Stimulus measures early in the pandemic injected massive amounts of liquidity into the economy. Meanwhile, many businesses feeling the uncertainty of the market have opted to park that money for now at their banks. What are banks doing with this glut of deposits? And does this mean they may actually turn away future deposits?
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Jim Young: Hi and welcome to the Purposeful Banker, the podcast brought to you by Precision Lender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, Director of Content of Precision Lender, joined again by Dallas Wells, our EVP of Strategy.
Couple of episodes ago, we devoted a podcast to this question which was, is commercial loan growth possible in 2021?
I won't go over all the material now but the too long, didn't read version of that is yes it's possible, but it won't be easy. You can listen to the rest of that episode for all those details.
That brings us back to today's episode. It's about deposits, which are obviously inextricably linked to the loan narrative and if we were asking about whether it was possible to grow commercial loans in 2021, well then that'll, today's episode should come as no surprise.
Does anybody want deposits anymore? And Dallas, I actually went back in the memory banks as I was putting together this podcast and thought about one I recorded a couple of years ago with Tim Shanahan and I got a chuckle because it was titled the Fierce Battle for Deposits: Who's Winning And Why?
So first, before we dive into today's thing of, does anyone want them, can you take us back to that time and remind us why deposits were so highly prized?
Dallas Wells: So, Jim, it strikes me now that you've now officially been talking about the baking business through a cycle. So you're now seeing all aspects of this. Yeah, congratulations, I guess. It was just a couple of years ago but banks were starting to get, at least compared to where they had been following the financial crisis, to a somewhat highly levered spot. So loan-to-deposit ratios were getting a little high. Some of those banks were getting some pressure from regulators to increase core deposits and to really stabilize their funding base and that doesn't have to happen in too many places, in too many banks in the market for competition for those deposits to really heat up. You could see evidence of it in all the premium, high yield savings accounts, all the online versions of those and sort of the highly visible, highly public rate battles happening there.
It's because those deposits had a lot of value. They had a ton of value to a few banks that really desperately needed them and so that drives up the price for everyone there. It typically is part of the economic cycle and as things are running really well and businesses are reinvesting a lot of their cash, they don't keep a ton of deposits around because there's better uses for it and so that's where we were again, not all that long ago, but where deposits were hugely valuable and there was tons of competition for them.
All right. So now let's fast forward, really again about literally 24 months or so, back to today and to the article that inspired this podcast and it's from S&P Global Market Intelligence. The title of it is, U.S. Banks Moved to Deflect Unwanted Deposit Inflows
And so Dallas, you kind of told us, explained to us of how we got to that point, where there was a fierce battle for deposits. How did we then, in the 24 months, get from that point to this point?
Dallas Wells: Yeah, and really we're talking about our two conversations being 24 months apart. The change actually happened much faster than that and it was bad exactly one year ago. As the pandemic hit, things just changed and economically they changed as abruptly as we've ever seen before.
We got a compressed cycle time. Now those things do swing and we'd been kind of long in the tooth. We actually talked about, are we getting nearer to that time of sort of if there is such a thing, a natural recession, natural correction in the economy and the pandemic just kind of compressed all those timeframes and sped it up.
So, part of it is just in a good economy, people reinvesting their cash. In a bad economy where there's high risk, people and corporations tend to sit on their cash. It's the more conservative thing to do is to up the liquidity levels and that means it sits in the bank.
On top of that, this time around then we've had all the stimulus measures. And I think both this time around and in the financial crisis of 2009 and all the Fed actions following, we've seen the monetary policy response to both of these recessions be unlike anything we've seen before there either. So massive amounts of liquidity injected into the system by the Federal Reserve. Some of that goes directly into the banking system. Some of it goes to other places too, but it ultimately tends to land in the banking system and so even the direct payments through PPP or stimulus payments, those land in a bank account somewhere.
