As rates continue to rise, it is critical to deploy a better metric to compare the costs of rate based deposit raising strategies against one another, and against alternative marketing or investment spending.
As banks continue to grow loans, they are seeking different avenues to maintain deposit growth at the same pace. Already we are seeing that the betas associated with promotional MMDA accounts are surpassing the historic industry’s experience early in the cycle. A deeper worry is that the Marginal Cost of Funds (mCOF) — the total cost of incremental deposit-raising after taking marketing, cannibalization and changes in duration into account — is for many banks unsustainable. The Marginal Cost of Funds in the current rising rate environment threatens to render certain aggressive loan growth goals uneconomic from a funding perspective alone. Deploying a better metric to compare the costs of rate based deposit raising strategies against one another, and against alternative marketing or investment spending, is an
Promotional Deposit Pressure in a More Competitive Market
In an environment where Retail deposits are more valuable and more expensive, the competition for deposits continues to heat up. Banks lacking liquidity often turn to promotional pricing to raise rate-sensitive deposits through promotional rates on both MMDA and CDs. These banks are seeing pressure on results from four areas:
- Acquisition: The continued shift in consumer preferences toward banking online, combined with new direct bank market entrants and increased sophistication in regional pricing analytics, has put pressure on interest rates required for acquisition. In addition, to achieve maximum acquisition, rate campaigns must be supported by additional marketing expenses, which must also be taken into account when analyzing deposit promotions.
- Cannibalization: At the end of the long low rate environment, most banks have large books of low-cost deposits sitting in statement savings, grandfathered MMDA, and even checking accounts. As banks look to compete for rate-based deposits, they open themselves up to significant repricing risk.
- Duration: With banks’ increased pricing sophistication, teaser rate pricing has become more prevalent, but customers are catching onto the game. Banks doing aggressive teaser pricing have seen higher balance decay levels and are paying customers a high rate for the intro period, only to see them hop to a different bank’s promotional offer at expiration.
- Opportunity cost: Offering promotional rates not only risks repricing the existing book of business, but also risks repricing BAU acquisition — deposits which would naturally have joined the bank at existing rates. This may represent significant incremental interest expense, particularly for banks with strong core checking and convenience-oriented savings growth.
Without accurate measurement, banks are unlikely to avoid some or all of these pitfalls. In a world where National banks continue to gain share, Regionals and Super Regionals cannot afford to misallocate scarce resources. Maximizing efficiency of both interest and marketing expense is critical.
Marginal Cost of Funds: An All-In Measure
Novantas has developed a Marginal Cost of Funds (mCOF) calculation to measure the financial impact of promotional pricing. It empowers banks to trade-off rate-based pricing against other potential growth investments. In addition to an all in acquisition cost, which includes both dollars of rate paid and incremental marketing costs, mCOF takes the expense of repricing/cannibalization of lower-cost savings into account, attrition after the promotion expires, and the effects of ‘promo hoppers’ who reprice to a subsequent promotional rate after their first promotion expires.
- The Marginal Cost of Funds across Novantas’s Comparative Deposit Analytics benchmarking consortium provides a number of insights into both typical and outlying promotional deposit gathering performance:
- The Marginal Cost of Funds for a typical bank using promotional pricing can be 2x to 3x higher than the nominal coupon rate — e.g., a bank offering a 1.00% promotion for 3 months might frequently see annualized Marginal Cost of Funds at 2.00% – 3.00%.
- Outlying results on any individual mCOF lever can significantly worsen the metric for a bank. For example, one bank, with no constraint on where the promotional funds came from, saw cannibalization comprise 75% of the promotional funds. The result was an mCOF of over 3.00% for a 1.25% promotion.
- Aside from cannibalization, balance decay of promotional funds after the promotion ends has an even higher impact on Marginal Cost of Funds compared to the cannibalization effect. The 12 month decay of balances acquired through promotions can range from 30% to 70% depending on the magnitude of acquisition rate, the differential between promotional and base rate, and the frequency of promotional activity.
For any individual bank, a detailed understanding of the overall mCOF and the levers that impact it, along with a comparison to benchmarks, allows the bank to diagnose potential issues. For example, some Novantas clients have used mCOF analysis to identify the need for tighter controls on new money criteria and the difference between compliant and non-compliant regions. Others have moved to more targeted pricing to specifically seek balances from customers with low potential repricing impact.
Ensuring accuracy of mCOF is clearly of the utmost importance as it is used to trade off investments. Consistency across the enterprise and organizational buy-in are crucial to identify and correct tradeoffs. Benchmarking is also critical to identify key areas of underperformance and monitor industry-wide trends.
Increased Urgency as Rates Rise
In a rising rate environment, we expect the Marginal Cost of Funds betas to exceed promotional betas. Put another way, the beta on the Marginal Cost of Funds is likely to significantly exceed 100%, making banks that have historically relied heavily on promotional tactics vulnerable to margin compression as rates increase.
Novantas projects 90%+ betas to Fed Funds increases for promotional acquisition rates in both MMDA and CDs. While broadly in line with the last rising rate environment, promotional betas could exceed 100%, especially in CDs, as rate information becomes more transparent online and competition increases, including among banks that are currently not competing for rate-based deposits.
Retention will also be impacted. Novantas benchmarks demonstrate balance churn increases by 50% in a rising rate environment compared to a low rate environment, impacting both cannibalization and decay. Cannibalization rates will increase as more customers are attuned to rate-based offers and as the offers increase in magnitude — especially around handle round number rates like 2.00%. Decay rates will also increase as customers become less tolerant of remaining at a base rate after promotions expire.
Finally, higher dispersion between promotional and base rates will increase the cost of repricing. While promotional rates will see betas of 90-100%, base rates and the ‘back book’ may only see betas in the 10-30% range. For each 100 bps that Fed Funds increases, the cost of cannibalization will therefore increase by up to 90 bps. The cost of cannibalization and opportunity cost of acquisition will begin to severely challenge promotional pricing.
How mCOF Insights are Driving Organizational Decision-Making
Best in class organizations have embedded Marginal Cost of Funds in several ways. First, they have socialized a standard calculation for Retail in concert with their Treasury and Finance colleagues. Often their Commercial colleagues undertake a similar exercise, facilitating trade-off calculations across businesses.
Second, they are making better informed spot decisions on near-term funding needs. For example, by shifting strategy between a mass Savings promotion, mass CD promotion or targeted DM campaign, Marginal Cost of Funds can identify the optimal time to grandfather a product, and the correct cadence for increhttps://novantas.com/wp-admin/profile.phpasing base and promotional rates. This dialogue enables the business and Treasury to look beyond average spreads to the incremental impact of specific
Third, banks that have embedded the Marginal Cost of Funds logic into their strategic planning and resource allocation process are improving their returns by addressing issues proactively rather than opportunistically. This approach, keyed to the annual planning and resource allocation process, enables these banks to answer questions like “Should we allocate more in marketing spend to support new balance acquisition, or instead, accept that we may need to price our rate paid on promotional deposits incrementally higher? Which approach is more efficient overall?”
Finally, the Marginal Cost of Funds can be used to influence decisions well beyond resource allocation within Retail. As a part of an enterprise funding planning exercise, the Marginal Cost of Funds, in concert with metrics from other lines of business, can help a bank decide whether, on the increment, the next $1B of funding should come from Retail promotional CDs or Commercial non-operating deposits. The Marginal Cost of Funds can also help determine whether, on the increment, asset growth might be slowed down to avoid spread disintermediation.
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