Street Talk | Episode 142: Despite Looming Rate Cuts, Strong Deposit Franchises Still Take The Cake

View Full Transcript

Nathan Stovall

Welcome to Street Talk, S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

I'm Nathan Stovall, and on this episode, we're talking about deposits, which banks boast the strongest funding, what attributes they have and how deposits continue to drive valuation across the banking industry, even with the Fed seemingly poised to cut rates again today on September 17. We recently co-hosted a conference focused on deposits with our friends at South State. At the event, we covered the competitive and regulatory landscape, ways to analyze and optimize the deposit business and highlighted some of the best franchises in the country through fireside chats with their executives while sharing the results of our proprietary deposit rankings. My colleague, Zane Tarit spearheads those rankings and took part in the conference and is joining me on the show today. Zen, thanks for being here.

Zain Tariq 

Thanks, Nathan. Excited to be here.

Nathan Stovall

So Zen, let's start off talking a little bit about the event and the rankings as well. This event came together some time ago with the idea that there isn't really an event focused on deposits. You and our team had worked to put together deposit rankings in January and then rebooted those ahead of this event to have a nice anchor associated with the conference. What are our rankings? Who do we rank? What are the groups and what is the approach to those actual rankings?

Zain Tariq  

Just some brief context, Nathan. We have written a lot about and talked a lot about deposits over the last 3 years, the importance of deposits, the competition as the rates went up, cost of deposits and betas. We saw noninterest-bearing deposits skyrocket post pandemic because of the massive amount of deposit inflows. What the banks did with those deposits is a different story. But as the rates went up, customers moved that money into higher-yielding accounts more aggressively. And we saw a rebound in that trend with almost all of the growth coming from interest-bearing deposits for several quarters. So retaining those deposits especially after the liquidity crisis in the spring of '23 became challenging. And all of that, I think, combined resulted in this idea to zero in on and highlight some of the best deposit franchises across the country as we believe deposits represent the true value of a franchise. So we created this model based on our annual performance rankings model, but strictly looking at the deposit side of things. We tested the model with different metrics and finalized 8 key metrics that we believe are the most relevant in the current market conditions and applied different weightings to each metric. Now these metrics include average noninterest-bearing deposit concentration over the last 4 quarters, -- just want to mention that we did use 4-quarter averages for most balance sheet ratios to basically avoid having skewed numbers because of one-off items at the end of a period. We weighted this one at 20%. As we all know, these deposits are an institution's most priced deposits. In addition to that, we included quarterly average deposit growth and deposit growth over the last 2 years, weighted at 10% basically to reward banks that were able to keep the deposit costs low without massive deposit outflows.

Nathan Stovall

I want to jump in really quick right there. And those 2, just -- I know we're going to get into the other 8 metrics, but I think it's really interesting as you led in, too, that noninterest-bearing deposits were down 30% since year-end '21. Interest-bearing are up 15%, as you outlined. So clearly, it makes sense to prioritize that noninterest-bearing deposit concentration. But I also thought it was a great idea that you had had to reward stability with the idea there, too, that you can't just have it fluctuate all over time, and we also didn't just wait on 1 quarter.

Zain Tariq 

Exactly. Yes. Yes, we had seen -- like while we were testing the model, we actually did see a lot of fluctuation, especially what has happened in the industry over the last few years, there was a lot of fluctuations. So we want to kind of normalize the data over the 4 quarters, and that gave us better results. But yes, definitely. And for the growth, we also included banks that had completed deals because we kind of wanted to showcase how some banks did use M&A as a strategy to build a stronger deposit base, and we did highlight them in our rankings as well. Another metric that we used was average deposits to liabilities, essentially showing how banks have been funding the business and keeping a relatively lower cost of funding compared to other borrowing sources. We weighted this one at 10% as well. And then cost of interest-bearing deposits for the last 12 months ending June 30, weighted at 15%, which is basically your interest expense relative to your interest-bearing deposits only. So even if you have a high noninterest-bearing deposit concentration, you would still have to perform better in this metric to be a top-performing deposit franchise. And similarly, interest-bearing deposit beta, we all know how the betas skyrocketed as well and how much of an impact that had on deposit flows. So we weighted that one at 10% as well. And the bank's reliance on term funding. So we had 2 metrics showing that. One was time deposit concentration and the other one was CDs repricing within a year, their concentration, and we weighted both these metrics at 10%. And then last but not the least, a new metric that we created earlier this year for our rankings in January as well as deposit efficiency, which essentially looks at the bank's last 12 months noninterest expense less amortization and impairment, less service charges on deposits, basically rewarding banks for that additional income on deposits relative to the average deposits. We weighted this one at 10% as well. And I do want to mention one more thing that we published these rankings on our platform a couple of weeks ago with the model attached in our rankings article. The model does allow you to change the weightings or metrics or even if you want to look at a different peer group. So if you have access, you can definitely go ahead and access that model and make those changes. But yes, that's essentially what these rankings are, and this is how we arrived at the model.

