What a difference a year makes. While interest rates have hovered near zero since the pandemic started, attention has moved from the specter of negative rates to the plausibility of higher rates sooner rather than later. Although we have been through this before, the deposit rate playbook for each line of business should be different this time from the one that was used in the last cycle.
There are increasing signs that rates could start rising as soon as next year as the economy expands (potentially increasing loan demand) and the Fed keeps a close eye on inflation. The good news is that higher rates may produce some long-sought relief to net interest margins. The challenge will be to position the bank so that it takes a coordinated, enterprise-wide approach to the new landscape. And there will also be pressure to avoid significant increases in interest expense following widespread cost reductions.
As always, the ultimate goal is to use customer-level analytics to acquire and retain primary relationships, retain low-cost, sticky deposits and avoid doling out higher rates to customers who aren’t price sensitive.
THIS TIME IS DIFFERENT
Critical distinctions between the current low-rate environment and the 2015 cycle mean old truths in commercial and consumer deposit-taking must be revisited. Curinos has identified eight key differences between the current climate and the 2015 cycle that will have assorted impact on betas and growth. (See Figure 1.)
Figure 1: The next rising-rate cycle will look different than the last one
Average Bank Rates For Savings/MMDA | Promo and Portfolio Beta | Jan '15 u2014 Jun '19
- K-SHAPED RECOVERY. The overflowing deposit coffers reflect the fact that a greater share of consumers have money in savings accounts than pre-pandemic due to federal and state stimulus programs and restrictions that reduced spending. More consumers than ever have some amount of savings, even as a smaller number hold a greater share of those deposits. This changes pricing dynamics.
- DIGITAL INNOVATION. The pandemic accelerated the shift to digital channels, challenging incumbent business models. Commercial units are investing in digital platforms to keep pace with their corporate clients changing expectations. Greater digital uptake by consumers lends itself to more transparency of rates and fees, along with lower barriers to moving money.
- EXCESS LIQUIDITY. The flood of deposits may make banks more tolerant of low deposit growth, or even runoff, after rate competition returns. (Indeed, some banks have already discouraged deposit growth from commercial clients.)
- GREATER FOCUS ON PRIMARY RELATIONSHIPS. The combination of an influx of liquidity and collapsing spreads forced commercial units to focus on primary customer relationships to boost fee income and guide difficult balance sheet allocation decisions (on the liability side).
- FED TIMING. The pace and magnitude of Fed increases will potentially impact competitive response, but both are unknown. Current projections indicate at least two hikes in 2023, but some Fed members anticipate rates rising as early as 2022. And even if loan growth normalizes before the Fed moves, it’s unlikely that banks will have lent through the full backlog of accumulated excess liquidity.
- FINTECH/DIRECT BANK EXPLOSION. Many consumer-oriented fintechs are focused more on acquisition than on profitability. (Some had started using rate just before the last cycle turned down.) The rise of disruptive fintechs offering compelling, low-dollar ways to invest in the markets is challenging traditional players. Fintechs are also disrupting commercial lines of business via charter acquisition and deeper capabilities in core cash management functions.
- DIRECT BANK PRICING. Most direct banks are pricing consumer deposits at 40-50 basis points, well below where they were at the end of the last low-rate cycle and under the 100 bp tipping point that typically drives higher acquisition.
- INSTITUTIONAL MEMORY. Corporates and banks remember the last rising-rate cycle (through July 2019) when betas on interest-bearing products were quite high.
- CREATE PLAYBOOK NOW, DON’T REPEAT HISTORY
Many banks were slow to develop a funding playbook in the last cycle. As a result, they lost valuable time in identifying the best way to respond to the changing landscape. (See Figure 2.) That’s why it makes the most sense to start now, when the planning cycle for 2022 is getting underway.
CREATE PLAYBOOK NOW, DON’T REPEAT HISTORY
Many banks were slow to develop a funding playbook in the last cycle. As a result, they lost valuable time in identifying the best way to respond to the changing landscape. (See Figure 2.) That’s why it makes the most sense to start now, when the planning cycle for 2022 is getting underway.
Figure 2: Betas typically accelerate after an initial lag
While the playbooks differ for each line of business, they should all consider current deposit needs and anticipated potential needs for the future and set programs for each macroeconomic and competitive scenario. (See Figure 3.) Chances are they won’t be the same; a short-term funding need that requires an aggressive rate posture will likely hurt the bank if it stays in place too long. And consumer promotional fatigue, in which customers stop responding to endless offers, is a real thing!
Figure 3: Scenario-based analysis is critical
Commercial banks, meanwhile, should and do compete for primary operating accounts through all cycles and scenarios. But treatments and exception pricing offers on reserve balances will vary significantly from one scenario to the next.
These playbooks should identify efficient growth and ensure sustainability for the future. Some key questions include:
- What is the marginal cost for current and historical strategies?
- How does marginal cost of deposit acquisition change as rates increase?
- How can funding be optimized across line of business and channel (e.g. branch versus direct)?
- What is the retention versus margin tradeoff in commercial standard rates and the consumer back book?
- What investments will be required (new products, capabilities) to respond and what lead time is needed to implement each?
- Does the bank have the customer’s primary cash management business today? If not, is there a reasonable chance of acquiring it?
- How does the pricing strategy drive product mix shifts and what impact will that have on net fee income (after ECR)?
- To what degree do product capabilities, especially digital ones, create incremental pricing power?
COMPETITIVE PRESSURES
A bank won’t know how the competition will respond to rising rates until it happens, but a well-developed playbook must take those scenarios into account as well. After all, higher rates typically drive higher balance churn. (See Figure 4.) Even banks with significant excess liquidity today are likely to see their growth rates come under pressure if others in the market begin to price up.
Figure 4: As rates rise, banks need to deal with higher churn and changing product dynamics
Finally, the development of a deposit rate playbook can’t occur in a vacuum. A good rising-rate playbook will need to take into account the holistic customer relationship and a strong assessment of both current and potential relationship primacy.
In consumer businesses, direct banks will be one of the biggest wild cards when rates rise. In commercial, it will be critical for banks to have robust pricing processes supported by timely and accurate data on market-cleared prices to avoid indexing to the least-disciplined competitors in the market.
Along the way, banks can’t lose sight of the need to manage core funding growth without compromising relationships. That means using customer-level analytics to avoid raising pricing on deposits that aren’t price sensitive.
Banks have largely weathered the pandemic by concentrating on core customers, closing branches and expanding digital capabilities. Rising inflation and loan growth will only provide more opportunities for banks to be a trusted advisor to their most important (and profitable) clients.
