The Fed eased up on the throttle ever so slightly, hiking the Federal Funds rate by 50 basis points (bp) to a target range of 4.25% to 4.5%. This move is consistent with recent commentary from Fed officials and reflects a slight moderation in the pace of price increases.
As we head into a new year, it would appear we’re also headed into a new phase as the Fed seeks to bring inflation in line with a long target of 2% while attempting to navigate the economy to a soft or “soft-ish” landing. Fed funds futures reflect a rate trajectory consistent with this scenario, with gradual hiking through the first half of 2023 followed by modest rate cuts in the second half of the year. This is a scenario we expect most market participants would welcome.
We would caution, however, against complacency. Don’t forget — at this time last year, markets anticipated 25-50 bp of rate hikes in all of 2022! Banks would be wise to plan for a range of scenarios, including hard landings both with and without continued above-trend inflation.
Even under the most benign scenario, 2023 will bring new challenges to banks in managing deposit betas. As we’ve seen before, we would expect deposit betas to continue to rise despite a Fed plateau as customers who haven’t yet received rate increases continue to re-price. In the last cycle, for example, commercial MMDA betas increased six points on a through-the-cycle basis during the approximately seven months of plateau before rates started to fall.
A low-growth, high-inflation environment of “stagflation” would bring a different set of challenges as we would expect the deposit drain to accelerate. And a true hard landing would likely bring material credit degradation for highly leveraged companies and individuals. These more adverse scenarios would also be likely to produce additional headwinds to home lending and small business operations, where deterioration in credit quality would hurt loan performance and lead to rising delinquencies.
With pitfalls a-plenty and challenges in navigating even the most favorable scenario, 2023 is looking to be a year during which strategy and tactics will matter. Navigating this environment will require banks to plan, assess and pivot based on evolving market conditions and customer needs. At the same time, they’ll need to help customers maintain financial wellness while protecting the shareholders’ bottom line.
Commercial: Déjà Vu
(And Not In A Good Way)
Commercial deposit markets are beginning to evoke a bit of déjà vu. In fact, while bank balance sheets remain overall flush with liquidity, commercial loan-to-deposit ratios have normalized to pre-pandemic levels, fueled by an 8% year-over-year decline in commercial deposits and a 14% year-over-year increase in commercial loans, according to a Curinos analysis. The scramble for balances is reminiscent of the mid-part of the prior cycle (2017 to early 2018). But rather than moving into the mild headwind of near-flat deposit growth, banks are hunkering down against the gale-force impact of $95 billion per month in quantitative tightening. In fact, recent Curinos research shows that 80% of commercial bankers were focused on keeping betas down in the first quarter – even if that meant losing some deposits – but 95% were focused on balance retention and growth by the third quarter – even at the expense of higher betas. (See Figure 1.)
And betas have indeed continued to march higher. Commercial interest checking betas were at 35% through the cycle as of the end of October, while commercial MMDA betas were at 44%. These levels are already approaching the full through-the-cycle levels of the prior cycle, even with more hikes and a potential plateau still to come.
Figure 1: Which of the following best characterizes your bank’s appetite for commercial deposit growth vs. beta management?
Retail: Continued Churn, Increasing Betas
Following a lag through the first four Fed increases, the deposit runoff and rate-based churn that began in August has continued and, in many cases, accelerated. (See Figure 2.) Retail deposits at traditional banks have decreased 4.5% since their April peak and are down more than 2% year to date. Churn to online banks has increased, with direct banks seeing historically high growth in the third quarter. And inflation and spending also are contributing to the runoff. (See Figure 3.)
In the face of runoff and churn, deposit rates have risen rapidly. Blended acquisition rates for savings and MMDA deposits reached 70 bp in October, up from 21 bp in July. And nearly a quarter of newly opened accounts were priced at or above 150 bp. Higher rates have begun to impact portfolio betas as well, with blended rates for all industry savings and MMDA now at 21 bp in October, up from just 9 bp in July. CD rates have increased even more dramatically, with blended acquisition rates for newly booked CDs reaching 246 bp, up from 86 bp in July.
History tells us that relief is unlikely soon even if the Fed slows the pace of increases. In the past two rising-rate cycles, deposit churn continued even after the Fed plateaued, driving a switch from low-rate savings to higher rates and CDs. The resulting pressure led to betas continuing to rise even after the Fed stopped increasing rates. And with a forecast for slowing economic growth and continued impact from inflation and higher prices, Curinos is forecasting continued consumer deposit runoff for 2023.
