Expect Funding Wars, Tech Troubles in 2023

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Back in January 2022, rising interest rates looked increasingly likely but weren’t yet a reality. In Bank Director’s 2022 Risk Survey, bank executives and board members indicated their hopes for a moderate rise in rates, defined as one percentage point, or 100 basis points. Of course, those expectations seem quaint today: In 2022, the Federal Reserve increased the federal funds rate’s target range from 0 to 0.25% in the first quarter to 4.25% to 4.5% in December — a more than 400 basis point increase.

A year ago, anyone looking at recent history would have been challenged to foresee this dramatic increase. And looking ahead to 2023, bankers see a precarious future. “We’ve never seen more uncertainty, on so many fronts, across the entire balance sheet,” says Matt Pieniazek, CEO of Darling Consulting Group. “Let clarity drive your thought process and decision-making, not fear.” 

While we can’t predict the future, we can leverage the recent past to prepare for what’s ahead. Here are three questions that could help boards and leadership teams plan for tomorrow. 

How Will Rising Interest Rates Impact the Bank?
Despite the rapid rise in the federal funds rate, just a handful of banks pay savings rates north of 3%: These include PNC Financial Services Group, which pays 4%; Citizens Financial Group, at 3.75%; and Capital One Financial Corp., at 3.3%. Most still pay the bare minimum to depositors, averaging 0.19% as of Dec. 14, 2022, according to Bankrate.

Pieniazek believes this will change in 2023. “[Banks have] got to accept that they were given a gift [in 2022].” Because of an environment that combined a rapid rise in rates with excess liquidity, banks were able to delay increasing the interest rates paid on deposits.

Funding costs are already beginning to reflect this changing picture, rising from an average 0.16% at the beginning of 2022 to 0.64% in the third quarter, according to the Federal Deposit Insurance Corp. 

“The liquidity narrative is changing,” says Pieniazek. “Our models are projecting that there’s going to be substantial catch-up.” Typically, deposits start to get more competitive after a 300 basis point increase in the federal funds rate, he says. We’re well past that.

That means banks need to understand their depositors. Pieniazek recommends breaking these into three groups: the largest accounts, which tend to be the smallest in number and most sensitive to rate changes; stable, mass market accounts with less than $100,000 in deposits; and account holders between these groups, with roughly $100,000 to $750,000 in deposits. Understand the behaviors of each group, and tailor pricing strategies accordingly. 

Will Banks Feel the Pain on Credit?
“Most banks are cutting their loan growth outlook in half for 2023, versus 2022,” says Pieniazek. Bank executives and boards should have frank discussions around growth and risk appetites, including loan concentrations. “Are we appropriately pricing for risk? And are we letting blind adherence to competition drive our loan pricing as opposed to stepping back and saying, ‘What is a fair, risk-adjusted return for our bank?,’ and level-set[ting] our loan growth outlook relative to that.” 

Steve Williams, president and co-founder of Cornerstone Advisors, sees less weakness in bank balance sheets — credit quality remained pristine in 2022 — and more concern for shadow banks and fintechs that have grown through leveraged, subprime and buy now, pay later loans. If these entities struggle, it could be an opportunity for banks. 

“The relationship manager model, in certain segments, has great runway,” says Williams. But that doesn’t mean that banks can simply ignore the disruption that’s already occurred. “We’ve been telling our clients, ‘Don’t dance in the end zone and be cocky,’ because … these blueprints for the future are still there,” he explains. “If we’re going to fight the funding war, we’ve got to do it in modern terms.” That means continuing to invest in technology to deliver better digital services. 

How Will the Tech Fallout Impact Banks?
It’s been a rough year for the tech sector. Valuations declined in 2022, according to the research firm CB Insights. Talented employees lost their jobs as tech firms shifted from a growth mindset to a focus on profitability. 

“Tech has never been cheaper than it is right now,” says Alex Johnson, creator of the Fintech Takes newsletter. “There [are] ample opportunities to snap up tech companies in a way that there just has never been.” 

Many banks aren’t interested in investing in, much less acquiring, a tech company, according to the bank executives and board members responding to Bank Director’s 2023 Bank M&A Survey. Just 15% participated in a fintech-focused venture capital fund in 2021-22; 9% directly invested in a fintech. Even fewer (1%) acquired a technology company during that time, though 16% said it’s a possibility for 2023. 

Snatching up laid-off talent could prove more viable for banks: 39% planned to add technology staff in 2022, according to Bank Director’s 2022 Compensation Survey. Many tech workers, scarred by last year’s layoffs, will seek stability. Over the last 10 to 15 years, “tech companies were the most valued place for employees to go; they were paying the highest salaries,” says Johnson. “It’s a huge, almost generational opportunity for banks, when they’re thinking about what their tech strategy is going to be.”

