The Fed raised the Fed Funds rate by another 25 basis points to a range of 5.00% to 5.25%. Futures markets are anticipating that this will be the terminal rate for this cycle, setting up a plateau before expected cuts later in the year. The FOMC members’ own outlook, expressed through the dot plots, suggests a sustained plateau at current levels. These outlooks are broadly in line with improving inflation data and a slight cooling in the pace of wage growth despite a stronger than expected April jobs print.
But even as the Fed appears ready to tap the breaks on Fed Funds increases, monetary conditions continue to tighten. The Fed announced no change to quantitative tightening, which is pulling $95B per month out of the economy. In addition, the combination of higher rates and tighter lending standards are contributing to headwinds for private-sector credit creation. Finally, while the outcome of negotiations remains unknown at this time, a debt ceiling compromise entailing some reduction (or slowing growth) in government spending would further tighten economic conditions.
For banks, a potential Fed plateau coincides with intensifying pressure on profitability as interest income faces challenges from a flat yield curve and a potential slowdown in loan growth while interest expense continues to increase due to costly remixing of funding sources. Remixing comes in two varieties: rising costs on existing customer deposits and replacement funding for deposit outflows.
Within current customer books we continue to see consumer balances shift into higher-rate CDs, with 4% of total savings balances shifting to CDs over the first quarter — more than 15% on an annualized basis. In commercial, customers continue to shift balances out of ECR (earnings credit rate) DDA into interest checking and MMDA products. Additionally, back book rates on MMDA are becoming less and less common.
The other big challenge is deposit outflows. Traditional banks continue to face significant headwinds as customers shift to direct banks, which have seen net inflows that include $130B moving from traditional banks in the last calendar year. In commercial and wealth, the flows are driven by movements to money funds, which have seen aggregate inflows of more than $300B in commercial balances and $400B overall since the collapse of Silicon Valley Bank (SVB) and Signature Bank NY.
Because of the overhang of investment portfolio positions carrying negative marks, this deposit squeeze is coming at an inopportune time. The situation reinforces the need for banks to sharpen the pencil on funding plans, especially in light of evolving customer behaviors, especially in uninsured deposits. It’s also an important time to revisit deposit forecasts across a range of scenarios including, on the one hand, more persistent inflation than is reflected in current Fed Funds futures markets and, on the other, a harder landing than is reflected in the dot plots.
Commercial Deposit Focus: Rates Up, Balances Down
Commercial outflows continued through the first quarter on an aggregate basis, while we saw significant deviation in bank-level performance, even among regionals. On average, commercial deposits were down 15.6% at regional banks through the first quarter. The largest banks fared much better, however, with average corporate and commercial balances down 2% QoQ. In addition to flows into the largest banks, there have been more than $300B in net flows into institutional money funds since March 10th.
Just since the start of the year, the average interest expense on commercial portfolios has increased from 1.24% to 1.51%, which has been driven by two factors. First, there has been a four-percentage-point remix of balances from non-interest-bearing to interest-bearing products. Second, within interest-bearing products, portfolio rates have been increasing rapidly, with the average commercial MMDA rate rising from 2.31% at the start of the year to 2.81% at the end of March. So even with a Fed plateau coming into focus, commercial portfolios have continued to reprice rapidly.
And the outlook doesn’t get any rosier going forward. Increasing customer focus on bank relationships will put pressure on remaining back-book rates. Meanwhile, a move to modestly increase diversification of exposures across bank groups will put more balances (and fee volumes) in play for competitive bidding. This all underscores the need for deep relationships across credit and payments solutions to drive stickiness and pricing power across the total relationship.
Consumer Deposit Focus: Stability May Lead To More Competition, Higher Costs
Despite all the media attention and concern, consumer deposits were remarkably stable despite broader instability in the wake of the SVB and Signature failures. While there was a modest increase in outflows of high balances – customers with deposits of more than $250k – inflows into smaller-dollar accounts counterbalanced them. The comparative stability and value of consumer deposits were underscored by outflows and volatility in commercial and wealth. While this appears positive on its surface, the net effect may be a higher degree of competition as banks look to defend and grow.
Under a scenario of higher competition, a few distinct challenges emerge. First, macroeconomic factors continue to drive overall consumer deposit run-off. Slowing GDP growth combined with persistent inflation have led to a deposit decline of almost 2% since April 2022. The decline is more pronounced at branch banks, which declined 4% last year and 1.5% in Q1 this year, due to a higher mix of checking and remixing to direct banks, which grew 14% last year. Not all banks will be able to grow in a market in which deposits are declining.
Second, a Fed plateau will lead to increasing deposit costs regardless of the level of competition. In the prior rate cycle, consumer deposit costs increased 15 bp over the three months following the last rate hike. This was driven primarily by continued remixing from lower-cost into higher-cost deposits, including CDs, promotions and exception rates.
Third, marketing expenses are likely to increase. With greater attention on acquisition and retention of primary relationships and the associated deposits, higher competition is likely to emerge for both marketing space and customer incentives. Targeting and efficiency will take on increased importance to ensure the long-term value of what’s being acquired. Marketing flexibility and targeted personalization, moreover, will maximize both response and value returned.
Wealth Deposit Focus: Steep Declines, High Volatility, Uncertainty Ahead
While consumer deposits were stable through the market turmoil, showing only modest declines, wealth deposits have been under far greater pressure. Even before the SVB and Signature failures, wealth deposits had been declining much more rapidly than retail. Industry-wide, wealth deposits declined 9.6% in 2022 and an additional 5.2% in January and February of this year, with runoff across both checking and savings/MMDA as spend increased and customers rotated funds into fixed income to seek assets with higher yields than deposits.
