After a brief, one-meeting pause in June, the Fed’s Federal Open Market Committee (FOMC) raised the Federal Funds rate by .25% to a target range of 5.25% to 5.5%. Futures markets indicate an expectation that the Fed will most likely leave rates at this level through the end of 2023, with some possibility of a further 25 bp increase in the fourth quarter. The Fed also announced no change to its previously articulated program of quantitative tightening.
For financial institutions, these market conditions add incremental pressure on net interest margin (NIM) from all angles — or, put more simply, profitability headwinds. Higher rates, tightening credit conditions and an inverted yield curve are all putting pressure on asset yields. One of the areas where this is most readily apparent so far is in the pullback of portfolio mortgage originations, also known as balance sheet lending. (See related article below.) At the same time, increased competition for a shrinking pool of deposits is driving funding costs higher. And to add fuel to the fire, customers across all segments have become more attuned to their banking relationships since March, and those still earning comparatively low rates on their deposits are making up for lost time by shopping for a better return.
These headwinds are coming at an inopportune time because of these three factors, any or all of which could require more capital:
- Banks are increasing reserves for a potential uptick in credit losses, particularly in commercial real estate. Quite simply, higher-for-longer rates and lower-for-longer office occupancy (in several important markets) are an unfavorable combination.
- Fed Vice Chair Michael Barr recently laid out a framework that will increase capital requirements significantly, including for regional banks with assets of $100 billion or more.
- The issue of unrealized losses to securities portfolios on bank balance sheets hasn’t gone away. While the Bank Term Funding Program has provided temporary relief, banks sitting on unhedged securities-portfolio positions accumulated during the 2020-2021 deposit surge will need time and funding to fully digest these losses.
In short, market conditions are set to put a dent in bank earnings at the very time that banks are looking to retain those earnings to bolster their capital positions.
But even in the face of these headwinds, there are several ways financial institutions can differentiate their performance. First, with retail rates approaching an inflection point, they have the opportunity to navigate to their advantage the first major CD bubble in a generation. Second, as investments in digital channels and AI meet their moment in the market, non-rate drivers such as marketing personalization have never held greater potential. Third, product and channel innovation in small business can lead to taking share in what has proven to be one of the most valuable deposit pools throughout this cycle. Finally, in commercial, accelerating customer churn and an increased focus on deposit diversification are creating an opportunity to reset the relationship-pricing value exchange. Based on the characteristics of the customers relationship, there’s an opportunity to optimize deposit NIM and non-interest revenue.
In summary, tighter monetary policy, tighter expected credit conditions and indications of tighter capital requirements amount to a challenging set of operating conditions for financial institutions. But these are also exactly the conditions that reward superior strategy and execution.
Retail Spotlight: Money In Motion Keeps The Pressure On Costs
With the Fed now expected to be higher for longer than many had predicted at the start of the year, Curinos continues to see pressure on deposit betas as rate-sensitive money repositions to higher-rate products. The impact has been particularly acute on CD portfolios. As of June, over half of CD balances on average are garnering rates of more 400 basis points (bp). (See Figure 1.)
Figure 1: Average Industry Balance By Rate Bucket | CD | Jan ‘22 — Jun ‘23*
Source: Curinos Retail Deposit Analyzer | Note: Simple averages displayed. Rate tiers for all accounts are tagged every month | *June ‘23 data is preliminary.
As the higher rate trend continues, so will money in motion, with more and more liquid deposits moving to higher-yielding CDs. Meanwhile, even with the Fed closing in on what may be its final act of the rising cycle, CDs booked in the latter half of 2022 will be coming to maturity in a rate environment as high as 500 bp (by comparison, CDs coming to maturity in the next three months have on average a maturing rate of 200 to 250 bp), adding significant cost pressures to portfolios. And these renewals assume the money sticks. If not, the cost to replace it with newly acquired customers will be even higher.
One bright spot is the small business segment, which continues to represent a lower-cost option for deposits. Similar to the last rising rate period, from 2016 to 2019, Curinos data show rates for small business deposits today to be almost 50% lower than those for consumer and commercial. (See Figure 2.) This favorable deposit mix is mainly because most of a business’s deposits are in the operational account — 68% of small business deposits are in checking. As a result, and in general, small business customers are less focused on rate and tend to rely on other factors when selecting and maintaining their banking relationship.
