Today the Federal Reserve raised its benchmark Fed Funds rate by a quarter point, and signaled that the likely path for short-term rates is three more one-quarter point increases in each of 2017 and 2018. Banking industry executives breathed a collective sigh of relief, knowing that at least part of this rate increase will rapidly translate to higher spread revenue and bank earnings.
While profitability for deposit gathering business units will rise, we see four clear signs that this rising rate period will be more difficult than prior ones for both Retail and Commercial deposits.
- Headline Rate Competition: Promotional rate betas to date are higher than the prior cycle.
- Churn Is Up: More deposits are in motion now than in recent low-rate years.
- Bloated Cash Accounts: Determining deposit quality, especially for DDA, is tougher than ever.
- Liquidity Complications: The three factors above, plus enhanced industry liquidity constraints, make optimizing bank-wide funding (across business units) even harder.
Deposit executives should avoid complacency and take action now to optimize deposit rates and balances in what will be a turbulent funding environment.
I. Headline Rate Competition: Promotional Rate Betas are Higher than the Prior Cycle
In Retail deposit units, many bankers may be thinking, “I held the line on the first increase, so we are in for a smooth ride.” However, results from recent promotional pricing campaigns to grow Savings/MMDA balances belie that hope. The Novantas Comparative Deposit Analytics (CDA) benchmarks allow us to tie changes in coupon rate to portfolio-level interest expense change. Looking on banks that used promotional acquisition rates of at least one percent, we found that price competition following the first 25 bp Fed Funds increase in December 2015 is already outstripping the first Fed Funds rate increase in the last rising rate environment. [See Figure 1]
In Commercial units, deposit gatherers are deploying higher deposit rates to acquire both short-term and long-term funding — at some banks in part due to a push toward unit self-funding. We see this trend in Novantas ongoing commercial deposit surveys, which reveal that exception rates are bulging — from two to five times the standard rate for earnings credit rate on operational accounts, as well as for interest rate exceptions on non-operational MMDA/Savings deposits. Banks are reporting that up to 20% of new deposit deals offer exception rates, reflecting 40% of total deposit volumes in their portfolios. [See Figure 2]
II. Churn Is Up: More Deposits are in Motion Now than in Reecent Low-rate Years
On the Retail side, we are observing higher deposit balance churn alongside price competition. Our CDA benchmarking reveals that while balance growth has been consistent, decay trends for acquired vintages are beginning to accelerate, requiring increased acquisition to maintain a similar level of growth. [See Figure 3]
Higher balance decay demonstrates growing “promotional fatigue” — banks that keep relying on promotional pricing are driving previously attractive economics into a downward spiral. Novantas measures promotional results by looking at the all-in interest expense for acquisition — adding to direct promotional interest paid the incremental interest expense for cannibalized low-rate funds, acquired promotional deposits that later leave, and the re-pricing of acquired balances. Looking at banks with a recent promotional MMDA rate of 1.00% or higher, we see that promotional acquisition rates have increased an average of 10 bp since September 2015, and that the true marginal cost to acquire balances has increased by an average of 15 bp — compared to a Fed Funds rise during the same period of 25 bp.
On the Commercial side, we have seen this past year an increased propensity for corporate clients to move funds for yield. In a proprietary Novantas survey of corporate depositors, two-thirds of companies reported that they would move deposit balances for a higher rate. Nearly 40% of these companies said they had already recently moved balances for a higher rate. Large Corporates that we advise for treasury management needs tell us that they are increasingly looking for ways to improve the return on their liquid portfolios, and we expect this dynamic to accelerate as market rates continue to rise.
Separately, we see an opportunity for banks to capture corporate liquidity currently sitting in money market funds. Money market fund reform has reduced the attractiveness of prime funds, and nearly a trillion dollars of corporate cash has rapidly shifted out of these prime funds, largely into low-yielding government funds. Much of this money could ultimately move into deposits or other instruments that are willing to offer relatively higher rates. And with increasing adoption of short-term investment portals, companies also have easier, more automated access to investment and deposit alternatives and can quickly evaluate options and move funds.
III. Bloated Cash Accounts: Determining DDA/MMDA Deposit Quality is Tougher
Current DDAs — both commercial and retail — are awash with non-operating or payments-related deposits. Our ongoing Commercial Deposit Study finds that 50-60% of corporate cash is held in transaction accounts — which some banks assume are entirely operating deposits. This stands in stark comparison to prior high rate environments, when only 20-30% of corporate cash was held in transaction accounts. [See Figure 4] Even if corporate depositors maintain a post-crisis conservative cash buffer, we anticipate that a substantial portion of these funds are poised to move with higher rates. A remixing here will likely affect both deposit rates and fee pricing for cash management services, as banks will be scrambling to meet growth plans or even to maintain revenue in the face of this headwind.
