Butterfield Bank's recovery is contingent on retaining clients and deposits in a low-interest environment that is dampening its earnings.

That is the view of experts from Bermuda Investment Advisory Services Ltd. (BIAS), who also told investors at the firm's Quarterly Market Briefing yesterday that a possible unintended consequence of the bank's upcoming issue of $200 million of preferred stock could be a depletion of its deposit base, as the bank's customers invest in the shares.

Answering questions from investors at the lunchtime briefing, BIAS chief executive officer Robert Pires said he thought the bank should have used more local advice in planning the preferred stock issue.

"I'm not impressed with how the bank has dealt with this," Mr. Pires said. "They should be engaging with each and every company with expertise in this area and they have certainly not consulted us.

"My view is that the issue should be all in US dollars and there should be an equity kicker."

An equity kicker is defined as a loan agreement under which a lender agrees to charge lower than normal interest rates in return for a share of ownership in the business.

Butterfield needs to raise the $200 million to comply with regulator the Bermuda Monetary Authority's requirement for banks to have a "capital buffer" sufficient to withstand the effects of a severe economic downturn.

Government has guaranteed the capital raise by agreeing to purchase any of the preferred stock not subscribed by the private sector by June 30.

Butterfield has said it hopes to release details on the issuance this week.

Asked by an investor what kind of returns Butterfield would need to offer on the preferred shares, Mr. Pires said: "Let me answer that by saying that we can get Government-backed preference shares in major banks, such as the Royal Bank of Scotland, returning between 17 and 20 percent."

If some of the Butterfield offering were denominated in Bermuda dollars, then he estimated that it might give investors a yield of eight or nine percent.

Because the stock is guaranteed by the Government, there has been strong interest in the upcoming offering, including among Butterfield's customers.

"One potential danger that nobody's talked about is that this could be a draw on Butterfield's deposit base," Mr. Pires added.

BIAS vice-president Mark Melvin had previously pointed out that the bank's balance sheet showed deposits had fallen 15 percent by the end of the first quarter compared to a year earlier.

Based on past bond issues by organisations like the Bermuda Housing Corporation, Mr. Pires estimated that local investor capacity for such an issuance would normally be in the region of $8 million to $9 million.

Butterfield's common shares plunged after the capital raise was first announced in February all the way down to $3.50, but since the bank announced a first-quarter results less than two weeks ago, the common shares have rebounded to $5.45, as of the close of trading yesterday.

"We are very supportive of Butterfield," Mr. Pires said. "It's a great bank with wonderful people working there, offering great service. We really want the bank to survive. But no-one has asked us what we think."

"We may see the share price halve, because there will be dilution," Mr. Pires said. "At some point it will probably affect the taxpayer, but this is all supposition.

Earlier, Mr. Melvin had outlined good and bad points about Butterfield's situation.

Retaining clients and deposits was essential, Mr. Melvin said, and the recent affirmation of Butterfield's short-term deposit rating at the highest level of Prime-1 by Moody's could help to stop deposit drift, as could the confidence generated by Government backing. But the cutting of the bank's financial strength rating by one notch was a negative point.

After the $200 million or so of write-downs of investments tied to US residential mortgages, a point in Butterfield's favour is that it believes that only another $13.5 million is significantly at risk of being written off in future.

And the remaining collateralised mortgage obligations and asset-backed securities in the bank's portfolio were all in senior tranches, implying lower risk. Counting against this was that the bank has given no guidance on these investments for 2010 or 2011.

The low interest rate environment would reduce Butterfield's earnings from loans significantly. However, the apparent ongoing stabilisation of world markets would bode well for fees earned from money management.

Mr. Melvin was Butterfield's loan book was "in excellent shape", thanks to conservative lending practices over the years, but loan losses could become a problem in the case of a worsening economic situation in Bermuda or the Cayman Islands, where the bank also does substantial business.

Cost cutting and efficiencies through selling its fund business to the Fulcrum Group last year and outsourcing its IT department had been achieved.

And Mr. Melvin said he expected the bank to sell more non-core businesses, as it focused on its core operations of banking, wealth management and custody.