The Fed again slowed the pace of rate increases, raising the target Fed Funds rate 25 basis points to 4.50%-4.75%. If inflation figures continue to show progress, markets are anticipating a plateau, with the Fed pausing rate hikes to examine the effectiveness of the increases to this point.
That doesn’t mean it’s time to start celebrating. Historically, Fed rate plateaus have introduced their own set of challenges for the industry. Most importantly, betas have notably continued to increase even after the Fed stops raising rates. Curinos projects this will continue to be the case and that betas, which were initially slow to rise last year, are likely to accelerate notably.
Broadly, and across segments, three primary factors drive additional increases in betas during a Fed plateau:
- Churn: It will be driven by customers moving within an institution from a lower rate (back book) to a higher rate (front book), either within a single product or shifting between products. For example, customers may have repriced earlier in the rising-rate environment to a level that now is less attractive than other options. And some customers may now want to lock in funds with a CD that is priced higher than just a couple of months ago.
- High-rate acquisition replaces low-rate attrition: Regardless of rate competitiveness, normal run-rate attrition takes place across products and rate bands. Acquisition, however, is heavily tilted towards front-book products at more attractive rates. The natural acquisition replacing attrition, therefore, increases overall weighted rates within a deposit book.
- Rate increases: Financial providers that find themselves behind competitors are forced to increase rates to spur increased retention and/or acquisition. Curinos has historically observed an increase in posted rates even after the Fed’s final increase of the cycle. (This isn’t consistent across all of them, however.)
Critically, bankers must keep abreast of these effects and take appropriate action. Although the Fed may pause, customer behaviors won’t!
Retail Focus: Changes Continue To Accelerate
Within the consumer business, deposit runoff continued during the fourth quarter of 2022. Aside from a seasonally typical pause driven by normal holiday and bonus-related inflows, runoff was present in both checking and savings/MMDA, although overall deposit runoff improved slightly from the third quarter. Consumer deposits at branch banks declined 1.3% in the fourth quarter compared with 2.5% in the third quarter; strong CD growth accounted for much of the turnaround.
This turnaround has come at a cost, with betas increasing from floor levels. Average portfolio rates for savings/MMDA now exceed 0.50%, with the average bank in Curinos’ Comparative Deposit Analytics observing a total consumer portfolio beta of 10%. Interest expense increased 0.43% through the first 4.25% Fed increases.
As noted above, Curinos expects continued beta pressure even in the event of a Fed plateau. In the three months following the last Fed increase in 2019, 4% of savings balances and 6% of CD balances switched to higher rates, driving portfolio interest expense an additional 0.15% higher after the final Fed increase. (See Figure 1.)
With the gap between back book and front book rates significantly wider in this cycle compared with the last, the same level of churn could have even greater effects. Additionally, the potential for an extended plateau leads to ongoing risk of interest expense creep. Bankers must be on the lookout for this and create plans to manage it.
Consumer Portfolio Interest Expense Changes During Last Fed Plateau (Dec. 2018-June 2019)
Source: Curinos Comparative Deposit Analytics (CDA)
Commercial Focus: Competition Heats Up
Commercial banks are entering 2023 following double-digit loan growth on a year-over-year basis in 2022 and a 11.7% year-over-year decline in deposits. Sentiment shifted decisively in 2022 to focus on growth and retention instead of lagging the Fed’s rate hikes. In response, betas accelerated through the second half of the year. But that wasn’t enough to stanch the balance outflows as quantitative tightening drained liquidity from the market. Commercial customers stepped in to buy bonds, filling the funding need created as the Fed reduced its balance sheet. In turn, commercial deposits drained from balance sheets.
Looking at what’s in store for 2023, commercial banking businesses face three distinct challenges:
- Continued back-book repricing of interest-bearing deposits, even as the Fed funds rate plateaus. While average commercial MMDA betas are now at 48% through the cycle, roughly 25% of balances are still priced below 50 bp. There is significant room for betas to increase further if a portion of these balances move toward market average (or higher) rates. (See Figure 2.)
- Rotation of balances from non-interest bearing to interest bearing accounts. Average ECR balances were down 9% in the fourth quarter, while interest checking balances were up 3.9% and MMDA balances were flat. While an increase in realized net fee income can cushion some of the earnings impact from this rotation, it can be quickly overwhelmed by the added interest expense on larger balances.
- Ongoing headwinds to growth as the Fed maintains the pace of quantitative tightening. While there is a wide range of possible balance growth scenarios under various macroeconomic conditions, the most likely scenarios point to another year of negative commercial deposit growth.
Optimizing commercial deposit portfolio performance in this environment will require agility in responding to enterprise funding needs and a comprehensive approach to relationship pricing. The combination will help balance shifting economics across loan and deposit spreads and fee income.
Commercial Middle Market MMDA Balances by Rate Bucket (Dec. 2022)
Home Equity Focus: Volumes Stay Elevated,
But Potential Obstacles Loom
Home equity closed out 2022 with record volumes that were similar with the rising-rate cycle of 2017-2018. While rates are forecasted to remain at elevated levels in the coming months, which should allow home equity growth to persist, lenders are faced with new obstacles. Rate-sensitive borrowers may delay large purchases and debt consolidations, both of which will challenge core growth in home equity balances and HELOC utilization.
