US Regional Banks: Balance Sheet Effects Will Lift Margins at WFC and RF

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July 8, 2013

US Regional Banks: Balance Sheet Effects Will Lift Margins at WFC and RF

  • We expect net interest margins at WFC and RF to lift 0.30-0.35% (off base figures of 3.35% and 3.05% respectively) as the deposit/loan ratios renormalize towards 110% from over 120% currently. This balance-sheet effect is independent of the direct margin impact of the yield curve through product pricing and not expected to the same extent at other banks.
    • For WFC, changes in the deposit-to-loan ratio have explained 97% of the variation in the net interest margin in recent years; corresponding results are 39% and 26% for KEY and RF respectively, with no meaningful relationship for other banks in our sample.
    • Our focus is on WFC and RF where the deposit-to-loan ratios are high at 120% and 125% respectively versus 111% for KEY.
  • The balance sheets at WFC and RF have become excessively deposit-skewed, despite pricing policies that would normally have had a mitigating effect, because of the run-off of legacy loan portfolios; this is now nearing completion so that loan growth will resume and excess deposits can be more profitably deployed.
    • We note WFC generated excess deposit growth despite conservative pricing and RF had negative loan growth despite aggressive pricing (see Exhibit below).
  • Given RF’s strong balance sheet, we expect a narrowing of the discount in the valuation relative to peers as the margin improves; specifically, using current valuations as a baseline, we expect the tangible price-to-book ratio to increase to 1.6x from the current 1.4x.

Exhibit: Performance Metrics and Valuation for Selected US Banks


Investors are focused on the aggregate impact on bank net interest margins of changes in interest rates through pricing; however, there is significant variation in the behavior of net interest margins across banks and there are two banks in particular (WFC and RF) that will see margin-improvement because of balance sheet effects independent of the direct margin impact of interest rates through product pricing.

Exhibit 1 illustrates the striking differences in the behavior of bank net interest margins over time and despite (obviously) a shared rate environment. For example, WFC consistently had the highest margin among our sample of regional banks from 2005-2010 but has steadily lost ground, relative to peers, since then. CMA has a longer-trend of declining margins with a shift in geographic mix being a recent contributor. On the other hand, PNC which had the lowest net interest margin of our sample from 2005-2008 moved to best-in-class with the acquisition of National City.

Exhibit 1: Net Interest Margin %, and Margin Rankings, for Selected US Banks over Time

Source: SNL, SSR Analysis

Impact on Net Interest Margin of Changes in the Balance Sheet

These margin divergences arise because mix-shifts in the balance sheet can be more important to margin dynamics than the direct impact of a changing yield curve on product (i.e. loan and deposit) pricing. At WFC, for example, over 95% of changes in net interest margin over time can be explained by changes in the deposit-to-loan ratio without independent reference to the yield curve. We note that the relationship is striking in the more extreme interest rate environment since the 2008 financial crisis and not as strong beforehand (see Exhibit 2).

Exhibit 2: Net Interest Margin vs. Deposit/Loan Ratio for WFC

Source: SNL, SSR Analysis

Of course, it is not surprising that the deposit-to-loan ratio tends to affect the net interest margin: if there is a deposit-shortfall loans must be funded with borrowings, such as bank-debt, which typically cost more than deposits; and if there are excess deposits these must be invested in assets, such as debt securities, which typically yield less than loans.

However, it is surprising that the impact varies so significantly across banks: in particular, increases in the deposit-to-loan ratio explain 97%, 39% and 26% of the declines in margin at WFC, KEY, and RF respectively but have a not meaningful relationship at other banks in the sample. This suggests these three banks have important franchise characteristics or pricing policies in common that are not shared by other banks.

Limits of Pricing Efficacy

It turns out that a characteristic common to WFC, RF, and KEY and not shared by other banks is that these three banks are pricing outliers (see Exhibit 3 and Appendix). Specifically:

  • WFC is generating the most excess deposits despite the most conservative pricing.
  • RF has priced loans aggressively but nonetheless has meaningful negative growth.
  • KEY has priced both deposits and loans aggressively but is not able to generate growth.

Exhibit 3: Growth and Pricing at Selected US Regional Banks for Loans and Interest-Bearing Deposits

Source: SNL, SSR Analysis

Our interpretation is that WFC, RF, and KEY are closer than other banks to the limit of their ability to manage the net interest margin through pricing. In all three cases, the banks have made strategic decisions to run-off large legacy real-estate portfolios suppressing loan growth despite, in the case of WFC and RF, strong production volumes. In the case of WFC, the franchise is generating large volumes of new deposits despite offering low rates.

Independently of the operating environment, the run-off of these legacy portfolios will complete; then, in the case of WFC and RF, deposits can be redeployed from the securities portfolio to the now-growing loan portfolio providing a lift to the net interest margin. There will not be the same tailwind at KEY because, unusually among banks, the firm has a target range for the deposit-to-loan ratio and is currently at the upper end of 110% (compared with deposit-to-loan ratios of 119% and 127% for WFC and KEY respectively); in other words, there are fewer excess deposits to redeploy. Furthermore, despite shifting the deposit-mix from higher-cost CDs to lower-cost transactional balances, KEY has the highest cost of interest-bearing deposits among the banks in our sample (see Exhibit 4).

Exhibit 4: Cost of Interest-Bearing Deposits and Yield on Loans/Leases Q1 2013

Source: SNL, SSR Analysis

Quantifying the Impact and Risks

We quantify the potential impact on net interest margins at WFC and RF from a renormalizing deposit-to-loan ratio using the relevant coefficients from the regression analysis summarized in Exhibit 2 above. These were 3.6x and 2.1x suggesting that declines in the deposit-to-loan ratio of 10% and 15% respectively (to bring the ratios to 110%) would tend to give rise to an increase in the net interest margin of 0.32% and 0.36% respectively.

A risk to the analysis is that the benefit to WFC and RF of starting with excess deposits is eroded because they are less effective than peers at raising new deposits. This is unlikely at WFC which, as noted earlier, is generating strong deposit growth despite conservative pricing. However, Exhibit 3 suggests RF is not growing interest-bearing deposits at peer-rates despite paying a cost that is in line with the peer average.

Furthermore (see Exhibit 5), total deposits in the most recent quarter were down 3% year-on-year (largest decline of peer group) and 1.4% sequentially (third largest decline of peer group after KEY and STI). However, this appears to the result of a pricing decision by RF whose cost of interest-bearing deposits has fallen most among peers over the year (except for KEY) and is now the lowest (with CMA).

Exhibit 5 – Total Deposits $bn

Exhibit 6 – Cost of Interest-Bearing Deposits

Appendix: Growth Metrics for Selected US Banks

CAGR’s are calculated from 2009-2012 to avoid some of the distortion created by several acquisitions in 2008 including JPM/Washington Mutual, PNC/National City, and Wells Fargo/Wachovia.

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