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More Than Ever, Deposits Are Key To Profitability

U.S. bank deposits dropped by nearly $500 billion year over year in Q1 2023, according to the FDIC – the largest decrease since the early 1980s. On top of that, deposit betas are rising as customers are waking up to the prospect of higher yields.

As banking institutions increase their focus on retaining existing deposits and attracting new customers, threading the needle between deposit runoff and increasing costs is becoming more difficult. Profitability is being squeezed as low-cost deposits grow scarce, and the downstream implications are significant (See Figure 1). Credit standards are tightening, and budgets for marketing and distribution are being slashed. In some cases, these moves to protect near-term profits are putting long-term growth at risk.

Figure 1: Surge Deposits | Jun ‘19 – Jul ‘23

The banking industry observed a surge of liquidity post-COVID-19, but $2.3T
(60% of the original surge) has left the banking system in the last 17 months
Source: Curinos Analysis; S&P Global; FRED H8 Report | Surge Deposits measured as deposit growth from 2020-2023 in excess of median growth rate from 2016-2019 | H8 deposits grossed to equal total commercial bank deposits from call reporting

These pressures may abate, but they’re not likely to recede entirely any time soon. Continued quantitative tightening by the Federal Reserve, the lagged effects of inflation and off-balance sheet rotation are all headwinds to deposit growth, which Curinos projects will be well below historical averages at least through 2024. And even during Fed plateaus, interest expense has historically risen across segments, largely because of rotation of deposits from the back book to the front book.

In the longer term, other profitability pressures are emerging for banking institutions. Customer preferences and behaviors continue to shift, which are rendering the tried-and-true levers of differentiation increasingly obsolete. There will need to be a next act, and that’s particularly true for regional banks with aging customer bases originally acquired through a physical presence. This next act needs to start today, with investments that will help build for the future.

The winners in this challenging environment will be the institutions that can combine surgical and proactive management of deposit costs with the right longer-term franchise investments. Those unable to navigate successfully will miss profitability targets and find more efficient growth difficult to come by. At that point, those that can’t invest in the future may not be able to compete in the future.

Getting It Right In The Near Term

The immediate profitability imperative all institutions face is how to maximize retention and hit volume objectives while keeping interest expense in check.

For consumer deposits, the most significant short-term challenge will be upcoming CD maturities, which will come in two waves. (See related article in this issue: “Higher Rates Push Banks to Draft a CD Maturity Playbook.”) The first wave will see lower-cost CDs maturing into a higher-rate environment. These were booked at rates ranging from 2.00% to 4.00%. The challenge will be balancing renewals, which will require a meaningful increase to interest expense, against limiting that expense, which may increase deposit runoff.

In the second wave, with rates already above 4.00%, expense pressure will increase, particularly with an inverted yield curve, in anticipation of falling market rates. Even if CDs renew at the same rate, margins will decrease on renewing CDs. This is because consumers historically have shopped for rate and created churn even before the Fed rate drops.

Rates may begin to fall, but the pressure on renewing CDs will continue. Although some mix shift occurs to liquid deposits whenever rates fall, Curinos anticipates that substantial deposit volume will remain in CDs for the medium to longer term, in what’s expected to be a prolonged interest rate environment in the range of 3.00% to 4.00%.

Commercial and wealth deposits share similar challenges, and understanding the different segments of customer needs of each is critical (See Figure 2). Exception requests granted at the peak of a rising-rate cycle may end up having a long tail, particularly if a Fed Funds plateau lasts longer than it has historically. That’s because it’s difficult to decrease a customer’s rate in a flat-rate environment. But with continued rotation from the back book, which exhibits standard rates and no exceptions, to the front book, which exhibits new rates and market-level exceptions, pressure on interest expense will continue to intensify.

Figure 2: Cumulative Balance Growth | Jan ’19 – Jun ’23

Deposits are down across segments, with
Commercial and Wealth showing steeper declines
Source: Curinos Consumer Deposit Analyzer | Curinos Commercial Deposit Analyzer | Curinos Wealth Deposit Analyzer

Investing For The Longer Term

Once near-term performance is shored up, the imperative shifts to the longer time horizon. Banks will need to make the right investments today to increase the proportion of low-cost deposits through any future rate conditions. What follows are three investment options worth taking into account as institutions work to position themselves for profitable years to come.

First, today’s regulatory regime appears to be shifting back toward M&A permissibility – a bright spot in this environment. The difference this time, however, is that deposits – which generally have been an afterthought – will need to take center stage in both the evaluation and execution of any transaction. Stability, relationship depth and relative cost of deposits must all be considered carefully. In addition, more attention than ever must be paid to retaining deposits after the transaction. Curinos benchmarks show a range of 5% to 17% deposit runoff between the announcement of a merger and the systems conversion. While losing some deposits from an acquired institution may have been acceptable, if suboptimal, in the past, today it can make the difference between whether a transaction is accretive or dilutive.

Second, investing in customer growth will drive the deposit franchise of the future. As interest expense has increased, many institutions have responded by cutting marketing budgets. While understandable in the near term, economizing now will mean a further reliance on rate in the future. One opportune way to grow lower-cost deposits is through targeted use-of-cash offers, the costs of which haven’t increased as much as rate. Customers today, and increasingly in the future, also expect marketing and digital tools that speak directly to them and make it easy to deal with their financial provider. If their incumbent institutions can’t provide them, they may well find them at fintechs or other new entrants.

Third, a segment focus can help grow long-term customers and deposits, but only when executed thoughtfully. For many institutions, the answer to a segment focus has often been, “We’ll win small businesses and the mass affluent.” While these segments offer opportunity, competition for them is growing, and for mass affluent and wealth specifically, deposit costs have been rising faster than retail as a whole. Small businesses offer more attractive deposits – 50% lower than the cost of consumer or commercial deposits – but banks need to carefully weigh how to win them through an overreliance on rate that would erode the cost advantage. (See related article in this issue: “Small Businesses Offer A Clear Profitability Upside For Banks.”)

Perhaps more than ever, deposits are influencing banking profitability, and not always for the better. But the good news is that, because of their influence, deposits can also be used as a lever to improve profitability in the future.

What’s needed is a short-term plan and a long-term strategy. In the short term, FIs need to manage renewing CDs in a manner that won’t risk repricing the back book and to limit exception pricing for commercial and wealth customers. In the longer term, they will need to consider marketing as an investment in new-customer growth rather than as an expense, put in place a plan that can mine deposits from opportune customer segments, and weigh whether buying deposits through acquisition is more cost-effective than growing their own.

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