BankFinancial: Wild Card Is Interest Expense On Deposits (NASDAQ:BFIN)

BankFinancial Corporation (NASDAQ:BFIN) is a bank that was founded back in 1924 and as of today has a market capitalization of only $92.50 million. Over the past few months, after SVB’s bankruptcy, regional banks have experienced a period of severe stress that has led them to downsize, and BankFinancial is no exception. But how solid is this small bank? What are the most important aspects for its future?

In this article I will answer these questions, based on Q1 2023 data.

Income and financial analysis

As a first point, I think it is appropriate to start with the most important one, which is the cost of deposits. As expressed by CEO F. Gasior during the conference call, the future of BankFinancial depends mainly on this element:

Well, as we said last quarter, the wildcard was deposit interest expense, and it remains the wildcard. That is going to be the key to what happens next. And actually, we’ve been saying it for about a year now. As the deposit competition is intensified, it obviously means that we’re going to have potentially a higher interest expense even if we are successful bringing in new deposits in the commercial side. So I’d say, number one, higher deposit interest expense is the greatest challenge in terms of maintaining and expanding net interest margin.

Deposits are the lifeblood of any bank’s balance sheet, and if their cost increases too much it can lead to serious income difficulties. It all starts here, because if deposits are expensive, then the bank will have to charge a higher interest rate on its loans to earn from the spread. Unless it wants to reduce its profit margins, which no manager hopes for.

At this stage it is very complex to keep the cost of deposits below 1%, as there are many alternatives in the money market that yield much more. T-bills yield even more than 5%, so why settle for a lower interest rate? This is the question depositors are asking themselves, and it is driving the cost of deposits higher and higher.

So, the main problem for BankFinancial, or more generally for all banks, is that they are now too dependent on an exogenous factor that they do not control, namely the Fed’s monetary policy. The CEO would not give any official predictions about future deposit trends, but he did offer some interesting insights into what would be considered good results for BankFinancial:

So at the end of the day, we’re mindful of what’s going on with deposits. There’s still quite a bit of competition. Don’t really want to make hard and fast projections about deposits right now, other than the work we’re doing on deposit insurance has provided some stabilization and some growth. We’re going to continue to work the commercial side to see if we can get some additional growth to offset any runoff we might have due to retail competition, and we’ll see how we do from there. But if we can keep deposits stable, maybe even growing a little bit by the end of the year, that same 2% to 3% and keep our loan-to-deposit ratio in the 90%, 91%, 92% range, that would be a good result by the end of the year for us.

But then, what is the current interest rate on deposits?

The average cost of total deposits amounts to 0.70%, not too high then. Not a few regional banks are forced to offer an interest rate on deposits around 1.50-2%, so I think as of today 0.70% can be considered a decent result. It is obvious that compared to Q1 2022 where the average cost was 0.12% there has been a deterioration, but of course it should be taken into account that now the Fed Funds Rate is at 5-5.25%.

Regarding the latter, the Fed Funds Rate now seems to have peaked and the market expects a gradual decline as early as the second half of 2023. However, according to F. Gasior’s words, it is unlikely that the cost of deposits has also peaked. There are still too many variables that suggest it has not:

I think it’s too early to make a statement like that. I think part of this is you’ve got a severely inverted yield curve. And in terms of calling a deposit expense peak, I think it comes down to what is the level of Fed funds in the 3-month, 6-month T-bills. You’re competing against short-term money market funds that are funding in that short duration. And until that changes, I think it would be difficult to call a peak. So we don’t particularly believe there’s a Fed pivot in the short term here. We’re thinking and planning as if there is not. So I think that is going to be probably the key fact. If all of a sudden, there’s a material change in short-term monetary policy, if the market’s right that there’s a Fed pivot in the second half of the year, then I think it might be appropriate to start looking at a deposit interest expense peak, but probably not before then.

In light of this pessimistic view, we can therefore expect that the cost of deposits will rise further during the year. This could prove to be a problem, but at the moment the situation remains stable, as asset yields have risen more than the cost of liabilities. In fact, the net interest margin has improved by 93 basis points compared to Q1 2022.

But what is driving up the average yield on assets? Mainly the origination of new commercial loans at a rate it around 8.67%.

Overall, the multi-family segment remains the largest weight, but with high rates it is struggling to grow. In contrast, the commercial loans segment has loan originations in line with past quarters. At the same time, however, it is the segment most sensitive to the macroeconomic environment and therefore the riskiest.

The risk of excessive concentration of the loan portfolio is around the corner, but at the moment this does not seem to worry the CEO, who remarked during the conference call that the real estate portfolio is doing very well. In fact, despite the large exposure to commercial loans, for now there is no reason to think otherwise.

The increase in nonperforming commercial loans from $1.31 million to $8.80 million in just 3 months was generated by an event of a nonrecurring nature concerning government equipment according to the CEO, and there is no cause for concern:

That’s in the government equipment space. We wrote about it in the 10-Q, and we probably can’t talk much about it. It’s going to go through a government claims process. There is an issue between the government and the vendor, where we’ve reviewed it with outside counsel. We’re comfortable with the collection position, both as far as the government is concerned, and if necessary, potential avenues of recovery with the private contractor and the vendor. But this process is going to take a while, and usually a minimum of 120 days is what we’re being told. This is the first time we’ve actually had to go through it in the many years we’ve been doing this. But at the moment, we were comfortable with where it is. We put it on nonaccrual given the claims process duration and then wrote about everything we could write about in the 10-Q.

Conclusion

BankFinancial is a small bank that is facing a banking crisis whose magnitude is still unpredictable. On paper, this bank is not in bad shape; in fact, the average cost of liabilities is 0.98%, compared with an average yield on assets of 4.39%. Compared to last year, the net interest margin has improved despite all the difficulties encountered in operating in an inverted yield curve environment.

The biggest problem is probably overexposure to commercial loans, but now the situation is stable. Moreover, it is the origination of commercial loans that is improving the average yield on assets, thereby increasing the net interest margin. This is a risky choice, but so far it is working.

The future of this bank will depend mainly on deposit beta, namely how quickly the cost of deposits adjusts to money market rates. The CEO believes that the peak has not yet been reached, so I expect a worsening in the coming quarters regarding the cost of deposits.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.