So as the article points out, massive multi-trillion dollar growth in deposits and specifically in transaction accounts that are low cost; so checking accounts, savings accounts, those things where the money is literally just sitting there as a part of a rainy day fund in many cases.
Jim Young: Okay and I'm going to tiptoe very carefully here because I don't want to necessarily seem like I am discussing the pros and cons of federal policy, but the idea of we got to inject some liquidity, we've got to give basically make it easy for people to get a hold of money and then they turn around and take that money and just park it somewhere. It makes me wonder how much we needed to get money for them to get a hold of. If I'm oversimplifying it, let me know.
Dallas Wells: Over simplify and I'm sure misstate some things here as well, but there's really two big components to a fully functioning economy when it comes to money in the system. Number one is the supply of money in the system and that's what the Fed can control pretty well. They have, nowadays a digital printing press, they can, there's all kinds of memes that you can find that have jokes this, but they push the button and voila, instant money.
The other component though, is velocity and I think that's really what you're getting at, is how is that money actually flowing through the economy? That's the one that's much harder to actually, for the Fed to actually control and to actually force. That's why, where you hear a lot of the policy discussion around, "Well, where should this money go?" And it's a combination of where is it needed and also who's actually going to spend it.
That's part of what's been really interesting about the response to this particular crisis is because of how quickly it's all happened and the need for a speedy response. The policy response has been to err, on the side of, when in doubt, just send money. So what you ended up with was a lot of people who basically got forgive the phrase, but got bailout money but didn't need it. Who, so got stimulus payments or got PPP loans and didn't necessarily need it to survive, but they're like, "Hey, it's either free or cheap money. I'll take it just in case and then I'll sit on it." That's what I think a lot of the discussion now is around later rounds of the stimulus is can we get more targeted with it?
Again, yes, it's partially need, but it also is because who will actually take that money and go use it on something, go buy something with it and then it flows through the economy. Somebody has to build something. Somebody has to sell something, somebody operating a storefront for that to happen. That's the actual business activity thereafter. That's probably as deep as you and I want to get into Econ 101, but that's the basics of it.
Jim Young: All right. I'm going to gingerly step away from deciding public policy on this podcast here and go back to more of the banking sort of stuff.
So, all right, thanks for getting that inflow of this capital. Right as they're seeing a point where they, as we discussed before, increased difficulty in finding outlets for it. So pretty simple to stop taking deposits. We're good. Wrap this podcast up.
Dallas Wells: Just lock the doors and nobody comes in. That's the tricky part with rates where they are. In prior banking cycles, you could push your rates low enough where that's effectively what you did. As you said, "All right, no more deposits. Everybody else is paying three or 4%. We'll pay one. Our loyal customers will stay. Nobody else will park any money here." Well, when the difference is instead of 3%, 1%, it's like 0.02% or 0.07%, who cares. Nobody's going to notice or basically you can't go low enough to influence money to go away, that way.
With a - and I'm sure we'll get into this - but for now an effective zero bound, everybody's in kind of a similar neighborhood as to what they pay on deposits. The other tricky part of this is that most of this growth is not like from new accounts being opened. It's not like you got new customers out of this. It's just that your average balance per account went way up and as this article pointed out, a very large chunk of this deposit growth was from commercial deposits.
So it's from existing commercial customers who are your best, long-term most profitable customers, many of them because they carry big deposit balances with you. You don't really have a great outlet to go to them and say, "Hey, I know we've been begging you to bring us more deposits for the last eight years. Now that you finally did, can you please take some of those somewhere else?" So the reality is, is that banks are stuck with a lot of this and with another stimulus package in route, there's just, there's more of it coming, There's not a lot of ways to stop it. It's just going to have to be like, "Okay, well, what do we do?" Knowing that that's the reality that those dollars are going to be here.
Jim Young: Yep and that is essentially the next question I was about to ask. You've got that long time, valuable, large commercial client come to you and said, "Hey buddy, here's some more deposits I want to bring on board." What's the conversation you have there where you can't say no. Is there something else, any other options you can put out there? Can you slash, should you have a transparent conversation about this too of, "Like, listen, I understand why you want to bring them here, but let me explain to you why this is not great for me and so therefore let's do X."
