The past 15 months have transformed the rate environment, the liquidity environment and operating environment for banks and corporates alike. As the economy emerges from the pandemic, we explore implications for commercial deposit pricing in a future rising-rate scenario, new strategies to grow loans and fee income, advanced approaches to customer profitability and the latest innovations in digital banking.
It’s Not Too Early to Prepare for Higher Rates
The most recent Fed dot plots now point to two hikes by the end of 2023. This constitutes a narrowing of the window that banks have to prepare for a rising-rate cycle that will be different from any previous cycle. With a market awash in liquidity, the traditional supply and demand dynamics for funding are unlikely to apply this time around. As a result, banks will need to be much more precise about how and where they pass through deposit rate increases.
Data from CDA shows that deposit balances continue to grow – up 2.3% during the first quarter (see Figure 1). And as we have noted previously, there are structural drivers, including ongoing Fed asset purchases and fiscal expansion, that will continue to push balance levels higher in the near term.
On a year-over-year basis, deposit balances have grown 17% in aggregate while loan growth was negative 5.6% overall. For the average bank, the disparity was even more acute with mean YoY deposit growth of 35% while mean YoY loan growth was negative 1%. (See Figure 2.)
Figure 2: YoY Commercial Loan and Deposit Growth
1Q20 to 1Q21
Source: Novantas CDA, SNL, SBA PPP Lender Information, Call Reports, SEC Filings | Note: Loans are composed of C&I Loans, CRE, Multifamily and Total Leases
The implication is that, despite emerging optimism on loan growth, banks have a massive wall of excess liquidity to lend before normal supply-demand dynamics return. It also means that, in the early stages of the next rising-rate cycle, banks simply won’t be able to afford to pass through rate increases on large segments of their deposit book.
That said, as the Fed begins to move rates, banks will face pressure from corporate clients to pass through higher deposit rates. To protect (or grow) NIM, banks will need to know where to use rate (e.g. to protect primary relationships) and where to hold the line. Integrating data and primacy analytics into relationship management and pricing is a process. With a narrowing window until the next rising-rate cycle, the time to act is now.
Digital Innovation Gains Traction
Digital innovation continues to be at the forefront and key initiatives are targeting remote onboarding, from user experience to core functionality. Financial institutions are embarking on this journey quickly to solve for the complicated manual process of commercial account opening and onboarding, sometimes inviting fintechs to participate. Neo banks have set the stage for innovation as well, with their focus primarily on a “digital-only” process for customers. The pandemic, which restricted customer interaction and kept employees working at home, has also accelerated the adoption of these processes.
This is pushing banks to improve or lose in the competitive landscape. Legacy systems have hampered modernization in the past, but with open banking and API enabled cloud-based systems, solutions are arriving faster than ever before. Outside of platform reconfiguration, the three main drivers that are advancing remote onboarding and account opening are digitized KYC (Know Your Customer) processes, advanced document centers and smart contracts.
The adoption rate of digitization among the top financial institutions is quite high, with smaller banks further behind. Digital onboarding is an imperative feature in the consumer and small business space, but the commercial line of business is just warming up.
In the past, the KYC process could take weeks, primarily due to lack of technology and stringent security measures required by in-person verification. The process has somewhat improved, moving from face-to-face with relationship managers to virtual meetings. Now, AI-powered KYC technology identifies users within minutes, initiating an end-to-end digitization process that is being linked to corporate platforms. AI-based technology verifies users anywhere in the world in real time and relies on government databases. The three main identifiers are facial recognition, voice biometrics and document validation.
These are being revamped into a support center for administrators by using digitized built-in forms. New functionality allows users to view and take action on all agreements and forms, including the ability to download, sign, upload and view historical information. The traditional process included submission of hard copies of documents, which led to additional verification requirements and extended the timeframe. Key forms available include commercial account agreements, commercial DDA requests, treasury master agreements, product enrollment form and IRS-W9. Digitizing this process eliminates float time, reduces waste (supporting the “Net Zero” motto) and adds a key layer within the remote onboarding process. A new key feature that has been widely integrated is the capability for treasury agents to be notified when documents have been uploaded.
Smart contracts are gaining a foothold and represent a critical layer in the digital platforms that are powered by blockchain technology. Use cases began in payment execution and onboarding of new hires and are now being used for account opening and onboarding. Widely accepted and a secure method of contract execution, they are designed to automatically execute on the date preset, verify all parties and honor the terms and conditions within the agreement or transaction. Third-party interference and additional timely processes associated with compliance or administration are avoided, transactions are recorded between parties and are transparent to all who are able to access. This process, which is essentially equivalent to the real-time payment process, rules out confusion or inefficiencies.
A New Formula for Customer Profitability
The pandemic has required both bank management and the Fed to develop new playbooks. All in all, the industry’s performance has been remarkable over the last 15 months. But the pandemic did lay bare several areas of weakness in commercial lines of business – digitization of customer-facing processes, overreliance on NII and customer profitability measurement.
We believe a more advanced approach is needed that incorporates both relationship potential and customer primacy logic. (See Figure 3.)