The conundrum banks will face is whether to accept deposit runoff – potentially at an increased pace – or to use increasingly high rates to retain existing deposits or grow new households. In an environment with low overall growth, or even net runoff, pricing for growth risks being expensive and inefficient unless done with precision.
Figure 2: Total Balance Growth | Indexed to Apr ‘22
Figure 3: Key Drivers of Branch Deposit Runoff | Jan ’22 – Oct ’22
Home Equity: A Banner 2022, But Now What?
Rising rates have led home equity to a record year as price-conscious homeowners seek to preserve their low first-mortgage rates. But with rates forecasted to remain elevated in 2023, they could present profound challenges to home equity originations and balances. That’s because those same homeowners may delay large purchases or new home equity offerings, which would cause home equity balances outstanding to stagnate.
The good news, however, is that unlike previous rate cycles, the rapid increase in the federal funds rate (which directly correlates to prime index-tied HELOC products) has opened new growth opportunities for closed-end home equity loans. These allow homeowners to achieve the necessary cash-out on their home while still preserving their low, fixed-rate first mortgage and having the safety of a fixed-rate junior home equity loan.
Curinos has seen the closed-end home equity loan market grow substantially over the last two quarters, by as much as 80%, creating new opportunities for lenders to drive home equity products.
The recent success of home equity has also caught the attention of new lenders hoping to capitalize on this recent homeowner trend. Non-banks and fintechs have entered the market promising competitive rates and products and, importantly, funding loans in a fraction of the time of conventional home equity lenders.
Mortgage: More Tough Times
Many mortgage lenders are now in survival mode. Looking to 2023, they see headwinds persisting, with a significant degree of uncertainty around the ongoing fight against inflation. First, homeowners will continue to have a first-rate bias to do anything to preserve their historically low first-mortgage interest rates. Second, home prices will continue to decelerate, alongside declining sales volumes (already approaching decade lows), and affordability will continue to be a challenge for first-time home buyers. Looking at demographics, will Millennials and Gen Z consumers continue to rent, or will they move toward home purchases in their prime buying years as many predict? Many big bank executives foresee a recession in the second half of 2023, predicting that interest rates will drop next year and offer much-needed relief to a challenged residential home-lending sector. According to Fannie Mae’s November forecast, rates will begin 2023 at 7.00%, end the year at 6.50%, continue to decline into 2024 and bottom out at 5.9% at the end of 2024.
Assuming a recession materializes, is this enough to ignite the mortgage markets? In a harder landing outcome, does credit-quality deterioration and loan performance become a larger issue and force strategic attention? We have already started to see savings rates plummet and credit cards become the preferred borrowing means for consumers. There are clearly many variables influencing the average consumer’s balance sheet that need to be considered.
In terms of strategic execution, lenders will need to stay close to borrower preferences and financial situations. Priorities include an emphasis on financial wellness and pinpointing what consumer products benefit the customer most — not necessarily the cheapest to originate or which asset to acquire. Further consolidation is to be expected, with those evaluating more than just price being able to gain market share and expand their customer base. Success in 2023 will demand that product offerings are aligned with prudent risk management. Lenders can remain hopeful in their outlooks for next year, but hope alone isn’t a viable strategy against severe headwinds and a potential storm brewing on the horizon.
Small Business: Bumpy Road Ahead
It has taken a while, but rising rates are beginning to influence loan preference among small-business owners. Curinos benchmarking data show a shift in application volume in the past eight weeks from revolving lines of credit to fixed-rate loans. Indeed, the NFIB’s latest Small Business Economic Trends point to business owners becoming more cautious before borrowing as they continue to work through supply chain disruptions, declining consumer sentiment, challenging labor markets and a looming recession. Despite these headwinds, small-business owners remain optimistic.
Since small-business loan rates move in step with Fed Funds rates, business owners should plan to see higher borrowing costs in 2023. In addition to higher rates, borrowers could face difficulties securing financing as inflationary pressures potentially cause financials to deteriorate and lenders begin to tighten underwriting guidelines to avoid credit losses if economic conditions worsen.
Curinos believes the following will be key for small-business lenders in 2023:
- Cycle time for new credit originations: Our benchmarking data have shown reductions as high as 25% in app-to-book cycle times since mid-year. As more non-banks enter the space, is your institution equipped to provide credit to businesses when they need it?
- Margin preservation: With borrowing costs higher, competition will intensify as business owners shop for better rates. Lenders armed with a data-driven pricing strategy will be poised to succeed in retaining market share and potentially to increase margins in a
- Relationship as a competitive advantage: In times of economic uncertainty, business owners are looking to their trusted advisors. Curinos research has found that small business increasingly value lenders that are easy to work with and provide financial advice. (See Figure 4.)