Texas Capital Bancshares: Deposits Cost Is Rising Dangerously (NASDAQ:TCBI)

Texas Capital Bancshares, Inc. (NASDAQ:TCBI) operates as a bank holding company for Texas Capital Bank and was incorporated in 1996. It is headquartered in Dallas, Texas. Like all regional banks, TCBI is in a difficult time because of the enormous pressure on the entire industry after the failure of SVB.

In this article, based on the latest data available from the quarterly report, I will give my opinion on how this bank is currently positioned in the market and how it is managing the major banking risks.

Volatility of net interest margin

As a first aspect, I would start by analyzing the change in the net interest margin, as it allows us to analyze several key aspects right away. The next image shows average values.

Net interest margin reached 3.33%; it increased 7 basis points from the previous quarter and 110 basis points from Q1 2022. A good result, but unlikely to be repeated in the coming quarters. The cost of liabilities is rising faster than the yield on assets, and as early as next quarter we may see a struggling net interest margin.

• Total earning assets 5.45%, 291 basis points higher than Q1 2022.
• Total interest bearing liabilities 3.90%, 329 basis points higher than Q1 2022.

In my opinion, the main problem lies in the rate of total interest bearing deposits, a whopping 3.63%. This is a very high figure and definitely higher than last year’s 0.40%. On the one hand, it is true that the Fed’s monetary policy has forced the bank to adjust the rate offered on deposits, but the situation may have gotten out of hand. Those who offer such a high interest rate probably do not have sufficient bargaining power, and thus are forced to accommodate customers’ requests.

Compared to last year, non-interest bearing deposits have decreased by nearly $4 billion and the trend does not seem to be stopping. In order to cope with this outflow, the bank may have been forced to raise the rate on its deposits to attract customers. After all, the alternative is borrowing at a higher interest rate.

In addition, non-interest bearing deposits are still $10.25 billion, thus a good part of the funding sources, and this is preventing the total cost of liabilities from going totally out of control.

Overall, the Fed’s sharp increase in rates has generated a twofold deterioration in deposits:

• The first concerns the composition of them. Non-interest bearing deposits were 51% in Q1 2022 while now they are 43%.
• The second concerns the total amount of deposits. In Q1 2022 they were $28.12 billion while in Q1 2023 they dropped to $23.65 billion.

So, deposits are not only less but also have lower quality.

Deposit beta is definitely an issue and is unlikely to decrease in the coming quarters as short-term risk-free rates yield more than 5%. CFO Matt Scurlock on this issue appeared rather doubtful during the conference call:

I think terminal beta implies you know where the Fed is going to stop. And at this point, I don’t think that we do. I think the broad deposit shift, certainly, in our base have occurred. We wouldn’t expect a continuation of that trend. But I would expect interest-bearing deposits to generally stay on the same trajectory in terms of beta until the Fed let slow their trajectory.

Rightly, no one can know when the Fed will stop raising rates, but from his words we can expect deposit beta to remain high and static. Instead, as for the shift from non-interest bearing to interest bearing deposits, it may have ended. I hope so, otherwise, it would mean further pressure on the cost of liabilities and thus on net interest income. The latter has already stalled for 3 quarters.

Anyway, in spite of countless issues with the cost of deposits, so far Texas Capital Bancshares has held its own thanks to rising yields on its assets. The only blemish has been mortgage finance with a yield 53 basis points lower than the previous quarter. In a macroeconomic environment with rising interest rates this is a rather peculiar result, but the CFO gave a clear explanation on the matter:

So as you know, the mortgage loans do have similar repricing and beta characteristics for the rest of the LHI portfolio, but there is a relatively static portion of the mortgage finance deposits that received payment through yield. So as the warehouse balances come down and the deposit level stay stagnant, you’ll see a compression on the printed mortgage warehouse yields. As you move into the second quarter, and those loan balances expand seasonally, you’ll see some of that pressure abate would be a more logical representation for you.

Liquidity and market risk

Liquidity risk refers to the inability to cope with a sudden outflow of money, typically due to a demand beyond expectations for repayment of deposits. In the case of Texas Capital Bancshares, liquidity risk is currently under control, probably even more so than its competitors.

As we can see from this image, in percentage terms, Texas Capital Bancshares has a less risky liquid asset composition than its competitors.