Figure 3: Advanced approaches to measuring customer profitability incentivize different RM behaviors
Source: Novantas Analysis
Traditional Approach (Rearview Mirror)
New Approach (Forward-Looking)
Not surprisingly, it takes enterprise commitment to develop forward-looking profitability measures that reap the benefits of this advanced approach.
First, the bank needs to ensure executive commitment and get all levels of management to align on a customer primacy definition and the metrics used to track it. Second, the data and analytics infrastructure must be developed to support this approach, including an integrated data warehouse, BI tools and third-party data. Finally, customer profitability measures must be incorporated into LOB P&Ls, RM scorecards and compensation plans. Without the latter step, the right profit-producing behaviors won’t be developed in the coverage teams.
Leveraging Analytics to Support Commercial Loan Growth
Many CEOs are expressing strong optimism that commercial loan growth will rebound in the second half of the year. These hopes are on the back of a slow first quarter in which year-over-year C&I lending was essentially flat and CRE showed a modest 2% increase. The second quarter seems weak so far, with C&I lending down 15%, according to S&P Global. Despite these tepid numbers, the optimism for a recovery in the second half comes from improving sales pipelines and the expectations that the opening of the economy will spur continued GDP growth and company investments.
The immediate challenge will, of course, be the massive amounts of cash in company coffers. For investment-grade companies, the median cash ratio, a measure of liquidity that compares a company’s cash and cash equivalents with its current liabilities, was 33.3% at the end of the fourth quarter of 2020, according S&P Global. That is far higher than the 19.3% at the end of 2019. In addition, PPP loan forgiveness and the normal cadence of payoffs and amortizations will challenge growth.
What to do? It is time to ramp up the use of analytics. And we believe the opportunity is a bit different across the prospect universe versus current customer segment. For prospects, the focus should be to use analytics to prioritize RM efforts and enable marketing support (See Figure 4.)
Figure 4: Leveraging Analytics to Support Commercial Loan Growth
Source: Novantas Analysis
First, prioritize the prospects into tiers for consistent RM time allocation and effort. The prioritization algorithm should include both quantitative and qualitative criteria organized in two categories:
- Attractiveness (e.g., revenue-to-bank potential, prospect brand name, industry, location, product usage)
- Probability to convert (e.g., timing, competitive situation, depth of relationship, COI influence).
Second, using the prioritization scheme and insights gleaned from prospect profiles, leverage marketing automation to present the bank’s best ideas and nurture the opportunity in concert with the RM’s activities.
For current clients, use credit fair share curves to identify headroom. These can be built using existing bank data or licensed from third parties. The foundation of the model will be a combination of current credit position and operating business – identifying clients where you have the opportunity to move up in the credit and/or replace an existing provider (based on the value the bank is providing in the current relationship).
Second, refresh customer profiling analyses to identify opportunities in the specialty lending space (e.g., EF, ABL). Many banks don’t do a great job of coordinating between these specialty lending teams and the primary coverage team.
Pre-pandemic, much of the focus was on leveraging current credit relationships to sell more operating business. Today, we need to take those same analytic processes and skills and focus them on originating credit.
TM Fee Pricing, ECRs Need New Focus
As COVID-19-related restrictions ease and the economy kicks back into gear, it is important to properly coordinate TM fee pricing and ECR pricing strategies. Fees are an increasingly large strategic focus for many commercial banks that are looking for revenue growth while NIM is constrained by high deposits levels, low loan volumes and continued low rates. As such, many banks raised prices in early 2021, albeit the increases were mostly smaller than usual. Now as the economy recovers and inflation ticks up, banks must again start looking at their ECR pricing strategies especially in concert with fee pricing.
Data from NDepth showed no measurable relationship between ECR rate and TM fee discounting. And when we stack ranked clients by TM discounts or ECR, there were no changes in the averages of the other metric. (See Figures 5 and 6.) The lack of relationship between the two suggests that banks are pricing deposits and fees in separate silos versus considering them on a holistic relationship basis. This is a lost opportunity to optimally position pricing to client preferences and a fair value exchange.
Figure 6: Quartile TM Market Discount
Average ECR by TM Market Discount Quartile
|TM MARKET DISCOUNT QUARTILE||AVG. ECR|
Average TM Market Discounts by ECR Quartile
|ECR QUARTILE||AVG. TM MARKET DISCOUNT|
Source: Novantas Analysis
Since the trade-off between pricing TM fees and ECR directly hits the bottom line, it’s imperative that banks find the right alignment to meet their clients’ preferences and their own financial objectives. If clients are getting advantageous pricing on both fees and ECR, then they aren’t generating optimal value for the bank. If pricing is not positioned to meet client preferences, then banks aren’t positioned to win and maintain valuable relationships. TM Fee and ECR pricing cannot exist in separate vacuums.
Despite the deposit surge and current low rate environment, banks need create a better linkage between ECR and TM Fee pricing now. While current forecasts don’t expect rate increases until 2023, this can quickly change.
Banks need to start preparing that rising-rate strategy for commercial deposits now (see first section in this report) or risk being unprepared and reactive when rates suddenly change. That strategy must work in concert with their TM fee pricing strategy. Banks that don’t tie the two together risk losing out on client value or the ability to compete effectively.