Deposits are the lifeblood of all banks but for years have been underappreciated, undervalued, and basically ignored by executives who were more interested in 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 few banks not only took the deposit portfolio for granted but adopted the incredibly reckless strategy of investing excess liquid funding 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 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? Evidence suggests that they have, as most banks, especially high performing ones, have increased their focus significantly on building and maintaining strong core deposit portfolios.
Balance Sheet Strategies Vary
During the Fourth Quarter, there was considerable variation in the balance sheet strategies across the industry, with most of our banks achieving growth on both the asset and liability sides of the balance sheet. We expect an increased focus on growth in most of these banks over the next 12 months if, and this is a big “if”, the economy cooperates. We also expect a few banks that have relatively high CRE concentrations to continue to try to trim these portfolios and replace these loans with a more diversified mix. The charts below show 2024 asset and deposit growth performance for each of our banks. Most of this growth was organic except for a couple of banks that completed significant acquisitions (e.g., AUB).
A key driver of performance will continue to be a bank’s ability to generate core, stable funding at an acceptable cost. Our experience is that those banks that can consistently generate lower cost core funding to support growth will likely outperform those that rely on higher cost sources.
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 shareholder value 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.
Well, a funny thing happened on our way to proving our hypothesis. For the first time in a long time, there was almost a one-to-one correlation between deposit growth and cost of funds. This has not been the case over the past two years. However, as interest rates increased, some banks started offering more attractive rates to attract new depositors, and it seems to be working. Virtually all of our banks (with two notable exceptions) that grew their deposit portfolios faster than their peers also had higher funding costs. The charts below show the top two highest organic deposit growth banks in each of our industry segments and their reported Cost of Funds relative to their sector peers. The only two banks that we cover that had relatively high deposit growth and low cost of funds were Huntington (HBAN) and Western Alliance (WAL). Consequently, we have named these two banks the coveted winners of the 2024 deposit wars.
However, while we found a direct correlation between deposit growth and cost of funds, we have seen no consistent correlation between cost of funds, deposit growth, and share price performance. Apparently, the market doesn't really care about the inputs, it cares about the outputs: how balance sheet management has translated to overall financial results.
However, while the stock price has not reflected this growth/COF ratio, market valuations have, with banks achieving relatively higher deposit growth rates, even while paying a higher funding cost, being rewarded with both higher PE and P/B multiples.
While we do understand the difference between correlation and causality, we do expect deposit generation, within a reasonable cost, to continue as a primary driver of market performance. We believe the banks that can grow while managing their funding costs lower than peers will over time realize better net interest margins and superior financial performance.
Information not Recommendations
We do not invest in individual bank stocks or make recommendations on market timing or investment strategies. We provide information that hopefully can help inform individual investment decisions. As always, before making any investment decisions one should consult with a qualified and licensed investment advisor.
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