Curinos Perspective: Fed Pauses, But What Lies Ahead Is Less Clear

Today, the Fed announced a pause in rate hikes, leaving the benchmark Federal Funds rate unchanged at 5.00% — 5.25%, while leaving the door open for future rate increases. Following a series of rapid increases, the Fed has signaled less certainty about the path forward. Statements from FOMC members have offered multiple possibilities, from rate decreases as soon as the fourth quarter to continued aggressive increases. Which path the Fed takes will depend heavily on the path of inflationary measures but also potentially on the health of the overall banking system.

With a path forward difficult to predict, banks will need to plan for multiple scenarios to ensure that strategies used today will not leave their institutions in a difficult position down the road. Each potential Fed path offers different challenges to be aware of and plan for, and the most successful banks will be those that thread the needle through careful planning.

If the Fed decreases rates, there will be opportunities to decrease interest expense. The lower betas in the up-cycle, however, will limit the ability to fully realize savings in the down-cycle. Demand for CDs will decrease, and flows to online banks may slow. But even in this scenario, pressures will remain as long as the Fed maintains its long-term target range of 3.00% for Fed Funds. Product rotation from DDA to interest-bearing deposits will continue, and elastic customer segments will maintain their expectation to receive rate. Maintaining the flexibility to decrease top-of-market rates with a near 100% beta will be critical. In this scenario, keeping term and rate guarantees short will allow maximum flexibility. Banks will also need to maximize down-pricing of high-rate customers.

Retail Spotlight: Competition Heats Up

Early in the rate cycle and continuing through the end of last year, many banks were focused more on deposit cost and beta than deposit growth. The slowest growing quartile of banks tracked in Curinos’ Consumer Deposit Analyzer saw 12% consumer deposit runoff in 2022, though they were able to maintain an extremely low 3% through the cycle beta in return.

Pressures on deposit growth, however, have been mounting, leading to a shift in stance. A combination of quantitative tightening, slow economic growth and inflation have led to continued deposit runoff – both systemwide and in consumer deposits. The failures of Silicon Valley Bank, Signature Bank NY and First Republic, moreover, have increased the relative value of retail deposits, because of their stability, compared to other lines of business. The net effect has been more competition and higher rates, even in a challenging growth environment.

Illustrating the increased competitiveness:

  • The rate of deposit runoff for the slowest-growing quartile of banks has been cut by 50% since March.
  • Total consumer deposit costs increased 25.7 bp in Q4 ‘22 and 29.1 bp in Q1 ‘23, and they are now on pace to increase 34 bp in Q2.
  • 51% of deposits at branch banks are now acquired above 400 bp compared with only 19% in February.

Commercial Spotlight: Pressure On Betas And Elevated Churn Set To Continue

A pause in Fed Funds hikes will provide little in the way of respite for commercial deposit managers. That’s because three key factors are driving increased competition. First, there’s a significant amount of potential repricing risk in commercial portfolios. Second, customer behavior is changing. Third, numerous forms of funding concentration risk are causing many banks to aggressively pursue deposit-growth plays.

On potential repricing, approximately 30% of the average commercial portfolio are reserve balances in an MMDA account. The average rate on these deposits is just over 3%, and today more than a quarter of them are priced below 2%. (See Figure 1.) By comparison, money market mutual funds (MMF) are yielding nearly 5%. And as long as the Fed’s policy on the Reverse Repo facility remains unchanged, these funds will have ready access to a near-100% beta outlet for new money. 

Figure 1: Commercial MMDA Balances by Rate Bucket

Source: Curinos Commercial Analyzer

On behavioral changes, two important factors are contributing to beta headwinds for banks. First, companies are expected to diversify their deposits across a larger set of banks in response to the recent failures of Silicon Valley Bank, Signature Bank NY and First Republic. (See Figure 2.) Second, company treasurers are increasingly doing the math and electing to move deposits out of ECR accounts and pay their bank fees with hard dollars while earning interest on their deposits. Because of the discrepancy between ECR rates and interest rates, it’s a move that, in many cases, is financially beneficial to the company.

Figure 2: In light of recent market events, do you think clients are likely to diversify their deposits across more banks (i.e., less concentration with the primary bank)?

