Brian Mischel

Core deposits, by definition, are those deposits that either don’t bear interest, don’t reprice in tandem with market rates or reprice more favorably than market rates at the time of repricing. Accordingly, core deposits are traditionally a lower cost of long-term funding directly affecting bottom-line profit. Generally, core deposit inflows will have a positive effect on the bank’s interest rate risk profile and bottom-line profitability by enhancing margins, noninterest income and potentially the bank’s ability to compete for and retain loan customers.

Balance Sheet Management

During periods of slow loan demand, increasing core deposits can allow banks to focus on overall balance sheet management. A strong foundation of core deposits reduces dependence on alternative funding sources, such as brokered certificates of deposits and Federal Home Loan Bank advances. Core deposits have a predictable cost, imply a degree of customer loyalty and are less interest-rate sensitive than alternative funding sources. Dependence on noncore funding may constrain liquidity, heighten interest rate risk and subject a bank to increased credit risk to preserve interest margins.

The overall funding structure and loan-to-core-deposit ratio can be significantly improved during periods of slow loan demand. The size and stability of core deposit positions affects asset/liability management risk. Periods of slow loan demand can allow banks to significantly reduce exposure to the risks associated with noncore funding. The net noncore funding dependence ratio measures the degree to which a bank is funding longer-term assets with noncore funding. The following graph illustrates the noncore funding dependence ratio in recent years for all banks in the nation.


Information per Federal Financial Institutions Examination Council (FFIEC) Uniform Bank Performance Reports

Increasing values for this ratio generally indicate declining liquidity, as experienced by many banks in the liquidity crisis of 2008. Higher ratios reflect a reliance on funding sources that may not be available in times of financial stress or unfavorable changes in market conditions. The cost of core funding in recent years adjusted nominally in response to movements in market rates, demonstrating the cost of core funding is less likely to react unfavorably than noncore funding during adverse business conditions. The following graph illustrates the cost of funds for different products in recent years for all banks in the nation.


Information per FFIEC Uniform Bank Performance Reports

A large quantity of core deposits allows banks to hold higher-yielding, longer-term assets without incurring undue interest rate risk. High levels of stable core deposit funding provide an institution with significant control over its interest rate risk profile and reduce interest rate risk. Bank regulators consider the strength of core deposit positions in assessing a bank’s overall interest rate risk profile.

Multibank Holding Companies

Multibank holding companies have unique opportunities to manage their balance sheet. Loan demand for banks within a multibank holding company can be shifted from banks with excessive loan demand to others with minimal loan demand through sales or participations. Subsidiary banks with a stronger base of core deposits can fund liabilities for other banks in the group. Such transactions within a multibank holding company can create efficiencies, reduce risk and increase earnings potential.

Supplementing Retail Banking Product Development

Core deposits represent reliable sources of fee income and opportunities to cross-sell other products. High-performing banks typically develop and market other products to enhance core deposits and offer their customers a greater variety of products and services. Most banks perceive this broadening of the products and services as essential to remaining competitive with other bank and nonbank competitors. For example, many banks offer cash management services for business customers, remote deposit capture, insurance services, repurchase agreement related products and other point-of-sale products. These products also serve to compete for and retain loan customers. Ultimately, inflows of core deposits breed a customer base, which generates noninterest income through increased transaction volume, related retail banking product sales and eventually an increase in loan customers.

Considering Customer Demographics

The demographics of the bank’s customer base can affect loan demand market share between competitors in the same market. Focusing on demographics of core deposit customers may enhance the bank’s ability to compete favorably and retain customers, including profitable loan customers. Focusing on demographics of the bank’s market and offering products that compete favorably for desired segments of the market can help a bank gain market share as loan demand returns. A bank can use a variety of implicit and explicit pricing structures for its core deposit products, including tailoring product features and pricing to attract a customer base with demographics considered to be more favorable or desirable in periods of increasing loan demand. For example, a bank may waive certain account fees for retail customers who maintain minimum balance requirements. Commercial customers may be given an “earnings allowance” for demand deposit balances kept in lieu of paying account fees. A bank also can tier pricing strategies to separate its customer base into high-balance, rate-sensitive customers and low-balance, rate-insensitive customers.

Increasing Franchise Value

Although premiums paid for core deposits vary from deal to deal and period to period, banks have realized significant premiums paid on core deposits. Thus, enhancing core deposits builds up a substantial off balance sheet asset, which can be realized through the sale of branch locations or whole bank itself.

The current banking crisis will likely have a prolonged effect on deposit insurance premiums and assessments. The impact will be enhanced as the assessment base comprised of deposit liabilities grows. The current environment also may generate a negative spread on deposits for some banks because of the soft loan demand. However, the competitive, risk management and profit enhancement benefits of building core deposits in a low to moderate loan demand environment far outweigh the drawbacks. Developing a strong core deposit base will better position banks for long-term success.

This article first appeared in the January 2010 issue of BankNews. Reprinted with permission.