Dallas Wells: There are some of those conversations that happen. These are typically some of your best customers. You have good relationships with them and you can kind of say, "Hey, is there somewhere else that you can park this?" And we've actually seen some banks do kind of a reverse tiering of the rates that they pay, or the credits that they give, depending on what kind of account we're talking about.
We're typically as you go up in volume or up in balance, you get bigger rates paid and bigger discounts on things. And instead, they're kind of doing the opposite where they're saying, "Hey, for kind of your typical level of accounts, here's the business terms. If you bring me a bunch of extra, the terms actually get worse for you." So you can still bring it. It's just not as beneficial to you to do so.
That's effectively, through business terms, having that same conversation. We don't love the fact that you've got an extra 600 grand parked in your account that isn't usually there. Or for some of the very larger, where a lot of this is coming from, from your very, very big deposit customers where it's like, there's an extra 30, 40, a hundred million dollars there. That's where it's like, what do we do with this? Especially when they could, at any point, use big chunks of that money for something else and it goes away. You can't effectively invest it very well.
Really, I think the key here is that deposits and those deposit relationships, although the value of those will move up and down through the cycles, the short term measurements of those, move all over the place. And right now actually, we've gotten lots of questions from clients where they're saying, "Hey, we, plugged these deposit accounts through the math engine here and as we model it out, these deposits actually, so that they have a negative value. We're losing money on them." Like that's probably the reality. In some cases that's the mathematical truth is that you are losing money based on today's circumstances to bring those deposits in house.
So instead you have to look at the deposit business as a much longer term, sort of franchise value proposition and what we saw through the last cycle was that there were some banks who said, there's red numbers involved here, red ink involved in doing this right now, but we know that over a 20 year timeframe, the banks that have lots of cheap funding do the best.
So when everybody else is doing one thing, we're going to do the other, we're going to go grab those deposits while we can. That's going to be our strategy.
Yeah It's, basically you went right into a couple of different questions that I had on this and one of those was, could we see, I think I put in my notes, Beal Bank, because we talked about that one time in a previous podcast, a different story
about how these kind of zigged, when a bunch of people zagged in the market. And I'm not sure if it's applicable because some of the stuff we're talking about are enormous commercial accounts, but is there an argument for a bank to say, "Yeah, the short-term, these things are not great, but A, we know that long-term, it's good to have this low funding and B, if we think we can pick off some customers and say, listen, come on over here, we'll offer you this much more for your deposits if you bring over..."
I mean, I guess it'd be sort of like a reverse kind of thing where if you then, your next loan goes with this, it feels like we're usually doing, we'll do the loan if you give us the deposit. But this is like, we'll give you... We'll let you part deposit so if you do a loan, can you do that? Or maybe could you only do it at a private bank where you don't have to have a shareholder and an analyst call where you try to explain why you're doing something that looks very unprofitable right now.
Dallas Wells: Well, I think the benefit to taking some of those counterintuitive, maybe strategies like that, is that you do have the cover of a really tough environment. So in other words, I think it's okay for your margins to look a little ugly right now because everybody gets it.
So yes, there may be, I'm sure there will be some short-term pain in the stock price. There will be some grumbling about it but it is understandable that like, Hey, it's part of the business model. This is what happens when things look like this. Everybody else is in a similar boat, maybe not to the same degree, but basically you've got some cover to go make some strategic decisions like this.
We are seeing banks get now, again there's only so much you can pay for deposits, but for commercial accounts, the treasury cash management kind of business that goes along with a lot of those deposit accounts and is the driver of so much of the profitability. We're actually seeing some more competition there, under this exact approach, where there are some banks saying, "Hey, right now, while maybe that bank that they're at is going to be a little less likely to really dig in their heels and defend it because they don't desperately need the deposits right now, let's see if we can pick it off." And maybe that is more aggressive tiering and structuring and pricing on their, on their treasury business. We don't need the balances so much, but we'll always take that fee business.
