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PCBB Banc Investment Daily November 26, 2013
Banc Investment Daily
November 26, 2013

Singing About Bank Failures and Cost of Funds

We saw that 1960's icon and Canadian musician Joni Mitchell is having her 70th birthday. She's an artist we enjoyed as a kid and into adulthood, as her intelligent style migrated from folk to jazz and beyond. Her talents covered a broad spectrum as a singer/songwriter. She influenced artists such as Madonna, Prince and Led Zeppelin, and was known during her most popular era for her frank and sometimes brutal criticism of her colleagues. She also turned the same criticism back on herself with scathing autobiographical lyrics--it seemed no one was exempt from dissection.
It's never fun to be criticized, but a little banking industry self- examination to find the causes of failure and weakness is a smart thing to undertake, as there are lessons to be learned. Over 400 banks have failed since 2007 and much of the blame was placed on problems in the credit portfolio. However, one of the other ingredients in the failure of many of these banks was a high cost of funds and wholesale funding.
In our current times of high liquidity, we have to pause and recall what business was like in 2007; loan growth was through the roof, and many banks could not keep up with the deposit growth. As a result, many banks used every available avenue to bring in funds: Brokered deposits, FHLB advances and CD rate specials in banks' own market footprint were all common. We know all of these funding sources cost more than core deposits, but times were good so bankers really didn't care very much. As long as loan growth continued, everything was mostly okay.
Looking back at banks that failed, we wondered just how high the cost of funds had climbed in these banks. Our analysis found the median interest bearing deposit (IBD) cost of funds (COF) ranking for these 421 banks was in the 90th percentile. Clearly these banks' cost of funds was problematic, and that in turn drove behavior that one could argue was a search to find enough margin to overcome those high costs, ultimately resulting in taking on riskier and riskier assets. Then, when credit portfolios began to crumble, the wholesale funding base began to erode. Without a solid base of core deposits, these banks could not find merger partners given the credit crunch and for some, the FDIC could not find buyers.
That was then, and the cost of funds is much lower now. As such, many banks may feel there is not much more to be done on that side of the balance sheet. While it is true that few banks carry brokered deposits and high rate specials have mostly gone away as banks are very liquid--memories fade. The key to success is to remember this lesson and recall that work on funding costs must be constant. This is one of the few areas banks can control and it has a big impact on your loan performance; consider that banks with solid core funding can make a reasonable margin with a lower lending rate given lower funding costs.
There's a lot more to funding than a tweak here and there, and it takes an institution-wide approach that begins with management and ends with the most important work being by sales staff. Give PCBB a call to find out how we can help your bank improve earnings now and reduce interest rate risk in the future. Banks that have higher funding costs than peers are at a disadvantage when it comes to the rate you can ultimately accept on a given loan, so take steps now.