Chief Investment Officer
the year of the deposit
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THE YEAR OF THE DEPOSIT
2005 is the year of deposit gathering. For the first time in five years, loan growth has outstripped deposit growth. As rates continue to rise and the yield curve to flatten, the value of core deposits had increased tremendously.
In the early 2000s, the cost of borrowing, particularly FHLB borrowings, was so low that CFOs nationwide opted to fund their balance sheet growth through wholesale sources. Core deposits were too expensive and were negatively margined to FHLB funding costs.
The absolute low level of the yield curve in those years also contributed to the perceived lack of profitability of deposits. Many retail franchises were assigned loss numbers in banks' P&Ls, as wholesale deposit sources were both cheaper to gather and commended lower interest expense. The bloom was off the interest-free checking account rose.
CDs became the least attractive deposits, fixing interest rates as they declined and costing banks many a basis point. Variable rate funding was the battle cry for all.
In addition to these trends, loan demand slacked off. The economy experienced a mild recession, followed by years of uncertainty. The result was lower capital expenditures, lower borrowings against lines of credit, and overall lower loan demand.
Things have changed dramatically in the past twelve months. The Fed started tightening and rates rose. Economic activity picked up, including loan demand. Wholesale funding costs moved much faster than deposit costs, and became more expensive than core funding. Banks nationwide started experiencing margin pressures, and those led to taking a fresh look at deposits. Interest free checking accounts looked quite attractive, now that the situation has reversed. Unfortunately, the very same banks realized that they can't turn their balance sheets on a dime. Instead, they had to start driving core deposit growth. CDs were now included in the drive for deposit growth, since they offered a fixed cost liability during rising rate times.
The massive movement by so many banks to rediscover deposits has created intense competitive and pricing pressures. This trend coincided with the decline of the "Free Checking Plus Gift" boom, as a saturated market continued to be bombarded with free checking solicitations. Most customers who were interested in switching banks have already done so, and the new offers attracted mostly gift-loving non depositors. The industry is experiencing a common quandary: how to grow deposits, especially core deposits, when the bank next door is bidding up deposit prices, offering significant cash amount for checking account openings and appears to be destroying the pricing discipline in the marketplace?
The answer to the deposit growth question isn't easy. It starts from the basic tenets of deposit pricing, which the mega banks have figured out some time ago, but many other banks haven't focused on fully yet. Most large banks have already picked a point on the pricing range they'd like to be on, and stay true to it almost at all times. Some large banks with a significant network advantage, i.e. those who have good branch coverage in a market, consistently price below market rates, since they offer superior convenience that helps attract depositors.
Many other banks have not articulated internally nor externally their deposit pricing position. Many aren't sure whether they wish to be at the top of the market or bottom quartile. As a result, the marketplace, including customers and prospects, isn't sure what their pricing position is and what to expect from future deposit pricing activities.
The first step toward an effective deposit gathering strategy is for the bank's senior management to decide where on the pricing curve they want to be, and then fulfill on that promise consistently. For example, some banks are known to chase "hot" money. Their customers know that they are likely to get the best price in the market, and remain loyal without much shopping throughout rate cycles. This is a valid position, although an expensive one, to take. Others choose different rate curve positions, such as not competing on price but on other variables, are equally valid and often more profitable. Commerce's strategy of leading with convenience and not with rate is a good example, and their deposit growth hasn't slowed down despite intensifying competition. The bank's margin is being squeezed, but it's funding continues to grow.
Once a global deposit pricing strategy has been set, there is much flexibility within this framework to achieve deposit growth in different customer and price segments. Here are some thoughts:
For geographically-diverse banks: price more aggressively in low cost markets and lend more aggressively in high yield markets. For example, a bank with branches in the west coast and loan activities on the east coast will be best serve to generate more deposits out west and more loans out east, since the east cost has traditionally been a more expensive market for both loan and deposits than the west coast. While most banks do not have this geographic span, they do have pricing disparities within their markets. Identifying those disparities and targeting low-cost geographic pools for deposit gathering is a winning strategy.
- Focus on low-cost populations: certain customer segments are less price-sensitive. They look for other value drivers, such as convenience, true service differentiation, one-stop financial solutions to name a few, and are willing to give up some price differential in order to receive the elements they value most. Surprisingly, certain wealth management clients define value as a much more complex proposition than price alone, yet they have large deposits under their control. Other examples are abound. These low-cost populations are typically not huge, and require specific targeting, segmentation and pricing work. However, the pay-beck is huge, as TCF and Commerce can attest.
- Develop products that encourage deposit aggregation: Banks have been bound too long by unyielding technology that impedes them from offering true relationship pricing. The time has come for this advancement, and certain banks, such as Webster and Flagstar, are moving in that direction more rapidly than others. In general, most banks do not give their customer a financial benefit for being loyal and aggregating their deposits in one spot. Relationship pricing, i.e. increasing yields as the customer builds deposits with the bank, is an idea whose time has come. It is up to us, the banks, to give our customers a reason to do more with us beyond just telling them how great we are. Relationship pricing is one answer.
