Banks may want to shrink rather than pay up for loan growth

As deposit competition intensifies, banks should consider slowing or even stopping growth to mitigate credit risk and threats to their net interest margins, according to South State Bank Director of Capital Markets Chris Nichols.

Deposit costs rose more quickly in the fourth quarter as liquidity pressures grew across the banking industry, with the industry recording a quarter-over-quarter, interest-bearing deposit beta — the percentage of change in fed funds passed on to depositors holding interest-bearing accounts — of 44.6% in the fourth quarter, up from 32.8% in the third quarter and 17.7% in the second quarter. Nichols said in the latest Street Talk podcast that he has seen the same experience among the more than 1,000 banks that South State interacts with through its correspondent bank. He noted that banks face competition from digital-only banks and money market accounts paying 3.5% or more on deposits as well as retail and corporate customers moving funds into higher-yielding alternatives in the bond market.

"We haven't really seen this ever in the history of banking where rates are being raised, the economy is still good, money is being sucked out of the system on the Fed's balance sheet, and we have all these banks like a Goldman Sachs and Morgan Stanley that were traditional investment banks in the past, but are now in this cycle are full-fledged banks with the ability to raise FDIC-insured deposits," Nichols said in the episode.

When competing for deposits, Nichols strongly discouraged institutions from simply marketing with rates. He said that approach is "truly destructive," because it only attracts rate-sensitive customers and trains employees to be rate sensitive. The latter is detrimental, Nichols said, because marketing with rate should be the last tactic a bank employs to attract and retain customers. He noted that a single rate-sensitive customer might come and go, but employees that lead with rate will bring similar customers back to the institution in the future.

"I don't think many banks realize the cannibalization that goes on," he said.

He also said banks need to be thoughtful about how much they are leveraging their funding right now, particularly since underwater bond portfolios leave institutions with one less liquidity lever to pull.

"Most banks are geared with a loan officer, Chief Credit Officer, a loan committee, but very little focus on deposits and very little respect for how to build and how to structure your deposit base, so it lasts through a down and up cycle," Nichols said.

He further advocated banks to reduce their growth goals to protect against credit risk and headwinds to margins in the future as funding costs continue to accelerate. A few banks like FB Financial Corp. said during fourth-quarter earnings season that they planned to limit loan growth to keep their loan-to-deposit ratio steady and brace for a potential recession. However, many other institutions like Customers Bancorp Inc. and Capital Bancorp Inc. actively grew certificates of deposits, or CDs, to fund loan growth in the period,

Nichols said banks need to question if they are willing to live with every new loan they put on their books through a potential downturn and should focus on adding quality customers that generate attractive loans but also good relationships that lead to more deposits and cross-selling opportunities, particularly since the Federal Reserve has a history of overshooting when raising interest rates.

"When you look back at any downturn, it's still 2 years before the downturn that gets banks in trouble," Nichols said. "I don't think we're heading into a recession. I do think you have to have a probability 20%, 25% that, hey, we could be overshooting here shortly in the next year and have to pay more and more attention to credit and margins."

Chris Nichols serves on the advisory board of S&P Global Market Intelligence's Community Bankers Conference and will be one of the speakers at the event, which will take place in Texas in late May. For more information about the conference, visit this link.