The Fed didn’t change the target rate today, but the probability of a rate cut in 2019 remains elevated. The industry, therefore, must deal with continued deposit-cost creep in the near-term, and also prepare for declines over the coming months.
The first instinct of many bankers may be to decrease deposit rates at a 100% beta. While this may seem to be a logical strategy given deposit-cost pressures, there are systematic and idiosyncratic factors that would create risk in this across-the-board approach.
HISTORY SHOWS LOW COSTS AREN’T GUARANTEED
The previous falling-rate environment, which occurred nearly a decade ago, can be difficult to disentangle from the global financial crisis; both deposit growth and changes in interest expense were highly variable across banks. Banks generally reacted quickly during the first 100 basis point (bp) decrease, with betas on non-promotional and renewal retail CD offers decreasing by approximately 100%, although promotional and back-book rates on Savings/MMDA only decreased 50%. (See Figure 1.)
Liquidity-constrained banks, however, continued to see deposit-growth pressures, forcing other banks to compete with institutions that kept deposit rates higher. More banks were squeezed as the year progressed, sending betas much lower during the third 200 bp decrease. Retail CD betas were even negative during the latter part of 2008 due to the financial crisis — promotional rates actually increased. Through the cycle, banks decreased non-promotional and back-book rates at a higher beta than promotional rates. Given the size of the retail back book relative to the front book, banks achieved substantial interest expense savings through these tactics.
Direct banks, though a much smaller segment of the market in 2007 compared with today, were one of the players that initially decreased rates at 100% beta. But competition from liquidity-constrained competitors forced them to increase rates during the latter half of 2008. With their low servicing costs, however, direct banks ultimately maintained floors on both CD and MMDA rates.
Commercial deposit rates fell aggressively with the first 50 bp in rate reductions in 2007, often at greater than 100% betas. These movements slowed due to expectations that more rate cuts were coming and that the high betas were unsustainable.
Contrary to conventional wisdom, banks with a higher need for commercial and retail deposits grew at a slower rate than banks with excess deposits — despite offering higher rates. This phenomenon has generally become known as a flight to quality in which perceived “safe banks” experienced a greater influx of deposits even though they offered lower deposit rates. (See Figure 2.)
While this effect was real for a select few, several other banks developed thoughtful deposit-gathering strategies that were aimed at preserving margin, while also increasing balances.
The top banks took a surgical approach to the timing of rate decreases, assessing the competition and actively looking to take share at the expense of their competitors. Given the large retail CD mix at the time, time deposit renewal bubbles were top of mind, with many banks offering featured terms that allowed banks to acquire longer-term funds.
2019 RATE CUTS: NEW ENTRANTS CREATE INSTABILITY
This time, while few foresee a liquidity crisis, pricing will not necessarily be less competitive. Deposit competition has increased and become more sophisticated since the financial crisis. The growing presence of direct banks, broker-dealers and fintechs, in addition to a renewed focus on the North American operations of foreign banks, has created an environment ripe for competitive disruption.
In particular, the direct-bank market is much more competitive today than it was in 2007. Not only are there more pure-play direct banks, but several regional banks have pursued aggressive out-of-footprint pricing. Depending on the size of their deposit books, direct banks may face challenges if they are forced to choose between interest-expense relief and deposit growth. New direct-bank entrants may have greater ability to steal share from more established direct banks by using rate more effectively since they have smaller deposit books.
Potential deposit-growth needs, combined with the increasing relevance of direct-bank rates, may well augur a more competitive environment even if rates fall. Competitive effects among direct banks and other banks that need more growth may cascade down to local markets. Promotional rates may remain elevated in some geographies even if portfolio rates decrease. This could limit growth for banks that choose to deploy a 100% downward beta.
PLANNING AHEAD: HOW CAN BANKS RESPOND WHEN RATES FALL?
In consumer portfolios, bankers cannot blindly depend on the beta history from when the last time rates fell. Neither should they rely on funding plans that were developed during the recent rising-rate cycle. Meanwhile, the back book will offer limited interest-expense relief because rates there are already low.
