FHLBInsider

By James Eibel, consulting manager, assistant vice president

"Find me a good asset to finance,
and I will find the money."

Walter Wriston, Former Chairman of Citibank

It’s double jeopardy. Financial institutions must grow to generate the earnings demanded by shareholders, but increasing competition and declining saving rates have slowed or stopped deposit growth. The escalating imbalance between retail loan and deposit growth is changing the way financial institutions manage their balance sheets.

Where have all the deposits gone?

The combination of increasing competition and lower saving rates has made the task of growing deposits difficult or impossible. Savers have numerous alternatives to the retail deposit programs provided by the local community bank. Mutual funds enable fixed income investors with as little as $500 to invest in everything from U.S. Treasuries to commercial paper, junk bonds, high dividend stocks, real estate investment trusts (REITs), and even bank CDs. Most financial institutions cannot price competitively with mutual fund alternatives without destroying the value of their core deposits. As a complicating factor, the personal savings rate has fallen from 8% to only 4% during the past 20 years (Browne and Gleason, p.15). In other words, there has been increasing competition for a shrinking savings market. As expected, increasing competition and decreasing savings rates have adversely impacted deposit flows. In Indiana and Michigan, total deposit growth for banks and savings institutions has fallen to an annual average of only 2.7% over the past three and one half years. Since this figure includes interest credited, actual deposit growth was flat or slightly negative during the period.

The lack of deposit growth presents a major challenge for financial institutions. For most institutions, earnings growth is a product of asset growth. In order to maintain ROE and its component ratios (such as ROA), asset growth must be proportionate to the rate of capital growth through earnings retention. Thus, the growth required to maintain ROE can be calculated by the following equation:

Growth Required to Maintain ROE
Based on Current ROE & Earnings Retention

In other words, ROE will decline unless asset growth is at least equal to the rate of capital growth through earnings retention. For example, an institution with an ROE of 12% retaining two-thirds of earnings will grow capital 8% annually. To maintain ROE, this institution must increase earnings 8% annually. If the current ROA can be maintained, this will require asset growth of 8% per year. If margin pressures result in growth below the current ROA level, assets will need to increase by even more than 8%. How will this growth be funded if deposits are flat or declining?

Over the short run, investment portfolios can be liquidated to help fund loan growth. Ultimately, insufficient deposit growth necessitates going outside of current markets to obtain other funding sources. While acquisitions and building new branches are possible solutions, they can be expensive and difficult to execute as funding needs arise.

Wholesale funding is a logical answer to the deposit deficit. Wholesale funding possibilities include brokered CDs, fed funds lines, repo lines, and of course, Federal Home Loan Bank (FHLB) advances. The Federal Home Loan Bank of Indianapolis provides members with the ability to access the exact type of funding needed, at the exact time, in the exact quantity, and at market rates. This provides members with the flexibility to tailor borrowings to specific needs. Since mortgage loans represent eligible collateral for FHLB advances, financial institutions can continue lending without fear of quickly exhausting their borrowing capacity.

It should be noted that the use of wholesale funding will distort the traditional loan-to-deposit ratio. Users of wholesale funding should consider adopting policies based on either loans-to-total funds or loans-to-total assets. Either of these measures provides a better picture of overall portfolio composition and liquidity when non-deposit funding sources are used.

References:

Browne, Lynn Elain and Gleason, Joshua, The Savings Mystery, or Where Did the Money Go?, New England Economic Review, Sept./Oct. 1996, p.15.

This article has been presented for educational purposes only.  The FHLBI is not a financial or investment advisor.   It is solely the reader's responsibility to evaluate the risk and merits of any funding strategy or business proposal.

Copyright 1997, Federal Home Loan Bank of Indianapolis