Don’t Rely on Inertia to Manage Deposit Pricing

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After a year of steadily increasing interest rates, bankers may be feeling hopeful that the Federal Open Market Committee will soon slow its pace so deposit pricing can get under control.

But even if the Fed’s rate-setting body eases up on raising the federal funds rate, it’s unlikely that will immediately translate into lower deposit costs, simply because liabilities and assets will reprice at different times and frequencies.

“The Fed may stop raising rates at some point, but the cost of deposits of banks most likely will keep going up, only because they’re catching up,” says Christopher Marinac, director of research at Janney Montgomery Scott. “Some of it is just timing: If you have [certificates of deposits], and they are renewing in the third and fourth quarter, those are generally going to be higher than they were a year ago.”

Deposit betas, or the portion of change in the fed funds rate that banks pass onto their customers, occupy a good deal of bankers’ attention right now. Higher deposit betas mean higher rates paid on deposit accounts, and lower deposit betas mean lower funding costs. Banks that want to improve their net interest margin generally want to know how to keep their deposit betas lower without sacrificing liquidity.

A recent analysis by S&P Global Market Intelligence showed that a sample of 20 banks with lower deposit betas in the fourth quarter of 2022 were generally more likely to let money walk out the door in search of higher rates. That in turn allowed those banks to expand their margins more substantially through the end of the year.

Broadly speaking, however, inertia has worked in a lot of banks’ favor when it comes to deposit pricing, Marinac says. Though some high net-worth or commercial customers with significant deposits are increasingly asking for higher rates, which is leading bankers to implement exception pricing, most deposit clients simply don’t bother.

But some banks already feel that exception pricing has become unsustainable, says Neil Stanley, founder and CEO of The CorePoint, a consulting firm focused on deposit pricing. Because exception pricing decisions are made on an ad hoc basis, it can be difficult for banks to anticipate scenarios and build forward guidance. Exception pricing can become a problem if those decisions are too frequent, and are seen as random and even discriminatory.

Stanley also points out that compared to past periods of Fed tightening, a much larger proportion of bank deposits are now noninterest bearing demand deposits, meaning that while they may cost the bank next to nothing, they can also walk out the door at any moment.

“How long will those deposits stay on your books at no interest? That is a huge question,” Stanley says. “Without a really good answer to that, we’re left in a very vulnerable spot.” The advent of open banking may change the game this time around. Open banking gives people more control over their finances, allowing them to leverage application programming interfaces to move funds. Google and social media also give customers an additional window into which banks offer better rates, adding a new layer of complexity. In response, Stanley generally advises that banks maintain a good mix of time deposits like CDs that have a bit more staying power compared to noninterest bearing checking accounts.

Bank boards play an important oversight role in asset/liability management at their financial institutions. Stanley recommends that directors ask management for a list of the bank’s largest deposit holders, and know who is in charge of tending to those relationships. Bankers should check in with those clients and make sure they aren’t feeling neglected, especially if they could pull their money at a moment’s notice. Directors might also consider establishing a chief deposit officer or otherwise centralizing some authority over the bank’s deposit gathering efforts, including exception pricing decisions. And bankers should have a clear line of communication to that person so they can quickly respond to requests for exception pricing.

Banks have grown accustomed to a low-rate environment with little competition for deposits. That’s changed. “When we had a surplus of deposits, it didn’t make any sense to put time and energy into it,” Stanley says. “Now, [banks] don’t want to be laissez-faire. They want to be intentional.”

Along those lines, bank leaders should evaluate their current suite of deposit products and services, and understand how those compare with nonbank competitors. And they can think about how to emphasize the value of keeping cash in accounts insured by the Federal Deposit Insurance Corp.

Finally, while it’s ostensibly on the other side of the balance sheet, bank leaders could consider the importance of commercial and industrial lending as part of their broader asset/liability management strategy. C&I loans reprice faster, which can prove beneficial in a rising rate environment. Those clients — many of them small businesses — can also become a source of stickier, lower cost deposits.

“C&I customers have deposits, and they tend to put deposits with banks,” Marinac says. “That’s kind of the secret sauce.” And financial institutions should view building core relationships as something that happens in good times and bad. “Some organizations are wired that way, so it’s not a problem,” he says. “Other organizations are not.”

The Issue Plaguing Banks These Days

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Net interest margin lies at the very core of banking and is under substantial and unusual pressures that threaten to erode profitability and interest income for quarters to come. Community banks that can’t grow loans or defend their margins will face a number of complicated and difficult choices as they decide how to respond.

I chatted recently with Curtis Carpenter, senior managing director at the investment bank Hovde Group, ahead of his main stage session at Bank Director’s in-person Bank Board Training Forum today at the JW Marriott Nashville. He struck a concerned tone for the industry in our call. He says he has numerous questions about the long-term outlook of the industry, but most of them boil down to one fundamental one: How can banks defend their margins in this low rate, low loan growth environment?

Defending the margin will dominate boardroom and C-suite discussions for at least eight quarters, he predicts, and may drive a number of banks to consider deals to offset the decline. That fundamental challenge to bank profitability joins a number of persistent challenges that boards face, including attracting and retaining talent, finding the right fintech partners, defending customers from competitors and increasing shareholder value.

