What Is a Banker to Do?

Published in Topics: Risk Management

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Abstract

The current banking environment might be described—to rephrase an old adage—as "loans, loans, everywhere but no funds to make them."

The year 2005 marks the third year in a row in which loans grew at a faster pace than deposits based on industry totals. It’s no surprise that many banks have been forced to look outside the realm of deposits to fund loan growth. Whenever this occurs, banks do so at a higher rate of interest. Moreover, these costs in 2005 were much greater than in the past two years because of the uptick in interest rates.

Margins Continue to Compress in 2006

Adding to that problem, the bulk of new deposits in 2005 were primarily CDs rather than cash-type deposit as in 2003 and 2004—thus, at higher rates. As we enter 2006, the current bear-flattening yield curve is characterized by rising short-term rates outpacing the rise in long-term rates. That continues to compress margins in 2006 even more than in 2005. In such an environment, what is a banker to do?

In this quarter’s deposit monitor, BNK offers a summary of what occurred in the deposit markets over the past year plus a review of funding alternatives for the coming year. One of the alternatives to consider is brokered CDs, which, if used properly, have real benefits for banks that seek to grow loans when regular sources of deposits are hard to find.

2005 Year in Review

Last year was an interesting year in the deposit arena in both rates and balances. As the treasury yield curve flattened throughout 2005, the CD curve also flattened, but not as much as treasuries (see Figure 1). Of course the CD rates presented in Figure 1 are rollover rates and not special-term, rates which can vary greatly. (Later in the article we will discuss the premiums that banks are paying on CD specials in order to bring in new deposit, as well as to retain maturing CDs.) The comparison between 2004 and 2005 rollover rates shows that it is costing more today to fund loans than it did a year ago.

Figure 1: CD rates (%)

Source: DataTrac and Federal Reserve Statistical Release H15.

Not only have CD rates increased, but banks are finding that they constitute more of the deposit mix than in 2004. In Figure 2 we present the yearend deposit structure for the industry for 2004 and 2005. As can be seen, the percentage of time deposits increased while all other categories declined between 2004 and 2005.

Figure 2: Deposit Structures

Source: Federal Reserve Statistical Release H6 dated Feb 9, 2006.

To top it off, the banking industry put on more loans in 2005 than they acquired in deposits forcing many institutions to utilize wholesale funding to cover the difference. In 2005, aggregate loans grew by $597 billion while deposits grew by $556 billion, resulting in a shortfall of $41 billion or 7% of new loans. This requirement to cover the funding shortfall with wholesale funding has put increased pressure on margins as well as loan-to-deposit ratios.

Year over year, banks experienced a decline in net interest margin of four basis points (3.53% in 2004 to 3.49% in 2005). Note that this has been the third consecutive year of a decline in net interest margin with no relief in sight.

As we look to the remainder of 2006 with the Fed expected to increase short-term rates at least one more time and possibly more, we can't help but wonder what 2006 will bring. In the "ABA Community Bank Competitiveness Survey 2006," it is suggested that "2006 will look an awful lot like 2005, only, for many bankers, grimmer. Much effort will go into merely maintaining positions."

Funding Issues in 2006

In the ABA's survey it was reported that 53.1% of respondents "believe that funding will be harder to come by in 2006." And while 46.3% of respondents stated that they never used brokered deposits or institutional funds, they could be heading that way as Joseph Vich, one of the members on the survey’s advisory committee, suggests that "bankers will need to diversify their funding sources" as a result of "deposits remain[ing] difficult [to] obtain at a competitive rate."

Oftentimes, banks will attempt to escape the use of wholesale funding by way of premium rate special-term CDs. The theory is that if you offer a premium rate the deposits will come. While this is a logical assumption, is it an efficient solution? The one issue bankers tend to forget is the marginal cost of funds when offering premium rate products. In Figure 3 we show the weighted average premiums of special-term CDs in the 15 largest deposit markets.

Figure 3

American Banker, volume CLXXI No. 42, p 7, March 3, 2006.

The marginal cost of funds (MCOF) takes into account the cost associated with the funds that will likely shift from lower-rate deposit accounts into the premium-rate CD. (To learn more about MCOF read our February 2006 newsletter titled “The Marginal Cost Tells the Story.“) Therefore, the true cost of funds generated through a special-term CD promotion will be higher than originally anticipated.

To escape the higher than expected MCOF issue, a banker needs to obtain funds that are either restricted to outside its current market area or utilize wholesale funding. There are a number of alternative (wholesale) funding sources available to banks, such as federal funds, FHLB advances, repurchase agreements and brokered CDs. In Figure 4 we compare the rates of brokered CDs and FHLB advances to special-term CD rates using the weighted average premiums shown in Figure 3.

Figure 4

* Interpolated Rate
Source: American Banker, DataTrac, Banxquote and FHLB of Pittsburgh.

In Figure 4 we can glean that brokered CD rates are higher than special-term CDs but lower or similar to FHLB advances. Given this one might ask, where is the advantage? To answer this question we will have to look at the MCOF of the special-term CD. Let’s assume that through a 9-month CD special at 4.51% the bank brings in $5 million of which $4 million is new money and $1 million flowed in from other accounts at the bank with a weighted average rate of 1%. Using these assumptions the MCOF of this product is 5.39%—88 bp higher than the advertised rate! Furthermore, this is higher than the brokered CD rate and the FHLB advance rate even before you account for the cost of advertising and processing of these accounts ($2,000 in advertising alone would push the MCOF up to 5.44%). Thus, the advantage of using wholesale funding is obvious…a known locked-in cost.

So, which is the better choice: the FHLB advance or the brokered CD? While each are similarly priced the brokered CD offers some advantages. Unlike FHLB advances a brokered CD does not require collateral and they count as deposits on the balance sheet so the will help the bank’s loan to deposit ratio. The one characteristic they do have in common with FHLB advances is their availability.

Although 2006 may seem to be another hard year, there are opportunities out there that just need to be searched out. This is not the first time we have been faced with a difficult year and, unfortunately, it is unlikely to be the last. While in the process of exploring different funding sources many banks are taking the time to review their business models and determine where they want to be in ten years. BNK has worked with many banks on both the funding and strategic planning fronts and has already completed a number of strategic planning retreats this year. Give us a call if you would like to further discuss funding alternatives or set up a strategic planning retreat.