The Fed’s move to hike the target Federal Funds rate by 75 basis points for the fourth consecutive time comes at a point when customer behavior and bank response are already accelerating significantly. With the top of Fed’s target range now at 4.00% and deposit runoff increasing, many banks are moving aggressively to retain balances rather than reacquire them down the road at a higher price.
Most notably, the consumer segment had been an industry bright spot of lower churn and low betas early this summer. Since the Fed’s fourth increase at the end of July, however, rate-driven balance runoff has increased substantially, product rotation into CDs has begun and betas have risen quickly off floor levels.
Banks are left in a challenging position. Most rates have lagged and are still under 0.10%, but competitive rates have hit and, in some cases, eclipsed 3.00%. The net effect is that a small increase may not be sufficient to change customer behavior but a large increase risks even more churn.
Commercial deposit betas and runoff picked up earlier than in the consumer portfolio and those trends have persisted. Additionally, commercial earnings credit rate (ECR) betas have begun to move, albeit at a much slower pace than interest-bearing rates. As ECRs increase, so does the rotation of balances into interest-bearing accounts.
Additionally, the combined impact of commercial deposit runoff across segments has begun to push loan-to-deposit ratios higher. Super regional and community banks have both seen increases of more than 6% on average from the third quarter of 2021 through the second quarter of 2022, though they remain well below pre-pandemic levels. For most institutions, funding isn’t yet a concern, but the trend lines present a future worry given the pace of runoff. Many banks are therefore taking more aggressive steps to retain balances, which continues the spiral of changes in customer behavior.
Consumer Deposits: Churn Behavior Past The Point Of No Return
Over the last three months, consumer behavior has gone from stagnant to at or above levels observed in 2019 at the peak of the last rising-rate environment. This is a substantially faster shift than was observed in either of the last two rising-rate cycles. Indeed, data from Curinos’ Comparative Deposit Analytics (CDA) reveal these significant shifts:
- Churn to higher rates increased from an annualized 5% of the average bank’s portfolio in March to more than 16% of the average bank’s portfolio in September
- Switch from savings to CDs has increased from negligible to an annualized rate of 4% of total portfolio as of September (See Figure 1.)
- Account and customer attrition — representing closed accounts and relationships — had been steady through July but increased markedly in August and September. This suggests some customers aren’t just reducing balances — they are leaving banks entirely
- Online banks recovered from lower-than-historical growth rates in 2021 and through the first quarter of 2022 to reach double-digit growth pace in the third quarter
The shifts in customer behavior have led an increasing number of banks to use rate to retain balances and relationships, with 28% of banks offering a top savings/MMDA rate above 0.50% in September compared with only 9% of banks in May. The rate increases are affecting savings portfolio rates as well, increasing by 10 bp over the last month.
On top of the rate-driven shifts, inflation and spending continue to impact consumer balances, particularly in lower tiers. Low-tier checking runoff — atypical for a rising-rate environment — has continued alongside savings remixing into checking. These effects have pulled overall consumer deposit growth lower — with even the fastest growing quartile of CDA participants seeing consumer deposit runoff since the April peak.
The positive news is that consumer betas remain well below prior cycles, but the danger is that the small rate increases being offered by some institutions won’t have a material impact on declining balances. First, the runoff being driven by inflation and spending won’t be impacted by rate. Second, the gap between base rates and top market rates has hit an all-time high. With online bank savings rates between 2.25% and 3.00% and CD rates eclipsing 3.00% at both branch and online banks, a small increase in rate may only have limited impact on customer behavior. And with larger rate increases comes increased churn. Historically, churn within a bank has increased as the difference between lowest and highest rates widens.
The net effect is that following an initial lag, consumer deposit managers need to be prepared for challenging times to continue. The changes observed in the last two months are more likely to be a sign of times to come rather than a temporary blip.
Figure 1: Annualized Switch to CDs
Commercial Deposits: Continued Pressure On Rates And Balances
Commercial deposit outflows have been averaging approximately 1.5% per month since June, bringing total year-over-year balance declines to 8.2%. In dollars, these outflows align reasonably closely with the amount of liquidity that the Fed is draining from the system through quantitative tightening. Unlike in the prior period of quantitative tightening (2017-2019), economic growth is weak. That means there isn’t an organic monetary offset to the Fed’s balance sheet reduction. Unless banks significantly increase deposit rates, it is unlikely that this trend will reverse until either the Fed eases up on tightening or economic growth picks up. Given persistently high inflation and consensus economic forecasts, neither of these appears imminent.
