Core deposits continue to shrink at banks in most parts of the country - squeezing margins and dampening earnings - and experts say the trend will get worse before it gets better.
Though U.S. commercial banks' deposits rose 8% last year, to $5.73 trillion, the amount of money in transaction accounts dropped 2.7%, to $659.7 billion, according to Federal Reserve data.
Meanwhile, the amount of money in nontransaction accounts, such as certificates of deposit, rose 8.4%, to $5.1 trillion. With rates steadily climbing, customers have been taking money out of lower-yielding accounts and putting it into higher-paying accounts.
Banks are also borrowing more and using other alternative funding sources, including repurchase agreements, to counter core deposit declines.
The result is that at many banks funding costs are rising and eating into earnings, said Gary Townsend, an analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Va.
"Most banks out there have shown themselves to be somewhat liability-sensitive," he said, "so in a rising rate environment their liabilities are repricing faster than their assets. This has created a less-than-happy environment for banks."
Fed data does not include thrifts, but Mr. Townsend said the trends are amplified at many thrifts. Since they have mostly retail customers, they do not have a lot of lower-cost commercial deposits to offset the higher-yielding CDs that most thrift customers demand.
Deposit trends are not expected to improve soon. Grant Thornton LLP's 13th Annual Survey of Community Bank Executives, to be released Feb. 20, found that only 29% of bankers expect core deposits to increase this year. Nineteen percent predicted a decrease and the rest said core deposits would remain roughly the same.
The deposit trends are one reason why community bankers' outlook for 2006 was bleak, Grant Thornton said. Just 38% of the bankers surveyed said they were optimistic about the state of their industry, versus 73% in last year's survey.
"They realize that net interest margins aren't going to increase overnight, and they may remain tight for a while," said John Ziegelbauer, the national managing partner of Grant Thornton's financial institutions industry practice.
Gerard S. Cassidy, a managing director for bank equity research with Royal Bank of Canada's RBC Capital Markets in Portland, Maine, says the decline in core deposits should level off sometime in the third quarter - several months after the Fed stops raising interest rates, which will most likely be in March.
To be sure, many banks withstood the funding challenges and posted record fourth-quarter earnings. Loan demand was still robust in pockets of the country, and many banks reported healthy loan growth, essentially offsetting the higher cost of funds.
And not all banks' core deposits are down. West Coast banks, particularly in California, have generally fared better attracting and retaining core deposits than banks in other regions, analysts say. They have paid up for certificates of deposit to appease customers, but many have also had modest growth in low-cost commercial deposits.
Still, more than a few banks took significant hits in the fourth quarter, and blamed higher funding costs.
Earnings at Century Bancorp Inc. in Medford, Mass., were sliced nearly in half, to $1.2 million, as the company put higher-cost CDs and borrowings on its books to make up for declining core deposits. Its interest expense rose 44%, to $9.4 million, while it net interest margin fell to 2.44%, from 2.67% a year earlier.
"They're getting slaughtered, because they can't keep money market accounts on their books, and they're being forced to use higher-cost CDs and wholesale funding to replace them," Mr. Cassidy said of Century.
Washington Federal Inc., an $8.3 billion-asset thrift company in Seattle, said a 62% increase in deposit costs, to $38.9 million, was the main reason its net income of $36.26 million was flat from the year-earlier quarter despite a 20% rise in loans. Core deposits dropped 8.5%, to $5 million, while CDs and borrowings increased; as a result net interest income fell 2%, to $64 million.
Washington Federal's performance was typical of thrifts throughout the country, but banks on the West Coast are telling a different story.
James Bradshaw, an analyst at D.A. Davidson & Co. in Portland, Ore., said, "Core deposits are growing faster for West Coast companies than the industry average, because of the better population migration trends here."
"But since loans are growing faster than deposits over all, banks here are still having to borrow money and use higher-cost CDs to fund that growth," Mr. Bradshaw said. "While this may cause margins to drop slightly, loan volume will be up, and so will earnings."
He said one of the best examples of a company escaping the national trends is the $1.27 billion-asset Cascade Bancorp in Bend, Ore.
Cascade's core deposits grew 25%, to $1 billion, in the fourth quarter, and made up nearly all of the deposit base. Its cost of funds increased slightly to 1.49%, from 1.36%, as Cascade paid more on money market accounts and the few CDs on its books, causing its margin to remain relatively stable at 5.66%. But a 22.1% overall increase in loans, to $1 billion, led to a nearly 50% increase in net income, to $6.8 million.
George Darling, a consultant in Newburyport, Mass., recommends that banks and thrifts consider using more alternative funding sources - such as Federal Home Loan borrowings, repurchase agreements, and brokered CDs - instead of offering CD specials to all customers.
"You're seeing way too many banks paying up for deposits without knowing the true costs," Mr. Darling said. "They risk cannibalizing much of their existing CD base, instead of getting a lot of new money." If banks do offer CD specials, he added, they should do so only in new markets, or to select customers.
Brett Rabatin, an analyst at First Horizon National Corp.'s FTN Midwest Securities Corp. in Nashville, said start-up banks especially are aggressively pricing their CD offerings for rapid deposit growth. Others, including most of the Korean-American banks in the West, can easily absorb the high expenses from offering large amounts of CDs, because their loan demand is so high, Mr. Rabatin added.
At three such Los Angeles banks - the $1.8 billion-asset Nara Bancorp, the $3.4 billion-asset Hanmi Financial Corp., and the $1.6 billion-asset Center Financial Corp. - CDs make up a substantial portion of the deposit base. But since their customers also take out plenty of lucrative commercial real estate loans, the banks' earnings have not suffered (they are to report their fourth-quarter earnings next week).
Christopher Marinac, an analyst at FIG Partners LLC in Atlanta, said companies should not rule out paying up for CDs if it helps strengthen customer relationships.
"But I'd much rather see community banks focus more on getting core deposits from small businesses, by offering better cash management services than they could get from larger banks," Mr. Marinac added.
