What is the better banking strategy: low expense v low deposit costs?

Here is a question that dogs us: should we follow a strategy that drives top quartile performance in operating expenses or cost of deposits? If your answer is "yes", your execution better be flawless. Because the two don't often go together. In my search, described below, only one bank made top quartile performance in both categories.

The low operating expense bank typically comes with a limited branch network. Bank futurists think this a good thing since branches are millstones around our collective necks. So in order to attract deposits, these banks tend to use premium rates to get people comfortable with not having a nearby branch. 

Low expense banks tend not to have sophisticated commercial banking operations too. Preferring instead to focus on residential real estate lending combined with transactional commercial real estate lending. By transactional, I mean the bank may resort to price to get deals, and not extensive customer relationships, as many of these customers don't value relationships anyway.

Conversely, low cost of deposit banks tend to have more expansive branch networks to get core retail and business account balances. Anecdotally, the most often heard reason a business customer objects to opening an operating account at a bank is because it lacks a nearby branch. But, admittedly, that could just be an objection that is not the "real reason".

Also, low cost of deposit banks tend to be heavy commercial lenders, both commercial real estate and business loans. That requires a good product set, and lots of resources. Asset-based lending requires much greater borrower interaction than plain vanilla commercial real estate lending.

So which strategy results in better performance? I went to the numbers (see table), and it's tough to tell.

I searched for banks of a certain size ($1B - $20B in assets) to eliminate trading anomalies from very large and very small banks. I also controlled for capital levels and asset quality to limit the number of factors impacting pricing. 

The picture is not totally clear on which strategy delivers the better returns or higher trading multiples. To be sure, both sets of top quartile banks are well run and rewarded with relatively high trading multiples. And they have delivered very good results, as indicated by their 3-year price changes.

So, which one is better? I think it depends on each financial institution's individual circumstances. Do you operate in slow to no growth markets? Perhaps a low operating expense/cash cow strategy is appropriate. 

Is your FI in business-rich markets and your niche is concierge-like service to tech firms? Well the low cost deposit strategy with higher expense ratios may be appropriate. 

Whatever strategy you choose, I implore you... to choose. The zigging and zagging, the all things to all people, the yes, yes, and yes strategies are misallocating resources and driving our financial institutions into homogenized and commoditized, irrelevant, soon to be sold and quickly forgotten memories that our 7,000 brethren that have been sold since the early '90's have become.

Are we going to let it happen?

~ Jeff

Community Financial Institutions: Parking Lot for the Benjamins

The current market volatility has been with us for nearly three years. To resuscitate the economy, the Fed is doing everything possible to keep interest rates low through monetary policy. First dropping the Fed Funds rate to near zero, and most recently with Operation Twist designed to guide long-term rates even lower. The Euro Zone debt crisis and resulting lack of investment alternatives makes US Treasuries, as one economist put it, the "best house in a bad neighborhood".

This has kept investment options for community financial institutions at historic lows. Low loan demand further exasperates the challenge.

While investment options dwindle, FIs find themselves awash in cash. Market volatility and prolonged low bond yields is keeping investors on the sidelines. The sidelines, as it turns out, is in banks. This led to Bank of New York Mellon's decision in August to begin charging very large depositors fees for parking their money. There simply isn't any place for them to lay it off.

Community FIs are experiencing similar activity from their Main Street customers. From December 31, 2009 through June 30, 2011, deposits for all FDIC insured depositories increased 5.84%. But average deposits per money market account, according to my firm's peer database, increased 31% during that same period (see chart). Community FI customers are parking their money waiting for better, more certain times.

At first, senior managers of FIs felt good about the inflow. Loans from 2002 through 2007 generally grew faster than FIs' ability to fund them. This resulted in FIs turning to CD rate promotions, brokered CDs, and FHLB borrowings to bridge the funding gap. Deposit mixes became more expensive and less attractive.

But with loan demand at historic lows, FIs began running off their high-cost CDs and other so-called "hot money" to right-size their funding sources. This may have created a little hubris among senior managements, thinking it was the quality of their service and the value of their brand that attracted the core funding. But looking from a wider lens shows us it has been an industry phenomenon more than what any institution did on their own.

This is creating uncertainty with Treasurers across the landscape. What does the FI do with the money? How long will the money remain in the FI before migrating back to the market or the hottest CD promotion? With historically low re-investment rates, FIs are keeping the money highly liquid. FDIC insurance costs, on average, are 12 basis points on deposit balances. This, and the operating costs for maintaining the accounts, is resulting in some core deposit accounts actually being unprofitable... a highly unusual situation.

But this too shall pass. If FIs are pleased at their current mix of funding, perhaps they should take positive action to maintain it. Initiatives could include a disciplined onboarding program for new customers, and a timely calling program for existing ones. Your customers may certainly be parking their money at your FI, but they probably have money elsewhere too. If you demonstrate service beyond what they experience at their other FIs, perhaps you can win their loyalty, including their core deposit balances.

Alternatively, you could do nothing, stuff your vaults full of cash, and pray that customers stick with you. Hey, it's possible, just not probable.

What do you suggest FIs do to keep core deposit customers?

~ Jeff

Note: I will be part of a panel discussion at the Financial Managers Society (FMS) Philadelphia Chapter on Wednesday, November 9th to discuss liquidity, value, and profitability of core deposits.