- Do not get hooked on those odd-maturity specials: Off maturities are in vogue now. 7, 11, 13 months CDs are offered by many banks who are looking to grow deposits without having to price their entire portfolio. This strategy is effective, but it is also addictive. Those deposits will come back home to roost as they mature, and the improved rate will be part of the customer expectation for renewal. Also, so many other banks have figures out this simple solution and are following it, such that odd maturities aren't that odd anymore. This tactic is a double edge sword, and needs to be evaluated carefully in the overall strategic context of the institution and its desired balance sheet structure.
- Bring your sales culture to bear: Many banks are boasting of their sales culture and how far they've come, yet when it's time to leverage that investment by gathering deposits without a price premium the sales force fizzles out. The definition of a sales isn't a giveaway; it is about meeting customers' needs without compromising the needs of other constituencies, such as the shareholders. A true sales culture means that your folks are better than other banks' in finding out what customers really need and giving it to them, offering a complete value proposition of care, service, price and other elements on the customer's terms. I have not seen many examples of the sales culture paying off as described above, but a bank with a true sales culture will be able to capitalize upon the investment in building it by mobilizing their bankers to sell customers more deposits than they have ever done.
- Focus on high-average balance segments: Some segments offer higher balances than others, yet many of those segments are under the radar screens of the mega banks, or aren't in the center of competitive pressures. Small business is an example of a neglected segment that is deposit-rich and potentially very loyal. It is the bread and butter of quite a few banks whose interest free demand deposit to total deposit ratio exceeds 35%. The mega banks have specialized deposit sales forces that cater to this segment, but they can't offer the relationship orientation that other banks tout as their competitive advantage. This segment is a perfect target for relationship banking. Those that have executed well on this proposition have not experienced the same margin compression that others have, and are often in a margin expansion mode, due to a high percentage of true core funding. This is one example of the leverage opportunities that community banks need to capitalize upon.
Focus on specific ethnicities as target markets: Certain ethnic groups have strong saving culture. There are banks that dedicate themselves to gathering those deposits, such as the Asian banks that have been sprouting and growing across the country. Other banks become multi-cultural, go beyond their core ethnic group, and serve several high-savings customer segments. In Chicago, for example, the banks that serve the Ukrainian and Polish communities have continued to experience deposit growth beyond the city's average since they targeted deposit-rich segments that aren't on everyone's "hot" list. Every market has such opportunities; it is up to each bank to focus on these opportunities and execute well by creating trust and a comfort level among the target segment's population.
Incent your customers to remain with you: Banks strive to achieve customer retention, since it is the best predictor to future earnings growth and stability. At the same time, customers rarely get "retention bonuses", unlike coveted employees, who do. Banks have developed golden handcuffs to support employee retention, as well as bonus structures to achieve the same result. Why not do so with those very special customers? Why not offer differential pricing to reward loyalty, tenure, etc.? There is much banks can learn from the airlines' loyalty programs in this regard.
- Make switching costly. Switching banks can be a costly move for customers. In addition to the annoyance and aggravation associated with such a move, there are other costs:
- Transaction costs: the direct costs of starting a new relationship (such as ordering new checks, for example)
- Learning costs: Developing a comfort level with the new bank's products, operations etc., such as learning ATM locations, phone tree information or a new online bill payment process
- Contractual costs: Some banks impose penalties on customer defection or simply make it harder to leave. For example, automatic direct deposit of paychecks is difficult to unwind.
The higher the switching costs, the longer a customer stays with you. In other words, give your customers both positive and negative incentives to stay with you.
Customer retention drives deposit growth. One major bank's statistics indicate that 25% of the customers drive 85% of the dollar attrition. The opportunity to curb the tide among existing customers' attrition is huge. Calculating what 1% deposit retention is worth to the bank is a first step to inspire all to ensure customer retention is at a minimum. This is one of the more important lessons that can facilitate deposit growth.
Consider these facts: 1. 70% of all new money in most banks comes from existing customers. 2. There is a direct and positive correlation between tenured employees and tenured customers. In other words, employee retention leads to customer retention.
Both these facts offer opportunities for deposit growth. The first implies that, short term, the best source of new money is existing households. Yet, they are rarely the subject of major marketing campaigns. Most of our attention is directed to acquiring new customers, not cross-selling existing households. Banks that will redirect some of their attention to building existing relationships will experience faster deposit growth at lower rates than those who are exclusively hunting for new accounts.
In the longer term, the second fact is most meaningful. It implies that as banks work to retain their own employees and reduce turnover, the customers will follow. Yet employee retention isn't at the forefront of many HR directors. A cohesive program to improve employee retention isn't easy to execute, but the long-term payoff is significant across all fronts: customers, employees, and shareholders.
Deposit gathering is the challenge of the moment. The solutions are many, and those who think out of the box and develop their own original answer to the problem will do the best. There is nothing wrong with borrowing great ideas from others' success, but being Last In and Last Out in any initiative won't pay off.