As interest rates rose last year, banks were able to lure customers back into certificates of deposit and other savings instruments. But this achievement could display its downside this year, as rising deposit costs put a strain on net interest margins.

Jon R. Burke and John W. Coffey, analysts at Atlanta-based Robinson- Humphrey Co., said in a recent report that "the period of easy, cheap money is over" for banks.

This implies, in their view, "increasingly aggressive deposit pricing," as well as "an increase, perhaps significant, in the cost of funds for all market participants."

"The banking system has been underpricing deposits for the last couple of years because it's had plenty of liquidity. Now, with a full year of loan growth under its belt, liquidity is probably again going to become an issue," Mr. Coffey said in an interview.

Banks' cost of funds, in longer-term instruments, did rise sharply in 1994, spurred by six Federal Reserve rate increases since last February.

According to Bank Rate Monitor, average one-year CD yields jumped from 3.08% last January to 5.47% by December; five-year CDs went from 4.64% to 6.58%.

Bank money market accounts showed much less movement, gaining only 36 basis points, on average, from 2.35% to 2.71% during the year. That compares with a 5.53% return that investors can now earn on a three-month Treasury bill.

"Clearly, there is an up trend in deposit costs from where they were at the first of the year," said Kenneth R. Stancliff, treasurer for Charlotte, N.C.-based First Union Corp. "But they still haven't moved up anywhere in relation to other rates, like fed funds and Treasury bills."

Mr. Stancliff, like many bankers, believes deposit rates will continue to creep up in 1995, particularly if the Fed keeps raising short-term interest rates. So far, he estimates, the increase in bank rates has kept pace with only about 25% of the rise in other rates.

In 1995, that percentage is likely to balloon to 70%, according to Mr. Stancliff, as banks are compelled to get their short-term rates more in line with the market.

"If that's the correct scenario, one would suspect there would be some pressure on bank margins in general and therefore some pressure on the growth in net interest income," Mr. Stancliff said.

Banc One Corp. has been trying to stay ahead of this curve. Steven Bluhm, vice president for funds management in Columbus, Ohio, said the company began "aggressively" bidding up for deposits last spring to correct a liability-sensitive balance sheet.

"We were looking for fixed-rate liabilities," Mr. Bluhm said. "We had to pay national market rates or we had to pay our customers. It's much more prudent to pay the extra rates to the customers."

But Mr. Bluhm doesn't agree that higher deposit costs necessarily translate into thinner net interest margins. "All things being equal, we pay more for deposits and, yeah, that's going to impact our margin," he said.

"However, the theory here is that rates are going up on both sides of the balance sheet. We are paying more for deposits, but we should be receiving more on our loans and our securities portfolio. So that's a hard one to call."

Loan demand is a key variable in any scenario for 1995. "If loan demand starts falling off, there's less need for the funding," said Dale W. Polley, vice chairman of First American Corp. in Nashville.

"But in the process of moving those interest rates up, if it doesn't curtail the loan growth, there will be the need for the deposits, and I think there will be some pockets of price wars. In Tennessee right now, you still have pretty good liquidity in the banks, so I don't think you'll see that in the near term."

Other bankers agreed that any price competition is likely to be restrained.

"If any particular organization was to increase their deposit rates substantially, then the most likely thing to happen is all the competition follows," said First Union's Mr. Stancliff. "So, if the goal was to raise more deposits, they're probably not going to."

Paris Thermenos, treasurer and chief investment officer for Barnett Banks Inc. in Jacksonville, Fla., points out that consumer funds in recent years have increasingly flowed into two categories: investment products, such as CDs and mutual funds, and the standard checking, savings, and money market accounts, or core deposits.

As more customer money migrates into the investment category, core deposits have become less price sensitive, according to Mr. Thermenos.

"Rational players in the market will look at alternatives like securitization and other forms of attractive funding as a way of augmenting the natural growth that will occur in their deposit base, and rely less on just raw pricing to try to attract back investment dollars that are appropriately invested in alternative investments," he said.

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