Core Deposits & Core Deposit Premiums

What they are, why they're important, and how to calculate them

Greetings! This week we’re going back to basics with an overview of core deposits and their role in evaluating banks and their corresponding valuations. Based on some of the interactions I’ve had with readers so far, my sense is that many subscribers are already quite familiar with analyzing banks. For you, this will likely be rudimentary, but part of my goal with Conversion Confidential (other than to review thrift conversion investment ideas) is to educate those who may not be as familiar with banks and financial institutions. After all, many investors fear or avoid banks altogether given their leverage and unique financial statements. Perhaps I can help change that though.

To start, deposits are the most common funding source for many banks and other financial institutions. They show up on the balance sheet as a liability (money owed to a customer) and are used to finance the loans a bank makes as well as invest in a securities portfolio. Among deposits, there are various types that differ in both stability to the bank and customer profile characteristics.

Defining Core Deposits & Why They’re Important

“Core deposits” is a term used to describe a subset of all deposits which are more stable (less likely to leave the bank for a slightly higher yield) and a lower cost source of funding. This latter point is important because at the most basic level, the gap between what a bank generates on its loans and investment portfolio and what it pays to its depositors - known as the “spread” - is a large determinant of its earnings power and profitability levels. Core deposits also have another benefit in that they typically lag other funding sources (wholesale funds, debt, etc.) in repricing higher during a period of increasing interest rates (I know I know, we haven’t had of those in a long time).

Core deposits are typically funds of customers that have loans or other business relationships with the bank. A common example for commercial customers is that they will deposit an agreed upon amount cash with the bank that earns no yield as a precondition of receiving a loan from the bank. This creates a “non-interest bearing” deposit and from the bank’s perspective is ideal. At no cost to the bank, this is as good as a liability as you can get! Just note, deposits don’t necessarily have to be non-interest bearing to be considered core.

Core deposits are defined in the Uniform Bank Performance Report (UBPR) User’s Guide as the sum of all transaction accounts, money market deposit accounts (MMDAs), non-transaction other savings deposits (excluding MMDAs), and time deposits of $250,000 and below, less fully insured brokered deposits of $250,000 and less.

In practice, look on the balance sheet or deposit footnotes for line items labeled checking, savings, transaction or money market accounts/deposits. Some folks may also include certain time deposits, but I typically exclude them. What you want to avoid is brokered, internet or certificates of deposit. These are higher cost deposits that are also more likely to chase yield, or leave in search of higher deposit rates. In a severe case, this can become a liquidity issue for a bank trying to fund their loan portfolio and has caused bank crises in the past.

Calculate what percentage of total deposits are comprised of core deposits. A strong franchise will have a ratio of core deposits to total deposits of 85%-90% and upwards. Also look to see if the core deposit mix is improving over time. Ideally, the bank will also have a decent proportion of non-interest bearing deposits. As a generalization, I would say <20% of all deposits is subpar, 20-30% is decent, and 30% or higher is pretty strong.

For some examples of assessing a real bank’s funding profile, take a look at the deposits sections of my previous write-ups. At one end of the spectrum is Eureka Homestead Bancorp which essentially has no deposit franchise or core deposits to speak of. Meanwhile, Northeast Community Bancorp has a more nuanced deposit situation, but is still less than ideal.

Core Deposit Premiums

Hopefully I’ve established that core deposits are valuable to banks. And we also know the US is overbanked and consolidation has been occurring for decades. Finally, acquisitions are a common exit strategy for thrift conversions after they’ve been public for the mandatory three years minimum. The rationale for these acquirers is that they can cut anywhere from 20-40% of a the acquired bank’s non-interest expenses (operating expenses) and leverage the deposit base to further expand their loan portfolio growth. Unlike acquisitions in many industries, these synergies are very real and capitalizing on them has been a recipe for repeated success in the banking world for decades.

One method by which acquirers establish a range of values for a potential takeout is the core deposit premium. If businessmen are using this to assess the intrinsic value of a thrift than so should we. Calculating the core deposit premium of a takeout is essentially a comparable sales valuation method, just like comparing multiples of TBV. Remember, thrifts typically don’t have much in the way of earnings power and are over-capitalized so PE ratios are distorted and less commonly relative to TBV and core deposit premium multiples.

To calculate, find the premium paid over tangible equity as a percentage of core deposits in a transaction. For example, if bank ABC has $100 million in equity, $1 billion in core deposits and is acquired for $200 million, that would equate to a 10% core deposit premium (($200m - $100m) / $1 billion). In order to value a bank you believe will eventually be acquired, rearrange the formula and add the core deposit premium to tangible equity. Make sure to use core deposit premiums as valuation method when and where it makes sense. As I noted above, ERKH essentially has no deposit franchise to speak of so a potential suitor probably wouldn’t utilize this method.

Premiums of 5-15% are a decent start for a few point estimates of most community banks/thrift conversions. 15% is probably on the high end, but if the bank is larger, it should probably earn a larger premium since the acquirer is getting a higher amount of core deposits at their disposal. If interest rates ever increase meaningfully again, perhaps a 20% premium could enter the high end of the range again. Right now, the world is awash in liquidity so it isn’t all that difficult for banks to gain access to low cost deposits. If this were to change, I believe the value placed on core deposits would rise and be reflected in acquisition values. Perhaps this is just wishful thinking.

Hopefully you’ve found the above helpful and will remember to apply core deposit premiums into your valuation work for thrift conversions going forward. If you think any of my rules of thumb look off or have a strong opinion on where core deposit premiums are headed, feel free to leave a comment below. And of course, if you know anyone who might enjoy reading Conversion Confidential, please don’t hesitate to forward this onto them. Until next time!