There has been much discussion surrounding retail opportunities and challenges but for community banks maybe the most feasible growth option is in the commercial and public fund sectors.

Both commercial savings accounts and public funds are highly punitive for complying LCR banks. In fact, BB&T has publicly stated that, “the LCR will virtually eliminate the willingness of banks to be depositories for public funds.”

This challenge for larger institutions represents a much-welcomed opportunity for community banks. The scale and opportunities are massive, a few larger commercial and/or public relationships may be able to fund a significant portion of future balance sheet growth.

Obviously collateral requirements need to be evaluated. But for all the concerns around the future of the retail sector there is equal opportunity to grow deposits through these channels. If this isn’t already a core competency, it’s an area to investigate for 2016.

Take advantage of LCR

For the first time this decade bankers face the prospect of higher funding costs. Liquidity challenges for some are beginning to mount as loan growth is outpacing deposit expansion in many markets.

Developing proactive deposit product and pricing strategies can drive growth and protect net interest margins. The LCR provides a helpful framework for community banks to learn from the experiences of larger banks, while potentially benefiting from the exemption of overly restrictive policies in certain deposit product sets.

The unintended consequence of ignoring the LCR is higher funding costs, muted growth opportunities, lost market share, and longer-term franchise dilution.

Be proactive. Gather information to help reduce funding costs, grow deposits and build market share.

About the author

Justin Bakst provides risk management education and consultation to financial institutions, leveraging the firm’s data-driven software solutions. His focus is developing and implementing tools that analyze deposit and loan customer behavior patterns to proactively manage embedded risks and drive higher levels of earnings. He is a frequent speaker and author on analytics and asset liability management topics.