But what about vendors? The number of startups working with banks proliferated over the past few years. Amid this volatility, Johnson advises that banks sort out the “tourists” — opportunistic companies working with banks to demonstrate another avenue for growth — from providers that prioritize working with financial institutions. In today’s tougher fundraising environment, “if you’re a fintech company, you’re basically pulling back from all the things that you don’t think are core to what you do.” 

2023 could make crystal clear which tech companies are serious about working with banks.

Strengthening Financial Performance in a Rising Rate Environment

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Interest rate volatility has been a dominant theme this year and inflation worries have begun morphing into recession fears.

For banks, rising rates are generally a positive trend; they tend to result in higher deposit franchise values and higher net interest margins. While unrealized losses in the available for sale bond portfolio also typically increase during rising rate environments, adhering to a disciplined investment framework can help bank leaders avoid knee-jerk reactions and put unrealized losses into the right context (discussed previously here).

As rates continue to rise, it’s time to check the pulse on your institution’s pricing model. In addition to pricing assets accurately, a successful bank also focuses on funding cheaply, using a number of models to identify relative value and hedging interest rate risk when necessary. Here, we’ll dive deeper into three principles that can help institutions strengthen their financial performance.

Principle 1: Disciplined Asset Pricing
Capital requirements mean that a bank has a finite capacity to add assets to its balance sheet. Each asset going on the balance sheet must be critically evaluated to ensure it meets your institution’s specific performance goals and risk mandates.

Using a risk-adjusted return on capital (RAROC) framework for asset pricing and relative value assessment helps establish a consistent, sustainable decision-making framework for capital allocation. Clearly, different assets have different risks and returns. An effective financial manager ensures that the bank is meeting its hurdle rates, or return on capital, and that the model and assumptions are as accurate as possible.

A mispriced asset isn’t just a risk to margin. It also represents liquidation risk, as assets priced incorrectly to market perceptions of risk have a higher likelihood of poor sale performance, such as losses on sale or failure to sell. The value of the institution can also be impacted if the bank consistently — even marginally — misprices assets. Overall, if an asset is not appropriately priced for the risks and costs associated with it, then a bank should critically evaluate its role on the balance sheet.

Principle 2: The Value of Deposit Funding
Banks benefit from low-cost, sticky funding. Core deposits typically comprise the largest and cheapest funding source, followed by term and wholesale funding and all other, generally short-term, funding sources.

Understanding your funding’s beta is a key first step to unlocking better financial performance.

In this application, beta is a measurement of the relationship between a funding source’s interest rate and an observable market rate; it is the sensitivity of funding cost relative to a change in interest rates.

As rates rise, low beta funding results in greater growth in franchise value compared to high beta funding. As assets reprice to the higher rate environment, balance sheets with low beta funding will see margins steadily widen. Banks with high beta funding tend to exhibit margin compression and declining valuations. Conversely, low beta funding results in more stable valuation as rates rise.

Principle 3: Risk Management in an ALM and RAROC Framework
Borrowers and depositors maximize their own utility, which often presents a dilemma for the financial institutions that serve them. When interest rates are low, borrowers typically want long-term, fixed-rate loans and depositors keep their deposits shorter term.  When interest rates are higher, we typically see the opposite behavior: depositors begin to consider term deposits and borrowers demand more floating rate loans. This dynamic can cause mismatches in asset and liability duration, resulting in interest rate risk exposure. Banks must regularly measure and monitor their risk exposure, especially when rates are on the move.

Significant divergence from neutral rate risk — a closely aligned repricing profile of a bank’s assets and liabilities — exposes a bank’s return on equity and valuation to potential volatility and underperformance when rates move. That’s where hedging comes in. Hedging can assist a bank by reducing asset-liability mismatches, enhancing its competitiveness by locking in spread through disciplined asset pricing and stabilizing financial performance. After all, banks are in the business of lending and safekeeping funds, but must take on risk to generate return. Hedging can reduce discomfort with a bank’s existing or projected balance sheet risks and improve balance sheet strategy agility to better meet customers’ needs.

There are opportunities for banks all along the yield curve. But institutions that don’t hedge compete for assets in the crowded short duration space — often with significant opportunity costs.

Rising rates generally result in stronger margins and valuations for well-funded depositories; disciplined asset pricing in a risk-adjusted framework is critical for financial performance. As a financial professional, it’s important that the board has a firm understanding of what drives deposit franchise value. Take the time to ensure that the entire leadership team understands potential risk in your bank’s ALM composition and be prepared to hedge, if needed.