We are seeing that and it's basically where some of these... those are hugely valuable prized customers and I think a lot of banks are looking at this and saying, "Look, this may be a once in a decade or more opportunity to maybe pry a couple of those loose, that we won't otherwise have the chance at, because no matter how aggressive we went in there and got, the incumbent bank would be like, it's fine. We'll match. Just don't leave." And now you may actually have the chance where they'll say, "Yeah. All right. Fine. I can go."
So I think we are seeing some of that and I think that's, every bank if they're not going to do it, should at least be discussing it. Run the math on it a little bit. See what you feel like you can tolerate and this is one of those times where you got those prospects that you've had on your list for maybe forever, wanting to go after and pick them off. And you know, they're a trophy client; go take your shot. The bank is drowning in all these deposits and is thinking, "Man, there's just too much of this. If some of it ran off, I wouldn't be that upset." Maybe this is the day that, that offer sheet should come across their desk. And they're like, "Fine. At those terms, just let it go." And it's a good long-term play, so I think that's perfectly reasonable.
Jim Young: Okay. You mentioned within that again, what we're talking about here with that reasonable, because as you mentioned, it's long-term. It's really, really cheap source of funding but I'm thinking about that in terms of what we keep hearing about is his margin compression and boy it's... Margins getting really tight.
I guess my question is, is yes, when you're talking about something, LIBOR or to Prime or something like that, but with again, the funding we're talking about is really, really cheap and you patiently off-air explained this... Some of this how it works. I won't make you go through that but essentially, are banks factoring that in the fact that, "Hey, this funding is really, really, really cheap that we're going to be using on this." Or, are they too caught up on the lending side for what the margins are? If that makes sense.
Dallas Wells: Yeah. I think what you're asking is basically is, is all this stuff sort of changing the appetite for new business and that's on both sides on, on deposits and on loans.
Effectively what's happening is, because of the level of deposits that everyone has, your appetite for things to do with those deposits goes way up. I would love to have more relatively high yielding assets to put on my books. I don't want to go buy treasury bonds and agency mortgage backed securities and things that essentially have no yield. That doesn't keep the lights on for me, so I would love to have more loans. So those hurdle rates on those loans, that number that's sort of mysteriously was set sometime back in the, I don't know, the 1950s and nobody's changed it since then. Nobody even knows how to go about such a thing, this is where those banks that can do that a little more dynamically, do have an advantage because they can say, "Look, we've got liquidity sitting around everywhere. We think it's going to be here for a while. Let's get a little more aggressive than we normally would, but let's be really targeted about it.'.
It's not an across the board, put the yellow banner in the parking lot loans are on sale kind of approach, but it is for certain kinds of customers in certain industries, in certain markets, we want to be more aggressive. Well, reduce your ROE targets or your hurdle rates there, so that they're easier to clear and they're easier to clear through maybe tighter spreads, maybe reducing fees, maybe waving some stuff that you wouldn't otherwise wave, but it gives your banker some flexibility to do just that, to get a little more aggressive and go chase good business.
In areas that are still high risk, or you just don't want any more of it, or heck maybe it's an industry that typically brings along lots more deposits with it again, leave the targets where they are. We don't have the appetite for that. But those should be dynamic strategy changes that you can make on the fly and a lot of banks just plain can't. They don't have the infrastructure in place to do that and it shows, where they're just like they end up making all these exception, pricing exception decisions on a one-off basis, and they have a whole lot of executives on the credit side of their business, who that's their day now, is doing exceptions for all the deals that they're either trying to bring in, or that they're trying to protect from the other equally desperate competition.
There is a better way to do that. You don't just have to spend all day in your inbox saying "Yes, approved. Yes, approved. Yes, approved," to all those pricing exceptions. But that does take some effort to set that up, up front.
