Will Long-Term Effects of Deposit Surplus Speed Banking Consolidation?

During the pandemic and well into the recovery depositors have socked away trillions of dollars while business borrowers find themselves hamstrung by supply chain disruptions. By some estimates it could be two years before the situation evens out, and by then the profit squeeze could force more institutions to sell. Some institutions are countering with aggressive strategies.

More than a year since deposit growth began to soar, financial institutions remain flooded with deposits and loan demand has remained stubbornly low, putting pressure on net interest margins. But that’s only part of the difficulties banks and credit unions face.

Corporate and commercial borrowers, which are expected to lead a recovering economy, are themselves faced with a severely disrupted supply chain, meaning even if they wanted to borrow grow their businesses, they’re stymied by a historic lack of materials. As a result, many recipients of Paycheck Protection Program loans, worth trillions of dollars through the past year, have parked those funds in deposit accounts instead of disbursing them back into the economy.

Key Question:

Will declining net interest margins discourage financial institution investors and subsequently accelerate industry mergers?

On the other hand, while acknowledging what some call an unprecedented economic challenge, financial institutions have found ways to deal with excess liquidity issues throughout the pandemic period. These include boosting efforts to attract new customers, entering new markets, increasing marketing to generate new loans, deemphasizing deposit products, even shifting deposits off of balance sheets. In addition, banks and credit unions have pursued new lines of business.

“I don’t think many of us thought that a year after the pandemic [started] that our balance sheets would be substantially bigger,” observes Jill Castilla, CEO of Citizens Bank, Edmond, Okla. Although, as she points out, excess liquidity is a better problem to have than the opposite.

“It always used to be deposits, deposits, deposits, and loan growth upon loan growth,” says Robert Kunisch, president and COO of Howard Bank, based in Baltimore, who has been in the business for more than 30 years. “And now we find ourselves awash [with cash].”

Though not as dire a situation as lack of liquidity, bankers appreciate the serious impact of the situation. “[Clients] just don’t need the money today and I think until they’re able to start building inventory here, we’re going to struggle,” said William Demchak, CEO of PNC Financial Services, during the Bernstein Strategic Decisions Conference.

How PPP Loans Helped Drive Down Margins

The numbers tell the stark reality: In just 14 months the total amount of deposits in commercial banks went from $14 trillion to $17 trillion, as of June 2021, according to the St. Louis Federal Reserve Bank’s FRED economic database. Ellen Zentner, Managing Director and Chief U.S. Economist at Morgan Stanley, estimates that between March 2020 and April 2021, U.S. households built up about $2.2 trillion in total excess savings.

Highly liquid bank balance sheets

March 31, 2021
($ billions)
QOQ change YOY change
Total loans $10,825 -0.40% -1.20%
Total loans (excluding PPP) $10,356 -1.00% -5.50%
Total securities $5,479 7.20% 30.20%
Total fed funds and repos $298 11.50% 4.40%
Interest-bearing balances $3,357 14.80% 54.20%
Cash & noninterest-bearing balances $271 2.80% 18.00%
Total deposits $18,459 3.60% 17.00%

Source: S&P Global Market Intelligence

Meanwhile, loan balances dipped 1.2% year over year (or 5.5% when excluding loans made through the Paycheck Protection Program). Median net interest margins dipped to 3.31% in the first quarter 2021 from 3.37% in the fourth quarter 2020, while the median among the 20 largest U.S. banks fell to 2.10% from 2.18% in the prior quarter, according to S&P Global Market Intelligence. The industry’s loan-to-deposit ratio dropped to 58.64% in the first quarter 2021 from 69.48% a year earlier.

A big source of the deposit influx has been the disbursement of PPP funds to bolster small businesses through the pandemic.

Best Laid Plans:

The theory was that recipients would plow PPP funds back into their companies and communities. Instead, many parked the funds in deposit accounts.

“We isolated all those PPP loans into new checking accounts to do our best to attempt to track how our customers were utilizing those funds,” says Kunisch. “The challenge was, some customers would move them instantly into their main operating account.”

What Could Accelerate Consolidation

Lurking in the background is the specter of a profit squeeze, which could have serious consequences.

