Today the Federal Reserve raised its benchmark Fed Funds rate by a quarter point, and signaled that the likely path for short-term rates continues to be two more one-quarter point increases in 2017. While Retail and Commercial deposit pricing trends have not shifted dramatically since the last Fed Funds increase in December 2016, Novantas continues to see market shifts that signal increased competition:
- Retail Direct Bank Competition: Strategies Shift toward CDs
- Non-Operational Commercial Pricing: Premium exception pricing sometimes exceeding 100% beta
- Regional Differences: Beta differences emerging more starkly
Given these pressures, banks must revisit key elements of their pricing strategy, e.g.: CD vs. savings-led growth, Commercial exception pricing policies, and leading vs. lagging market increases.
I. Retail Direct Bank Competition: Strategies Shift Toward CDs
After little response to the first Fed Funds increase, the Retail direct bank market has heated up over the last two quarters, with increased competitiveness across both CDs and savings products. We expect these trends to continue, with additional new entrants representing the largest factor driving potential outsized moves.
There has been a marked shift toward CDs across the direct bank market. Six major direct banks that “led” with savings rates prior to the first Fed Funds increase have lagged savings and now have 1-year CD rates higher than savings. Competition has crowded the top of the CD market — the number of direct banks within 0.25% of top-of-market has doubled from six to twelve. Ultimately, both betas and top of market rates have increased significantly since December’s Fed Funds increase.
Figure 1: Average of Top 5 Direct Bank Rates
Direct Bank CD beta is currently 38% compared to Fed Funds.
Source: Informa Research Services
The apparent decision by many direct banks to pivot to CDs as a lead product has generally muted liquid increases. The Top 5 Direct savings beta has remained constant at 16%, as direct banks are largely lagging pricing for liquid savings.
A compounding impact on betas is the likelihood of new entrants in the direct bank space. To gain share of mind, new entrants have historically priced headline products well above established competitors — as much as 0.25% in a lower rate environment, and up to 0.50% when Fed Funds was above 3.00%. The recent entry of PurePoint Financial may be an example of the typical strategy of new entrants. Shortly after PurePoint entered the market at a 0.05% – 0.15% rate premium, multiple competitors increased rates to retake top of market.
As we look at the retail direct banking landscape going forward in 2017, we ask:
- How quickly will consumer deposits shift back to CDs. The gap between savings and CD rates has increased substantially — from 0.12% at the Top 5 Direct banks in 2005 to 0.24% today. Novantas’ Comparative Deposit Analytics consortium indicates similar shifts for brick & mortar banks — those who have grown CDs in the last 12 months have evidenced 0.24% higher rate paid on CD acquisition vs. on savings acquisition, suggesting that a shift toward CDs may be near at hand. Additionally, leading banks are analyzing whether leading with CDs might lower their marginal cost of funds relative to broad liquid product rate increases.
- Second, how many new entrants will join PurePoint. Given the lack of brand equity of any new entrant, a rush risks pushing direct bank betas up, with knock-on effects to the brick and mortars.
Figure 2: Acquisition Rates for Banks Growing vs. Running off CDs
Banks growing CDs have typically priced CDs well above Savings.
Source: Novantas Comparative Deposit Analytics
II. Commercial Non-operational Pricing: “Premium” Exception-Pricing Approaches 100% Beta
Banks generally held standard commercial deposit rates steady after the first Fed rate increase in December 2015. Deposit rate betas for standard earnings credit rates on commercial DDA accounts were zero — median rates actually declined by 0.02%. Earnings credit rates had been at or above market rates for several years, with standard market ECR rates generally between 0.20% – 0.30% when the Fed Funds rate was at 0.25%. As ECR rates have held steady at 0.20%, they are now significantly lower than the Fed Funds target of 1.00%. The lack of rate movement is evidence that banks are not generally using rate to win operational deposits.
While rates for operational deposits remain steady, rate competition is growing for non-operational commercial deposits — deposits that could be substituted with alternative short-term investments. Prime money market funds are offering rates of 0.55% – 0.57%, and Treasury and Government Institutional funds are offering rates of 0.32% – 0.33%. Banks are increasingly competing with money funds and non-banks for non-operational deposits, and we see banks starting to increase rates on MMDA and interest-bearing DDA accounts to maintain a competitive position.
