U.S. bank deposits are in decline, down 2.4% since peaking in April 2022. That doesn’t sound like a lot, but those declines are unprecedented. And they translate to $440 billion in deposit outflows from banks.
Still, about 90% of the surge, or $3.4 billion of balances, is sitting on bank balance sheets. Given the current balance of monetary tightening and growth, these balances are set to decline by between $50 billion and $100 billion per month with some seasonal variance. This will be felt most acutely by banks with a higher level of reliance on commercial deposits and large-dollar retail savings accounts.
As a whole, banks continue to sit on significant excess liquidity, with loan-to-deposit ratios well below historical averages. But with deposits draining from the market, there is an increasing sense of urgency from banks to understand where deposit levels go from here.
Some banks, moreover, already face significantly more acute funding pressures. Why? Because the 2.4% aggregate decline in balances is unevenly distributed across deposit pools. Consumer balances are down only modestly, while commercial deposits are down an average of 8% year over year. Small business and wealth deposit performance are situated between the two, though somewhat closer to retail. The mix of customers and funding that a bank has across those segments is having a large impact on bank performance.
As of today, there is little visibility into what 2023 will bring and there are multiple (and dramatic) scenarios that could occur. In all cases, banks will need to focus on fundamental portfolio quality and agility as market conditions change.
To understand where balances may be heading, we need to consider the drivers of total deposit levels. First, it is critically important to make a distinction between dynamics that increase or decrease the total supply of deposits versus those that cause a mix shift in deposit pools.
There are two primary factors that influence the total supply of deposits: monetary policy and total system leverage.
For most modern economic history, monetary policy largely influenced the amount of systemwide leverage on the margins by managing the cost of borrowing funds. This modestly adjusted supply and demand for loans. That all changed with the advent of quantitative easing and tightening, which allows the Federal Reserve to affect money supply much more directly through the purchase or sale of securities.
The second factor is leverage. This is closely correlated with overall economic growth. There are two primary drivers of total leverage: private sector credit extended to consumers and business and public sector leverage undertaken to finance fiscal policy.
Between March of 2020 and mid-2021, monetary policy (primarily in the form of quantitative easing) and fiscal policy (primarily in the form of government stimulus checks to individuals and PPP loans to businesses that were ultimately forgiven) contributed to a massive surge in deposits of about 38% — or $5 trillion in total deposit balances. Curinos estimates that approximately $3.8 trillion were unnatural “surge” balances that resulted from the fiscal and monetary response to the COVID-19 pandemic.
The future of the surge deposits will be linked to the mechanics of money supply. When asked a year ago when these deposits would recede, our base-case answer was that they mightn’t recede at all. We cautioned, however, that the risk to the base-case forecast was a faster pace of quantitative tightening and a sharper increase in Fed Funds rate.
Figure 1: Which of the following best characterizes your bank’s appetite for commercial deposit growth vs. beta management?
A lot has changed since then. In the U.S., the Fed has raised rates by 425 basis points since March. Geopolitical factors have continued to snarl supply chains and roil energy markets. In addition, lags in monetary policy have famously been long and variable, and there is an increasing awareness of the impact of asset price inflation caused by ultra-low rates and unprecedented monetary stimulus. As a result, the Fed has acted much more assertively to combat 40-year highs in inflation. In short, the downside risk we warned of has materialized in an acute form, prompting bankers to juggle deposit balances and rising betas. (See Figure 1.)
Looking forward to 2023, recessionary fears are dimming the outlook for economic growth. And at the same time, the Fed is reducing its balance sheet at a much brisker pace, now running quantitative tightening at $95 billion per month. Even though GDP grew at 2.9% annualized rate in the third quarter, the impact of quantitative tightening more than offset this growth, with the monetary equivalent of approximately a 5% recession. The net effect of these forces was reflected in the 2.4% decline in total deposits.
Along the way, retail deposits have rotated to commercial deposits as higher spending and inflation of goods and services outpace wage growth. Commercial customers have reallocated reserve balances from bank accounts to purchase securities sold by the Fed as part of the quantitative tightening program.
Laying Out The Scenarios
Declines in bank deposits are often a precursor to recession. In short, companies begin to run out of money, then borrow to keep the ship afloat. Eventually, softening demand collides with higher borrowing costs. It’s possible that we are beginning to see that dynamic play out, but the key determinant will be the balance of quantitative tightening and economic growth. And the range of potential scenarios to plan for is exceptionally wide. We offer a few to consider:
Worst-Case Scenario – Stagflation: Inflation persists due to energy turmoil and supply chain woes, but the continued impact of higher rates drives the economy into a deep recession. Stuck between an incredibly difficult choice of breaking the back of inflation versus alleviating economic pain on businesses and individuals, the Fed forges ahead with quantitative tightening. In this scenario we would expect a severe drop in deposit balances.
Moderate Scenario – Soft-ish (or better) landing: This scenario would see a gradual easing of inflationary pressures without a major recession. Curinos would expect very modest declines in total balances to persist as the Fed continues to drain liquidity through quantitative tightening. These outflows would be at least partially offset by increase in leverage as growth returns.
Best-Case Scenario – Light at the end of the tunnel: Geopolitical tensions ease. Energy markets normalize. Businesses and individuals continue to resume pre-pandemic behaviors while major urban real estate markets adapt to shifting patterns of work, living and recreation. In this scenario, robust growth would support modest increases in total deposits, similar with what the market experienced between 2017 and 2019.
How To Prepare For The Unknown
What does this all mean for banks? Given the range of potential scenarios and the unreliability of most macro-economic crystal balls, the keys to success are fundamental portfolio quality and agility in the market.
Fundamental portfolio quality means having a diversified book of primary relationships across consumer and business segments. This requires long-term strategy and execution. Environments such as the one we’re in underscore the value of such a strategy. But unfortunately, you can’t dial one up on a dime.
Fortunately, agility is a faster-acting medicine. The key components of agility are portfolio analytics to understand the drivers of portfolio performance in near real time. They include:
- Systematic methodologies to evaluate the cost of funding sources across client segments.
- Playbooks to respond to scenarios as facts shift on the ground and in the market.
- Relevant and timely benchmarks to execute what’s in the funding playbooks.
- Digital channels to efficiently reach the right clients with the right targeted messaging.
The stakes will be high. Banks that run low on funding without a plan are punished in the market if they are forced to pay premium rates for low-quality deposits. It’s much more efficient to build the infrastructure that pivots on the front end of a change in market conditions than having to play catch-up on the back end.