“A bank’s not going to fail because it doesn’t have the same amount of loans that it had before,” Josh Siegel, Founder and CEO of StoneCastle Partners tells The Financial Brand. “But a bank will see its profitability dwindle. If that happens, what investors are going to come in?

“If the rate of return isn’t attractive enough, then eventually shareholders will decide to get out, which dries up capital and drives banks out of business.”

— Joshua Siegel, StoneCastle Partners

“We’re not going to see trillions of dollars in additional household and business savings absorbed by loan demand overnight,” says Greg McBride, chief financial analyst at Bankrate.com. “That’s why you’re going to continue to see consolidation in banking.”

The key is how long financial institutions must wait for an increase in loan demand. “Margins have definitely been squeezed but the economy is ramping up,” McBride states. “So the potential that we see in an increase in loan demand does have some promise for those financial institutions that are sitting on a surplus of deposits.”

In the short term, he says, part of the strategy regarding getting deposits off a balance sheet is to start pricing them noncompetitively and increasing marketing for loan products. That’s one avenue Howard Bank has taken.

Before the pandemic the Maryland institution actually sought new funding for its mortgage company by offering promotional rates on CDs, “Now, we’ve let those just run off or stay on the books but renewed at a significantly lower rate,” says Kunisch.

But that only goes so far, says Siegel.

“We have a lot of banks that have said [to customers] not only do I not want new money, I’m going to close out your account,” Siegel says. “We have others who just said I’m going to pay nothing, and the money is still coming in, because where else do you go?”

Business Loans Will Be the Key

Another approach for shedding deposits is to arrange with companies like StoneCastle and IntraFi to place deposits from high-balance depositors with a network of other banks. That’s what Planters First Bank, Perry, Ga. does. “The benefit to the bank is that we maintain the relationship but can move the funds off the balance sheet as needed,” says Dan Duchnowski, chief marketing officer.

But even StoneCastle’s Siegel says that’s not the whole answer. “There’s no yield,” he says. Also, according to both Duchnowski and Castilla, who also has made use of these options, sometimes they’ve become fully subscribed and not able to accept more deposits.

All these bankers point to commercial and industrial loan demand as key to the economy’s rebound as well as their liquidity situation. But many businesses are faced with raw material or product shortages due to major disruptions in supply chains, leading to a lack of everything from microchips to plywood.

“The largest component to loan demand is going to be inventory builds, which isn’t happening yet,” says PNC’s Demchak. “You look at sales-to-inventory ratios, they’re as low as they’ve ever been.”

“A good example is the lumber industry,” says Castilla. “Right now costs are exceptionally high, which is driving the cost of home prices up and driving down supply of new homes.” McBride says this situation should work itself out in the next 12 to 24 months, eventually leading corporations to pursue funding of new capital investments.

Read More: How One Community Bank is Reinventing Itself for Future Relevance

Making Whatever Adjustments You Can

Pushing back against this headwind, Howard Bank decided to aggressively expand its market area with a new sales team that brought with it a number of long-term relationships. The result was record loan originations in the fourth quarter 2020 and first quarter 2021. In addition the bank’s correspondent mortgage lending group, started in September, has been successful in backfilling the refi runoffs in its portfolio by focusing on jumbo mortgages, according to Kunisch. The $2.6 billion-assets bank also invested in broker marine operations, prevalent in the Chesapeake Bay region, “Just in time when everybody in America is buying a boat,” says the COO.

The much smaller Citizens Bank hunkered down on its core competencies. “We’re a very traditional community bank,” says Castilla. “We have a lot of small business customers dominated by consumer depository accounts, and then some larger kinds of business accounts. On the lending side we’re primarily commercial real estate lending and small business lending.”

Her bank, which has assets of $352 million, does do consumer lending, but that area has been soft. The low supply of new and used cars results in flat lending opportunities.

Even so, Castilla sums up a hopeful outlook among the bankers interviewed here: “I think there’s a lot of optimism in the economy about our ability to recover. There’s just so much pent-up demand that the main concern is the supply chain and when we can get that stabilized.”

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