- In commercial, the key challenges in managing deposit betas in a falling-rate environment are the back book of interest-bearing deposits and non-interest-bearing DDA.
- In consumer, interest expense will increase until the first Fed rate cut as deposits continue their rotation from lower-rate checking and savings into high-rate products.
- In small business, deposit costs are likely to stay lower than other lines of business, while in wealth, the worst has passed, though some headwinds remain.
The base case for 2024 is that the economy will continue along a path of moderate growth, inflation will continue to normalize, and the Fed will gradually cut interest rates by 75 basis points over the course of the year while continuing to wind down its balance sheet.
In this scenario, we would expect deposit growth conditions to be better than 2023 on a full-year basis and directionally similar to the second half of the year. This would translate into the average commercial book remaining roughly flat and the average consumer book seeing very low single-digit growth or decline. Even as balance pressures moderate, however, pricing pressures will likely remain. In fact, in some segments, interest expense may actually increase modestly even as the Fed begins to cut rates. For these reasons and more, we see 2024 as the year of the liquidity manager.
In commercial, two major factors will make it harder to manage betas in a falling-rate environment. The first is the back book of interest-bearing (IB) deposits (Figure 1). Portfolio betas on MMDA have shot up to 70%, as the majority of balances are now priced at or above 400bp, but roughly a quarter of all balances are still priced under 300bp. In interest checking, 45% of all commercial balances are priced under 300bp. Banks will be wary of waking up these balances with modest rate cuts given that the replacement costs are much higher, thus limiting the amount of downward beta they can take. And back-book balances that do wake up and demand higher pricing will further offset any front-book savings.
Figure 1: Rate Bands By Product, Oct. 2023
A very strong disconnect remains between front book and back book in commercial interest-bearing products
The second major factor is non-interest-bearing DDA. Non-interest-bearing (NIB) deposits are down 15 points as a share of total deposits since the start of the cycle, but they still represent about a third of all commercial balances. While most of these carry an earnings credit that can offset bank fees, they don’t count against interest expense. How these balances perform in a higher-for-longer scenario, even factoring in the expected Fed cuts next year, will be key in determining overall commercial portfolio interest expense.
We’re often asked to consult our crystal ball on the future of NIB commercial deposits. The short answer is, “It’s complicated.” Earnings credits are a relic from the Regulation Q era when banks were banned from paying interest on most commercial checking accounts. Reg Q was repealed more than a decade ago, but since then earnings credits have provided a value for commercial cash at or above the interest-bearing alternatives. That’s far from the case in the current cycle, as banks have held earnings credit betas to a mere 10 percent.
Most companies could earn 2% to 3% incremental total return by bidding out their deposits and paying their treasury management fees out of pocket. But behaviors, account structures and budgeting expectations are deeply ingrained. In a conservative scenario, continued re-mixing from NIB to IB will add 5bp to 10bp of interest expense to a typical commercial portfolio in 2024, even if the Fed cuts rates.
In consumer, interest expense will continue to increase until the first Fed rate cut. Though the velocity of rate-seeking behavior has declined from peak levels, Curinos data continue to show rotation from lower-rate and back-book checking and savings deposits into high-rate savings, MMDA and CDs. With close to half of savings and MMDA deposits priced under 25bp, the impact of repricing is highly significant (Figure 2). Additionally, deposits that run off, regardless of whether the runoff is due to rate-seeking or natural attrition, must be replaced with high-rate acquisition.
Figure 2: Average Consumer Savings Balance By Rate
Just under half of branch savings balances were under 25bp in Q4, even as the percentage at 400+ bp continues to grow
In small business, while runoff has increased markedly, deposit costs have remained lower than in any other line of business. The good news for 2024 is that deposit costs are likely to remain lower. The level of rate-seeking churn is still well below consumer, and the high proportion of deposits in DDA will keep overall portfolio costs in check. Less positive is that deposit growth is likely to remain challenged. Small business deposit levels have been adversely affected by factors depressing both consumer and commercial growth, including inflation, wage growth and debt paydown. With a recession looking less likely, we may also see less cash buildup.
In wealth, the worst has likely passed. Rate-seeking behavior came earlier, and deposit runoff and deposit costs leveled off sooner than consumer. While this is good news, a likely headwind to growth in wealth deposits in 2024 will be reallocation of cash as portfolios are rebalanced. Because investment markets typically outperform during the interval between rate hikes and cuts, advisors will certainly recommend that clients take advantage of strong equities and bonds should this pattern persist in the current rate cycle.
The bigger challenge banking institutions face with their wealth clients is building a more durable proposition that lasts through future rate cycles. How can product structures and pricing strategies align to present a compelling case for clients to maintain deposit levels in all rate environments without needing to match money market mutual fund (MMMF) rates to the basis point? How can forecasting and valuation better predict future flows and help futureproof them? The industry must move beyond copying consumer products and pricing in developing a better business case for both the bank and the wealth customer.
What If 2024 Doesn’t Go As Expected?
If the market has learned one thing from the past couple of years, it’s that the outlook can change quickly – as a reminder of this, one need only to look at the forward curve as of late 2021. So it is important that banking institutions plan for a range of rate and macroeconomic scenarios. We’ll quickly consider deposit implications for both higher- and lower-than-expected rate scenarios.
A lower-than-expected scenario could materialize based on a range of conditions. The most favorable would be normalization of inflation and moderate growth occurring faster than currently anticipated. In this scenario, we would expect similar deposit-growth dynamics to the base case but relatively less pressure on rates. But it’s unlikely to play out in this fashion. The alternative path to a lower-rate scenario would likely entail either a mild recession or isolated credit events in certain market segments that would result in less deposit demand and less price competition
A higher-than-expected scenario seems a remote possibility given the December FOMC Summary of Economic Projections. However, given that both 2022 and 2023 confounded forecasters, it would be prudent to briefly consider the possibility. This scenario would be more difficult to manage because it would likely drive an uptick in back-book deposit repricing across segments. It would also increase the strain on bank balance sheets by narrowing margins and exacerbating negative marks on remaining unhedged fixed-rate assets originated during the ultra-low rate period.
The most likely outlook for the year is neither smooth sailing that benefits all nor such rough waters that few stand a chance. Instead, it will be choppy, and skill will be rewarded. Challenges must be dealt with, including managing the wave of first-time CD maturities and navigating the product rotation from non-interest-bearing to interest-bearing deposits in commercial.
But there are also real opportunities for banks to be on the front foot and use targeting, personalization, customer-level treatments and total-relationship solutions to acquire valuable customer relationships. This will require good strategic decisions across lines of business to optimize the marginal cost of funding for the organization while also balancing the need to grow long-term franchise value by investing in the most valuable customer relationships.
