What about Deposits? – Don’t Forget the Importance of Deposits in the Credit Downturn

What about Deposits? – Don’t Forget the Importance of Deposits in the Credit Downturn

The downturn in the financial services industry seems to be getting worse, particularly as far as the media is concerned. Certainly the news from IndyMac, the concerns with the GSEs, and the speculation of additional depository failures will continue to weigh on market sentiment for investors and depositors. Just as we wrote in our May column, industry “experts” are still trying to guess when the worst will be over and how much worse it could get. Credit quality issues continue to grab the headlines. Although loan losses are destroying earnings and market value at many institutions, it is important to think about what will remain on the balance sheet after portions of loan portfolios have been “burned down.”

As we know, deposits are critical to the operation of a bank because they are (at most banks) the primary source of funds to be implemented on the asset side, typically in the form of higher yielding loans. From an earnings perspective, the lower the cost of funds, all other factors being equal, the more profitable a bank will be. A greater interest spread fuels higher returns. Aside from yield, the life (or “stickiness”) of deposits is a driving factor in the value of a deposit. Moreover, the value and volume of assets that a deposit customer participates in further enhances the value of that deposit relationship. It is really no mystery why Wells Fargo works so hard to cross-sell its products – the more a customer is entrenched, the harder it is for them to take their typically below-market yielding deposits elsewhere and the more valuable that relationship is.

In this period of turmoil in the financial services industry, concerns over a bank’s funding mix should be a close second behind credit concerns. Many banks – both large and small – funded their exorbitant loan growth with wholesale funds, including brokered deposits. While, in many Western U.S. markets, brokered deposits provide a cheaper source of funds than in-market CDs, they are not relationship driven by any means and provide no value other than temporary liquidity and a modestly lower funding source than some in-market CDs. In their general effort to shore-up balance sheets, regulators are pushing harder for banks to reduce their reliance on “volatile” funding sources. Given the concerns about the integrity of the balance sheets at some financial institutions, which were recently amplified by IndyMac’s failure, it isn’t likely that the supply of deposits in the market is going to increase anytime soon. Therefore, deposit prices will not likely be dropping and competition will remain challenging.

During the initial phase of reducing its brokered deposits, a bank is typically not in a strong enough liquidity position to wait to bring in cheaper, core deposits. The fastest way to fulfill its liquidity needs is to pay an above market rate to quickly bring in deposits. The higher the rate, the more funds usually come through the door, which will translate to a lower return on the bank’s equity. Clearly, the less reliance an institution has on volatile funds, the less susceptible its operations and earnings will be to turbulent market conditions.

We talk to many institutional and private equity investors about their thoughts on the prospects of specific banks and the market in general. When a bank has credit quality concerns and its solvency is in question, aside from figuring out what potential charge-offs may be, the main fundamental factor considered by an investor in his decision on whether to allocate capital is the bank’s deposit base. A bank’s current level of core deposits and its ability to generate them in the future is a pillar of franchise value.

As one would expect, and as the charts above indicate, banks in the Western Keefe Bank Index (WKBI)[1] with greater reliance on volatile funding sources (like brokered deposits) trade at a lower premium to core deposits while banks with a higher volume of noninterest bearing deposits are rewarded with a higher valuation.

[1] The WKBI represents the Western Keefe Bank Index (64 select Western Banks with Assets $400mln-$15bln). For this example, the 61 banks with the required data points are included.

Note: Share prices are as of July 11, 2008 and deposit data is as of March 31, 2008.