Novantas surveys banks with Commercial deposits on a regular basis and divides the balances between standard rates, typical exception rates, and “premium” exception rates. With that said, banks have increased standard rates and typical exception rates only modestly. However, banks reported significant increases to the premium exception rates they are willing to offer to win these deposits. Premium exceptions for these aggressive corporate rate seekers have risen such that the beta on some segments has exceeded 100%. In addition, banks report using exception rates on bigger portions of their large corporate and public sector segments than before.
Figure 3: Commercial Deposit Rate Betas (After First Fed Move in Dec 2015)
Banks are making a tradeoff as interest rates rise — retaining low rates where possible while using aggressive premium rates to win rate-sensitive deposits.
Note. Data provided by participating banks, rates reflect Commercial / Middle Market segment.
Source: Novantas proprietary U.S. Commercial Deposit Study, Dec 2015 and Oct 2016 data
Given a general industry focus on securing operational deposits, which have more favorable LCR treatment, why would banks offer such high rates on non-operational deposits? Banks face disintermediation of deposits as rates rise and corporations deploy cash to optimize yield. In higher rate environments, corporates have historically held 30% of their cash in bank deposits. Today that number is artificially high at 60% and banks can expect some funds to flow out of deposits and into MMF and other direct investment instruments. While holding these balances is comparatively more expensive, some players may have HQLA headroom to make this feasible, or lack the capabilities and discipline required to gather operational deposits instead.
III. Regional Differences: Emerging More Starkly
While rates appear to be rising rapidly and converging in the direct space, there are still substantial regional differences in promotional rates and betas that are increasing at the start of the rate cycle.
Regional macroeconomic and customer preferences play a role. However, experience from last time suggests that the largest driver is the concentration of deposit-needy banks, often regionals and community players, who are pushing for deposit growth. As the environment unfolds, a key question will be whether aggressiveness from select regional players continues to drive regional variances, or continued direct banking penetration begins to level the geographic playing field.
Regardless, banks will need to continue to hone regional pricing capabilities — down to a state level at a minimum and increasingly at a sub-state level. Tracking and elasticity modeling is of the utmost importance to ensure not only awareness of geographic differences, but also optimization across markets to drive the lowest possible cost of acquisition.
Figure 4: Rates by State, Betas by State
Differentiation in rates by state has increased dramatically due to equally large beta differences.
Source: Informa Research Services
Figure 5: 1 Year CD beta (Change since Sep 2015 vs. 0.50% Fed Funds increase)
CD betas by state vary dramatically, with no consistent regional trends.
Source: Informa Research Services
Key Deposit Strategy Questions and Implications
1. Should retail growth be focused on CDs vs. liquid products?
While we expect re-mixing to term for the industry, banks may push for greater term growth earlier based on:
- Market-by-market competitive dynamics — growth may be less expensive in some markets vs. others for banks with larger footprints. A few may find contrarian positions to grow less competitive products in certain markets.
- Existing portfolio dynamics — banks with difficulty in managing promotional leakage in liquid products may look to CDs as a natural “fence.”
- Funding demands — as a generalization, banks seeking larger incremental retail funding needs may find CDs to be a more effective growth lever relative to risking cannibalization in their low-cost liquid portfolio.
2. Where should we be more vs. less aggressive with commercial rate re-pricing?
Banks will face customer and competitive pressure to increase rates with each Fed rate move, but need the right segmentation, profitability, and pricing tools to be more precise in their rate decisions:
- Be cautious with rate increases — if banks increase rates too aggressively, they will degrade spread income, increase rate sensitivity, and reduce net fees. However, if they increase rates too conservatively, they risk losing deposit balances, and their ability to attract new deposits.
- Segment commercial deposits — banks need to segment their commercial deposit portfolios to isolate and manage customers based on estimated rate sensitivity, but many lack the capabilities to segment and manage their portfolios at this level of granularity.
3. Should we lead or lag the market in retail prices?
Absent a funding need that makes near-term pricing an imperative, banks may choose either strategy, though each will come with inherent risks:
- Lead the market — in less expensive markets, where growth may be obtained for under the national average, banks may find it cost-effective in the long term to lock in deposit costs before competition increases. However, to the extent that current market trends continue, banks may pay in anticipation of competition that never arises.
- Lag the market — while margin-enhancing in the short-term, banks who lag too long may find increased attrition of not only rate-sensitive, but also relationship deposits that will be much more expensive to replace.