Deposit Costs Creep Up Following Rate Increases

The rapidly rising interest rate environment is beginning to impact the funding dynamics at banks as deposit competition increases and they pay up for time deposits.

While rising rates are generally good for lending, the unrelenting climb in interest rates hasn’t been uniformly positive for banks. Since the pandemic, many banks have had historic deposit growth and liquidity. The aggressive and continuous rising interest rate environment could change that.

There was a 1.1% drop in total deposits at all Federal Deposit Insurance Corp.-chartered banks in the third quarter, according to a November report from analysts at Janney Montgomery Scott. Excluding time deposits like certificates of deposits, or CDs, core deposits dropped 2%. But over that time, 40% of banks reported positive deposit growth in excess of 1%. That could mean that as core deposits leave banks, they are growing time deposits.

The median cost of deposits for banks in the Kroll Bond Rating Agency universe more than doubled in the third quarter to 37 basis points.

“No longer content with letting the hot money exit, this sharp increase in deposit costs is the product of a strategy of rate increases designed to stem outflows of less sticky or rate sensitive deposits,” wrote KBRA in a Nov. 15 report.

One reason for this deposit shift is consumers and businesses are leveraging technology to move their funds into higher rate accounts. Core deposit outflows in future quarters could be unpredictable for institutions: they might happen at a faster pace or higher volume than a bank is prepared for, or a few large, important deposit relationships may leave. This could deplete available cash on hand that an institution would use for ongoing operations or to fund new loan opportunities.

“The last time we went through a significantly rising rate environment, in the 1970s, money market funds did not exist. People were captive to the bank,” says Nate Tobik, CEO of CompleteBankData and author of “The Bank Investor’s Handbook.” “Now we’re [repeating] the ’70s, except there are alternatives.”

One option banks had in the past to raise short-term liquidity – selling securities marked as available for sale (AFS) – may be off the table for the time being. The bank space carried a total unrealized loss, mostly tied to bonds, of more than $450 billion in the second quarter, according to the FDIC. This loss is recorded outside of net income, in a call report line item called accumulated other comprehensive income. Selling AFS securities right now would mean the bank needs to record the loss.

“Over the past couple weeks, we have had multiple discussions with community bankers that have been very focused on deposit generation,” wrote attorney Jeffrey Gerrish, of Gerrish Smith Tuck, in a late October client newsletter. “Unfortunately, many of these community banks have a securities portfolio that is so far under water they really don’t see the ability to sell any securities to generate cash because they cannot afford to take the loss. This is a very common scenario and will result in a pretty healthy competition for deposits over the next 12 to 24 months.”

In response, banks will need to consider other options to raise alternative funds fast. Noncore funding can include brokered CDs, wholesale funding or advances from the Federal Home Loan Banks system. Tobik says CDs appeal to banks because they are relatively easy to raise and are “time deterministic” – the funding is locked for the duration of the certificate.

All of those products come at a higher rate that could erode the bank’s profit margin.

Another ratio to watch at this time is the liquidity ratio, wrote Janney analysts in a Nov. 21 report. The liquidity ratio, which compares liquid assets to total liabilities, is used by examiners as a more “holistic” alternative to ratios like loans-to-deposits. The median liquidity ratio for all publicly traded banks at the end of the third quarter was 20%, with most banks falling in a distribution curve ranging from 10% to 25%.

The 20% median is still 4% higher than the median ratio in the fourth quarter of 2019. The effective federal funds rate got as high as 2.4% in summer 2019, compared to 3.08% in October. Janney did find that banks between $1 billion and $10 billion had “relatively lower levels” of liquidity compared to their smaller and bigger peers.

But for now, they see little to worry about, but a lot to keep their eyes on. “Our analysis shows that while liquidity has tightened slightly by several measures since a [fourth quarter 2021] peak, banks still maintain much higher levels of liquidity than prior to the pandemic and have plenty of capacity to take on additional wholesale funding as needed to supplement their core funding bases,” they wrote.

Going forward, banks will need to balance the tension between managing their liquidity profile and keeping their cost of funds low. What is the line between excess liquidity and adequate liquidity? How many deposit relationships need to leave any given bank before it starts a liquidity crunch? What is cost of paying more for existing deposits, versus the potential cost of bringing in wholesale or brokered deposits?

The answers will be different for every bank, but every bank needs to have these answers.