It may be tempting to assume that higher rates automatically translate into good news for the banking industry. Loan rates go up, deposit rates lag the hikes imposed by central banks, net interest margins (NIM) expand and banks rake in profits, right?
It won’t be that simple this time around.
The banking industry looks very differently today than it did when the Fed last started raising rates in late 2015 — not to mention that it already looks different from just a few months ago. Overdraft revenue is dissolving, direct banks and fintechs are much bigger competitors than in prior cycles, big banks are awash in deposits and the recent green shoots seen in commercial and industrial (C&I) lending are driving rate competition for the best credits.
To be sure, traditional financial institutions initially may be able to make hay by lagging rates, resulting in some spread expansion. But chances are that won’t be enough — and it probably won’t last.
Curinos has identified six opportunities that will allow banks to outperform in the coming months. (See Figure 1.) Not all financial institutions will be able to pursue each path and not each path is right for each institution. For some, a focus on one or two may be sufficient. Others — depending on size and focus — may be able to adopt multiple strategies.
Figure 1: Don’t let rising rates delay transformation.
Restructure the Mass Market
Optimize Margins & Pricing
Reimagine the cash management product set and mass market economics
Pricing playbooks and optimization across deposits and loans
Customer-targeted pricing (no more mass marketed promotions)
Transform branch operating model
Continued branch closures
Drive DAO while maintaining quality
Commercial Customer Primacy
Double Down on Affluent & Small Business
Home equity resurgence
Value proposition and digital innovation
Source: SNL (2021), Curinos Benchmarks
Restructure Mass Market
After years of stability, the industry’s approach to consumer checking and cash management has been turned on its head. Overdraft policies have been completely overhauled, with big and small providers cutting fees, eliminating them or dropping them altogether. As a result, Curinos estimates that as much as $10 billion in fees may be lost – representing one-half to two-thirds of current overdraft fee income. (See Figure 2.) Smaller banks could feel the effect disproportionately since they have higher concentrations of overdraft fees.
This could be a seminal issue for financial institutions that consider the mass market to be a strategic part of the business. Overdraft fees are very much a part of the profitability of the mass market. The good news is that there is already a growing list of options and banks are adopting them quickly to compete with non-bank providers. These new sources of revenue will likely come at a lower yield than overdraft, but should be more consumer-friendly to pass muster with regulators.
Those providers who don’t consider the mass market to be a core strategy may be forced to consider other areas of focus.
Figure 2: NSF/OD moves have removed industry revenue and will be difficult to replace.
Note: OD Fee Income = $15B (adjusted for COVID-19 impact); Excluded banks with <= $1B in total assets; Pre-Tax Income defined as retail income, incl. interest income from deposits and consumer loans
Source: SNL (2021, 2020), Curinos Benchmarks, Curinos BranchScape (2021), Call Reports as of 12/31/21
Optimize Margins and Pricing
The deposits that poured into banks during the early part of the pandemic are still in the system. As the Fed moves to tightening, some of these surge deposits may leave. More importantly, the surge deposits on many individual bank balances sheets have already begun decreasing, moving from where they entered the system and finding their way into other industry deposit pools like non-operational corporate and institutional deposits.
But nobody knows when or under what circumstances the surge deposits exodus from traditional bank balance sheets will accelerate. Will a burst of C&I loan demand coincide with a depletion of surge commercial deposits or will yield-hungry customers pull out their surge deposits and chase rate elsewhere? Will industry-wide deposit levels decline as the Fed unwinds its balance sheet or will deposits just continue to flow between pools? Are the core deposits claimed by banks across the size spectrum really core? Will the Fed’s attempt to squelch inflation propel loan demand or will the green shoots of C&I loan demand be buried by ongoing concerns about the global pandemic and geopolitical risk?
Curinos data reveal that more than 25% of direct banks increased rates on at least one product by an average 15 bp at the end of 2021. That’s because many direct banks without checking bases don’t have the luxury of overflowing deposit coffers and need to be aggressive in wooing new deposit customers. Many of these targeted new players didn’t even exist the last time around. When these players start to pay above the 100 bp “handle rate,” Curinos expects that appeal of yield to start to be more palpable for consumers.