Nathan Stovall

Sure. And the point of being able to tinker with them is a good one for anybody who has access to our platform. We do feel strongly about it, though, and I think it lands pretty well, and we've seen some consistency in terms of the top performers. And on that last one, too, you and I have talked a lot about how do we come up with a deposit efficiency metric, and we road tested it for a while. But the idea there was there is a cost to managing your deposit franchise beyond interest expense. You've got branches, you've got technology, you've got marketing spend. We talked a lot about those actually at our deposit conference as well. And so there wasn't a perfect way where all of those disclosures are uniform, where you have specific breakouts for some of those items. But we effectively were able to look at, call it, a modified efficiency ratio while, as you said, giving credit for any revenue generated from those deposit bases. And one of the things I shared at the event was when you look at that metric across different asset groups, it's pretty interesting. community banks and then banks $100 billion to $250 billion have a much higher deposit efficiency metric than the nation's biggest banks, those over $250 billion as well as larger community banks and smaller regionals. And that's been true for several years. And why would that be? -- smaller banks don't have enough scale. The $250 billion have higher regulatory burden. The over $250 billion have the scale and the ability to spread tech costs across a larger base and that $10 billion to $100 billion group doesn't have as much of a regulatory burden as their larger counterparts. So we thought that was pretty interesting. But we saw -- when you look at the winners, we broke down in a couple of asset groups. And I think it makes sense to hear about those. How do we break those down? And who were the winners? What were some of the attributes?

Zain Tariq  

And definitely agree on your point on coming up with the deposit efficiency metric after we tested quite a lot of things, deposits per branch, average deposits and then eventually, deposit efficiency worked out the best because it accounted for your digital expenses in addition to your branches. So if we had any branch-light models, I think this was the metric that basically accounted for all those caveats that we had with other metrics. But when it comes down to different groups, we have 3 different asset groups, small community banks, which is banks with less than $3 billion in total assets, large community banks, banks between $3 billion and $10 billion in total assets and then large deposit franchises, which was banks above $10 billion in total assets. breaking these downs and the winners in each of these categories. for small community banks, we had more than 3,800 banks eligible for the analysis. So a lot of banks in this bucket. We ranked top 100 deposit franchises. And 2 Texas-based banks, Titan Bank and Tejas Bank retained their spots from our January rankings, while a Kansas-based bank, Integrity Bank grabbed the second spot. They were ranked fifth in our previous rankings. It climbed a couple of spots to grab the second spot. Titan Bank, obviously, a very interesting and unique model, around $700 million in total assets. It was also ranked among our top-performing community banks this year. The bank has very high noninterest-bearing deposit concentration, around 55%, which is more than twice the median we had for all the banks in this analysis. I think that was around 21% -- they had very low reliance on time deposits and a really good deposit efficiency ratio as well.

Nathan Stovall

With one branch and operating a nationwide business, helping spread that out on scale, it's definitely a unique model.

Zain Tariq  

Really unique model, very low cost of funding. And we have talked about this bank previously as well, really good numbers for a bank this size. KHS Bank at #3 is a merger target now as some of these deposit franchises have caught the attention of buyers. 3 other banks, I think, in this ranking are now merger targets. And if we look at the large community banks bucket, we had 227 banks eligible for the analysis. We ranked top 50 deposit franchises. And similar to our small bank rankings, the first and third bank from our previous rankings retained their spots. Number one, we had Oklahoma-based Stride Bank. And number three, we had New York's Amalgamated Financial Corp, while North Carolina's Fidelity Bankshares rose from seventh spot in our previous rankings to grab the second. We have talked about Stride a lot as well. The bank has fintech partnerships. It offers banking as a service, which may come with its own set of troubles. We have flagged these items in our full rankings that we published. And we have also talked about this, and we have mentioned and we talked about this at the deposit conference as well, if you do it right with proper compliance and risk management, you can be profitable and outperform the industry. But if you don't, it could lead to some uncomfortable discussions with the regulators and possible consent orders, which we have seen in a lot of cases over the last couple of years. But definitely, it requires a lot of investment.

