Financial markets expect the Bank of England to increase interest rates as early as next spring as evidence grows that a hot U.K. labor market is spurring wage and price inflation. The good news is that higher rates may produce some long-sought relief to net interest margins. The challenge will be to position your bank to take a coordinated, enterprise-wide approach to the new landscape. At the same time, there will also be pressure to avoid significant increases in interest expense following widespread cost reductions.
As always, the ultimate goal is to use customer-level analytics to acquire and retain primary relationships, acquire sticky deposits at low cost and avoid doling out higher rates to customers who aren’t price sensitive.
Apart from the brief rising-rate cycle of 2017–2018, UK interest rates have been at an historical low since 2009, further flattened by the economic impact of Brexit and the pandemic. The last sustained rising-rate cycle goes all the way back to 2003–2007 – possibly beyond the living memory of those currently managing deposits portfolios at U.K. banks today. This means that the next cycle will be largely uncharted territory for many U.K. bankers. That said, there are useful lessons to be learned from their U.S. counterparts whose last experience of rising rates was as recent as 2015–2019.
BIG DIFFERENCES FROM LAST TIME
Curinos has identified five key differences between the current climate and previous cycles that will have assorted impact on betas and growth.
- BoE Timing. The cadence and size of Bank of England rate hikes will potentially impact competitive response, but both are unknown. Previous projections had indicated the first rise in interest rates from the historic low of 0.1% to 0.25% at the end of 2022, but more hawkish indicators suggest a change between February and May of next year.
- Excess Liquidity. Like the U.S., U.K. banks are awash in deposits as the pandemic has severely curtailed spending by both consumers and companies. This flood of deposits may make banks more tolerant of low deposit growth, or even runoff, after rate competition returns. This will be especially true if current expense and profitability pressure and lower loan growth continue. (See Figure 1.)
Figure 1: Six-month combined balance growth for cash ISA, non-ISA and current accounts
- Digital Innovation. The pandemic accelerated the shift to digital channels, challenging incumbent business models. Greater digital uptake by consumers lends itself to more transparency of rates and fees, along with lower barriers to moving money. The new frictionless open banking paradigm has made current account switching easier while the advent of mass-market self-trading products indicates a new level of confidence in certain consumer segments.
- Challenger Growth. Challenger banks focused more on acquisition than on profitability are inclined to sacrifice short-term net interest expense by driving headline rates to grab market share. The rise of disruptive fintechs offers compelling low-cost ways to invest in the market is challenging traditional players.
- Greater Focus on Primary Relationships. There is evidence over the past year that banks are starting to show a small but perceptible reduction in the proportion of their current accounts that are considered “prime” due to several factors, including the impact of changing consumer behavior during the pandemic. This has implications for managing net interest expense in a rising-rate cycle because there is strong evidence of an inverse correlation between primacy and cost of funds. (In other words, the stronger the relationship, the more cost-effective is the investment in marginal cost of funds.)
TIME FOR A NEW PLAYBOOK
The biggest learning from the last U.S. cycle was the value of developing a funding playbook in time to identify the best way to respond to the changing landscape (See Figure 2.) That’s why it makes the most sense to start now, when the planning cycle for 2022 is getting under way. And don’t assume that your last playbook will resonate in this environment.
Figure 2: Betas typically accelerate after an initial lag
Today’s playbook should consider current deposit needs and anticipated potential needs for the future – and set programs for each macro-economic and competitive scenario. These won’t all point in the same direction. For example, there are distinct drivers towards lower betas, such as low loan-to-deposit ratios and slow loan growth coupled with industry profit pressures. These are counterbalanced by drivers towards higher betas, such as increased customer elasticity arising from increased online shopping/purchasing and the impact of digital challengers and fintechs.
Of course, a bank won’t know how the competition will respond to rising rates until it happens, but a well-developed playbook must take those competitor scenarios into account as well. After all, higher rates typically drive higher balance churn. Even banks with significant excess liquidity today are likely to see their growth rates come under pressure if others in the market begin to price up.
Finally, the development of a deposit rate playbook can’t occur in a vacuum. A good rising-rate playbook will need to take into account the holistic customer relationship and a strong assessment of both current and potential relationship primacy. This means using customer level analytics to avoid raising pricing on deposits that aren’t price sensitive.
Curinos has leveraged its global consumer deposits database across over 5,000 behavioral dimensions to identify seven primacy segments, each with different characteristics of price sensitivity, shopping propensity and persistence. Each segment has major differences in historical cost of funds and therefore potential treatment strategies designed to focus actions on the most productive efforts to ultimately maximize customer lifetime value. Banks that use this segmentation can track customer migration patterns across time to analyze success in generating primary customers.
The new challenges facing those entrusted to steer U.K. deposit portfolios safely and profitably through the impending rising-rate cycle will require a complex set of strategic and operational decisions. Those best equipped to optimize their decision-making will have invested in playbooks to anticipate unfolding environmental and competitor scenarios. By combining these playbooks with customer-level analytics that enable pricing and product decisions to be executed with optimal precision, these banks should be well-positioned to achieve their objectives.