There is little doubt that the immediate impact of the transition to higher rates has been rapid — and this is likely just the beginning. The U.S. has experienced two consecutive quarters of GDP decline, stock markets dropped 20% from 2021 peaks, existing home sales plummeted, consumer confidence is uneasy at best and there’s another election around the corner. Elsewhere around the world, central banks also have boosted rates, warned of recession and are wrestling with political upheaval.
Although significant uncertainty remains (especially with the recent news that U.S. inflation rose in August despite declining gasoline prices), the consensus is that the U.S. and many other economies are on the verge of a technical or mild recession. Still, there are many unknowns and few, if any, are willing to bet on one particular outcome. How long will it take to tame inflation? What impact will the situation in Ukraine have on global energy supply? How quickly will supply chains return to normal operations? What will happen in the political environment over the next year or so? It is all confounding to executives and economists alike.
The current degree of uncertainty is highly unusual and demands careful scenario planning. Financial institutions will find themselves positioned to withstand whatever comes next by creating playbooks for a few important areas that underpin long-term performance, namely deposit costs, credit management and operating costs. And the secular trend to digital transformation will continue in any economic environment.
Deposit management has gotten tricky ever since COVID-19 sent a flood of liquidity into bank coffers. The deposit surge triggered a new focus on primary relationships, but the skills of actually managing interest expense atrophied throughout the industry when rates were low. It’s now time to exercise those muscles. (See Figure 1.)
Figure 1: Rate Expectations Have Shifted Dramatically and Rapidly
The rate indifference and customer inertia that dominated when rates were low have already started to disappear. The recent rapid pace of large rate increases has drawn widespread publicity and depositors are keenly aware of the rise in short-term rates. Increased awareness of higher-rate alternatives will continue to drive up deposit costs. That is especially the case for wealth customers, who are moving quickly and with purpose, and commercial accounts. (See Figures 2 and 3.)
Figure 2: Betas for Branch Savings/Mma Remain Near Zero, But Have Begun to Increase
Figure 3: Commercial Interest-Bearing Rates Are Also Rising
Excess deposits at the start of this cycle can provide flexibility as certain banks tolerate lower deposit growth and continue to execute on growth plans. Other banks with fewer primary relationships will witness higher deposit outflows and will compete on price earlier. Since the pandemic accelerated the shift to online banking, digital disruptors are more prevalent and already offer more aggressive pricing because they have fewer surge deposits than traditional bank counterparts.
Curinos estimates that interest expense for the top-performing banks in the 2015-2019 rising-rate cycle were 20 basis points lower than the average bank. These banks largely had deposit bases dominated by primary relationships and used data analytics extensively to manage deposit pricing.
The current rising-rate cycle presents new challenges that banks will need to address. That means scenario planning will be critical. The fact is that the Fed is raising rates faster than in any period for the last several decades, creating an awareness of the rate disparity that incentivizes customers to act. There will likely be key thresholds that will drive more churn in different segments of their deposit base as rates rise and that awareness grows. In previous cycles, 1.00% has been a key threshold that drove greater consumer awareness. If short-term rates remain above 3.00% for an extended period, what will the ultimate through-the-cycle beta be? Will there be a continuation of the 150-point gap between the Fed Funds rate and industry deposit rates that existed in the last rising-rate cycle or will increased consumer awareness and technology advances significantly shrink that gap for certain depositor segments?
It will become even more difficult to manage deposit costs in a deep recession. At that point, banks will have to analyze their deposit needs against a declining demand for loans. For example, will the need to rein in costs mean that banks reduce deposit rates even if central banks keep them elevated? And if commercial deposits are already declining in a mild recession due to quantitative tightening and other reasons, will they fall further if the recession becomes severe?
Banks will need both an explicit funding playbook, as well as deposit data and analytics, to manage the rapid rate increases and impact of technology.
Retail Credit Management
Like deposit costs, credit losses have been low for years. Curinos anticipates minimal credit issues in a technical or mild recession, although the extension of credit could be constrained by reduced demand from clients that are impacted by higher long-term rates. For lenders, that means a need to focus on targeted industries on a bank-by-bank basis. In previous mild recessions, net charge-offs hovered around 1.00%.
A forward-looking approach to credit risk is essential, especially when common credit risk metrics such as credit scores are based on lagging indicators and don’t fully capture a borrower’s risk profile. It’s important for lenders to determine whether their credit-risk appetite should remain as-is or be reined in. A common practice that many lenders actively use today is reducing the debt-to-income (DTI) threshold versus minimum FICO requirements to ensure that, in the event of more stressed cash flow in the future, the borrower’s ability to pay will be less affected. Additionally, enacting minimum “cash on hand” requirements is also a useful tool because it helps lenders determine the number of months a borrower can fulfill their debt obligations in the event of income disruption.