Jim Young: All right. So one more question and I feel like I should almost whisper this one, but you talked about you before about, Hey, these gains are as low as they can go and I guess my question is, is that actually true? Could we go even lower? Could we even go negative rates on this sort of thing? It feels like crossing the streams from Ghostbusters.
Dallas Wells: It does. If you sit down and try to think about it does break your brain just a little bit, as you get kind of deep into all the implications that that has for a bank balance sheet. That said, it's not unheard of. There are places in the world where this is true today, in parts of Europe and in Asia, there are markets where they're operating with essentially negative rates.
It's still a spread business when you get right down to it. So mathematically, whether there's a negative sign in front of it or not, shouldn't really matter, as long as there is a spread between the deposit side and the loan side of the house, when you get just down to the super simple view of it.
Now here in the states, most of the banks that we work with, it's been hard enough for them to get their systems updated to where they can price on something besides LIBOR Like, okay, let's add SOFR. Well, great. But that's calculated in arrears is the... So it's a backwards looking index and that's ... I won't get into the nitty gritty, but the systems weren't designed to handle things the way SOFR works and so it's led to some, to the need for some changes to the systems, to the core accounting systems in a lot of cases, and that is always a nightmare, especially for the larger banks that have been really put together by a series of dozens of mergers over the last 80 years. The tangled web of systems for things like rate changes is really, really complicated, more so than you would imagine.
So many of those also, they just plain don't have the ability to put negative rates in and we know that because we've had some clients who are going through projects where they're saying, "Hey, the risk and compliance team, has sent us around to all the systems that use interest rates with the simple question, does your system operate with negative rates?" And it's a yes or no. And we're just kind of taking a tally. And there are a whole bunch of systems that just can't handle negative rates.
When they were created in the, some of them in the 1980s and prime was at 14%, a negative rate didn't seem like something that we needed to worry about. In fact, it was put in as a check, right? Make sure it's a positive number in that field. Theoretically, yes, we could do it. It works. It's has worked other places.
Pragmatically, if you went to the bank and said, "Hey, on all of our loans right now, where we're charging 3%, make it so that we're charging negative 1%." I promise you the systems will crash. So pragmatically, we're a ways away from being able to do that. But the more time we spend near zero, it causes more banks to go research that, to go request from their vendors that they add the ability to do that just in case. We're getting closer to that being a reality. We're not there yet, but I think it is something that banks should be preparing for, should be ready for, should be thoughtful about and to just, again, remember it as a spread business and we just need the systems to be able to maintain that integrity.
Jim Young: All right. Well, I'm going to go ahead and wrap this show up before you try to, and don't think I didn't notice it, steer the conversation towards LIBOR. That was, I'm not going-
Dallas Wells: You can only avoid it for so long.
Jim Young: I know. I know. I'm gritting my teeth. I know we're going to need another LIBOR podcast coming up soon, but that is not today. Today we will stick with a theoretical net negative rates.
Okay. That will do it for this week's show. Dallas, thanks for coming on.
Dallas Wells: You bet. Thanks Jim.
Jim Young: And thanks so much for listening and now for a few friendly reminders, if you want to listen to more podcasts, check out more of our content, you can visit the resource page, precisionlender.com or head over to our homepage to learn more about the company behind the content.
If you like what you've been hearing, make sure to subscribe to the feed in Apple podcasts, Google Play, or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young, Dallas Wells. You've been listening to Purposeful Banker
About the Author
Jim Young, Director of Content at PrecisionLender, is an award-winning writer with experience in a range of positions in media and marketing, from reporter to website editor to content marketer.
Throughout his career Jim has focused on the story – how to find it, how to understand it, and how best to share it with others. At PrecisionLender, he manages the many ways in which the company shares its philosophy on banking and the power of relationships.
Jim graduated Phi Beta Kappa from Duke University and holds a masters degree in journalism from Columbia University.
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