The trend of compressing margins has been a concern for banks even before the Federal Open Market Committee dropped rates to near zero in March 2020 as a response to the coronavirus pandemic, but it has become an increasingly urgent issue, Carpenter says. That’s because for more than a year, bank profitability was buffeted by mitigating factors like the rapid build-up in loan loss provisions and the subsequent drawdowns, noise from the Paycheck Protection Program, high demand for mortgages and refinancing, stimulus funds and enhanced unemployment benefits. Those have slowly ebbed away, leaving banks to face the reality: interest rates are at historic lows, their balance sheets are swollen with deposits and loan demand is tepid at best.

Complicating that further is that the Covid-19 pandemic, aided by the delta variant, stubbornly persists and could make a future economic rebound considerably lumpier. The Sept. 8 Beige Book from the Federal Reserve Board found that economic growth “downshifted slightly to a moderate pace” between early July and August. Growth slowed because of supply chain disruption, labor shortages and consumers pulling back on “dining out, travel, and tourism…  reflecting safety concerns due to the rise of the Delta variant.”

“It’s true that the net interest margin is always a focus, but this is an unusual interest rate environment,” Carpenter says. “For banks that are in rural areas that have lower loan demand, it’s an especially big threat. They have fewer options compared to banks in a more robust growth area.”

The cracks are already starting to form, according to the Quarterly Banking Profile of the second quarter from the Federal Deposit Insurance Corp. The average net interest margin for the nearly 5,000 insured banks shrank to 2.5% — the lowest level on record, according to the regulator, and down 31 basis points from a year ago. At community banks, as defined by the FDIC, net interest margin fell 26 basis points, to 3.25%. Net interest income fell by 1.7%, which totaled $2.2 billion in the second quarter, driven by the largest banks; three-fifths of all banks reported higher net interest income compared to a year ago. Carpenter believes that when it comes to net interest margin compression, the worst is yet to come.

“The full effect of the net interest margin squeeze is going to be seen in coming quarters,” he says, calling the pressure “profound.”

On the asset side, intense competition for scarce loan demand is driving down yields. Total loans grew only 0.3% from the first quarter, due to an increase in credit card balances and auto loans. Community banks saw a 0.5% decrease in loan balances from the first quarter, driven by PPP loan forgiveness and payoffs in commercial and industrial loans.

On the funding side, banks are hitting the floors on their cost of funds, no longer able to keep pace with the decline on earning assets. The continued pace of earning asset yield declines means that net interest margin compression may actually accelerate, Carpenter says.

Directors know that margin compression will define strategic planning and bank profitability over the next eight quarters, he says. They also know that without a rate increase, they have only a few options to combat those pressures outside of finding and growing loans organically.

Perhaps it’s not surprising that Carpenter, a long-time investment banker, sees mergers and acquisitions as an answer to the fundamental question of how to handle net interest margin compression. Of course, the choice to engage in M&A or decide to sell an institution is a major decision for boards, but some may find it the only way to meaningfully combat the forces facing their bank.

Banks in growth markets or that have built niche lending or fee business lines enjoy “real premiums” when it comes to potential partners, he adds. And conversations around mergers-of-equals, or MOEs, at larger banks are especially fluid and active — even more so than traditional buyer-seller discussions. So far, there have been 132 deals announced year-to-date through August, compared to 103 for all of 2020, according to a new analysis by S&P Global Market Intelligence.

For the time being, Carpenter recommends directors keep abreast of trends that could impact bank profitability and watch the value of their bank, especially if their prospects are dimmed over the next eight quarters.

“It seems like everybody’s talking to everybody these days,” he says.

This Is a Red Flag for Banks

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yield-curve-7-5-19.pngThe yield curve has been in the news because its recent gyrations are seen as a harbinger of a coming recession.

The yield curve is the difference between short- and long-term bond yields. In a healthy economy, long-term bond yields are normally higher than short-term yields because investors take more risk with the longer duration.

In late June, however, the spread between the yield on the three-month Treasury bill and the 10-year Treasury note inverted—which is to say the 10-year yield was lower than the three-month yield.

Inverted Yield Curve.png

An inverted yield curve doesn’t cause a recession, but it signals a set of economic factors that are likely to result in one. It is a sign that investors lack confidence in the future of the economy. Or to put it another way, they have greater confidence in the economy’s long-term prospects than in its near-term outlook.

Long-term yields drop because investors want to lock in a higher return. This heightened demand for long-dated bonds allows the U.S. Department of the Treasury to offer lower yields. The historical average length of recessions is about 18 months, so a 10-year Treasury note takes investors well beyond that point.

Short-terms Treasury yields rise because investors are skittish about the economy’s near-term prospects, which requires the Treasury Department to entice them with higher yields.

It turns out that inverted yield curves have a pretty good track record of predicting recessions within the next 12 months. The last six recessions were preceded by inverted yield curves, although economists point out that inversions in 1995 and 1998 were not followed by subsequent downturns. And more than two years passed between an inversion in December 2005 and the onset of the 2008 financial crisis.