This shift in demand will likely cause lenders to experience incremental volumes of higher-risk segment borrowers seeking credit. Lenders must decide whether a shift in their credit buy-box is warranted in order to keep up with demand. At the same time, they must balance the credit-risk impact to their portfolio performance as the severity of a looming economic downturn remains uncertain.
Mortgage Focus: Headwinds Abound,
With No End In Sight
After two consecutive banner years, 2022 ended with many lenders in survival mode. What’s in store for 2023? The 2023 landscape so far offers little reassurance: potential recession fears persist, and higher rates and low inventory have crippled loan demand. While rates have recently eased since peaking in October, origination costs continue to escalate. According to Curinos LendersBenchmark data, retail locked average rates are now 42 bp lower than their 2022 peak in October. And according to MBA, origination costs now exceed $11,000 per loan, an all-time high. It’s no surprise, then, that first mortgage volumes are down as much as 40% quarter over quarter, prompting many of the country’s largest money center banks and other lenders to scramble to cut costs and maintain revenue and market share.
Nowhere is the mortgage shakeout more apparent than in the wave of mergers and acquisitions that have washed across the industry ever since interest rates started to rise. Courageous buyers view the upheaval as an opportunity to enter new markets and then cut costs from overlapping operations. As these are early days, it is unclear whether these classic strategies to grab market share will ultimately succeed. If economic conditions deteriorate and credit trends weaken, some lenders may experience buyer’s remorse.
This means that buyers can’t rely on new geographies to guide them to better times. Instead, lenders will need to keep charging ahead with efforts to optimize margins by using granular pricing strategies. They also must have a clear retention strategy for their mortgage servicing portfolio because recapture will represent a significant opportunity when rates start to come back down.
Technology is another area of opportunity. The overhaul of the loan origination systems and adoption of new hedging platforms, servicing systems, new CRM systems or POS platforms can all lead to greater efficiency.
Lenders must understand that cutting costs is only one piece of the equation. Uncertainty in the markets can constrain liquidity, which is the lifeblood for many lenders today, particularly those that rely on warehouse financing and don’t have balance sheets.
In the end, thoughtful decision-making will be necessary to navigate 2023. Otherwise, M&A may be the only way to survive.
Small Business Focus:
But So Does Demand For Credit
For small-business owners, cautious optimism is likely to be a theme in 2023. Although they continue to remain wary as they work through 2022’s economic challenges, business owners are nonetheless exhibiting the need for access to capital, according to the NFIB’s latest Small Business Economic Trends report. Meanwhile, the Curinos LendersBenchmark for Small Business Lending Originations consortium reports that market demand softened in the fourth quarter but remained favorable compared with the same time a year earlier. Much of the growth in demand was seen in unsecured lines of credit, which now comprise more than half the total market volume.
Because rates for small-business loans move with the Fed funds rate, business owners should prepare to see borrowing costs increase through the first half of 2023 but at a slower pace than experienced throughout last year. Lenders could therefore see a softening in market demand, especially in commercial real estate, as borrowers put larger projects on hold.
With this in mind, Curinos believes lenders should consider these dynamics as 2023 unfolds:
- Margin preservation: Margins remained steady through 2022 despite rates rising at a record pace. As demand softens, however, business owners may start to look for better rates, putting pressure on credit pricing. For lenders to stay ahead of their peers, pricing analytics will be increasingly essential.
- Cycle time for new credit originations: Cycle times have improved 18% for commercial real estate loans, reflecting improved operational efficiencies.
- Unsecured is driving demand: Micro loans and lines have become an attractive solution for small businesses that need quick access to capital. Our benchmarking data show demand for unsecured loans was up 29% in the fourth quarter year over year for unsecured lending even as average rates increased 224 bp.
Digital Banking Focus:
Apps Need To
Go Beyond The Basics
Inflation is showing signs of easing, but that doesn’t mean consumers are feeling much better about their financial situations. Indeed, a recent study from Affirm shows that the average U.S. consumer worries about money six times a day and more than half say they often overextend their spending and are left in a difficult position.
Today, digital banking apps that meet a user’s essential requirements are table stakes. It’s time for financial institutions to develop more innovative experiences or risk being left behind.
Roughly two-thirds of U.S. bank apps tracked by the Digital Banking Hub show pending checking account transactions, offer downloadable statements and enable recurring bill payment. More than half allow users to block or freeze their card.
But the leading-edge brands are taking in-app banking to the next level. They offer dispute resolution, advanced card management, targeted messaging and simple, guided support that reduces anxiety. In doing so, they’re taking their cues from leaders in other industries that are continually raising the bar and, with it, customer expectations.
According to Curinos Digital Banking Hub ACE capability scoring, the digital banking frontrunners are continuing to bolster their interactive support, including chatbots that can better understand user intent and thereby anticipate behavior. Many also present customers with a wide, even full, view of their personal finances by connecting them to their accounts outside of the provider alongside those within it.
It’s clear that success in digital banking is evolving rapidly from day-to-day transactions to overall financial planning and management. The winners going forward will be those that can apply their creativity and technical innovation to the user experiences required to make that happen.