First Internet Bancorp Could Be in Trouble With Fed Interest Rates on the Rise

On May 1, the small $4.3 billion asset First Internet Bancorp (INBK 0.70%) announced that it had terminated its planned acquisition of First Century Bancorp, sending First Internet’s stock price tumbling by more than 14% that day. First Internet had previously announced the acquisition in November.

While the Federal Reserve approved the deal recently, the bank could not complete the acquisition right away due to a statutory waiting period. This forced First Internet to try and extend the merger agreement, at which point the deal fell apart because it looks like First Century may have asked for a higher price tag.

Losing First Century is a blow for First Internet Bancorp and puts the bank in a difficult position with the Fed now aggressively raising interest rates. Here’s why.

Person on couch looking at computer.

Image source: Getty Images.

It’s all about deposits

First Internet wanted to purchase First Century because of its strong deposit base. One of the most important parts of any bank is the deposit base because banks need deposits to fund loans and bond purchases. The less interest a bank has to pay out on its deposit base, the wider its margins on loans and bonds will be. Additionally, lower-cost deposits tend to be from customers who aren’t looking for yield and therefore are less likely to leave the bank when the Fed starts hiking interest rates, which eventually results in higher deposit costs across the industry. First Internet has never had a low-cost or sticky deposit base.

First Internet Bancorp Deposit Break Down.

Image source: First Internet Bancorp.

At the end of the first quarter, only 4% of First Internet’s deposits were non-interest-bearing, meaning the bank doesn’t pay any interest on them. That’s a very low amount. Even more problematic is that 37% of the bank’s total deposits are from certificates of deposits and brokered deposits. This type of funding costs the bank more interest and isn’t stable, meaning the bank will have to pay up as the Federal Reserve raises rates because this is money looking for yield.

First Century was going to help improve First Internet’s deposit base. The bank has over 1,500 deposit relationships from its homeowner’s association business. The bank in total has roughly $330 million in deposits, with 70% of those in non-interest-bearing deposits, which carry a total cost of just 0.06%. In comparison, First Internet’s total deposit costs at the end of the first quarter of this year were 0.81%. First Internet management also believed they could ramp up First Century’s deposit base to $500 million over two years.

First Internet Bancorp and First Century Bancorp Pro Forma Deposit Base.

Image source: First Internet Bancorp.

As you can see, if they had achieved that $500 million goal, First Internet would have made meaningful progress on improving its deposit base by increasing non-interest-bearing deposits to more than 17% of total deposits. But the deal extension came at a bad time because every bank knows deposit costs will soon be moving higher with all of the Fed’s planned rate hikes, which makes First Century a lot more valuable today than six months ago, and it looks like management knows it, too.

A blow for the bank

First Internet management has been making moves to improve the bank’s deposit base organically by running down CDs and brokered deposits and growing cheap deposits from its banking-as-a-service business. But it will be hard to replace the First Century deal, which would have given First Internet $330 million of cheap deposits overnight. First Internet also likely spent a good amount of resources trying to get the deal done.

First Internet’s CFO Kenneth Lovik said on the bank’s recent earnings call before the deal was terminated that the bank expects deposit costs to be stable for the remainder of 2022 (there’s typically a lag between when the Fed raises rates and when banks start to increase deposit costs). But with rate hikes moving quickly and the First Century deposits gone, First Internet may start to see deposit costs rise sooner than anticipated, which would cut into the bank’s margins.

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