Still, an inverted yield curve is an economic red flag for banks. The industry’s performance inevitably suffers in a recession, and even the most conservative institutions will experience higher loan losses when the credit cycle turns.

An inversion is a warning that banks should tighten their credit standards and rein in their competitive impulses. Some of the worst commercial loans are made 12 to 18 months prior to an economic downturn, and they are often the first loans to go bad.

Ironically, if banks tighten up too much, they risk contributing to a recession by cutting off the funding that businesses need to grow. Banks make these decisions individually, of course, but the industry’s herd instinct is alive and well.

It’s possible that the most recent inversion presages a recession in 2020. In its June survey, the National Association of Business Economics forecast the U.S. economy to grow 2.6 percent this year, with only a 15 percent chance of a recession. But they see slower growth in 2020, with the risk of a recession by year-end rising to 60 percent.

This has been an unprecedented time for the U.S. economy and we seem to be sailing through uncharted waters. On July 1, the economy’s current expansion became the longest on record, and gross domestic product grew at a 3.1 percent annualized rate in the first quarter. Unemployment was just 3.6 percent in May—the lowest in 49 years—while inflation, which often rises when the economy reaches full employment because employers are forced to pay higher salaries to attract workers, remained under firm control.

These are historic anomalies, so maybe the old rules have changed.

The Federal Open Market Committee is widely expected to cut the fed funds rate in late July after raising it four times in 2018. That could both help and hurt bankers.

A rate cut helps if it keeps the economic expansion going. It hurts if it makes it more difficult for banks to charge higher rates for their loans. Many banks prospered last year because they were able raise their loan rates faster than their deposit rates, which helped expand their net interest margins. They may not benefit as much from repricing this year if the Fed ends up cutting interest rates.

Is an inverted yield curve a harbinger of a recession in 2020? This economy seems to shrug off all such concerns, but history says yes.

Will Higher Rates Help or Hurt Banks? The Answer Is “Yes.”

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interest-rates-12-28-15.pngWill the long awaited hike in interest rates turn out to be good or bad for U.S. banks? The honest answer is probably yes to both possibilities, depending on the size of the bank in question and how the Federal Reserve manages monetary policy over the next couple of years.

In case you just got back from Mars, the Fed announced on December 16 that it was raising the interest rate on overnight borrowings between banks (known as the federal funds rate) by a quarter of a percentage point. The significance of the Fed’s action had less to do with the size of the increase than with the fact that this was the first time the central bank had raised rates in more than seven years. There was a lot of commentary after the rate hike about how this would impact the U.S. economy, although a strong case can be made that this was actually a vote of confidence in the economy’s long-term prospects. The job market has rebounded since the recession ended in June 2009 and unemployment was 5.5 percent in May, according to the Bureau of Labor Statistics. While the recovery is still a work in progress, Fed Chairman Janet Yellen expressed confidence in the economy’s future during a press conference after the rate increase was announced.

Although the Fed’s central mission is to fight inflation, deflation—which is a persistent decline in asset values and consumer prices—has actually been a much greater risk in recent years. Having cut the fed funds rate to nearly zero, and embarking upon a controversial strategy of massive bond purchases to pump money into the economy—known as quantitative easing—there was little more the Fed could do other than wait for the economy to heal itself, which it largely has. Yellen and the Federal Open Market Committee, the 12-member group at the Fed that actually sets monetary policy, has been waiting for an opportunity to begin pushing rates back up. Clearly the time was right.

How will this affect the nation’s banks? The impact of a quarter-point increase in the fed funds rate should be manageable, at least for now. Comptroller of the Currency Thomas Curry has expressed publicly his concern that some banks might be exposed to interest rate risk as the Fed tightens its monetary policy. Large banks, which tend to use variable rate pricing on their commercial and industrial loans, permitting lenders to reprice them if rates go up, will probably experience less economic impact than smaller banks. Many small banks don’t have the same flexibility to reprice their business loans. So as rates go up, smaller banks could actually see their net interest margins tighten even more as their deposit costs rise.

Still, the rate increase had been anticipated, predicted and over analyzed for so long that no bank should have been taken by surprise. Managing interest rate risk is an important task for management and the board, and the industry has been given ample time to prepare.

Ultimately, the impact of higher rates on the banking industry might be determined by how quickly the Fed tightens its policy. The Fed has said that it wants to continue raising rates gradually over the next few years—the exact term it used was to “normalize” rates but how gradually? Hike rates too quickly and some smaller banks could be stressed if they can’t reprice their loan portfolios fast enough to keep pace. But if banks are impacted disproportionately depending on whether they are asset or liability sensitive (being asset sensitive means your loans reprice faster than your deposits, while being liability sensitive means the reverse is true), one thing that would hurt everyone is a slow-down in the economy. Here, I would expect the Fed to be very careful. Having nursed the economy back to health, I think the last thing it wants to do is tip the economy back into a recession by acting too aggressively.

At the very least, banks should know what to expect, and the Fed—which has been very transparent under Yellen—will no doubt let them know when to expect it.