Source: Curinos Commercial Analyzer

Finally, with elevated flows from traditional branch banks to direct banks and from wealth deposits into MMFs, there’s a broad set of banks looking for ways to raise deposits quickly. Regardless of segment, raising deposits is always a balancing act of speed, cost and quality. While commercial reserve deposits are no match for primary operating accounts when it comes to cost or stickiness, compared to other funding pools, they can be raised quickly and often at costs slightly below true wholesale funding alternatives. With many banks looking to raise funding, we therefore expect the market for commercial deposits to remain fiercely contested. (See Figure 3.)

Figure 3: In light of recent market events, do you think competition for commercial deposits will increase?

Source: Curinos Commercial Analyzer

Mortgage Lending Spotlight: Rising Rates Have Meant A Home Equity Surge

In recent years, the ebb and flow of home equity lending volume (lines and loans) has correlated closely with the movement of market interest rates. As a result, home equity originations in the first quarter of this year accounted for ~80% of all cashout transactions, up from well less than half of all cashout transaction volume only two years ago.

Because of the marked increases to fixed-interest cashout mortgage rates, this is hardly a surprise. For a borrower, the prospect of committing to a long-term contract at a rate far higher than it may have been only months ago is daunting indeed – if not foolhardy if there is an alternative. The shift to home equity has prevailed recently even though home equity rates average more than 200 bp higher than average mortgage cashout rates, though at considerably lower demand velocity versus 2022. (See Figure 1.)

Figure 1: Trends in Lending Rates

Source: LendersBenchmark HE Originations

Indeed, for a cashout mortgage to be a potentially better equity-access option for a homeowner than home equity, its annual percentage rate (APR), in a representative example, would need to drop by ~150 bp, from the current average level of 5.875% to below 4.4%. (See Figure 2.) Even with an anticipated pause to increases to the Fed Funds rate, that’s a gap that isn’t likely to close any time soon. Even so, home equity lines (HELOC) are sluggish so far this year – off by 23% year over year – which indicates borrower sensitivity to their high average rates, especially when a softening of market interest rates may be on the horizon.

Figure 2: Home Equity vs. Mortgage Cashout

Scenario 1: Home Equity Cashout
Scenario 2: Mortgage Cashout
Source: Curinos Analysis

Meanwhile, lenders are faced with a stubborn market dynamic: applications from lower credit deciles are up, but booked loans from these deciles aren’t. This means booked credit quality remains mostly unchanged even as demand from lower-credit deciles is accelerating. (See Figure 3.) And because utilization rates of the lines of super-prime borrowers often take several months on book to recoup lender-paid origination costs and the growing capital expenses on unused line commitments, the lifetime profitability of these lines is being squeezed.

Weighing on all aspects of mortgage lending is housing affordability, which, according to the Atlanta Fed, is at levels not seen since 2007, when unsustainable housing prices sparked the financial crisis of the following year. Housing starts are down 17% from two years ago and average monthly active listing counts are off fully 50% compared with 2019. Amid inventory shortages and rate hikes, homeowners simply won’t sell their homes even if they’re concerned about liquidity. And with more than 85% of them currently enjoying a mortgage rate below 5%, the inventory and affordability crunch is unlikely to abate any time soon.

Figure 3: Home Equity Application Trends by Credit Score Range

Source: LendersBenchmark Home Equity Data

For Primacy, Neobanks Direct Their Sights On Direct Deposit

Because it’s perhaps the most direct route to primacy, direct deposit is coveted among all banks. And because direct deposit usually takes hold in the first three months of a new relationship, it’s not uncommon for providers to roll out the red carpet in the first 90 days.

Perhaps not surprisingly, neobanks have been at the forefront. By pushing the innovative perks and digital capabilities they’ve become known for, neobanks are unsticking direct deposit customers, especially those less rate-sensitive than others, from their competitors.

A number of neobanks, for example, now offer fee-free overdraft protection to customers who set up direct deposit during the onboarding process. Early access to paychecks – often up to two days – is another perk that most fintech providers activate. And increasingly, many are offering automatic savings features, including the ability to set aside a percentage of the customer’s paycheck as it hits the checking account.

That’s not to say neobanks aren’t rate-focused. Many are offering preferred rates on the accounts where the direct deposit lands. Currently, leading neobanks are paying rates ranging from 4.00% to 5.00% APY (up to certain balances) to any customer who sets up direct deposit to their spending account. In comparison, the standard APY without direct deposit for these same providers has ranged from 0.25% to 3.00%.

One trend is clear: With some traditional providers now deploying similar tactics and with budgets being scrutinized for maximum advantage, competition in the digital space for direct deposit, and therefore potential primacy, is showing no signs of letting up.

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