• 46% is composed of cash & equivalents versus 14% of peers.
• 42% is composed of AFS securities versus 55% of peers.
• Only 11% is composed of HTM securities versus 23% of peers.

As a result, the cash & equivalents/total assets ratio is 13%, much more than the 3% of peers. But what can justify this choice? After all, having so much liquidity implies a not insignificant opportunity cost when the money market provides large returns.

In my view, such high cash & equivalents reflect management’s concern about a possible bank run. It is worth remembering that 45% of deposits are uninsured; this is a rather high figure for a regional bank. In the event of a generalized panic, uninsured deposits are the first to be transferred, typically to systemically important banks. In any case, Texas Capital Bancshares is currently well capitalized and has a solid contingency funding plan.

Between cash and available borrowings, the bank would be able to cover 153% of uninsured deposits. So, theoretically, even if all uninsured deposits were to disappear, still Texas Capital Bancshares would not fail.

Regarding the capitalization level, both CET1 Ratio and Total Capital Ratio are well within the minimum limits imposed by the Basel Committee and above the average of peers. Indeed, with such a percentage of cash & equivalents it was difficult to assume otherwise.

Now let us turn to the analysis of market risk, which is the kind of risk that is due to the changing macroeconomic environment and can cause major losses that adversely affect both bank profitability and equity. It is critically important to monitor it; suffice it to say that the trigger for the SVB crisis was primarily unrealized losses due to poor market risk management.

In this image we see the ratio of Equity to Unrealized Losses, where the latter relates exclusively to HTM securities. As we can see, Texas Capital Bancshares’ ratio is 6.7x, higher than its peers. So, at the moment the risk of getting an unrealized loss such that much of the equity is wiped out is averted. Clearly, if the Fed reduced interest rates the unrealized losses would decrease and the ratio would improve, but in any case, at the current level I don’t think there is any cause for concern.

Interest rate and credit risk

Interest rate risk, like its predecessors, is also under control. In particular, compared with the previous quarter, Texas Capital Bancshares was able to reduce the volatility of net interest income to changes in interest rates. In fact, the bank’s profitability is now less sensitive to the Fed’s monetary policy. This was made possible by a series of transactions:

• Securities were purchased for $850 million with a yield of 4.90% and reduced asset sensitivity by 70 basis points.
• Purchased swaps for $100 million with a fixed rate of 4.40% and a maturity of 3 years.

The result is virtually half the volatility of Q4 2022.

This is a model provided by the company, we find on the left the assumptions and on the right the results. As we can see, a 100-basis point positive or negative change in interest rates would cause a maximum reduction in net interest income of 4.60% and a maximum increase of 3.40 %. In short, the rate risk is definitely under control, partly because it is unlikely that there will be such a large change in interest rates this year.

Finally, the last risk to consider is the typical risk of banking, namely credit risk.

The predominance of C&I Loans (54%) within the total loan portfolio implies the willingness of Texas Capital Bancshares to face a major risk in order to achieve higher returns than its competitors. Should we be concerned?

Not at the moment, since NPAs represent only 0.33% of total assets, however, it is clear that the trend has taken on a bullish connotation. According to the CFO’s words, the latest increase in NPAs concerns only a small number of low LGD loans.

In an environment of high rates I think it is reasonable to expect that these figures may worsen in the coming quarters, especially if the Fed continues to raise rates.

Finally, the commercial real estate office segment has been of increasing concern in recent weeks, but in the case of this bank the risk is moderate.

The exposure is only $466 million, about 9% of the total commercial real estate portfolio. The current average LTV is 58%; over 75% of the properties are above Class A; 60% of the properties are in Texas.

Conclusion

Texas Capital Bancshares currently has all major banking risks under control except refinancing risk given the high cost of deposits. The latter are becoming increasingly expensive, much more than those of competitors. This is a major problem, not least because it would appear that non-interest deposits are declining quarter by quarter and deposit beta will remain high. With liabilities costing more and more it is inevitable that net interest income will get worse.

The only reason I do not consider this bank a sell is because in analyzing its tangible book value it looks highly undervalued. The 10-year historical average tangible book value is 1.59x, multiplying this figure by the current tangible book value per share of $58.06, the fair value of Texas Capital Bancshares is about $92 per share. As said, very undervalued, but I think it is best to avoid it at least for the time being since I expect significant earnings difficulties as early as the next quarterly report. Sometimes companies are cheap for a reason.