The banking industry has anxiously awaited a rising rate environment, anticipating that interest income from loans and investments will rise more quickly than interest expense on deposits and other funding. Sure that deposit rates will lag industry-wide, many banks believe they can win by simply coasting with market trends.
But much has changed since the last rate cycle, in particular the competition from direct banks, and the coming era may present a more complex and challenging setting for deposit pricing. And while Novantas research confirms a strong industry trend of lagging deposit rates in prior cycles, institutional performance was widely dispersed, with some banks faring far better than others.
As the Fed Funds rate rose by 422 basis points from the summer of 2004 to the fall of 2006, the most aggressively priced banks saw their cost of deposits increase by 329 basis points. By contrast, top performing banks saw an increase of only 140 basis points, capturing a funding advantage of 45 basis points per every 100 basis-point increase in the Fed Funds rate.
This is a huge difference when extended across multi-billion dollar deposit portfolios, and less-prepared banks could be further handicapped in the next rate cycle. The customary shift to higher-yielding certificates of deposit may be much more pronounced, leaving far less time for coping strategies than bankers have come to expect.
Rates in Motion
While the exact timing of the next upward rate cycle remains unclear, banks are definitely running out of time to prepare. Long-term interest rate swaps have already begun to rise from last year’s historic lows. And long-term CD rates have followed in some markets, showing the beginnings of a typical rising rate pattern.
Short-term rates will likely not begin to rise until after the Fed begins to taper quantitative easing, but this event may occur early in 2014. The next rate environment may be quite different for several reasons, and there are positive and negative factors that will impact banks’ ability to capture any net interest margin improvement. Among the negative factors:
- Compared with 2006, the Internet has become a much more powerful force in banking. This includes competition from direct banks, the advent of digital shopping for banking products, and the dwindling potential for customer engagement within the branch. While direct banks still have about a 5% market share of deposits, Novantas research suggests as many as 60% of customers shop online before they buy. Even for those customers who ultimately choose a traditional bank, direct banks increasingly influence shopping expectations, spurring rate competition.
- The erosion of branch traffic will make it more difficult to stem impending defection among established accounts. In prior rising rate cycles, a typical strategy to save high-value customers and large balances included “back pocket” or “desk drawer” offers, extended by branch and contact center reps empowered to offer a promotional rate to customers who threaten attrition. This technique will be less available to banks as more web and mobile customers “silently attrite” without a conversation with a bank rep.
- Pent-up rate hunger among depositors may unleash more of a shopping surge than what might have been seen before. Customers have struggled through a long era of depressed rates and have had little motivation to look around. But their appetites could easily be rekindled in a shopping event prompted by rising rates, accompanied by market excitement and heavy advertising from institutions needing to grow deposits.
- Core deposits are valued more highly following the liquidity crisis, both by regulators and bankers, suggesting more aggressive competition for retail deposits.
Among the positive factors:
- Retail banking returns are limping (down from 30+% pre-crisis) and banks are hungry to replace lost revenue, collectively incenting institutions to lag more aggressively.
- Novantas analysis suggests the biggest driver of deposit price competition is loan growth, and if the tepid recovery in credit continues, most banks will have less motivation to aggressively compete (However, those institutions with growing loan portfolios may be far more aggressive than the average bank).
- Typically in a rising rate environment, money flows out of deposits into money market mutual funds, but recent regulatory changes and the “breaking of the buck” issue have rendered money market mutual funds less attractive.
In combination, all of these factors will likely lead to a barbell effect as aggressive high-rate competitors clash with overall industry efforts to lag.
Market Imperatives
In this environment, pricing skills will be critical, including precision, planning and execution. Banks caught flat-footed could find themselves paying extra to replace balances that otherwise might have been retained at lower cost.
Precision. Banks will need to be able to gather rate-sensitive funds without repricing the entire book of business and giving up substantial margin. Regional pricing strategies (which were less critical in the low-rate environment) will be important again. Different markets exhibit substantially different competitive conditions, and banks will need the flexibility to react on a market-by-market basis.
But regional pricing skills will provide only part of the answer in the upcoming cycle. Technology and analytics have evolved to enable segment- and even customer-targeted pricing as well. Banks will need to identify and target those customers who are most likely to respond to rate offers and continue a pricing paradigm after account acquisition to make informed tradeoffs between balance formation and margin enhancement.
These customer-level techniques, similar to those practiced in the credit card industry for decades, had been viewed as inapplicable in traditional branch banking, which has struggled to deploy finely differentiated offers at the point of sale. But they are increasingly feasible in a “direct-to-consumer” world where more sales and account renewals are conducted electronically via online and mobile channels.
Planning. Banks can no longer rely on the periodic deliberations of executive committees to set deposit pricing. Given the rising need for quick responsiveness to a more electronically-driven market, the bank needs a set of flexible plans that are responsive to varied scenarios, considering funding needs and market conditions.
On the strength of this preparation, rate offers can change on a daily basis if needed, yet remain within the bank’s overall pricing framework. This allows for maximum responsiveness without placing undue burdens on executive time.
Execution. Banks will need to develop and test field capabilities before the rates rise in earnest. The analytic insights developed at headquarters need to be translated into a set of specific actions to be taken across the various regions, distribution channels and customer groups.
During the recent lull, some institutions have delayed investing in important capabilities, for example, customer level pricing analytics and delivery capabilities. They may be caught off-guard when the market moves, given that it takes time to fully implement these capabilities, including technology build, testing and rollout. Other banks have the capabilities but have not used them in a number of years, leaving institutions unsure of their potential effectiveness and the magnitude of customer reaction.
While a Fed Funds increase may be delayed, long-term rates often begin to rise well in advance. Coping difficulties in the prior rising rate cycle contributed to a dramatic performance gap, and the skews could be even wider next time around, given the new complexities of online competition and engaging the multi-channel customer. Winners will prevail on the strength of preparations underway now.
Mr. Solomon is a managing director, Mr. Stockton is a principal and Mr. Meleis is a managing director in the New York headquarters of Novantas Inc., a management consultancy. They can be reached at [email protected], [email protected] and [email protected] respectively.
