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Commercial Deposits On The Front Line Of The Profitability Squeeze

A commercial profitability squeeze is coming as net interest margin (NIM) is squeezed. There are factors on both sides of the balance sheet that contribute to these headwinds, but for the time being the most acute pressure is being applied to the deposit book.

Starting with the left side of the balance sheet, both loan demand and risk appetite are in decline. Combined with an expectation that the Fed is at or near the peak of this hiking cycle, asset repricing is set to slow down. At the same time, commercial deposit portfolios are facing a storm on three fronts: declining overall balances, increasing competition and shifting customer behaviors. The result: betas are continuing to push higher.

During 2022 the typical regional bank saw commercial deposits decline 10%-12%. This year has been even more challenging, with the average regional bank commercial deposit book down almost another 12%. There are three reasons for this. First, quantitative tightening is outpacing the factors that traditionally drive money supply growth (credit expansion and velocity of money). Second, in light of recent turmoil in pockets of the banking sector, commercial customers have increasingly moved balances away from banks into institutional money
market mutual funds, to the tune of nearly $400 billion since mid-March. Third, some net flows have gone to the nation’s largest banks.

Shrinking overall deposit supply is compounded by changing customer behaviors. Fully 65% of bankers expect commercial customers to spread their deposits across more banks going forward. (See Figure 1.) And the deposit challenges are not isolated to commercial. Wealth deposits have seen significant outflows since mid-March while traditional retail franchises face continuing rate-based competition from direct banks. (See accompanying article in this issue, “Wealth Deposits: Instability Grows. What Does the Future Hold?”) The net effect of all of this: 76% of bankers expect competition for commercial deposits to increase.

Figure 1: In light of the recent market disruption, please rank each of the following statements about impact on customer behavior

Source: Curinos Commercial Analyzer

And increased competition will continue to push betas higher. While the average commercial MMDA beta is at 60%, money funds offer betas of close to 100%. The betas for money in motion, moreover, are materially higher than portfolio averages. For example, acquisition betas for MMDA balances over $10M are between 80% and 90%.

Fewer deposit balances and higher interest expense mean that many commercial customer relationships will be less profitable in the near term than they have been in the past. In order to navigate this challenging environment, there are three levers that banks can pull to improve commercial funding resilience and business profitability: optimizing total-relationship pricing for existing customers; taking advantage of increased churn to maximize cross-sell; and acquiring customers who have a high potential to bring operating deposits and payments flows.

Optimizing total-relationship pricing requires systematic and dynamic measurement of the drivers of relationship value. With the contribution of deposit value in decline, treasury management (TM) fees are an increasingly important counterweight to the profitability squeeze. Banks can benefit from TM fees in two ways. They can either realize the fees directly, or they can allow customers to offset the fees with earnings rate credits (ECR) applied to non-interest-bearing balances. ECR betas have historically been much lower than betas on interest-bearing products, and that’s been the case in this cycle as well, with average ECR betas at 9% (vs. 60% for MMDA). (See Figure 2.)

Figure 2: Commercial Bank Average Portfolio Betas March 2022–April 2023

Source: Curinos Commercial Analyzer

In general, allowing customers to offset fees with low-rate ECRs has been highly profitable for banks because, historically, this approach has been a bit of economic inefficiency that many company treasurers have been comfortable with. In the past, in fact, it hasn’t been uncommon for treasurers to leave even more funds in their ECR account than have been required to offset fees.

But in light of today’s higher rates and tighter liquidity conditions, company treasurers are increasingly doing the math, and the result is that ECR balances are decreasing at roughly two times the rate of commercial balances overall. (See Figure 3.) The milder form of this behavior change has been for company treasurers to redouble cash forecasting and positioning efforts to reduce unnecessary balances left in ECR accounts. The stronger version is to elect to pay bank fees out of pocket and move all balances to an interest-bearing account. Both are on display in the market today.

Figure 3: Commercial Bank Average YTD Deposit Growth (April ’23)

Source: Curinos Commercial Analyzer

This puts banks in a tricky position because it’s very difficult for them to raise fees quickly enough to fully offset the impact of much higher interest expense. But banks are trying their best: many are planning their largest-ever repricing events. And despite the recent banking turmoil, 81% of banks expect to follow through with their pricing events as planned. While this is a good strategy for most banks to follow with their existing TM customers, these increases will generally not be sufficient to fully replace the lost revenue from a NIM squeeze as the Fed slows down but competition for deposits remains fierce.

To fill the gap, banks will need to double down efforts to cross-sell to existing customers and acquire new high-value relationships. Acquiring customers where the bank can establish a right to win meaningful operating deposits is especially important because the last few months have reinforced that not all commercial deposits are created equal. Operating deposits directly tied to frictional cash in the primary payments account have proven not only less rate-sensitive but also much stickier relative to non-operating deposits. Winning these relationships, however, often begins with a credit relationship that requires seamless integration between bankers, TM officers and service and fulfillment personnel to complete the sale. It also requires prospecting among the right prospective customers and offering compelling relationship pricing.

With a profitability squeeze on the horizon, it’s as important as ever that commercial business lines have a structured plan and the analytical tools to support bankers in executing that plan. Navigating a market in which both macroeconomic conditions and drivers of customer-level profitability can change on a dime requires both speed and precision to take the decisive action necessary to acquire and retain high-value customers.

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