It can be difficult for banks to track commercial deposit movements because market rate dynamics have driven the blending of cash segments. For example, companies have moved reserve cash — and even some strategic cash — into operating accounts, because earnings credit rates are often the highest marginal rate available. This has inflated operating balances, which in a higher rate environment would be limited primarily to true operating cash needs. Many banks now have an unrealistic view of their operating balances, which poses a high risk of balance attrition when rates rise. Co-mingled reserve or strategic cash could move out of operating accounts, seeking higher yields in savings accounts, or alternative short-term investments.
On the Retail side, understanding the nature and permanence of balances on the books is similarly challenging. Consumer Checking is currently a much higher proportion of total consumer deposits than it was at the end of the last rising rate environment — 34% today compared to 25% in 2005. In addition, prolonged low rates have made high individual DDA account balances more commonplace. Banks using promotional pricing are now seeing erosion of these large balance DDA accounts. For example, DDAs with balances of at least $25,000 account for 46% of DDA balances at banks not using promotional pricing, but only 39% at banks with higher promotional rates – having decreased 5% over the last year.
Additional analytic insights are pointing to a growing disconnect between product holdings and customer behavior. For example, we find that a customer’s aggregate balances held across products are a poor predictor for understanding that customer’s shopping behavior and price sensitivity. And we are seeing a higher divergence in the rate sensitivity of liquid balances that customers keep for day-to-day cash management compared to rates expected for longer-term aspirations.
IV. Liquidity Complications: Enhanced Industry Liquidity Constraints Make Bankwide Funding Management Harder
The above dynamics should be enough to give executives pause. As these adverse changes work their way into already-complex funding plans, deposit planning will become more difficult. Centrally, banks will be struggling to simultaneously minimize the all-in cost of funds while maintaining adequate headroom in LCR, NSFR, TLAC, liquidity stress testing, capital stress testing, and other metrics. While banks have largely relied on FTP to communicate funding value and cost to the business units, the mushrooming set of constraints and complexities are giving rise to a much more complicated set of enterprise-wide funding analyses and trade-offs.
The Deposit Gathering Agenda in this Rising Rate Environment
For Retail deposits, banks must understand both an accurate cost and the acquisition limit for each available strategy. Costs must take into account not only the headline rate, but also customer dynamics around cannibalization and repricing to account for higher customer churn. Potential strategies will then need to be traded off based on bank objectives, with a “playbook” developed depending on the relative importance, for example, of growing deposits quickly vs. maintaining margin discipline vs. optimizing exposure to different yield curve points. As rates rise, these funding plays can be executed as the bank’s needs and competitive situation evolves.
For Commercial deposits, rising rate playbooks are equally important, and need to be syndicated to client-facing sales and relationship teams as well as within the head office. Communication is key to ensuring rapid reaction to rate and market movements, without setting the expectation of a 100% beta. Second, deposit management should be aligned to how customers manage their liquidity — rates, product and value proposition must align to purpose of funds to minimize re-mixing risk. Finally, banks must develop strong, analytically-driven processes and governance to manage exception rates that map to the rising rate playbooks and incorporate enterprise deposit value.
For the enterprise as a whole, banks need to improve their strategic funding optimization capabilities in ways that span business units, time intervals, and potential macroeconomic, rate and competitive scenarios. For instance:
- Could enterprise LCR targets be better met by trading non-operational Commercial deposits for Retail CDs — even if Retail CDs are slightly more expensive in the short term?
- Would it pay to invest in augmented Treasury Management capabilities, if so doing would relieve longer-term pressure on stressed liquidity outflows by increasing operational deposits in Commercial?
- Can NSFR targets be safely met under most potential competitive scenarios, or does the bank need to start taking actions now to prepare for implementation?
Addressing these and other enterprise-level questions first will allow banks to set funding targets for each business that can be executed with existing business-level tool sets.
Adam Stockton is a Director in the New York office of Novantas, Chrystal Pozin is a Director in the Chicago office, Andrew Frisbie is a Managing Director in the New York office, and Pete Gilchrist is an Executive Vice President in the New York office. They can be reached at firstname.lastname@example.org, email@example.com, firstname.lastname@example.org, and email@example.com.