the value of building core deposits in a lagging loan demand environment

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The Value of Building Core Deposits in a Lagging Loan Demand Environment

January 2010

Author: Brian Mischel

Loan demand has been sluggish since the beginning of the 2008 liquidity crisis. Attracting and

attaining core deposits during periods of low to moderate loan demand can present bothadvantages and disadvantages to banks. Without question, the uncertaintyalong with rising

costs of deposit insurancecould potentially affect future bank earnings. Core deposit inflows

bring a regulatory compliance responsibility and can pressure asset yields and net interest

margins during periods of Federal Reserve rate reductions because of soft loan demand.

However, the advantages of attaining core deposits in a soft loan demand environment will

outweigh the disadvantages for most banks. Periods of slow loan growth provide opportunities

for banks to improve overall funding structure through balance sheet management.

Core deposits, by definition, are those deposits that either dont bear interest, dont reprice in

tandem with market rates or reprice more favorably than market rates at the time of repricing.

Accordingly, core deposits are traditionally a lower cost of long-term funding directly affectingbottom-line profit. Generally, core deposit inflows will have a positive effect on the banks

interest rate risk profile and bottom-line profitability by enhancing margins, noninterest income

and potentially the banks ability to compete for and retain loan customers.

Balance Sheet Management

During periods of slow loan demand, increasing core deposits can allow banks to focus on overall

balance sheet management. A strong foundation of core deposits reduces dependence on

alternative funding sources, such as brokered certificates of deposits and Federal Home Loan

Bank advances. Core deposits have a predictable cost, imply a degree of customer loyalty and are

less interest-rate sensitive than alternative funding sources. Dependence on noncore funding may

constrain liquidity, heighten interest rate risk and subject a bank to increased credit risk to

preserve interest margins.

The overall funding structure and loan-to-core-deposit ratio can be significantly improved during

periods of slow loan demand. The size and stability of core deposit positions affects asset/liability

management risk. Periods of slow loan demand can allow banks to significantly reduce exposure

to the risks associated with noncore funding. The net noncore funding dependence ratio

measures the degree to which a bank is funding longer-term assets with noncore funding. The

following graph illustrates the noncore funding dependence ratio in recent years for all banks in

the nation.
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Information per Federal Financial Institutions Examination Council (FFIEC) Uniform Bank

Performance Reports

Increasing values for this ratio generally indicate declining liquidity, as experienced by many banks

in the liquidity crisis of 2008. Higher ratios reflect a reliance on funding sources that may not be

available in times of financial stress or unfavorable changes in market conditions. The cost of core

funding in recent years adjusted nominally in response to movements in market rates,demonstrating the cost of core funding is less likely to react unfavorably than noncore funding

during adverse business conditions. The following graph illustrates the cost of funds for different

products in recent years for all banks in the nation.

Information per FFIEC Uniform Bank Performance Reports

A large quantity of core deposits allows banks to hold higher-yielding, longer-term assets withoutincurring undue interest rate risk. High levels of stable core deposit funding provide an institution

with significant control over its interest rate risk profile and reduce interest rate risk. Bank

regulators consider the strength of core deposit positions in assessing a banks overall interest

rate risk profile.

Multibank Holding Companies

Multibank holding companies have unique opportunities to manage their balance sheet. Loan

demand for banks within a multibank holding company can be shifted from banks with excessive

loan demand to others with minimal loan demand through sales or participations. Subsidiary

banks with a stronger base of core deposits can fund liabilities for other banks in the group. Suchtransactions within a multibank holding company can create efficiencies, reduce risk and increase

earnings potential.

Supplementing Retail Banking Product Development

Core deposits represent reliable sources of fee income and opportunities to cross-sell other

products. High-performing banks typically develop and market other products to enhance core

deposits and offer their customers a greater variety of products and services. Most banks perceive

this broadening of the products and services as essential to remaining competitive with other

bank and nonbank competitors. For example, many banks offer cash management services for

business customers, remote deposit capture, insurance services, repurchase agreement related

products and other point-of-sale products. These products also serve to compete for and retain

loan customers. Ultimately, inflows of core deposits breed a customer base, which generates

noninterest income through increased transaction volume, related retail banking product sales

and eventually an increase in loan customers.


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Considering Customer Demographics

The demographics of the banks customer base can affect loan demand market share between

competitors in the same market. Focusing on demographics of core deposit customers may

enhance the banks ability to compete favorably and retain customers, including profitable loan

customers. Focusing on demographics of the banks market and offering products that competefavorably for desired segments of the market can help a bank gain market share as loan demand

returns. A bank can use a variety of implicit and explicit pricing structures for its core deposit

products, including tailoring product features and pricing to attract a customer base with

demographics considered to be more favorable or desirable in periods of increasing loan demand.

For example, a bank may waive certain account fees for retail customers who maintain minimum

balance requirements. Commercial customers may be given an earnings allowance for demand

deposit balances kept in lieu of paying account fees. A bank also can tier pricing strategies to

separate its customer base into high-balance, rate-sensitive customers and low-balance, rate-

insensitive customers.

Increasing Franchise Value

Core deposits are a significant factor in determining a bank's overall franchise value. The value of

core deposits or the core deposit intangible can be a significant factor in the determination of the

bank's market value. Premiums paid for core deposits in acquisitions or mergers have historically

been significantly higher than those paid for a loan portfolio. Banks are typically sold and valued

based on a multiple of earnings. An earnings stream enhanced by a strong core deposit base

maximizes a bank's value. High premiums paid in bank transactions are typically the result of

substantial core deposits developed and retained through deposit relationships and retail funding.

The weighted average premiums paid for core deposits in acquisitions of whole banks by year

since 1993 have ranged from 3.19 percent to 47.79 percent. The following graph illustrates the

weighted average premiums paid for core deposits in recent years for all announced whole bank

transactions in the nation.

Information per Highline Financial

Information through December 14, 2009


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Data do not include hostile/unsolicited or terminated transactions

Although premiums paid for core deposits vary from deal to deal and period to period, banks have

realized significant premiums paid on core deposits. Thus, enhancing core deposits builds up a

substantial off balance sheet asset, which can be realized through the sale of branch locations orwhole bank itself.

The current banking crisis will likely have a prolonged effect on deposit insurance premiums and

assessments. The impact will be enhanced as the assessment base comprised of deposit liabilities

grows. The current environment also may generate a negative spread on deposits for some banks

because of the soft loan demand. However, the competitive, risk management and profit

enhancement benefits of building core deposits in a low to moderate loan demand environment

far outweigh the drawbacks. Developing a strong core deposit base will better position banks for

long-term success.

This article first appeared in the January 2010 issue ofBankNews. Reprinted with permission.

the value of building core deposits in a lagging loan demand environment

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