Small Business Deposit Betas: Why it's Important to Optimize
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Small business deposit betas measure the degree of sensitivity of deposit rates to changes in the Fed funds rate and are expressed as a percentage of those changes. If, for example, the Fed funds rate rises by .5% (50 basis points) and a financial institution (FI) raises rates on its deposits by an average of .2% (20 basis points), the beta on those deposits is 40% (.2% = 40% of .5%).
Deposit betas indicate the degree to which an institution follows the trend of short-term market interest rates in setting its own rates. If deposit betas are below 1%, the deposit rates are said to lag market rates. If they are above 100%, the institution has elected to be more aggressive in its rate setting than the current market would indicate.
In today’s banking marketplace, FIs typically display an array of rates and corresponding betas depending on which customer segments they are looking to attract or retain and at what rate. If they have an appetite to increase their deposits, their betas for new-to-bank money, reflected in their “acquisition rate,” may exceed 100% and be considerably higher than their “portfolio rate,” which is the blended rate paid on its current balances. If they’re satisfied with their level of deposits or don’t want to incur added interest expense, they may move their rates upward more slowly than market rates, if at all, thereby displaying a beta of less than 100%. Optimizing betas means achieving desired deposit volumes at the lowest possible cost.
Rates paid on deposits generally lag fed actions
Past rate cycles have shown that deposit betas at most traditional banks lag action taken by the Fed, whether rates are moving up or down (Figure 1). At the beginning of the upward phase of the cycle, most banks are loath to reprice balances held by deposit holders who may be indifferent to receiving a higher rate. These providers are protecting their “back book” even at the expense of not adding significantly to the front of the book. Then, when the cycle turns downward, many may not wish to risk balances running off the books by lowering deposit rates too aggressively. In both cases, where a significant existing deposits are in play, betas for these banks are typically less than 1% – they intentionally reprice more slowly than the Fed when it moves its market rates.
Figure 1: Cost of Interest-Bearing Domestic Deposits as % of Deposit Balance
Overall, bank deposit prices have historically lagged movements in the Fed Funds rate.
Source: Federal Reserve, FDIC, Novantas Analysis
Note: All figures represent interest-bearing domestic costs and deposits in all commercial banks
This is in contrast with most fintechs and direct banks, many of which have a much smaller back book to protect. In these cases, especially in a tightening rate environment, betas can be well above 100% in order to attract new money before the competition can. As their balances grow, however, they too need to guard against deposit flight, and their task when rates are falling may be more difficult than that of traditional banks. That’s because most of the customers they’ve attracted have come to expect higher rates and are more likely to switch providers for a more attractive rate. But if these providers shrink their betas, many may forfeit the very value proposition that got them to where they are in the first place.
Methods to minimize betas
Banks can use beta to employ a variety of strategies to minimize deposit costs. One of the most fundamental is to separate new money (front book) from existing balances (back book). During the rising-rate phase of the cycle, they may offer premium rates or cash offers in low-density geographies while maintaining existing rates on the core of their book. As relatively low-rate CDs renew in an environment of higher rates, they might also auto-renew as many as possible but offer a higher marquee rate close to the maturing rate to a rate-sensitive portion of the renewing book. This cohort may include first-time renewers, whose antennae are more likely to be up for a competitive market rate than those renewing for a second or third time. During the falling-rate phase, FIs may reduce rates on the proportion of balances held by customers who are indifferent to falling-rate moves because these customers may value other attributes and benefits besides rate that their institution provides them. Or they may reduce rate more aggressively on auto-renewing CDs, especially on those that may not be renewing for the first time.
Throughout all phases of the cycle, betas need to be analyzed and optimized to arrive at the best balance of volume growth and retention on the one hand and cost containment on the other. The stakes are enormous: on a $50 billion deposit book, for example, shaving an FI’s portfolio beta by an average of only 17 basis points per year can mean $85 million falling to the bottom line annually.
Managing Beta for Small Business
Figure 2: Small Business Deposit Rates and Product Mix
Source(s): Curinos Consumer, Small Business, Commercial Deposit Analyzers
Note(s) For Commercial and BB, Non-Interest Checking includes NIB DDA, and Hybrid DDA, Interest Checking includes ECR DDA
One of the most effective ways of optimizing betas is to understand how different customer segments respond to changes in rate. Small businesses, for example, tend to represent a source of low-cost deposit stability (Figure 2). This is because much of the cash they keep with their bank is in their operating account, which is usually a non-interest-bearing checking account. Business owners are also more likely to value benefits they derive from their bank that go beyond rate, like advice on managing their business finances. In both these segments, banks can keep these betas relatively low as a counterweight to segments that typically demand higher market rates.
Optimizing beta is key to optimizing profitability
Betas measure the relationship between short-term market rates, specifically those set by the Federal Reserve, and what financial institutions charge their customers or members for their deposits. They are thereby a gauge of an FI’s funding costs and, along with interest earned on its assets, determines net interest margin and, ultimately, profitability. That’s why optimizing beta is so important. It defines the most favorable intersection of desired deposit volume and the cost needed to achieve it.
But optimizing can be as complex as it is fast-moving, which is why analytical tools are generally required to truly optimize. These include Curinos Small Business Analyzer. For institutions with significant deposit books, putting it to work has been shown to yield multi-million-dollar annual improvements to their bottom lines.
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FAQs
What is a deposit beta?
Deposit betas measure the degree of sensitivity of deposit rates to changes in the Fed funds rate and are expressed as a percentage of those changes.
What are deposit betas used for?
Deposit betas allow financial institutions to measure the speed and level to which the interest rates they pay on their deposits coincide with the Fed Funds rate. To the extent FIs have access to rates paid by other institutions, it also provides a measure of their rate behaviors versus the competition.
What does it mean when a deposit beta is more than 100%? Less than 100%?
A deposit beta of more than 100% means an institution’s rate paid on its deposits has moved greater than the Fed Funds rate. A deposit beta of less than 100% means an institution’s rate paid on its deposits has moved less than the Fed Funds rate.
Why do deposit betas matter?
Deposit betas are a valuable and universally accepted metric for an institution to compare what it is paying on its deposits to market rates and to rates paid by its competitors. Using deposit betas makes it easier for institutions to analyze and understand their position in the deposit marketplace.
What are typical deposit betas?
As a rule, the more liquid a deposit – such as checking, savings and money market accounts – the lower the beta on the account. That’s because depositors are willing to accept rates below market rates for immediate access to their funds. Term deposits, which limit access to funds for set periods of time, generally have higher betas, and except in periods when the Yield Curve is inverted, the longer the term, the higher the beta.
Do deposit betas vary by types of deposits?
Yes. More liquid accounts tend to display lower betas than term accounts, and Commercial and Wealth deposits tend to display higher betas than Consumer and Small Business accounts. That’s because certain customer segments typically demand more on their deposits than others. Wealth clients, for example, have greater access to higher-paying nonbank alternatives. Small Business deposits, on the other hand, require lower rates because so much of a small business’s deposits are tied up in non-interest-bearing demand accounts for its operating needs.
Why is understanding deposit betas important to bank profitability?
Rates paid on an institution’s deposits vary significantly by type of customer and type of products they favor. Measuring what’s paid on all deposits and optimizing what needs to be paid on each type is critical to minimizing deposit costs while maximizing the probability of retaining those deposits, both factors of which influence net interest margin and overall profitability significantly.
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