Deposits are the lifeblood of all banks but for years have been underappreciated, undervalued, and basically ignored
Deposits are the lifeblood of all banks but for years have been underappreciated, undervalued, and basically ignored by executives who were more concerned about growing their loan portfolios and ancillary businesses than investing in the ability to build strong core deposit franchises. This neglect was exacerbated by the pandemic, when interest rates dropped to zero, stayed there, and consumers and businesses hoarded cash. The result was plentiful and cheap funding that was more than sufficient to support loan growth. A number of banks not only took the deposit portfolio for granted but adopted the incredibly stupid strategy to invest excess balances in longer term securities to juice yield and optimize net interest margin. That strategy had disastrous consequences for a few high profile banks as nervous depositors staged a 19th century style run on these banks using 21st century technology and crashed them seemingly overnight. While the impact on the shareholders of these failed banks was was catastrophic, the fallout impacted bank investors across the entire industry. The question is have both bankers and investors learned their lessons and started to pay attention to the size, characteristics, and strength of the core deposit portfolio as a primary driver of shareholder value?
Balance Sheet Strategies are All Over the Lot
During he third quarter, most Super Regional and Regional banks saw decreases on both sides of the balance sheet as loan and deposit portfolios were reconfigured to manage liquidity and reduce concentration risk. A number of Super Community banks were able to buck that trend and generate organic growth while achieving higher net interest margins and lower efficiency ratios than their larger competitors. It is not surprising that a few of our top performing banks continued to grow, most notably OZK, WAL, FITB, and MTB. We expect most banks to grow only marginally over the next 12 months as they continue to focus on funding costs, net interest margin and cost reduction to drive performance rather than loan growth. Additionally, banks that are heavily concentrated in Commercial Real Estate (CRE) will likely trim those portfolios and seek to replace those balances with a more diversified mix.
Funding Costs Continue to Rise
A key driver of performance will continue to be a bank’s ability to generate core, stable funding at an acceptable cost. Those banks that can consistently generate lower cost funds will significantly outperform those that rely purely on high interest rates to achieve funding objectives. These charts identify banks that were able to generate industry leading deposit growth during the third quarter while effectively managing cost of funds. Those that perform best on both deposit growth and cost of funds tend to have strong consumer businesses and dominant presence in attractive markets. Nor surprisingly, the banks that have been able to achieve the most balance between deposit growth and funding costs are a few of our highest rated Super Regional banks -- FITB, MTB, and RF.
Does the Market Care? As with all of our statistics, we constantly ask "Does the market care". The analysis may be interesting but if it doesn't translate into market valuation we want to know why or why not. In this case, and in this environment when funding is a hot topic, we would expect those banks that have shown the ability to grow the deposit portfolio at a relatively low cost would outperform those that have shown low to no deposit growth while experiencing high cost of funds. To test our hypothesis, we placed all our banks into categories based on whether their deposit growth and cost of funds was higher or lower than the median peer performance. Our categories were:
High Deposit Growth/Low COF
High Deposit Growth/High COF
Low Deposit Growth/Low COF
Low Deposit Growth/High COF
Well, a funny thing happened on our way to proving our hypothesis. As the chart below indicates, while we found that deposit growth had a major correlation with share price performance throughout the third and fourth quarters, cost of funds did not. In fact, during this period, those banks in the higher cost of funds categories actually performed marginally better than their lower cost peers. In fact, the differences in market performance are signficant. Since July 1st, banks in both the high deposit growth categories have outperformed their low deposit growth counterparts by about 50%. While we expect deposit generation to continue as a primary driver of market performance, we believe banks that can manage their funding costs lower than peers will realize better net interest margins and superior financial performance over time. Clearly, we understand that their is a difference between correlation and causality. and that many elements go into the market valuation equation. However, we believe that for the foreseeable future, deposit factors will play an outsized role in that equation.
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