Another complication is the fairly new Current Expected Credit Losses (CECL) accounting standard that has the potential to force banks to recognize significant losses that might never materialize. In an uncertain environment where credit losses can emerge quickly, this has the potential to take a big bite out of the income statement. Banks must continue to enhance their understanding of how CECL models will evolve through a downturn based on changing economic conditions.
Relationship lending will be the gold standard as lenders brace for bumpier credit performance by practicing sound portfolio management. In the case of home equity loans, for example, understanding borrower HELOC usage patterns and activity is a proven way to determine if the borrower’s risk to the organization has become elevated in recent months. A borrower who has fairly predictable usage and payment patterns over certain timeframes may sound an alarm if a lender sees a sudden spike in usage levels and changes within their repayment activity. The main idea behind sound portfolio management is identifying the risk before the borrower actually becomes a risk and draws down the HELOC to unmanageable levels.
Higher sustained rates and an already significantly constrained mortgage market (with more than a 50% decline in the market predicted for this year) will pinch lenders (and especially independent mortgage brokers) that have limited liquidity, technology and scale. (See Figure 4.) At the most basic level, lenders should be focused on retaining their current customer base and finding creative marketing campaigns to target new customers. A hard landing would decrease overall mortgage demand and ultimately drive interest rates lower. The potential for increased delinquencies and credit losses should prompt lenders to conserve capital and maintain appropriate risk reserves. Any uptick in mortgage foreclosures would lead to increased supply and more homes coming to market.
In small business, higher rates will eventually contribute to a decline in lending as supply chain issues and inflation remain as significant concerns. Financial institutions can re-evaluate pricing, promotions, relationships and rate structure to incentivize small business clients to borrow. A deep recession will trigger more revenue declines, increased credit risk and the potential for increased charge-offs due to decreased cash flows used to make loan payments. In that case, financial institutions should re-evaluate the credit box to mitigate risk and shift the product mix to more collateral-secured loans and credit lines.
Figure 4: Mortgage Volume Velocity, 2022 vs. 2021
Financial institutions, like other companies, have already begun to rein in operating costs due to concerns about the economy. The shift to digital channels is part of the ongoing effort, especially in commercial banking, which has lagged some of the advances in the consumer segment. Providers must continue to monitor that shift and adjust accordingly to meet customer needs.
For many providers in the U.S. and Canada, the opportunities for additional expense management lie within the branch network. Curinos continues to believe that both countries are still over-branched and the pace of closures should increase in the coming years because branch activity is declining at a faster rate than branches are. While closures must be carefully evaluated and planned to minimize the impact on employees and customers, the reduction of branch-related fee income and wage-related pressures — combined with the shift to online activity — make future branch closures inevitable. (See Figure 5.)
That said, deposit-gathering branches remain important when net interest margins expand as rates rise, so some deep analysis is required. On the flip side, branches will be less valuable in a deep recession because declining loan demand will eliminate the pressing need for deposits. It all means that networks need to be carefully reconfigured for efficiency and profitability.
In evaluating network economics, two opportunities stand out:
First, Curinos has long believed that branches can be more productive and profitable by developing new workforce roles and performance metrics. Today’s economic uncertainty makes that more important than ever, but few institutions have taken the leap so far.
Second, there are still too many branches in both a rising-rate and falling-rate environment. Potential closures can focus on thin markets where Curinos believes many banks are experiencing lower profitability and low growth. This makes it hard to justify the investment, especially where they have a market share of less than 6%. Curinos data suggest that regional banks in the U.S. generally have lower growth in these markets over the last three years. And there is still opportunity to accelerate closures in dense markets where customer shifts toward digital channels have reduced the activity within the branch, triggering the need to improve efficiency and productivity.
If identified areas have lower growth than planned, are returns meeting hurdle rates or other profitability targets through the cycle? The tendency is to keep branches when rates are rising and close them when rates are falling. Analytics should be done on branches through a business cycle. Of course, success in the digital domain helps make such decisions easier.
There is little doubt that the current economic uncertainty will unnerve financial institutions in the months to come, but banks can plan for a wide range of scenarios after assessing a complex set of factors that many haven’t experienced. As always, planning for multiple outcomes will be critical to allow for a quick pivot as economic conditions evolve.