Join our community of smart investors

The deposit conundrum

Attracting customers and deposits allows banks to reduce their reliance on wholesale funding, but competition is fierce
November 14, 2019

On 1 November, shares in Metro Bank (MTRO) jumped after a column in the Evening Standard suggested Lloyds Banking (LLOY) was weighing a bid for the beleaguered bank. Since then, the admittedly speculative report – whose chief source was “the man in the City wine bar with the chunky cufflinks” – has collected no additional substantiation, and Metro’s share price has returned to its familiar trajectory.

Yet according to the piece, as well as Metro optimists, such a deal would be logical. While the lender’s borrowing costs and overheads are high, so the argument goes, these have only suppressed the valuation of its assets, including a brand that remains popular with many businesses and individuals, judging by customer accounts growth throughout this year’s many tumultuous episodes.

Indeed, until this year, one of Metro Bank’s greatest achievements has been its ability to attract deposits. In the three years to December 2018, customer deposits grew from £5.11bn to £15.7bn, a compound annual growth rate of 45 per cent. Although this was outstripped by an even faster rate of lending activity – a strategy we have long viewed as unsustainable – Metro argued that this rapid growth could support its expensive physical branch-led strategy, winning more customers (and deposits) in the process. A balance would be found, at some point in the future.

Unfortunately for the bank, those plans are in flux, with deposit growth at the centre of its problems. In the first half of this year, customer money dropped 13 per cent, as several large commercial customers withdrew their cash. And while growth has since returned, Metro Bank is having to make sacrifices to attract savers. Even at 222p, some 90 per cent below its one-year high, it is still not clear that Metro’s share price reflects the uneven balance it has struck between a hyper-competitive lending market on the one hand, and its liabilities, funding costs and overheads on the other.

One should never rule out takeovers. At the right price, Metro will be an attractive proposition for an acquirer prepared to overhaul the business model. But the suggestion made by one City analyst canvassed for the Standard article – that “Lloyds gets to pick up the assets cheaply” and “chuck away” assets deemed surplus to requirements – relies on a dubious assessment of Metro’s deposit base.

Balance and competition

Such a reading of Metro’s liabilities also implies that its deposit holders would be content to see their current and savings accounts move house. Most of those customers presumably had a reason for overlooking the UK’s largest retail bank in the first place. And while Lloyds, like Metro, has a loan-to-deposit ratio above 100 per cent, this has been deliberately reduced since the start of the decade, reducing Lloyds’ reliance on – typically more expensive – wholesale funding in the process. Acquiring Metro Bank outright would add more loans and some expensive (and potentially flighty) deposits. 

Pulling in those deposits, particularly for smaller lenders, need not be hard. The executive of one UK lender recently told us that the billions of pounds sitting in would-be savers’ bank accounts make it “a straightforward exercise in targeting the top of the savings product lists”. As the likes of Paragon Banking (PAG) and OneSavings Bank (OSB) have shown in the past two years, the money comes flooding in soon after. 

Metro Bank appeared to have this strategy in mind last month when it increased the rate on its 18-month fixed-term savings account by 20 basis points to 1.9 per cent, just shy of the market leader. An “excellent” product rating from UK finance product data provider moneyfacts.co.uk immediately followed. The lender’s one-year fixed savings account, which pays out 1.8 per cent interest, is also currently the top pick in its category on Martin Lewis’s influential Money Saving Expert website. 

Many active savers will happily move their cash to the highest-yielding product, so long as it is protected under the Financial Services Compensation Scheme. For investors, this involves trade-offs, such as a higher cost of funding, and the need to compensate with riskier forms of lending.

Other savers are more reluctant to switch. High-street banks, which tend to offer meagre savings rates, appear to rely on the latter dynamic, while counting on commercial deposits looking for the safest home. That this funding advantage has not translated into strong share price performances in recent years for the likes of Lloyds or the Royal Bank of Scotland (RBS) has been a source of frustration to many investors.

Another way to attract deposits is to simply build a fresher brand, as the neo-banks’ digital-only operations have shown.

In 2018, fintech challenger Revolut more than quadrupled its deposit base to £928m, including £37m of “crypto assets” held at fair value. Starling Bank, which caters to both personal and business customers, is on course to quintuple its deposit base to more than £1bn this year.

In the 12 months to February 2019, Monzo managed to increase its customer deposit base by five-and-a-half times, from £71.3m to £461.8m. Such viral-like growth helps to explain why private investors were happy to value the group at £2bn in a summer funding round. But while lots of people have endorsed the company’s mobile app, the average Monzo customer has less than £300 in their account. The average balance for Lloyds’ 22m current account customers – let alone the bank’s savers – is more than 10 times that figure.

 

Favourite

To some investors, Secure Trust Bank (STB) looks like a high-risk business. Its seven product lines are split evenly between business and consumer finance, and lending terms are often for shorter duration. Changes in the group’s net interest margin – the difference between lenders’ income generation and the amount paid to deposit-holders – are therefore likely to be more abrupt than larger peers, who also boast access to cheaper funding. But with larger lenders constrained by the mortgage price war, we think investors in the sector need to take on a bit more risk if they want to see capital appreciation. The group also has zero exposure to sub-prime lending and to credit cards, while the residual life of its average loan is less than two years, meaning it can rapidly reposition its balance sheet if the UK economy enters recession.

 

Outsider

Who will step in to succeed Metro Bank’s larger-than-life chairman and founder Vernon Hill? His expedited departure from the board last month may have placated nervy bond investors – who demanded a 9.5 per cent coupon to help the lender merely boost its shock-absorbing capital – but a new leader will be fighting fires with the Financial Conduct Authority and have a battered market reputation to salvage. And while the brand may retain some cachet for a potential buyer, the investment opportunity – a targeted ‘low double-digit’ return on equity by 2023 – looks to us both meagre and fanciful, while the repeated lunge for deposit growth carries hidden liabilities.