Curinos (F)insights: Are Some Banks Misjudging The Deposit Repricing Cycle?

Peter Serene, head of commercial, and Adam Stockton, head of retail deposits, explain why they believe some institutions may have an overly optimistic outlook about when deposit prices will reach their peak.

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Hello, and welcome to a bonus (F)insights podcast where we dig into the implications of breaking news and financial services. As expected, the FOMC held the federal funds rate flat in the target range of 5.24% to 5.5%. The process of balance sheet reduction will continue at the previously communicated rate of $95 billion per month.

Here today to discuss the implications for the banking industry are Peter Serene, who’s managing director of commercial banking, and Adam Stockton, who is managing director, head of retail deposits here at Curinos.

Let’s dive right in, gentlemen. With the Fed pausing the increase in rates, where does that leave banks in the near term?

Peter Serene: Well, I’ll start by pointing out the things that are just as true now as they were before the FOMC meeting and in the weeks and months prior to that. Banks are in a fierce competition for deposits. The pool of available deposits is somewhere between shrinking a little bit and flat, and there are a lot of customers who have not fully participated in the increase in rates that we’ve seen from the Fed. That’s true across segments.

Where that leaves us is a market that’s very competitive with a outlook for continued price pressures on deposits as customers continue to shop for the best rate, whether that’s in a CD or high-yield savings from a direct bank in the retail space, or in the commercial space, whether that’s calling around across their group of bankers and asking for the best rate, taking a look at where they’re deploying money to non-interest bearing versus interest bearing deposits, or having a look at what the yields are on cash alternatives and money market mutual funds or securities investments.

Adam Stockton: Peter, I might build on one thing you said there, which is that customers have funds that have still been sitting out the rate environment. Those funds are under pressure, as you noted, with continued rotation both on-balance-sheet but higher rate alternatives, and off-balance-sheet alternatives.

One of the big differences, though, in a flat rate environment is you don’t get any incremental benefit on the deposits that stick around. When the Fed increases, that’s 25 extra basis points of margin on all of your zero-rate checking accounts. Each time the Fed goes up 25 basis points, those checking deposits stay at zero. I’m earning an extra 25 basis points on them. You’re not earning that extra today, but you still get the rotation into higher rate (deposits). And so, ultimately what we see on the deposit side of the house is a bit of a margin squeeze when rates stay flat.

That is with regards to consumer banking. You mentioned a little bit, Peter, for commercial banking. What else does this mean for commercial banking?

Serene: When we think about commercial banking, there are a couple of questions. One is, “What’s the outlook for the asset side of the balance sheet and loan growth?” Those outlooks have certainly gotten a little bit more optimistic than they were three or four months ago. There’s still quite a bit of uncertainty in certain sectors, but there’s increasing, I think, optimism about the trajectory of the economy overall. That will create more demand for credit in the commercial space relative to what we’d expected a short while back.

On the deposit side, there are really three dynamics that are playing out in the deposit space. First is those exception rates are repricing on the interest-bearing deposits as more and more customers sort of wake up and think, “I could actually be getting the best rate in the market right now, not just the good rate,” and looking around for how they might accomplish that.

The second is earnings credit rates. There’s still a third of commercial deposits that are sitting in this product called an ECR DDA, where instead of paying an interest rate, the bank essentially gives the customer a credit to use to offset their bank fees. This product is a relic of a regulation that was repealed over a decade ago, but it’s really stuck around. The interesting thing is that, for most customers, the actual economics aren’t great. If you look at the ECR rates, most of them are below 100 basis points, whereas the rates available in interest-bearing products are 300 basis points or better.

If you make this choice to take your money out of ECR and put it in an interest rate instead, you don’t get the full 300 bp because you’re going to have to start paying out of pocket for your bank fees. But in most cases, that’s a good trade-off for the customer, and more and more customers are starting to make that decision.

