Early in my valuation career, I was called upon to value what are called core deposit intangible assets of banks. But deposits are a liability for banks, so how could they be “assets”? There were no books or even articles on the subject, so I had to figure out what to do.
My investigation into the valuation of core deposit intangible assets was instructive not only for those particular assets, but also to my valuation education in general.
Banking Business Basics
Banks accept deposits from customers (in the form of checking accounts, savings accounts, and other depository accounts) on the liability sides of their balance sheets. The “asset” comes from the fact that banks then lend those funds to other customers in the form of loans (consumer loans, mortgage loans, business loans and more) on the asset side of their balance sheets. They also invest deposits in other earning assets (like government and municipal bonds, mortgage securities, and more).
Banks earn interest income on their loans and other earning assets (and fees as well), and pay interest expense on their deposits. Since there is little other debt on most banks, the (interest) cost of deposits is a significant expense for banks. The difference in interest income earned on earning assets and the interest expense paid on deposit funds is called a “spread,” or the difference between the earnings (or yield) on earning assets and the cost of acquired funds. This spread is also called net interest income (or interest income after paying interest expenses) The spread can be viewed in terms of margin or dollars.
Banks also earn a variety of fees on loans, deposits, and other services. These fees are referred to as “fee income.” They also pay operating expenses, which, after interest, consist primarily of personnel costs (customers want service), occupancy costs (branches and offices cost money), and all other expenses. These expenses also include the (non-cash) charge to provide for potential losses on loans or other earning assets. In combination, these expenses are called non-interest operating expenses.
Add up the net interest income and all fees and subtract non-interest operating expenses, and you have the earnings of a bank before taxes. And all profitable companies pay taxes.
We now have a simplified business operating model for a bank. Now, what about core deposit intangible assets?
Core Deposit Intangible Assets
Bank deposits were in the past and now are categorized into a few basic buckets, and I’ll simplify.
- Checking accounts. You have money in an account and write checks or use your debit card to spend money.
- Savings accounts. You have money you don’t need regularly and place it into a savings account that typically bears a greater degree of interest than do checking accounts.
- Loyal customer certificates of deposit. You have acquired $100,000 or more and place your funds with a bank in a “certificate of deposit.” For most consumers, these (and all prior deposits) are insured by the Federal Deposit Insurance Corporation (FDIC). You do business with your bank and are not swayed that a competitor bank might offer a bit more interest.
- Money market certificates of deposit. You have lots of money, and are keenly interested in the rate that you earn on your insured investments. So you look around for banks that offer the highest rate to CD (certificate of deposit) customers.
As customers move from #1 to #4 above, they tend to become less loyal to their “home bank” in terms of simply accepting interest rates paid on CDs. Further, as customer funds move from categories #1 through #4 (and beyond), the cost of acquiring funds tends to increase for banks.
Customers in categories #1 and #2 especially, and to a good extent those in #3 tended to be loyal customers who tended to stay with a bank through thick and thin. Their deposits are also the least expensive deposits on a given bank’s balance sheet. Lower interest expense given the yields earned on a bank’s assets meant higher spreads and higher earnings.
Customers in categories #1, #2 and #3 came to be called core deposit customers and their deposits were called core deposit liabilities, or simply, core deposits. The asset associated with core deposit was based on the spread that could be earned from investing them in a bank’s earning assets.
Valuation Implications of Core Deposits
We have already touched on the first valuation aspect of core deposits. They are low-cost and provide a disproportionate share of a bank’s net interest income relative to higher cost deposits. Logically, then, a lower cost funding source should be worth more than a higher cost source, other things being equal.
I mentioned that core deposits tended to be more stable than higher cost funding sources for banks. What this means is that customer relationships exhibit more loyalty and tend to last longer. So the higher spread that core deposits provide tends to be around for a lot longer than other forms of deposits.
To value core deposits, then, we had to examine the spread associated with them (and associated costs of servicing) compared with the spread available from more expensive deposits (and associated costs of servicing). Core deposit customer relationships have value at a point in time based on the expected future revenue they will provide for a bank for as long as those customers relationships are expected to exist.
The Concept of Attrition
Customer relationships do not last forever. Based on my study of bank customer relationships, I coined a phrase that I’ve used hundreds of times over the years:
“Every customer relationship has a beginning, a duration, and an end.”
I go on to say that businesses can influence the length of customer relationships, but they cannot stop the loss of customers, or attrition.
Individual customers die, move, get mistreated (or perceive so), and they move on. Business customers go out of business, get mistreated (or perceive so), get acquired, change their business models, and more.
The same is true of bank customer relationships. Slower attrition (i.e., higher customer retention) implies higher relationship value, other things being equal. Higher attrition, other things being equal, implies lower value.
Observations Regarding Attrition
We won’t go into the details of valuing bank core deposit intangible assets that result from deposit customer relationships, but we can observe make a few concluding observations based on the discussion to this point. Generalizing beyond only bank customer relationships, we can observe that:
- Every customer relationship has a beginning, a duration, and an end. There, I used that expression again. But it does have universal truth in business.
- This means that core deposit customers of banks, and all customers of all businesses, attrit. I just love that non-word. But customers leave businesses for many reasons. Businesses can favorably influence the rate of attrition, and must, if they are to remain profitable and in business.
- By inference, it is cheaper to retain an existing customer than it is to get a new one. Existing customers require only maintenance expenses, while new customers require efforts of staff as well as marketing and advertising expenses and set-up expenses.
- New business development, whether seeking new bank deposit customer relationships or more broadly, must accomplish two things if a business is to grow:
- Replace customers that attrit. When a business replaces as many customers as attrit in a year (assuming equal revenue and profitability), then it has the ability to maintain its revenue and earnings base. Assume a business has 100 customers and loses 10 per year on average. If nothing happens, it will have 90 customers at the end of the year. So the first goal of business development is to replace the 10 customers that attrit to get back to a break-even situation.
- Add more customers that enable the business to grow. If the business in our example adds 5 additional customers after replacing those that attritted, it will end the year with 105 customers, and will have grown 5%.
- Given a level of business development and ability to attract new customers, the slower the rate of attrition, the greater the growth. In our example above, the business gained a total of 15 new customers. Ten of those replaced the ones that went away, and five contributed to growth. Now assume that attrition was limited to 8 customers (8%) and a company still initiates 15 new customer relationships. It will grow by 7 customers, or 7% (or 15 customers – 8 attritted customers = 7 growth customers).
- Given a level of customer attrition, the greater the ability to generate new customer relationships, the greater the potential for growth. In the original example, assume attrition of 10 customers. If a business can generate 20 new customer relationships per year, it will grow by 10 relationships (20 – 10), or 10%, rather than 5%.
- Assume two companies identical in all respects except that one company experiences 10% attrition and the other experiences 15% attrition. The are both growing at 5% per year. The second company must generate more new customer relationships for the same level of growth and experiences higher customer turnover. It is riskier 1) because of the higher turnover, and 2) because it must generate a higher level of new business just to stay even.
We began with core deposit customer relationships and moved to generalizing about customer attrition in banks and other businesses. Enough observations for now.
We could mine this concept of attrition more, but we will wait for future posts to do so. What I do know is that while studying the valuation of bank customer deposit relationships many years ago, I learned things that have been helpful to be as a business valuator and as a businessman ever since.
The value of bank customer relationships is a function of the expected cash flows to be derived from those relationships, their expected growth, and the risks associated with achieving their expected growth. And so it is with customer relationships in other industries. And so it is with all banks and other businesses.
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