By Carl White, Senior Vice President, Supervision
This post is part of a series titled “Supervising Our Nation’s Financial Institutions.”
Two years ago, community banks cited the availability and cost of funding as their greatest challenges, according to the Conference of State Bank Supervisors’ 2019 National Survey of Community Banks. Interest rates had recently risen, increasing the cost of deposits and prompting more reliance on wholesale funding.
Slightly more than one-third of surveyed bankers said the cost of funds was the factor most likely to influence future profitability, ahead of loan demand, operating costs, loan rates and regulatory costs. The availability of core deposits—generally defined as consumer savings accounts, consumer and business checking accounts, and money market funds—was seen as a persistent problem that would only be exacerbated by a proliferation of new entrants and technologies into the banking system.
Then came COVID-19 and a rush of deposits. The influx in early 2020 can be traced to companies drawing down credit lines, the distribution of federal emergency stimulus funds and a slowdown in consumer spending. Although deposit growth has slowed recently as the economy has improved and consumers have resumed spending, many banks remain flush with low-cost funding at a time when loan demand remains tepid and returns on other investment opportunities remain low.
The turnaround in deposit growth has occurred among banks of all sizes. (See the table below.) In the year before the pandemic, total deposits increased 4.7% at all U.S. banks. In 2020, they increased more than 20%. Total deposits can be broken into transaction accounts and nontransaction accounts. Transaction accounts consist mostly of checking accounts. Nontransaction accounts consist mostly of money market deposit accounts but also include certificates of deposit (CDs) and other savings deposits.
|Bank Group||Dec. 31, 2018-
Dec. 31, 2019
|Dec. 31, 2019-
Dec. 31, 2020
|Dec. 31, 2020-
June 30, 2021
|All U.S. Banks||% Change||% Change||% Change|
|All U.S. Community Banks|
|All U.S. Community Banks <$1B|
|NOTE: Community banks are banks with less than $10 billion in assets.|
|SOURCE: FFIEC Reports of Condition and Income (call reports).|
The large increase in total deposits in 2020 at all U.S. banks was driven primarily by a doubling of dollars in transaction accounts; nontransaction accounts rose a more modest 6%. In the first half of 2021, deposit growth slowed considerably to 5.4%. Absent some very unusual circumstances, year-over-year growth in 2021 should be closer to 2019’s increase rather than 2020’s.
Deposit trends at community banks (banks with less than $10 billion in assets) followed a similar pattern. The shortage of deposits community bankers were concerned about in 2019 is reflected in that year’s very slight increase in total deposits of 0.3%. Transaction and nontransaction deposits both increased in 2020, though at about half the rate of the industry overall; growth in transaction accounts slowed in the first half of this year, while nontransaction deposit growth declined from the year-end 2020 level.
The smallest community banks (those with less than $1 billion in assets) entered the pandemic with even more anemic deposit trends. Overall deposits had declined more than 4% in 2018 and declined again in 2019. While these banks had a significant bump in transaction accounts in 2020, nontransaction deposits declined more than 8%. But unlike what occurred with their larger community bank peers, smaller banks’ total deposit growth in the first half of 2021 was more robust than the 2020 growth rate, primarily because the decline in nontransaction deposits was less pronounced.Some of the decline in deposits, especially for small banks, can be traced to banks moving to larger asset categories due to internal growth or mergers.
Although the inflow of deposits in a period of near-zero interest rates has led to a dramatic reduction in banks’ funding costs, it has also led to several challenges. Loan demand has not kept up with the increase in deposits, causing the industry’s loan-to-deposit ratio to sink from about 80% at year-end 2019 to 63% in mid-2021. Community banks have fared a little better: The loan-to-deposit ratio fell from 85% at year-end 2019 to 74% at mid-year 2021. Community banks typically aim for an 80% to 90% loan-to-deposit ratio because yields on loans exceed those of other assets, like investment securities.
Bankers do have ways to mitigate the funding glut, such as paying near zero on deposits and buying mortgage-backed securities and other short-term investments. Those strategies are not without risk, however, including credit risk tied to purchased securities. Banks also risk losing customers and their deposits to competitors if rates offered are significantly less than those of other financial institutions.
When loan demand does rebound, banks will want to deploy the cheapest funding possible. Purchasing investment securities in such an uncertain environment, while providing income, can also prove problematic if banks miss lending opportunities because deposits are tied up.
As we saw during the last financial crisis, an increase in low-cost funding can incentivize some institutions to deploy their excess liquidity into riskier asset classes or into loan types that are outside a bank’s core area of expertise. Just as a liquidity shortage posed a significant challenge to banks in 2019, it’s not inconceivable that this challenge could reappear in the future.
Banks that patiently assess new lending and investment opportunities and avoid unnecessary risks will likely fare better than those that chase yield. As always, appropriate match funding of assets and liabilities and risk management should be at the forefront before making any such decisions.