From a pricing standpoint, commercial MMDA rates averaged 116 bp at the end of September with interest checking rates slightly behind at 92 bp. Meanwhile, average ECRs have increased to 46 bp. The average rate for new commercial MMDA acquisition, however, was 151 bp. Approximately 30% of all commercial MMDA balances are now priced above 200 bp.
Despite many banks entering this cycle with substantial excess liquidity, pricing dynamics are on a trajectory to align with betas seen in the prior rising-rate cycle with the risk of moving higher in this sustained low-growth, high-inflation environment.
Figure 2: Mortgage Volume Trends
Mortgage: Strategies To Consider As Lenders Await Fed Pivot
After four hikes of 75 bp, is it time to start thinking about smaller increases? Indeed, the central bank’s next step in December is already top of mind for many in the mortgage business.
We know the impact of these Fed increases ultimately takes time to show up in terms of economic data and that the Fed relies heavily on that data to determine policy setting and market expectations of future Fed action. A pivot toward smaller increases would without question be a good thing for mortgages and provide incremental rate relief, which is something every lender regardless of size would welcome. Freddie Mac’s primary mortgage market survey (PMMS) is now above 7% for the first time since April 2002. Additionally, the Mortgage Bankers Association’s economic forecast in October predicts 30-year mortgage rates of 6.70% for the fourth quarter, up significantly from the 5.50% forecast that it announced just a month earlier.
Many of the largest U.S. depository banks recorded significant declines in their third-quarter mortgage originations, down 30-45% from the second quarter. (See Figure 2.) According to Curinos benchmarking data, third-quarter funded mortgage originations dropped 22% from the second quarter. Alongside this dramatic slowdown in volume, housing supply is suffering and new home sales are bottoming out. New home sales are now below recession levels of 2000 and have fallen all the way to 1996 levels, when interest rates were near 8%.
Despite these severe headwinds on origination demand and lackluster sales activity, lenders should be focused on a few strategic areas:
- Servicing Sales. Lenders with a servicing portfolio should consider monetizing that asset at a time of strong market demand due to higher rates and lower prepayment speeds. Many lenders have already capitalized on this strategy and are using it to prop up earnings.
- Optimize Tech Stacks. Technological advancements are key to creating operational efficiencies and thereby drive down operational costs for lenders. To create scale and secure profits, now is the time to reconsider technology platforms and providers and find those that recapture existing customers, entice new customers and eliminate redundancies.
- Margin Preservation. Despite some consolidation, competition remains amplified and pricing wars persist. Lenders that create visibility to all margin economics (price exceptions, risk-based pricing, purchase pay-ups) with a data-driven approach and strong leadership will succeed and create opportunities to preserve market share and even increase margins in this challenging environment. This will create even more opportunity if the Fed pivots its strategy.
- Counterparty Risk. Because lending is relationship-based, lenders should focus on developing trade partnerships with well-capitalized institutions that are experienced and transparent. It is prudent to have multiple outlets with similar product offerings to diversify counterparty risk.
Digital: Small Businesses Need More Help
It’s fair to say that economic headwinds will prompt small businesses to increasingly look for reassurance and guidance. As CBA president and CEO Lindsey Johnson recently told the Digital Banking Hub, “Our members are encouraging customers to forecast appropriately, to think about higher interest rates and to understand how they impact their businesses and lending needs going forward.”
But digital banking is falling short. Of the providers tracked by the Digital Banking Hub, a scant 30% offer the ability to view and compare, on a desktop, the movement of funds across key indicators such as account, date, location and merchant. On mobile, that figure drops to 23%. And only 15% of desktop providers allow users to view forecasts of cash flow based on upcoming and scheduled payments. Again, mobile is even worse, with that capability shrinking to just 3%.
To be clear, digital banking tools for small businesses have made huge gains in recent years, helping clients with daily operations and across longer timeframes. The addition of invoice and payroll-management functionalities are recent examples.
If conditions tighten as predicted, however, these businesses will likely continue to seek better ways to size up their prospects for the future. As much as forecasting tools within digital banking may be helpful during normal times, they’re likely to become essential when things get tough.