What is the biggest revenue line on a typical bank’s balance sheet? Interest income. What is the most technically complex function in a bank? Credit risk management. Why do banks typically fail? Unexpectedly high credit losses. Given these factors, why would the banking industry not agree that the credit side is where banks win or lose in terms of creating (vs. destroying) shareholder value? The glitch with this seemingly logical conclusion is that it ignores the impact the liability side has on both revenue and credit losses.
Two sides of the coin
While deposits on an accounting basis are an expense line item due to the interest expenses they generate, when viewed on an economic basis, they have their own measurable value. Specifically, most banks today have the sophistication of using Funds Transfer Price (FTP) curves to calculate the intrinsic value of deposits. An FTP approach recognizes deposits are less expensive than the alternative source of liquidity, i.e., market funding. Therefore, they generate value. As a result, an FTP approach separates a bank’s net interest income between the spread revenue generated by the loans vs. the spread revenue generated by the deposits.
More importantly than their contribution to revenue, liabilities can indirectly drive credit losses. An ignored liability side of the balance sheet will tend to fail in the competitive goal of attracting lower cost deposits. The resulting higher interest expense pushes banks to seek higher rates on the asset side to preserve their net interest margins. What happens next is predictable: higher risk loans are pursued in asset classes, segments, and geographies that the bank does not fully understand, often made to new-to-bank relationships. To make matters worse, this scenario occurs when rates rise, which typically happen in periods leading to recessions, i.e., in advance of increases in credit defaults.
Ideal deposit portfolios
Strength in the deposit portfolio occurs with the ability to maintain low interest expense and generate fees on a basis of active primary transaction accounts. Banks that do this successfully achieve three essential benefits:
- They produce higher spread revenue, when measured against an FTP curve.
- They generate higher fee revenue based on Service Charges on Deposit Accounts (SCDAs).
- They create lower credit risk because there is no undue pressure on lenders to seek higher rate/higher risk credits to preserve the bank’s Net Interest Margin.
An analysis of the previous growth cycle that ended in 2008 showed that banks that scored poorly on a Deposit Strength Index (DSI)—a blend of each bank’s loan-to-deposit ratio (the lower the better) and percentage of DDA in the deposit mix (the higher the better)—had a higher probability of failure during the ensuing period of 2008-2010. Among the institutions that did not go to “bank heaven,” the ones with strong DSIs created more shareholder value over the full cycle. Correlation of deposit strength (as measured by DSI) with Total Shareholder Return (TSR) was in the mid-40 percent and with P/B in the mid-80 percent.
The value of deposits
Knowing the importance of deposits and without taking any of the focus away from the credit side, banks should value deposits separately. On an economic value basis, it is critical for banks to properly calculate Funds Transfer Price curves and accurately calculate durations for indeterminate maturity deposits. Service charges on deposit accounts (SCDAs) are easier to attribute, and they should be.
In addition to the economic value that can be measured on a “spot” basis, the value needs to be measured on a strategic basis. There are deposit relationships that are less sensitive to the interest rates offered. Not only are they slower to react to increases in rates (i.e., they have low repricing betas), but they are also less likely to be lured away with marketing offers, like sign-up bonuses that tend to flood mailboxes. Strong, loyal relationships, based on customer satisfaction, are the Holy Grail. To build these relationships, successful banks focus on deposits (especially retail deposits) and invest in differentiating themselves. The more commodity-like a bank is, the less it is engaging its customers on an emotional basis. As a result, the more likely that bank is to see its deposit customers defect in response to $400 offers in the mail.
The reason why even seasoned bank executives fail to understand the issue is due to human nature. Gradual deviations from core credit competencies are not recognized for their cumulative impact. Decisions are heavily influenced by recent outcomes (in this case low credit losses in recent years). Lastly, it’s human nature not to want to be the one left out of a good deal. When competing banks, or even colleagues in the same bank, seem to be getting away with originating loans that a risk area might find objectionable, pressure is put for the bank to circumvent those rules and make exception after exception.
Building deposits takes time
So what should banks do? Building deposit quality takes time. It takes years. However a bank that never starts on that journey will never reach the goal. Banks with lower deposit strength need to take two steps:
- Make the strategic decision that deposits will be measured and valued on their own right. If this measurement does not exist, an FTP curve should be established and the duration of deposits properly calculated. For example, while DDAs can be withdrawn at any time, the correct duration is not a day or a week, but years. Link these measurements to goals and incentives. Present financials to the C-suite and the Board in the same manner, thus separating the revenue created on the liability from the asset side.
- Commit to becoming a deposit-focused bank. Allocate the resources necessary. Invest in understanding what drives loyalty with deposit customers. Identify the dis-satisfiers and pain points that stand in the way of long-term allegiance instead of just allotting more funds to marketing and sales. If your bank does not want to attract and retain deposit customers based on high rates, it is important to identify why customers should bank with you and not be swayed by the competition. The answer to this strategic question will lead to a shift or change in policies and procedures, in channels, in staffing, and many other aspects, but they need not happen overnight.
In the end, bank leaders need to provide a “north star”, i.e., a clear decision on what the deposit-taking retail bank stands for and a commitment to invest to make that vision a reality.
About the author:
Theo Moumtzidis managing director of Delos Advisors, a NY-based consulting firm that specializes in working with financial institutions in the U.S. and abroad. The company delivers growth strategies to increase profitability to shareholders, improve customer retention and reshape financial institutions through innovative thought leadership. For additional information, please call 212 235-0840 or send email to [email protected]
Tagged under Bank Performance, Deposit Trends, Feature, Financial Trends, Management, Lines of Business, Retail Banking, Risk Management, Performance, Revenue, Fair Lending, Operational Risk, Rate Risk, Profitability, Feature3, Commercial,