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There has been a lot of news in the financial press this week about banks' financial performance, as they start to announce earnings for the third quarter and the year to date.

Wells Fargo "disappointed" the investment community by missing consensus estimates of earnings per share by a penny--a small percentage difference in an aggregate total of $4.1 billion of net income.

But the interesting sub- headline to me was the slippage in the bank's net interest margin. With short-term rates maintained by the Federal Reserve at a relatively narrow spread above zero, one can appreciate the problems of negotiating the current environment in such a  way as to produce relatively stable and, hopefully, an increasing net margin into future quarters.

This is part of the problem that former Federal Reserve Bank of Kansas City's president, Tom Hoenig, subject of a recent blog, has been talking about for the last year and a half.

To his way of thinking, the artificially low interest rate environment is creating the raw material for funding new credit bubbles in the national economy.

To me, though, trained the "old fashioned way" on the value of core deposits, I wonder if the major impact of this phenomenon will be in a very different direction.

Banking's old answer to "chicken or the egg?"

At the start of my career in The Bank of New York's loan officer development program, we "newbies" were taught that one of the principal reasons for making loans was to develop deposit business. What a retro concept that seems to be today! At least, it seems so after living through the deregulation of interest rates that banks could pay and a couple of significant liquidity scares over the last 40 years.

Interest rates that banks were allowed to pay for years were mandated by the Federal Reserve and contained in Regulation Q. The limitations of Reg Q were phased out starting in 1980 on consumer deposits, but, until this very summer, retained for commercial demand deposits, with the prohibition that banks could not pay any rate of interest on corporate demand deposits.

For many years, until the current one, this gave commercial demand accounts a significant cost advantage in a bank's net interest margin. Banks that excelled in developing core deposits from commercial customers usually enjoyed a significantly better net interest margin than those banks that either could not or whose business model did not emphasize corporate kinds of banking business.

Dodd-Frank has changed that and now corporate demand deposits do not enjoy interest rate protection in the banks' favor.

Key to the stress on core

Core deposits have always derived their principal benefit from being what bankers call "face-to-face" deposits.

When the customer and the bank have a personal, direct, and most often a face-to-face relationship, depositor behavior has consistently reflected a higher degree of loyalty toward the bank than non-core sources of deposits.

A customer with frequent business contact is less inclined to be influenced by negative news in the form of reputation risk, too.

This is why core deposit funding ranks so high with examiners in their assessments of the stability and reliability of a bank's sources of funding.

Liquidity flood hides core-deposit importance

The bankers I talk with today are generally awash with liquidity. Loan-to-deposit ratios are considerably lower than they were at the height of the previous credit cycle and loan demand is anemic, on a national basis. So there is no great emphasis or internal push today to raise deposits in order to maintain loan growth.

In such an environment, core deposits are considerably devalued and I wonder, if the current interest rate environment lasts too many quarters longer, what behavioral changes will have found their ways into lender-borrower relationships.

Increasingly, I hear stories of banks actually turning away core deposit business simply because they don't need the deposits and don't want to materially lower their loan-to-deposit ratios nor inflate asset totals without the ability to earn a positive spread on the new funds.

A problem faced by larger institutions has been the persistent flow of liquidity into banks. Many very large institutions are perceived to have little or no solvency risk in today's environment and so become convenient places to "park" liquid funds where significant rates of return are not available for short term funds.

The Bank of New York Mellon began to charge a fee on excess demand deposits as these deposits increased their costs of doing business (additional equity capital to maintain debt to equity ratios and costs of deposit insurance) without affording the bank an opportunity to earn a positive return from the new money.

Even small banks have seen significant deposit inflows by customers seeking to take advantage of FDIC insured limits on deposits. The paradox here is that even though large segments of the banking industry, and especially community banks, were suffering from the effects of reputation risk owing to credit quality concerns, the deposits kept coming.

While this is how deposit insurance is supposed to benefit the small business customer and the consumer, it nevertheless seemed to surprise many bankers and banking industry observers.

But what about when things become "normal" again?

In thinking forward to an environment of increasing loan demand and the absorption of the accumulated liquidity that our customers have amassed, how will the banks fund themselves with lower risk (more stable) deposits? 

This is not an idle question. Lenders have seen how quickly customer behavior can change and how quickly their banks' internal attitude toward core deposits can shift given the challenge of managing a bank's net interest margin.

The important point here to me is that we may be reaching an inflection point with our customers.

One day, hopefully not too distant, demand for loan business will once again be robust. As this occurs, it presents a rare opportunity to return to that retro idea that lending money is ultimately about gathering deposits. We as an industry have forgotten some important lessons along the way. It's time to be thinking about what this new environment will be like and how we'll fund loan opportunities that will present themselves.

The banks that figure out how to do this well and early will have a significant competitive advantage in funding themselves with reliable, loyal, and reasonably priced core deposits. It's not too early to start figuring out the specific strategies on how to address these coming opportunities.

About Ed O'Leary:

Veteran lender and workout expert O'Leary spent more than 40 years in bank commercial credit and related functions, working with both major banks as well as community banking institutions. He earned his workout spurs in the dark days of the 1980s and early 1990s in both oil patch and commercial real estate lending.

    O'Leary began his banking career at The Bank of New York in 1964, and worked at banks in Florida, Texas, Oklahoma, and New Mexico. He served as a faculty member and thesis advisor at ABA's Stonier Graduate School of Banking for more than two decades, and served as long as a faculty member for ABA's undergraduate and graduate commercial lending schools.

    Today he works as a consultant and expert witness, and serves as instructor for ABA e-learning courses and has been a frequent speaker in ABA's Bank Director Telephone Briefing series. You can hear free audio interviews with Ed about workouts here. You can e-mail him at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it . O'Leary's website can be found at www.etoleary.com.

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