Given this uncertainty, it will be critical for financial providers to identify customers who are elastic, “partially elastic” or completely inelastic and ensure they keep the best of the different segments. Further, institutions must identify customers who represent primary or potentially primary relationships; higher rates may be needed to maintain a fair value exchange. This is especially critical for commercial customers, many of whom asked for increases in their deposit rates before the first Fed increase. It is time for individualized treatment of the portfolio of customers. Only then can you create customer-level treatments around rate actions as you determine which customers are worth keeping.
Different dynamics are at play in lending where, for example, mortgage is once again shifting to a purchase market and price competition is intensifying with expected reduction in revenues. In home equity, the market is coming back, but the question is how to drive the most profitable growth. Banks can improve lending margins (by as much as 5-10 bp) through more sophisticated optimization of pricing by market, product and other relationship and credit attributes. This can occur across thousands of pricing “cells,” leveraging accurate market pricing data and price elasticity analysis. Similar opportunities are available across all consumer and small business loan categories.
Everyone knows this has to continue. Transformation to digital channels isn’t a one-and-done effort. It also doesn’t mean that branches are going away anytime soon.
That being said, branches still aren’t being used as effectively and efficiently as possible. There are still too many of them. The latest annual tally from the FDIC shows that the pace of net decline in branches doubled to 3.8% between June 2020 and June 2021, with many of closures coming from the largest providers.
That means there is an urgent need to transform the branch operating model and revising the roles within the branch.
Meanwhile, financial institutions need
to continue to expand digital servicing and drive digital account openings. The trick is to ensure that you get high-quality customers and keep them engaged as digitally as possible.
The downside of the omnichannel transformation is that technology budgets and advertising/marketing expenses must grow in order to compete. That demands careful expense reallocations and productivity focus.
Focus on Lending Growth
The need for loan growth is at the top of most CFO agendas. As rates rise, the long boom in mortgages appears to be tapering off. The circumstances favor consumer loans outside of mortgage. Home equity and adjustable-rate mortgages — both of which have seen a long period of contraction — look promising. Consumer credit lines and credit card loans continue to boom. In all cases, digital channels will be increasingly important.
C&I loans showed promise in the fourth quarter and commentary on pipelines throughout the first quarter have remained very positive. However, C&I spreads are under pressure from heavy competition and covenant negotiation is increasing as well. Meanwhile, commercial real estate loans haven’t shown the same rebound in terms of new volume.
Corporate balance sheets have been expanding, inflating the deposits that companies hold with banks. As the pandemic has worn on, we have seen little signs that those excess cash reserves are declining. While banks intuitively understand that holding a company’s surge deposits or providing a PPP loan as a single service doesn’t mean that the customer is primary, many bank metrics define these customers as if they were. True commercial customer primacy is almost always accompanied by a significant treasury management relationship and high levels of digital engagement from the company’s treasurer’s office. As companies deploy their excess funds and seek new borrowing, there is a unique opportunity for banks to defend existing primary relationships and to build primary relationships with current customers and prospects. Prior periods of economic expansion and rising rates have presented the greatest opportunities to increase commercial primacy and we expect the same this cycle.
Small Business and
mass affluent segment associated with small business have long been underserved. The cost and complexity of relationship coverage for this segment has never really been viable. The good news is that these segments welcome digital banking and place the capabilities of digital banking at the top of their bank consideration criteria. Digital banking for these segments may finally address the economic and operational challenge of serving a segment that historically have been catered to by relationship managers. Banks need to identify new models for connecting with these customers (whether in person or remotely), accessible servicing and advice by phone and video. To be sure, some branch presence will be required as well, though not at traditional levels.
NOT EASY, BUT ESSENTIAL
Curinos believes these six opportunities can unlock sustainable advantage in a rising-rate environment and can lead to net positive new account growth. Not all of them can be tackled by every institution. All must take stock of their capabilities and franchise to determine which of the six can produce the best result with the least investment. But some combination will almost certainly be needed by every provider.