Nathan Stovall

Yes. And picking up on that real quick before we get to the other rankings. I mean one of the folks at the conference was Brett Pharrr, CEO of Pathward. We did a fireside chat with them. They're one of the longest-standing BaaS banks out there, trade at 3.5x tangible book, really high performer, have an envious deposit franchise, almost all noninterest-bearing deposits, and they even have a different metric that's not standardized, but where they try to report their all-in cost of deposits, the cost of compliance because their interest-bearing component is so small, but the cost of compliance of managing a BaaS bank against their deposit base, still, I believe, 1.45%. So 145 bps, that's 60 basis points below the industry. So still a very, very, very strong franchise. But to build on what you said, I think Brett opened with, I'm going to tell you about our model, and I think you're going to learn why you don't want to do this because it's so challenging. So he clearly believes in it, but there is risk that comes with it.

Zain Tariq 

Yes. It was definitely interesting and good to hear from Brett. And he named a couple of other banks as well that have started offering banking as a service, I think Colony Bank and lead bank and how they're really good on the digital front, but you're definitely going to make sure that you have that investment in compliance as well or later down the road, you're going to have a lot of catching up to do.

Nathan Stovall

Certainly, certainly. So who else rounded out that ranking?

Zain Tariq 

We had the large bank ranking. We had 149 banks eligible for the analysis in this one. We ranked top 50 in this bucket as well. The winner in this ranking was a Texas-based EB acquisitions company. It's the parent company of Mechanics Bank. It outperformed the median for all banks in the analysis and 7 of the 8 metrics analyzed, I think falling just slightly short on deposit growth. The bank announced the acquisition of HomeStreet, Inc. in a reverse merger transaction earlier this year. So it has made the news recently, a very strong deposit franchise. And number two, we had California-based CVB Financial, a $15 billion bank, $15 billion in total assets, very high focus on deposits. The company talks about banking high-quality customers who operate with excess cash balances and offers numerous banking products related to data management, fraud prevention and instant payments. And number three, another interesting bank, $14 billion in total assets, First Financial Bankshares, a name that consistently appears in our most expensive banks list. A very interesting bank as well. The company has one bank, multiple regions culture that they talk about, which basically consolidates its operations into 8 regions, allowing them to stay locally focused and build loyal relationships. And the model also enhances their efficiency and supports organic growth. So I think that's definitely something very interesting, which community banks are really good at, and it's good to see as banks grow in size, they continue to follow some of those strategies to basically win on relationships.

Nathan Stovall

You mentioned consistency and high-performer First Financial, CVBF was either the lowest or second lowest beta this tightening cycle, and they were the lowest in '16 to '19. So it's striking to me, you mentioned how some were past winners in January, too, a lot of these guys have been doing it right for a while and have clearly figured out a really good special sauce that works here. What other commonalities do we see across the rankings? I mean you just talked about some of the winners and you had mentioned earlier how we had some BaaS banks and some sellers, but what else do we see broadly?

Zain Tariq 

As you mentioned, BaaS bank, I think branch-like business models or you can say banks with a big focus on digital, which we have talked about for a while, how digital is becoming like really fundamental for the banking industry now. A couple of banks in the small bank rankings, and I think 4, I believe, in the large community bank ranking offered banking as a service. So I think these fintech partnerships are kind of paying off for a lot of banks, even if it's not just banking as a service, it's just partnering up with some fintech firms that's helping out and a big investment on the digital side of things. briefly mentioned the pros and cons of Banking as a Service earlier. Another thing that we highlighted was uninsured deposit concentration. So we have already kind of established now that in itself, these deposits are not really problematic unless they are concentrated in one sector and there is a liquidity need. But we did highlight those, and I think there were 8 banks with uninsured deposit concentration of more than 50% in our top 50 large community bank rankings. But I think the most common theme in all 3 rankings was M&A, especially for the large banks. 4 banks in our small bank rankings are merger targets showing how these deposit franchises are now attracting buyers. 5 banks in our large community bank ranking completed a whole bank deal in the last 12 months. And in our top 50 large deposit franchises, I believe we had 13 banks that completed a whole bank deal over the last 12 months ending June 30, and then we had 2 more deals closed after the conclusion of the second quarter. And there were 8 other pending deals among the top 50. So a lot of M&A activity going on there. And I think we could add one more to the list with PNC acquiring First Bank, which was also ranked among the top 50 large deposit franchises. I think on the geographic breakdown, I think there's no real surprises there. We had the most representation from Texas and California-based banks in all 3 rankings.