The result of that is a shift in balances from non-interest-bearing into interest-bearing, which really sort of upends some of the relationship profitability drivers for banks. It’s a really complicated environment that the commercial bankers are navigating on the deposit front as they balance both the interest rates they’re paying and what sort of relationship they have with their customers around fees for payment services.

Stockton: On the retail side, it’s interesting. The first one of those pressures is similar. We see customers continuing to rotate balances into higher-yielding alternatives. On the consumer side, in particular, that rotation starts later and lasts longer because your average consumer is managing their own deposits themselves. A corporation has a treasurer or a CFO who’s doing it. A wealth customer has a financial advisor who’s helping them figure it out.

But the average consumer is on their own, so they might’ve missed the first few months of the rising-rate environment, not realizing they could have gotten 200 or 250 basis points, or they might’ve just not done the math to figure, “Hey, that’s a meaningful amount of money.”

By the time rates hit 400 or 500 bp, we are seeing a lot more churn. And we see a longer tail in consumer land because, again, people maybe they moved up to a 3% CD and that 3% CD is coming up for maturity now. And so they have an opportunity to move that 3% CD into a 5% CD. Maybe they got an exception rate or a promo rate earlier in the environment and, again, that’s either held or expired and they have a chance to look at it again.

The average consumer also tends to look at their banking when they get more money, whether that’s a holiday check or a bonus or a tax refund. It tends to be much more event-triggered. The fundamental pressure is the same on the consumer side.

The second one, though, that’s a little unique to consumer is the inflationary pressure. This has less to do with costs and more to do with volumes and growth, but even as the inflation numbers have continued to get better, we’re still not yet back at a place where income growth is outpacing expense growth for the average household. If the current projections hold, we’ll probably get there sometime over the next year and that net negative savings rate will turn back around into a net positive savings rate, but it’ll still even then take a while longer before we get back to the historical levels of growth in terms of the average consumer’s balance sheet. The dual pressure of the rate-driven and the inflation- and spending-driven are really what’s hitting the consumer side right now.

Now, regarding deposit pricing, Curinos recently did a survey of commercial bankers and found that many of them believe that with this rate leveling off, we are getting close to the end of the deposit-repricing cycle. How does that line up with our views on deposit repricing, Peter?

Serene: That survey actually asked three related questions: “What’s your outlook on commercial deposit pricing? What’s your outlook on commercial deposit balance levels? And what’s your outlook on the mix of those deposits between non-interest bearing and interest bearing products?”

To summarize the answers, they were, “Most of the repricing is done, most of the remixing from non-interest bearing/interest-bearing is done, and we’re going to return to flat to growing balances.”

Now, that’s a very optimistic outlook, I think, relative to the data and our view of customer behaviors.

Can one or even two of those things be true? Absolutely. But in order for all of those things to be true, basically we’re going to have a slowdown in the amount of repricing, all of the outflows we’ve seen over the last 18 months from commercial portfolios are going to stop and things are going to level off, and a third of balances still sitting in ECRs that, for the most part, aren’t getting the best return on their cash that they could are going to be fine to sit there in a prolonged, elevated rate environment. This seems unlikely to us.

To be a little bit provocative about it, it’s almost sort of “magical thinking” to suggest that all of those things are going to happen. To think that some of them are going to happen, we think is correct and realistic, but there are going to be a hard set of choices to make as you trade off across those factors.

Adam, how does that go for consumer deposits? What are we seeing? Are the betas stable as the rates are leveling off, or is that not the case yet?

Stockton: That is not what we’ve seen historically and not what we would expect to see this time around, either. Those pressures that we see in a flattening rate environment, particularly in a market where that consumer behavior continues even after the Fed stops and the lag that banks benefited from at the beginning of the cycle, hurts them at the end of the cycle.

In the last plateau environment, in 2019, we saw consumer deposit costs increase by 15 basis points in the six months after the last Fed increase. That’s driven by continued rotation from checking and low-rate savings into money market and high-rate savings into CDs. It’s due to lower-rate CDs maturing and some of those balances moving into higher-rate CDs. It’s due to, look, customers move and they die and those balances come out at average portfolio levels. To reacquire a new customer to take their place, you have to do it at the prevailing market rates.