That means banks will need to pursue different tactics based on their growth objectives, while also seeking to minimize deposit costs. And, of course, they will need to factor in the competitive dynamics in individual markets.
For example, savings and MMDA promotions may require different rate structures to be successful. Banks will also need to minimize risk on guarantee periods, many of which stretched to 12 months when rates were rising.
While new savings products can provide a mechanism to lower deposit-acquisition costs quickly, they are not without risk. Performance will depend on current pricing structures, timing of launch, velocity and the magnitude of anticipated rate decreases.
CD specials may be risky with an inverted yield curve, but also can present a lower-cost alternative to maintaining high pricing on savings, especially for the segment of banks that need more aggressive deposit growth.
Finally, customer-targeted pricing can allow banks to surgically respond to CD renewal dynamics and optimize retention of deposits, but will require great agility and measurement. The difference in deposit tactic performance has significant impact on a bank’s ability to maintain growth and lower interest expense. Top performers will have proactive plans and be able to move quickly on the least sensitive products, while maintaining higher rate retention options to minimize attrition and cannibalization risk.
Competition for commercial deposits remains intense, and cuts to the Fed Funds rate represent an opportunity for banks to refine their rate strategy to optimize margins, boost growth and retain balances. As rates rose and competition heated up, banks aggressively deployed exception rates to win or retain business. (See Figure 3.)
Novantas research shows that only one-third of banks have robust analytics to drive pricing decisions, which means exception rates may have been used more than needed to win or retain the business. Novantas typically finds that at least 4-8 bp of margin improvement are available in commercial portfolios when better analytics are deployed, but banks are often hesitant to lower rates for clients where they are overpaying. Market rate cuts provide the catalyst and rationale to lower client rates so banks can be more aggressive in lowering rates where they are currently overpaying.
To take advantage of this opportunity, however, banks must have an empirical understanding of client deposit behaviors and a plan for how to translate those analytics into strategic actions. The key to a successful plan is the ability to segment clients and take targeted actions on specified sets of clients. Getting the segmentation right is critical because the objectives and outcomes will and should be different across client groups.
Additionally, banks gain process efficiency by executing differentiated pricing against groups of clients instead of trying to carve out manual, one-off exceptions for specific clients.
The right customer analytics can identify where client rates are misaligned with client behaviors or deposit value. These are generally rate-insensitive clients who currently receive higher than average rates.
Banks can also reduce betas in order to grow balances, accepting very low- or no-rate betas for some clients. Wallet-share analytics, coupled with rate-sensitivity analyses, can be used to identify clients who have demonstrated a propensity to increase balances when they receive higher-rate offers. Oftentimes, these clients may hold additional deposits at other banks.
Although keeping rates higher for a targeted set of clients can help pull in additional balances, banks need to make sure these clients are aware of the rate offer. It is a simple concept, but one that can get overlooked when banks take portfolio-level actions in a falling-rate environment.
In addition to the very high and very low beta clients outlined above, banks can further segment the resulting “masses” based on rate sensitivity. This will help determine which clients are likely to accept a 100% beta compared with those whom are more likely to attrite and, therefore, require a lower beta treatment.
TECHNOLOGY WILL BE KEY AS RATES FALL
Technology and analytics have advanced since the last time rates fell, arming bankers with a more advanced tool kit to navigate these trends. Banks that have positioned themselves appropriately for the rising-rate environment must also be proactive in positioning for a declining-rate environment. Top performers will stand out by using these tools.
First, business-intelligence tools enable banks to track inflows and outflows of not only their balances, but also balances of their peers. Real-time understanding of market dynamics allows bankers to react more nimbly and with greater sophistication.
Banks now also have the ability to be surgical with retention and acquisition plans. Traditional product strategies and promotional tactics must be fine-tuned and complemented with targeted marketing of customers. Tactics that were used last time rates fell may not work this time because competitive dynamics have changed.
Finally, banks should pair enhanced promotional practices with a test-and-learn approach when introducing new products and rate incentives. This combined approach allows for banks to quantify motivations behind each customer segment, optimizing balance retention and overall deposit profitability.
Principal, New York
Director, New York