The Big Idea

Balancing deposit and wholesale funding mix

Tom O'Hara, CFA | July 7, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Given recent bank failures and expected regulatory changes likely to dictate shorter deposit durations and tighter liquidity and funding requirements, banks may need to use more wholesale funding in the future.  As the current cost of unsecured debt is generally much higher than deposits, these regulatory developments will almost certainly drive bank interest expenses up and compress earnings—not a welcome development for most bank managers and shareholders.  While debt is more expensive than deposits, one positive offset for banks is that they may be able to lower their FDIC assessment charge by having more unsecured debt outstanding.

More funding diversification will be necessary and costly

Ultimately, banks are trying to maximize earnings for the benefit of their shareholders.  Even with rising deposit costs over the past year, deposits are still generally much less expensive than unsecured debt.  The median bank in the Santander US Capital Markets tracking group was paying 1.72% on interest-bearing deposits at the end of the first quarter 2023. That compares to a 5.48% cost of unsecured debt for US banks, based on the Bloomberg Investment Grade Banking Total Return Index yield at March 31.  So, while deposits continue to get more expensive each quarter, they are still almost four percentage points cheaper than unsecured debt.

Recent bank failures have nevertheless highlighted that deposits may not be as ‘sticky’ as historically modeled.  Liquidity has been the primary focus of bank treasury teams over the past few months, where the benefits of funding diversification could be existential while higher cost becomes a secondary, longer-term concern.  With some of this deposit duration tweaking currently being done voluntarily by banks, expected proposals for new bank regulation may make these tweaks mandatory.  Banks will look to issue more unsecured debt for the funding diversification benefits, to help rebalance their asset-liability management profile and to comply with potential new stricter Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) requirements.

Unsecured debt issuance can lower a bank’s FDIC assessment fee

While unsecured debt is currently more expensive than deposits, banks can get a credit from the FDIC on the assessment fee that they pay on their liabilities.  There are many inputs that factor into the assessment fee calculation, many of which are not public, such as a bank’s CAMELS rating, which stands for capital adequacy, asset quality, management, earnings, liquidity and sensitivity. These factors lead to an Initial Base Assessment Rate (IBAR), which multiplies the bank’s assessment base—the bank’s average consolidated total assets less average tangible equity, roughly equating to the bank’s liabilities (Exhibit 1).  A bank can lower this fee by issuing unsecured debt as this debt is not covered by the FDIC’s Deposit Insurance Fund (DIF) if the bank fails.

Exhibit 1:  Assessment rate schedule in effect Since 2016

Source: FDIC Staff Studies, Report No. 2020-01,  A History of Risk-Based Premiums at the FDIC

Minimizing FDIC assessment rate versus overall expense

Although a bank can lower its FDIC fee, the amount is limited. The drop in IBAR is limited to 5 bp or 50% of the IBAR, whichever is lower, and the assessment fee is minimized when 6% to 10% of the bank’s liability structure comes from unsecured debt (Exhibit 2). This reduction can amount to meaningful dollars. For a bank with $180 billion in liabilities, for example, this can amount to savings of $45 million to $90 million dollars annually (see Appendix: Unsecured debt adjustment calculations).

Exhibit 2:  Optimal debt issuance to minimize FDIC assessment fee

Source: Santander U.S. Capital Markets

A lower FDIC fee does not necessarily translate into lower overall funding costs.  In theory, if deposits cost the same as unsecured debt, a bank would fund itself with mostly unsecured debt to minimize the FDIC fee.  While the fee is applied to the bank’s entire liability structure, the handful of basis points is quickly dwarfed by higher funding costs.  In the current environment, unsecured debt is hundreds of basis points more expensive than deposits, and a bank looking to minimize cost would not issue any debt if they did not otherwise need to help their LCR and NSFR ratios as well as to offset the additional balance sheet interest rate risk that will come from shorter deposit duration assumptions.  Depending on the individual bank’s IBAR, an unsecured debt cost in the modest range of 35 bp to 60 bp higher than deposits would completely offset the unsecured debt adjustment benefit.

Other bank debt issuance considerations

It is important to note that FDIC assessment fee credit is only given for bank level issuance and not holding company issuance.  Also, banks stop receiving the FDIC credit when a debt issuance seasons to within one year of maturity. That is why some banks build par call options into their debt issuance.

Many banks have bank holding companies (BHC) that conduct activities such as securities underwriting, insurance business and merchant banking.  BHCs may also help to facilitate merger and acquisition activity, given that BHCs are regulated by the Federal Reserve and therefore may eliminate the need for specific state banking charters. As the BHC is structurally subordinate to the bank, the BHC will carry a lower rating (usually one notch) and also trade at marginally wider spreads than debt issued directly out of the bank. The BHC may issue debt to fund these additional activities, and it is also common for the BHC to issue subordinate debt where the proceeds are down-streamed to the bank and treated as additional paid-in capital.  This sub debt is treated as Tier 2 capital for the BHC but as Tier 1 capital at the bank.  This is an effective way for a bank to capitalize itself as the sub debt should be less expensive than Tier 1 equity capital, especially when a bank’s share price is relatively low, and the sub debt does not dilute existing shareholders or carry voting rights.  It is important to note that sub debt will start to loss its capital credit when the issuance gets to within five years to maturity, and credit is reduced by 20% a year and will receive 0% credit when within one year to maturity.

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Appendix:  Unsecured debt adjustment calculations

The FDIC assessment fee may be lowered to the extent a bank has issued unsecured debt, as this debt is not covered by the FDIC’s Deposit Insurance Fund (DIF) if the bank fails.  The formula to calculate the unsecured debt adjustment is shown below (Exhibit 3).  This unsecured debt adjustment is capped out at 50% of the IBAR or 5 bp, whichever is lower.

Exhibit 3:  Unsecured debt adjustment calculation

(Total qualifying long-term debt / assessment base) * (40 bp + IBAR)

 

Source: FDIC

While the IBAR unsecured debt adjustment is capped out at just a few basis points, the impact is applied to the bank’s entire liability structure, and therefore the adjustment results in a meaningful effective reduction in FDIC fees for incremental debt issuance as shown in Exhibit 4 below.  Here, a bank with a $180 billion assessment base and an IBAR of 5 bp would be paying $90 million a year to the FDIC (payments made quarterly) before consideration of any unsecured debt outstanding.  As more debt is issued, the FDIC fee payable continues to be reduced until the adjustment is capped out at 2.5 bp in this example, and the fee is reduced to $45 million.  This cap is hit when there is $10 billion of unsecured debt outstanding.  The FDIC fee savings effectively reduce the unsecured debt cost by 45 bp and take a mid 5’s yield down to low 5’s.

Exhibit 4:  IBAR 5 bp example

Source: Santander U.S. Capital Markets

Of course as shown in Exhibit 1, the IBAR may be much higher, and the higher the fee, the greater opportunity to reduce this fee through additional debt issuance as shown in the example below (Exhibit 5).

Exhibit 5:  IBAR 25 bp example

Source: Santander U.S. Capital Markets

In this example, given the higher starting IBAR, the unsecured debt issuance benefit is allowed to go to the full 5 bp cap.  Incremental debt issuance continues to lower the FDIC assessment fee until $14 billion of unsecured debt is issued, lowering the $450 million fee by $90 million.  This cost savings lowers the effective yield on bond issuance by 64 bp from mid 5’s to high 4’s.