Figure 2: Average Industry Rates Paid | All Products | Dec 2022
Source: Curinos Analysis, Curinos Business IQ, Curinos Small Business Deposit Analyzer
Commercial Spotlight: Making Sense Of The Shift In Mix
Commercial deposit outflows have levelled off in recent weeks but are still down about 10% on average through the first half of the year. And while the most acute concerns about commercial portfolio liquidity have moderated at most banks, liquidity managers are still grappling with how to manage the rotation of balances from non-interest-bearing accounts, such as earnings credit rates (ECR), to interest-bearing accounts like interest checking. Approximately one-third of commercial balances are still in non-interest-bearing accounts, but balances are running out of these accounts at twice the pace of total portfolio outflows.
It’s important to keep in mind, however, that commercial non-interest-bearing deposits are not entirely free to the bank. Depositors are typically compensated in the form of ECR rebates that can be used to offset the costs of payments services. But the value of these rebates is generally well below the rates offered to customers in interest-bearing accounts. The average ECR, which is calculated like a rate, currently stands at 76 bp while the average interest checking rate is 200 bp higher, 2.76% as of June. The problem that this gap presents is compounded if the bank has previously discounted the customer’s payments fees, which is common practice.
This dynamic is a particularly challenging form of back book repricing that is currently taking place in commercial portfolios, and with about a third of commercial balances still in non-interest-bearing products, it will likely continue in a higher-for-longer environment. While there’s not a simple strategy for mitigating these repricing risks, the best approach is to optimize across both rate and fee levers. Any ability to optimize fees, of course, is contingent on having the payments volumes on which to assess fees in the first place. This reinforces two fundamental disciplines that set up a commercial business for long-term success: focusing on acquiring primary relationships anchored on the main customer operating account, and regularly updating fees for payments services. That way, deposits will be less rate-sensitive and therefore sticker, and when depositors do seek rate, it leaves the bank with another method of getting paid for the value it provides.
Balance Sheet Lending: It’s Time To Calibrate. Or Has The Ship Already Sailed?
Liquidity remains the lifeblood of lending, and there’s no better liquidity mechanism than a depository institution’s balance sheet. Amid much of the pandemic fallout and subsequent market volatility, lenders with a balance sheet had a definitive competitive advantage over non-banks, with a cheaper cost of funds and less reliance on third-party aggregators and trading partners. This advantage allowed banks and credit unions to drive market share growth in 2022 and the first half of this year. According to Curinos’ Retail Benchmark, July 2023 year-over-year depository volume is down only 57% compared with the non-bank falloff of 77%.
But despite the depositories’ outperformance, the current economic climate is stirring up competitive headwinds: the decreased likelihood of a recession (Goldman Sachs Research indicates a 20% chance of recession in the next 12-months, down from earlier projection of 25%); a perceived Fed emphasis on rates being higher for longer; and concern about nonperforming assets and credit quality, which has been evident in some Q2 2023 bank earnings. In addition, new capital requirements are looming, and if adopted, present new challenges to banks of any asset size. Increased costs of allocated capital could be passed through to consumers, thereby expanding opportunity for the less regulated non-banks.
Indeed, with the second half of 2023 upon us, Curinos Retail LendersBenchmark Analyzer data reveal preliminary evidence of a shift. Comparing Q2 to Q1 2023, Top 20 Banks by asset size led the charge in balance sheet lending with an average increase of 86%. Within the same period, balance sheet lending for regional banks grew only 45% and for non-banks it was only 37%. (See Figure 1.) But after these first half increases, balance sheet lending is contracting across all banking categories (Top 20, regional and credit unions), rising only 13% in the most recent eight weeks ending July 16. Amid all banks, but especially smaller institutions, there’s every indication that calibration is accelerating.
Figure 1: Q2 vs. Q1 2023 Non-Conforming Volume Change
Institutions considering any sort of calibration to their balance sheet strategy will need to consider other loan alternatives or execution options, notably Fannie Mae and Freddie Mac production. But caution ahead: when they do, they’ll be wading into a segment of the market where non-banks maintain a healthy advantage. Of the top five sellers in Q2 2023 to the government-sponsored entities (GSEs), which include Fannie and Freddie, only one was a depository institution.
With no shortage of headwinds brewing in the overall lending market, the critical assessment for depository institutions will be how to respond to these factors and how aggressively. As balance sheet strategies evolve, we may begin to see further consolidation and, potentially, a new composition of market leaders.