Nathan Stovall

Yes, certainly. I mean people pay up for quality. You mentioned First Financial being high on the list in terms of their price tangible book. A number of these banks that ranked high had great deposit franchises attracted attention from acquirers. And you and I worked on something very recently that we shared at the deposit conference that really dug into that, looked at the valuation disparity between targets as well as publicly traded banks based on their deposit composition and cost. And not a real big surprise, but banks with higher noninterest-bearing deposit concentration get higher values, banks with less rate-sensitive franchises get higher values. I mean we looked at that going back to 2019, but if you just even zero in this year, if you look at targets with the noninterest-bearing deposit concentration that exceeded the industry median, they received a median of 161% of tangible book. That's 29 percentage points higher than targets whose concentration was below the median. And as we talked about, those have been the most -- they are always most prized deposits and they've been hard to retain as we've actually seen them decline pretty considerably. Similar thing with the publicly traded group. At the end of August, if you look at those who were above the median on their noninterest-bearing deposit concentration, they were trading at 136% of tangible book, 29 percentage points higher than those below the median. And that outperformance, this really struck me because this is not just a new thing, but that outperformance has held all the way back since the third quarter of '22. It's been greater than 25 percentage points, those with higher noninterest-bearing deposit concentrations versus those lower. And similar things on the cost of deposit front, where if you had a less rate-sensitive franchise, lower cost of deposits, outperforming considerably both in deals and in publicly traded space, the spread being pretty similar, 25 to 30 percentage points of actual spread. And if you look at the highest priced deals, I mean, you just mentioned PNC, it's the most expensive deal this year on price to tangible book. If you look at the 15 highest price ones, 11 of those, the target had a cost of deposits below the industry median. And in that case, First Bank's noninterest-bearing deposit concentration also stood out 33% of deposits, about 11 percentage points above the industry median. True value of the franchise, it's what people pay for. No real shock there. You and I have run this analysis a few times. But it's interesting that it's holding so firmly even with the Fed expected to cut today and then maybe again later this year.

Zain Tariq 

The last thing you said was that we have looked at a really long period, and there always has been a correlation. But again, this analysis showed the importance of deposits and deposits representing a true value of a franchise and just the gap between how these quality deposit franchises are kind of outperforming the rest of the industry. That gap has increased since 2022, I believe. And that really also explains why we did these deposit rankings and the deposit conference. It shows the importance of deposits and how some of these franchises are doing great. Another thing that we did have in that analysis was -- we also looked at deposit growth, the quarter-over-quarter deposit growth, which did have a similar kind of a correlation as with the other metrics like noninterest-bearing deposit concentration or cost of deposits. And initially, I would have thought that there would be some correlation there because of the amount of volatility that we have seen in deposit flows. But if you really think about it, I think it comes down to the quality of deposits. In itself, it doesn't tell you much, but you need to look at other metrics to gauge the deposit performance. And that is what we try to do in our rankings as well. So you can keep your cost of deposits low, but does that mean you're losing deposits at a higher rate. Similarly, you can bring in broker deposits or deposits through M&A, but how much of that you can actually retain in the longer run?

Nathan Stovall

And did you buy it? Did you pay up for it? Is it hot money? Or is it if there was a lot of growth and it's warm money is one of the people at my table at the deposit conference said, maybe that's okay, but you need to look at them connected. And one of the thing, too, we did this analysis, we should run this back again, look at quarter-over-quarter deposit growth, whereas in the rankings we gave more of a focus on longer-term stability. And so if you've gone back 8 quarters, maybe you'd see a little bit, but it says investors and buyers are a little skeptical about growth in a single quarter, maybe certainly growth for growth's sake, to your point. You need to look at it connected to those other things. One of the things I want to talk about, too, though, I mentioned Brett Farr. He was one of the guys we had at the event who has a different model, but you spoke with Esquire Bank at the event as well. And one of the things that we found is that niches work. and particularly in terms of building the deposit business. Tell us a little bit about Esquire. As we close up here, I think that's a good way for us to focus that, yes, all this composition is there, but sort of how do you get there? One of the interesting ways we found in stream niches, what does Esquire do? How are they different?

