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The Challenge Of Managing Net Interest Margins

Net interest income can drive as much as 75% of a bank’s revenue. Because of that, the recent rise in interest rates has helped banks maintain revenue momentum despite ongoing pressures on fees. Indeed, both components of net interest income — net interest margin (NIM) and volume — have grown significantly over the last six months. The looming challenge, however, is that NIM may be peaking.

NIM measures the difference between what financial institutions pay for interest-earning deposits and what they receive on loans. When rates started rising last year, loan yields increased more quickly than deposit costs on average because banks were able to lag deposit rates for some products. The problem looking forward is that at least some of the benefit observed to this point is likely to reverse. As central banks slow the pace of rate increases, deposit costs are likely to continue to rise while loan yields slow and ultimately stop increasing – putting pressure on earnings. To date, loan growth has been healthy so that even with a peaking NIM, total revenue momentum is continuing. But loan volume is clearly highly sensitive to any economic slowdown. It is prudent, therefore, to prepare for potential earnings pressures.

Assuming loan growth remains moderate and credit remains manageable (i.e., a hard recession is avoided), Curinos sees three areas of focus that can help counter a peak in NIM: a strategy to manage the inevitable rise in deposit cost, a fresh round of cost reduction and selective fee expansion.

Deposit costs are by far the most material of the three, followed by operating expense and fee expansion. Not all three are available for all providers and some may be able to pull multiple levers, but they can all help to ensure ongoing momentum.

NIM Squeeze Ahead?

One of the chief reasons that NIM expanded last year was because commercial and consumer depositors were initially slow to seek yield. Banks were able to keep deposit costs down even as central banks increased rates in an effort to tamp inflation. But Curinos believes NIM hit a peak in the fourth quarter as depositors woke up to higher rates and churn increased significantly. (See Figure 1.)

Furthermore, Curinos believes deposit betas will follow the traditional path of rising even after the Fed stops raising rates. Initially slow to rise last year, betas are now expected to accelerate notably. At the same time, the increased pace of churn is shortening the weighted average life of deposits, making it increasingly important for bank treasury departments to track deposit runoff. Meanwhile, loan yields will be likely capped because the competitive market won’t bear steep increases. That is especially the case when it comes to competition for variable-rate commercial loans.

The upshot: NIM is under pressure.

Figure 1: Net Interest Margins (%) By Quarter

Source: S&P Global Market Intelligence

Deposit Costs

While there are no silver bullets, good deposit management can help pull financial institutions out of a tough spot. Curinos estimates that there is significant potential to optimize deposit value in consumer portfolios, potentially offsetting some of the pricing pressure.

Because deposit costs are one of the most effective ways to manage NIM, institutions must understand the value of their deposits on a granular basis. It is essential for institutions to retain valuable deposits now or risk scrambling to acquire (or reacquire) them at a higher rate down the road. A continued emphasis on primary relationships through personalization, cross-selling to existing customers and total-relationship pricing will be critical – especially if loan volumes remain healthy. (See loan section below.)

This is especially important now because deposit balances and duration are declining rapidly — even for niche segments — as customers seek higher yields. Curinos now expects U.S. consumer balances to decline in 2023, in part due to inflation-driven spending. (See Figure 2.)

Figure 2: Curinos Forecast - Total U.S. Consumer Deposit Growth

2022
(1.5%)

2023
(3)-1%

2024
1-3%

Factors affecting deposit outlook

Inflation & Spending

Persistent inflation and increased consumer expenditure causing an overall remixing of deposits to commercial

GDP Slowdown

Based on historical data, slowing GDP growth (as opposed to perfect soft landing or recession) leads to slowing deposit growth

Source: Curinos Analysis, Forecast as of Jan 2023 

Meanwhile, national banks, direct banks and fintechs continue to grab primary consumer share and rate-sensitive money from regional banks, super regionals and community institutions. Rate awareness increased significantly toward the end of last year, sending U.S. consumers to switch out of liquid accounts and into higher-yielding CDs. (See Figure 3.) Smaller institutions whose deposit betas outperformed larger players last year are now likely to face rising betas as well. Unless providers have a superior product that keeps customers from moving their money, they will be forced to pay market (or above-market) rates. 

Figure 3: CDs | Jan '19–Dec'22

Source: Curinos Retail Deposit Analyzer | Note(s): Simple average displayed. CDs include all terms. Excludes online banks. Includes only retail deposits. Quartiles calculated monthly based on CDs as a share of overall portfolio or acquisition balances.