All of those churning factors point toward increasing portfolio interest expense on the consumer side, which is really hard for banks to get around, particularly if there’s any kind of a focus on deposit retention or growth. I wish I was giving better news. Sometimes in these cycles, I feel like I’m a bit of the harbinger of doom, but it is going to be a really tough environment going forward for the next year.

I think that the good news is there’s some relief on the horizon. By the second half of next year or at the latest 2025, if projections hold, we should be back in a place where we’re seeing better deposit growth. We may see some rate decreases in the second half of next year looking at the projections, and that will offer some opportunities to claw back some of the rate increase that we see in the plateau, but at least for the next six to nine months, it’s going to be some tough sledding.

Still keep a close eye on what’s happening to those betas. Now, the latest Fed “dot plot” shows expectations that rates will steadily come down in the next few years before leveling off around 2.5%, roughly three percentage points lower than where they are now. Now let me ask both of you, when you look at the dot plot, what do you see ahead for banks and the broader economy?

Serene: Well, I’ll start by saying I’m more focused on the outlook for the next 12 to 18 months than I am looking out in the longer-range projections.

First of all, I see a Fed that is a little bit more hawkish than where the market has been. Now, the market is adjusting to that in real time as we speak here, but it’s worth noting that the Fed dot plot’s outlook for 2024 came up 50 basis points from the last meeting at the median and is about 50 basis points more hawkish than the distribution of discounts in the futures markets heading into the meeting.

I am not surprised by that based on the economic data that we’ve seen, which has come in relatively strong. When I look at the big picture, I see an improving outlook for economic growth and a notion that inflation is going to come in line with the 2% long-term target and that the Fed is going to cut rates. Again, this is a case where it feels like one out of three or two out of three, but probably not three out of three.

If you ask for my crystal ball here, I would suggest that the most likely course is that we end up towards the upper end of that range of dot plots going into the end of next year. That is what we would call a “higher-for-longer” environment.

For all of the reasons that Adam and I have discussed around the stopping of the repricing on the asset side of the book and then continued pressures on repricing on the deposit side of the book, that creates net interest margin compression for banks or, in simple terms, profitability headwinds.

Stockton: As much as I’d like to disagree with something Peter said, I find it hard to, so instead I’m going to add on a little bit, kind of double click on the point around higher-for-longer because I feel like that is a piece that feels way out on the horizon.

Banks really aren’t thinking about that very seriously has been my experience to this point. But if we do, as the Fed is projecting, land in a long-term, call it 2.5% to 3% Fed Funds environment, that is wildly different than the last two low-rate environments where we have been at zero. When you’re at zero rates, you see a lot of stockpiling of money across all lines of business in zero-rate checking accounts because there’s no reason to put it anywhere else. You get deposit growth without having to think about rate, having to use rate, having to pay for that growth aside from core customer growth strategies.

That’s probably not where we’re going to land. We’re going to land in an environment where CDs remain a core part of most banks’ portfolios, unlike a zero-rate environment where almost no customers own CDs. We’re going to land in a place where acquiring new-to-bank customers using rate remains really important and a core part of any growth strategy, unlike the prior zero-rate environments, where it was “I acquire a checking account and I get some deposits along with it.” And we’re going to land in an environment where tactical deposit management across all products is a whole lot more important than it was in the last zero-rate cycle.

Maybe the one thing I would add is there’s a lot of focus, as there rightfully should be, on the next six to 12 months and “How do I get through this next challenging environment?” But I’ve started to hear more talk about, “All right, there’s a CD bubble that I have to manage that’s one-time. All right, once I can get through this declining deposit environment and get back to growth, it will get easier.” But it’s going to be a lot different than the zero-rate environments that we’ve been through.

Still interesting times ahead. We will have to see how it all plays out. But thank you very much for the insight. Thank you both, Peter and Adam, for joining us today.

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