Zain Tariq 

They target law firms, which is kind of complicated space, but definitely an underserved or you could say, overlooked market. So there was an opportunity there. Obviously, it comes with challenges. But if you're not following the crowd, you have to take that risk that the reward is great as well, and this is a great example of that. There is an inherent riskiness to the nature of the market when it comes to credit, but that's not really a deposit discussion. And I think Andrew Bank does really well. They do spend a lot of time and money on compliance and risk management. But they are a digital bank. So one of the things they focus on is having the right platforms and products and usability to serve their client needs. They can offer very competitive rates on loans as well as long as they can bring in the operating accounts, which helps them fund the business. So I think that is really the key. They have a very high noninterest-bearing deposit concentration as a result of that, roughly around 33%, very low reliance on term funding and strong average deposit growth of, I think, 4.5% over the last 2 years. The deposit efficiency was a little bit on the higher end. But again, when you're a digital bank, that's what we try to do with that ratio as well to basically account for all noninterest expenses. But I think that was the key to their success and makes them one of the best deposit franchises in the country. And I think one of the main takeaways from the discussion with Andrew on deposits was did not dime and nickel your customers.

Nathan Stovall

Yes, he talked a lot about -- I remember that about fees and not doing that. And the CEO, Andrew Sagliocca, and I want to go back to the fees thing, but I pick up on a few things you talked about that I thought were interesting, too. I mean he's a traditional banker. He's from North Fork, worked with John Kanas for years. And when he said he went into this, people thought he was crazy because this is lumpy. But basically, they understood the credit risk and that allowed them to actually price competitively. You'll have to remind me of the numbers, but I think it was we often see people pricing at 17%, 18%, but we can come in at 11%. And if you give us the noninterest-bearing deposit, maybe at 9%. So they can be really competitive and they've really understood it. And one of the other reasons why they can be competitive and offer that and win that business was the fee component as you talked about, not nickeling diming. What do you have to say about that?

Zain Tariq 

Yes. Yes, definitely. I think he mentioned that 19% and then he was asked if he can beat that rate. And it's like, I can definitely beat that rate if I'm bringing in all those deposits. So I think this is how he's running the business. And if you are bringing in enough deposits and you can maintain that relationship over time without having to worry about rates, why charge them $100 and risk that relationship. And I think this was also something that was referenced multiple times during the conference once Andrew mentioned it.

 

Nathan Stovall

Yes. We heard it from a number of other bankers who were there, right, including some who won awards and said, yes, we think it's just silly. And it's interesting because the holy grail for community banks is fee income. So I get it, but they're saying, who cares if it means you end up with this fantastic deposit base, you can find assets. You don't even need great lenders necessarily you can go buy them if you've got this envious deposit base.

Zain Tariq

Another thing that we did here at the conference, I think, kind of related to this was I found that very interesting, like do not try and win or satisfy customers on rate, try and win them on relationships. And I think this is one of the ways you can do it. If you can't offer a really high rate, you can definitely come up with other incentives or try to maintain that relationship. And obviously, that's what makes these deposit franchises different and unique. If everyone was able to market 5% CDs right now, we wouldn't have any deposit competition. I think that's what they're really good at, and that's what makes a successful bank. 

Nathan Stovall

For sure. And to your point, too, not just stay away from rate, but we had some good data and some analytics from some of the folks in the consulting community talking about how rewards programs can really work. But then we also heard on the product side, a great panel to close the event from a couple of treasury management professionals, Josh Fogel at S&T Bank, Kelly Dulle at First Bank and Len Devaisher at MidWestOne Bank, really just talking about -- thinking about the full relationship to your point. And if you're able to do that, then you can really compete. Whereas if you're leading with rate, then the only thing you've attracted the customer with is, again, that rate. So they're going to be more rate sensitive. So what you need to really do is just employ your people and get products in front of them, and that's how they get really, really sticky. I feel like we heard that a whole bunch.

Zain Tariq

Definitely. 

Nathan Stovall

Well, I think it's a great place for us to leave it. Tim, thanks so much. Really enjoyed the conversation, really enjoy the event with you. Look forward to doing it again.

Zain Tariq

Thank you for having me.