Like a welcome circadian reawakening, banks should revel in the cyclical revaluation of their core deposits in 1994 following the 1991-93 period in which the market harshly devalued deposits. Conditions still ought to be right in 1995 for banks to use deposit attraction and pricing strategies to boost bank net interest margins. What's more, 1995 may herald a bonus in the form of a 15-basis-point cut in FDIC insurance rates.

[Expanded Picture]The returns on deposit gathering are most favorable at times when loan growth exceeds growth in core deposits. Under such conditions, however, individual banks run the risk of deposit outflows. As a result, increasing or just holding onto core funds may be the most profitable tactic in the industry this year. Banks that prosper most may be those whose funding tactics respond most creatively to high loan demand.

And more than ever before, creative funds management includes the use of derivatives. Despite regulatory scrutiny and the threat of negative new accounting rules, treasury professionals aver that for all the flexibility they provide, derivatives - in the words of one bank treasurer - are "a godsend."

Below-market funding cost is one of the three elements that contribute to bank net interest margins. The other two elements - above-market spreads on assets and yield curve spreads - similarly are driven by the business and interest rate cycle. Of the three elements, conditions now favor funding costs as the best chance for propping up net interest margins.

The asset spread element may become a drag as competition for loan business heats up and loss reserves grow. Also, yield curve spreads will continue to fall, assuming further flattening of the yield curve. Flat yield curves eliminate the profits on maturity intermediation based on the funding of long-term assets with short-term liabilities.

By now, no one is surprised to see the yield curve flattening. The markets have expected it since early last February, when the Federal Reserve first signaled tight money following several years of loose money. Surprisingly, the yield curve did not flatten materially through the first half of 1994. Long-term interest rates moved up solidly, but short-term rates seemed to be stuck in the low 3% range. By year-end, however, interest rates had risen for the year by 2% or more across the breadth of the curve.

Rising short-term rates radically changed the composition of net interest margins. As short-term rates rose, banks lagged their core deposit rates behind the market, making them dramatically "cheaper" than they were a year ago. In the process, bank deposit bases regained a great deal of the value they had lost in the 1991-1993 low-rate period (see April 1994, "Bank Deposits Get Devalued").

Sources of Cheap Money

To exploit present opportunities in low-cost funding, John C. Mason, senior vice president with KeyCorp, suggests retaining or expanding retail deposits through the use of derivatives. Speaking before the annual Bank Administration Institute conference on Asset/Liability and Treasury Management in October, Mason explained how low deposit costs can be combined with interest rate swaps to support an aggressive push into retail term certificates of deposit.

While the method doesn't reduce either liability sensitivity or the cost of short-term funds, it does permit the bank to develop an unexploited segment of its core deposit market. At the very least, KeyCorp sees it as a deposit-retention program. Also, it enhances measured liquidity. By incrementally expanding core deposits, the approach reduces reliance on potentially skittish wholesale funding.

Here are the particulars of how Mason and KeyCorp launched a campaign that netted $250 million in new 18-month CDs using interest rate swaps to effectively swap wholesale for core funding. The example uses mid-1994 interest rates.

The bank offered consumers 5.00% and booked interest rate swaps receiving 5.84% (bond basis) fixed, and paying 3-month LIBOR (London Interbank Offered Rate) variable. On the strength of this data, the bank appeared to clear a super-low cost of funds rate of 3-month LIBOR minus 84 basis points (5.00% - 5.84% + 3-month LIBOR), a cost far below rates on its wholesale funding alternatives.

However, other expenses had to be covered. These consisted of advertising and promotion of the 18-month CD campaign and the cost of cannibalizing money from the bank's low-cost short-term deposits. The advertising and promotion expense was $300,000, or about 8 basis points annually on the funds raised in the campaign. In addition, the bank figured that, of the $250 million funds raised, as much as $150 million migrated from its own low-cost retail deposits. The bank took a loss on these funds because it now paid 5% for money that had an average cost on other short-term fundings sources equal to 3.9%.

The 1.1% cost on $150 million migrated deposits amounted to 66 basis points on the total $250 million attracted. Thus, the all-in cost of the 18-month account was:

Gross cost: 3-month LIBOR - 84 basis points

Advertising & Promotion: + 8 basis points

Cost increase, reintermediation: + 66 basis points

Total cost: 3-month LIBOR - 10 basis points

Although not a steal, the cost still looks reasonable compared with wholesale 18-month floating-rate costs. It does, however, convert term core deposits into interest-sensitive money: Its cost will increase in lockstep with short-term interest rates.

In actuality, the program does not appear to make significant new profit, if any, for KeyCorp. So isn't this a convoluted way to raise money? Mason contends that the real payoff comes from the expansion of core funding in lieu of wholesale funding. The bank extends its funding to an under-exploited segment of the market, 18-month maturities, one that its competition has not heavily pursued.

In so doing, KeyCorp potentially diversifies its deposit maturities, depending on whether or not it continues to swap the account. It ought to be able to retain most of the new accounts as maturities come due. Also, the CD campaign created a traffic bonanza in the branches and created lucrative cross-selling opportunities.

A more subtle payoff is the pricing flexibility this transaction gives a bank. For example, as market interest rates continue to rise, this new source of fresh funds may allow the bank to resist a knee-jerk increase in its short-term deposit rates.

If rate-conscious depositors react by withdrawing their funds, the bank can replace the lost funds with the new 18-month CD money, properly swapped into 3-month money. At current swap spreads, the swap lowers the cost to the level of short-term deposits. That's a much-preferred alternative for filling in for lost funds than pricey wholesale funding.

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