U.S. commercial deposit outflows, meanwhile, have exceeded expectations as corporations seek yield elsewhere, but loan growth is accelerating. (See Figure 4.) Commercial deposit balances declined an average of 2.3% in January from December 2022. It is clear that there is an increased focus by commercial customers on the opportunity cost of leaving funds in non-interest-bearing accounts.

Figure 4: Aggregate YoY U.S. Commercial Loan and Deposit Growth

Source: Curinos Commercial Deposit Analyzer, SNL, SEC Filings | Note: Loans are composed of C&I Loans, CRE, and other commercial loans, Curinos proprietary weighting applied to loan growth

In essence, financial institutions must become more surgical about identifying the right customers to keep and the right ones to bring in the door. The goal is to maximize portfolio value, target prospects more adroitly, improve onboarding and allocate marketing efficiently.

Expenses

Expense reduction should be an ongoing effort that isn’t directly linked to NIM expansion or contraction. And it is true that most financial institutions have reduced costs significantly in recent years – from branch closure to the use of paper.

But opportunities abound and that will only benefit profitability when NIM is squeezed. While technology investments are initially a cost, for example, the ultimate accomplishment is money-saving efficiency. The same goes for marketing investments that can yield expense reduction by targeting the right customers at the right price. 

Fees

The U.S. banking industry has recoupled much of the lost overdraft fee income, but there’s little doubt that fees remain under attack from many angles. (See Figure 5.) The phrase “junk fees” has entered the lexicon and the Consumer Financial Protection Bureau has proposed a rule that could reduce credit card late fees by as much as $9 billion a year. 

Figure 5: Change in U.S. Average Consumer Fee Income | Total Industry1 | 2019 vs. 2022

Note: 1 - Regulated depositories filing FFIEC 031/041/051 reports | 2 - Observed 35% decline, with many FIs still rolling OD changes, expected to reach 50% by EOY 2023 | 3 - The CFPB’s 2023 Q1 proposal to reduce late fee cap from $41 to $8 projects a 75% decrease in overall industry revenue from late fees
Source: Curinos Analysis, S&P Global CapIQ, FDIC Call Reports (2019-2022)

As a result, higher fee income is unlikely to offset NIM compression, but financial institutions can explore pockets of the industry that can bear higher fees. On the consumer side, the goal is to prove value in exchange for fees, particularly for wealth customers.

Meanwhile, commercial banks are planning ambitious treasury management re-pricing after years of trailing inflation. According to the most recent commercial Commercial Deposit Analyzer Executive Summary, 62% of banks are looking to increase treasury management pricing by 5%-10% in 2023 and 31% are looking to raising these fees by over 10%. All in, these increases could generate an incremental $1.5-$2.5 billion in top line fee revenue (although some of the increases will be offset by earnings credit rebates).

The Role Of Loan Volume And Quality

Many segments of consumer and commercial lending are unexpectedly strong at a time when recession remains a possibility. So far, credit risk seems under control with delinquencies and defaults hovering at historical rates. After all, the last thing that banks want to do is pay high rates on deposits to fund loans that may go bad.

But loan quality can change quickly, especially if, for example, lenders expand the credit box to make up for declining mortgage originations. Unsecured loans are surging, which is fine as long as credit quality remains strong. 

Relationship lending and loan specialization, such as so-called green products, can help protect banks from falling into a credit hole. Better technology to reduce loan cycle times will also help to win customers.

Ultimately, while contracting NIM is no doubt a challenge for the entire industry, Curinos believes banks that diligently focus on proactive management nevertheless have an opportunity to outperform. Discipline on tactical management, expense management and customer management will separate the winners from losers.

  • Author
    • Adam Stockton

      Adam is a Managing Director who leads the Retail Deposit & Lending businesses at Curinos. He has spent more than 18 years advising financial services companies on growth and profitability strategies, focused on product management, growth, profitability and pricing. Clients include a majority of the top 25 US banks, a number of the largest banks in Canada and Australia, brokerages, Credit Unions, direct banks and fintechs.​ Adam’s work leads to actionable, sustainable strategies that help clients grow economically through the application of granular analytics, purpose-built tools and proprietary benchmark data. He regularly publishes and speaks, particularly topics relating to product profitability and growth.​ His teams are responsible for Curinos’ Retail Deposit Optimizer product management and price optimization platform; Deposit Analyzer benchmarking products for Consumer, Wealth and Small Business deposits; LendersBenchmark Analyzers for Small Business Unsecured Lending; rate and fee data for Consumer and Small Business; and strategic consulting practices across the Retail areas. ​

      View all posts Managing Director, Retail Deposits and Lending
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