(Unprofitable) Deposits: Echoes of The Thrift Crisis?

by Howard Lothrop, Echo Partners

Ever notice how widely-held beliefs can, in retrospect, seem so obviously incorrect?
For instance, take the Thrift Crisis. For decades bankers (and regulators) acted as if the long-term fixed rate mortgage was one of the safest and best bank assets. Credit quality problems were rare, examinations focused on appraisals, and the tendency of collateral to appreciate resulted in relatively loss-free performance, even in the event of foreclosure. Generally, these long term fixed rate mortgages were funded with low-cost savings accounts. That was normal. It was what “everybody did." Looking back, it’s easy to see how an outsized asset liability mismatch could prove disastrous. But in the moment, it seemed like a “can’t miss” income stream. Then, as interest rates rose sharply, we saw the slow motion train wreck unfold before our eyes, as these loans grew ever further underwater and thousands of S&Ls failed.It’s important to remember that, on their own, long term fixed rate mortgages weren’t “bad” assets. Nor were low cost savings accounts “bad” liabilities.  It was their repricing differences that made them a toxic combo.

 We oversimplified, focusing just on the spread when all aspects of profitability needed to be considered.
Today, bankers are faced with another insidious profit drain, hidden behind other well-accepted but incorrect assumptions.

I’m talking about the Deposit Profitability Crisis.
I know it sounds absurd. Deposits are a core banking product. They’ve existed about as long as banking itself has existed. And just like long term fixed rate mortgages before them, deposits themselves are not the problem.

The problem comes from how we manage our deposits. Or more correctly, fail to manage our deposits.
In the Thrift Crisis, we failed to manage our interest rate risk because we failed to accurately measure our interest rate risk. Instead we relied upon rules of thumb and were content blissfully following our existing standard operating procedures.

Today, we fail to manage our deposit profitability because we are not accurately measuring our deposit profitability. ..
… And if we can’t measure it, we can’t manage it.
Once more, instead of doing the work of quantifying and discovering the answer, we rely on sound bites, slogans and marketing messages to avoid asking the question…

What if our deposits are not profitable?
For most financial institutions, the only deposit yardstick we use is balances. We see big balances and automatically make the leap to assume big profitability. But it’s not that easy.
Balances are aggregate measures, and they are notoriously unreliable for determining profitability.

We’re oversimplifying again, comparing deposit spread while ignoring all the direct costs of the deposit.
Pretty much all of us can think of bank customers who carry large balances that we suspect are getting a better deal than they should. It’s human nature to seek out the best deal, and some of our customers work very hard to make sure we don’t make much at all on their account.They do it by overusing expensive delivery channels, overloading us with excessive transaction volume, and getting us to waive (or not even impose) deposit fees.So if using aggregate measures doesn’t work, what does?

The answer is instrument specific, transaction detail deposit profitability measurement.
 Once again, this follows the path we previously saw with the Thrift Crisis. We finally got a handle on interest rate risk management when we turned to instrument specific measurement. Sure it seemed complex and maybe even a bit unrealistic at the time. After all how would we begin to estimate prepayment rates on individual assets when we could barely cobble together aggregate values?
 We had, or could derive, all the needed inputs. Still, many bankers resisted until forced to comply by their regulators.
 We’re in exactly this same place today with respect to deposit profitability.
Everything we need to calculate deposit profitability is already available within our bank, primarily in our core system. We just need to take the steps to organize and distill this data into actionable management information.

And it’s potentially a very big problem.
 Deposits represent about 90% of total banking liabilities, so the scope of the issue is huge. And the profit and strategic impact is immense. In fact, PwC’ s report “Retail Banking 2020: Evolution or Revolution” identifies improving customer profitability as a top 3 challenge in US banking (page 7) and states
 “Surviving banks will be low-cost producers, with nearly every product profitable on a stand-alone basis” (page 12).

The bad news is that most of our deposits are not profitable.
 When we do the math, we find over 50% of bank deposits fail to add even $1 to our overall monthly profitability. But it’s impossible to identify and segment winners from losers without running the numbers.
 The good news is that this problem can be readily solved.
Today’s money losers can quickly be turned into tomorrow’s profitable money makers. Start instrument specific, transaction detail profitability calculations and quickly focus on improving both your profitability and the quality of your deposit base.

For more information on this subject, you can reach Howard Lothrop at  howard.lothrop@echopartners.com.