Following the bank failures, wealth deposit runoff increased markedly – another 5.1% in the six weeks after March 10 – with the largest move appearing to be rotation off balance sheet. Retail money fund balances have increased by more than $70B since March 10 as customers have been moving toward lower deposit concentration and higher yield.
Even with the steep runoff, betas have continued to increase as well. Overall interest expense for wealth deposits has risen to 1.24%, with savings/MMDA costs now at 1.64%. We continue to see meaningful differences by balance tier, with customers with over $5MM in balances now earning 2.34% on savings/MMDA. New balances are also earning a premium, with new-to-bank acquired balances in March between 2.50% and 3.10% depending on balance tier.
With off-balance sheet alternatives and higher competition, wealth deposits are likely to remain under pressure, underscoring the importance of good analytics. Banks and wealth management firms need to understand the different segments of deposits and their underlying behaviors – what has strong through-the-cycle balance sheet value, and how it needs to be priced for retention and growth.
Mortgage Lending Focus: Production Turns The Corner As Rates Ease
After having climbed since the beginning of 2021, mortgage rates started to fall in the fourth quarter of 2022, thereby providing some much needed relief. The trend, however, was muted for non-conforming loans, which, compared with conforming rates, fell from its spread high of nearly 90 bp to a smaller gap of about 50 bp. (See Figure 1.)
Even though these recent rate declines have left us still well above historical averages, production across the country has responded smartly in both the purchase and refinance markets, with the majority of states seeing some degree of refinance growth relative to the prior quarter. (See Figure 2.) For the first time since early 2021, moreover, production has increased across all loan purposes, and what had been an ever-increasing purchase market is beginning to level out. (See Figure 3.)
Figure 1: Retail Purchase Locks
Average Rate Retail Purchase Locks
Rate Distance Relative To Conforming Retail Purchase Locks
Figure 2: Q1 2023 vs Q4 2022 Production Change
Retail Conforming Locks
Figure 3: Quarterly Retail Conforming Lock Volume
Likely stemming from other market factors including the failures of Silicon Valley Bank and Signature Bank, debt to income (DTI) and FICO credit boxes have contracted. Loan to value (LTV), on the other hand, remains elevated, which can be explained by an increase to loan sizes rather than a bucking of the trend toward contraction. (See Figure 4.)
Figure 4: Average Risk Metrics
Retail Conforming Purchase Locks
Small Business Focus: Headwinds Persist, As Do Opportunities
Small business owners continue to face choppy economic conditions as potential recession fears persist. The latest NFIB Small Business Optimism Index fell slightly in March, with job openings and inflation continuing to be owners’ top challenges. Despite these headwinds, consumer spending has remained strong, and businesses are still demonstrating a need to borrow. According to Curinos’ LendersBenchmark for Small Business Lending Originations consortium, loan unit demand was higher in the first quarter of 2023 compared with Q1 2022, but the average requested amount fell by about 17%, which indicates that businesses still need capital to operate but may be putting larger projects on hold. (See Figure 1.)
Figure 1: Small Business Lending Demand
Because small business loan rates have moved in step with the Fed Funds rates, business owners should expect higher borrowing costs to continue. Meantime, they’re finding it harder to be approved for a loan, with a net 9% of owners reporting in the NFIB’s March report that their last loan was harder to get than the previous one. General uncertainty in the economy and the fallout from the recent collapse of Silicon Valley Bank and Signature Bank could be causing some lenders to further tighten their credit policies.
To deal most effectively with their small business customers, Curinos believes lenders should weigh these considerations:
- Unsecured continues to drive demand. Small unsecured lines and loans are an attractive solution for small businesses because they offer capital when owners need it without lengthy underwriting. Our benchmarking data show demand for unsecured lending up 10% YTD compared with 2022 despite average rates increasing 400 bp.
- SBA. The SBA’s flagship 7(a) Loan Program is an attractive option for both lenders and businesses because it offers longer terms. That helps more businesses qualify while it reduces a lender’s capital and loan-loss reserve requirements. Our benchmarking data are showing an increase in SBA approvals and originations YTD.
- Maintain a holistic view of the small business relationship. As business owners face an increasingly challenging environment, they are seeking institutions that can simplify their life and allow them more time to focus on their business. This creates a tremendous opportunity for institutions that can meet these needs and capitalize on the demand.
Digital Banking Focus: Apple Enters The High-Yield Space, Smoothly
Apple launched its high-interest savings account in April, and even though fairly well anticipated, it still promises to disrupt the market. Debuting at 4.15% APR – about ten times the national average at launch – it’s offered to Apple Card holders and comes with the promise of no fees or minimum balances.
Apple has applied its UX expertise where others are failing: its account can be opened in just a few clicks and approval is nearly instantaneous. Once in, customers have the ability to deposit Apple Card’s cashback earnings into the savings account, and useful tracking visuals encourage the user to engage with the account regularly. It’s a promising product that sits comfortably in Apple’s growing portfolio of financial services, beside payments and its buy-now pay-later program.
The entry is more than just another tech-first firm moving into the high-yield savings space. Apple holds a number of competitive advantages, not the least of which are scale, technology, data and data management capabilities. It also features direct access through a complementary product with a great reputation, and, not so incidentally, it’s backed by Goldman Sachs. Market conditions are also ripe, with depositors pulling cash from low-interest accounts. That adds up to a powerful combination of reasons why competitors would be wise to keep tabs on the new savings player on the block.