With loan growth, banks seek alternative funding possibilities
There are two sides to the figurative coin. On one side, a banker helps a small business owner open a second store. The first-time homeowner makes a down payment and the 30-year mortgage clock starts ticking. A commercial real estate developer needs up-front funding. The loans have always been obvious.
On the flip side, the bank must bring in enough deposits to fund those loans. The established business owner’s payroll account, the retiree’s savings, and the young professional’s ACH paycheck all help fund those loans.
Nearly all banks focus on loans; that is, after all, how banks make most of their money.
As the economy recovers, loan demand has grown with it. In order to fund those loans, banks need to grow their deposits. Neil Stanley saw that need coming and thus started The CorePoint, a company that helps banks obtain deposits. That was 2010; he may have been a little early.
“It’s been a long haul since 2010,” said Stanley, who was in banking for 26 years before launching what was first known as Bank Performance Strategies, based in Omaha, Neb. “But it’s a lot of fun now.”
Stanley’s fun comes in part thanks to the improving economy. Businesses are more likely to risk growth, millennials are beginning to consider home ownership, and depositors may take the chance of leaving the safety net of a savings account for the thrill of a rising stock market. Each of those examples could include both a new loan and a deposit withdrawal to make the down payment on that loan.
In keeping with that public optimism, the Federal Reserve’s presumed rollback of its balance sheet will lead to fewer funds across the board. Call it a quantitative tightening.
“We have a Federal Reserve-induced surplus of money. … That has pushed interest rates to these very low levels and created an alarm that says be safe, get your money out of risk,” Stanley said. “The government has facilitated this stockpiling of cash.
“If they go the other way and stop facilitating it, then the banks are going to see a flow out of their ability to borrow and therefore it’s going to be more like the old days of a competitive marketplace where you have to win the loyalty of your deposit base again.”
Risks and rewards
The CorePoint focuses on strategies pertaining to termed, interest-bearing deposits — most notably, certificates of deposit. Ideally, a bank could fulfill its loan obligations courtesy of interest-free checking accounts but such an idyllic life will never be a reality.
“If you look at all loan demand in the country, it will never be funded by overnight, non-interest-bearing accounts,” Stanley said. “There are not enough people keeping money in a checking account to make all the loans in our economy.”
He estimates timed deposits make up no more than 40 percent of most community banks’ balance sheets, and it is more often closer to 10 percent. Rather than view those funds as commodities determined by only an interest rate, Stanley advocates for flexible maturation dates, lesser opt-out penalties and even, in certain circumstances, opt-out bonuses.
Country Club Bank Investment Officer Josh Kiefer sees the merit to such brokered deposits, especially if a slightly higher rate gives a bank the ability to pay off the CD at any point. Nonetheless, Kiefer remembers the role such deposits played less than a decade ago.
“Essentially, what played a role in not only bank failures but the struggle banks had to get back to making money again, is now resurfacing,” Kiefer said. “They are not bad. They were just mismanaged.”
He offered the example of a number of real estate development projects in the southeast from 2008. Banks paid up to gather deposits, both retail and brokered. When the economy faltered, investors defaulted on their development loans; that meant banks didn’t have the funds to pay time deposits when they matured.
“With brokered CDs, if you talk to examiners, the one thing banks always have to be careful of now is how high your ratio of brokered deposits is to your overall deposit base,” Kiefer said.
“When rates go back up, you’re going to see banks and credit unions across the country offering to refinance CDs and there are going to be winners and losers,” Stanley said. “The winners will be the ones bringing in the deposits in a robust fashion. The losers are going to be the ones who sit there and don’t know what to do.”
Institutional deposits are an option, said Bruce Fields, the head of investor relations at INTL FCStone, Inc., based in New York City. Institutional deposits typically require a higher capital ratio to satisfy regulators, due to the theoretical likelihood they will be withdrawn en masse sooner than retail deposits. Such a tradeoff may be necessary these days.
“Community banks have got to start looking outside their normal retail deposits,” Fields said. “Our hope is they do continue to get all the local, retail deposits and then feed those deposits back into loans in the area, but we think banks need to consider other sources.”
Investments into loans
During a period of low loan demand and high deposit retention, banks had another option for the excess funds. Call it the ridged edge of the aforementioned figurative coin. The banks could, and did, invest the money.
Kiefer said deposits may actually be holding up, but increasing loan demand is adding pressure to the loan-to-deposit ratio. If a bank previously had $100 million in assets tied up in loans and $50 million in investments, it is now more likely to have $125 million in the former and only $25 million in investments.
If the Fed does stop reinvesting in bonds and securities — instead collecting the funds due at their maturity — and continues to raise rates, then a bank’s investments could help aid loan growth.
“If rates go higher, banks want as much of their asset portfolio to roll off as possible so they can re-price it at these higher rates,” Kiefer said. “They want their assets to move in as much of lockstep with a higher-rate environment as possible.”
That would apply to both loans and investments, but if operating with the customer’s best interests in mind, a bank can expedite the payoff of a mortgage only so much. An investment, however, can be termed as quickly as the bank is willing to risk. A short-term investment could theoretically yield funding for loans in the near future. It is a risk, though, because no rate increase is a sure thing.
“No one on this Earth can tell you which direction rates are going, when they are going there and to what magnitude,” Kiefer reminded. “No one can. If they say they can, run.”
An M&A option
In an environment where deposits are valued but rate increases are not guaranteed, an otherwise sound merger or acquisition can be even more alluring if it comes with an influx of core deposits.
“A lot of buying banks are looking for a low loan-to-deposit ratio, because they’re looking for that cash to fund other activities,” said Marc Ward of Fredrikson & Byron in Des Moines, Iowa.
That impetus has contributed to the average price of acquisitions in 2017 through June 19 jumping to more than 160 percent of book value, per data compiled by Keefe, Bruyette & Woods, an investment banking firm in New York City. Dividing the average deal value by deposits generates a figure of 21 percent this year, compared to only 12.9 percent as recently as four years ago.
One way or another, both sides of the coin need to be accounted for. Banks will not complain about an increase in loan demand, especially after the slow past decade. Retail deposits simply will no longer be enough to fund it entirely.