Cost of funding for community banks has risen notably, but the banking industry’s rising deposit betas is creating a greater challenge for community banks. Deposit beta is the change in funding costs divided by the change in interest rates. Rising deposit betas may require some community banks to change their focus on customers, products and ALM assumptions or risk a reduction in NIM and profitability. In this article, we highlight the current and projected state of deposit betas and then outline ten of the best tactics for dampening or even lowering the beta at your bank.
Deposit Beta Trends
The graph below (from S&P Global) shows effective fed funds rate, cost of interest-bearing deposits, and deposit betas, in the last rising interest rate cycle (2005 and 2006), this cycle (2016 to 2018) and projections through 2021. The data indicates that deposit betas are rising and will reach normal industry levels next year (projected at 0.52).
Deposit beta for the banking industry rose to 37% through June 2018, from 20% in 2017. This rise in beta is being led by big banks offering higher-yielding digital deposit accounts. Four of the top 10 banks by assets recorded deposit betas of over 50%. While loan betas exceeded deposit betas through 2018, this will likely reverse if deposit betas reach historical averages and loan duration stays at historical levels. That means that banks will see NIM contraction as a result of continued rising interest rates.
The graph below is the latest FOMC dot plot following last week’s meeting. The FOMC expects to raise rates once more in 2018, three times in 2019 and once again in 2020.
In anticipation of rising interest rates for the foreseeable future, larger banks have been offering higher-yielding digital accounts (savings and money market), and the industry has been shifting back to CD accounts.
What Bankers Are Saying
In canvassing the banking industry, here are the general comments indicating that not only is the cost of interest-bearing deposits on the rise but that more banks are competing for scarce deposits and driving betas higher.
Central Pacific Financial Corp – “ The large CD portfolio by contrast in the second quarter had a weighted average rate of 1.46% and a rate beta over the last 12 months of 88%.”
Key Bank – “Our outlook assumes our betas will be ramping up to more historical levels in the mid-50% range during the second half of this year.”
Huntington Bank - “… our current forecast assumes an incremental deposit beta of approximately 50% for the calendar year 2018, driven by the shift in customer preferences to more rate-sensitive products, including money markets and CDs.”
Fifth Third – “The March rate hike resulted in a beta of approximately 45%, and we expect the June rate increase to result in a beta of approximately 50%. We expect incremental increases in deposit betas with additional future rate hikes.”
Impact on Bank Performance
If short-term rates continue to rise, and industry deposit betas return to historical averages, it appears that future fed rate hikes may not drive loan yields higher. Longer-term rates have continued to remain more stable, and competition for quality credits appears to limit the benefit of future rate increases on loan yield. As the yield curve flattens, banks that can control their deposit betas will see superior performance.
The graph below (from KBW) shows bank valuations stratified by deposit beta in the current cycle for banks between $2B and $20B. It is not surprising that the market attributes more values to banks with lower deposit betas.
The interesting development is that the national banks (the ten largest banks that control almost half of the domestic deposits) are leading the increase in rising deposit betas in this cycle. Community banks should be particular attention to national banks’ deposit pricing and strategy in this interest rate cycle.
10 Tactics To Dampen Deposit Betas
Reducing or limiting deposit betas starts with designing and executing a coherent deposit strategy. This includes making sure you have a chief deposit officer and a management team that is accountable for deposit performance. Then the strategy may include all or some of the ten most important tactics outlined below:
- Stop Advertising Rate – Posting a rate or promoting your CDs likely does more to destroy franchise value than help it. If you say your bank’s main strength is service, then advertising a rate sends the wrong message to both customers and employees. Market anything you want, but rate.
- Create Products With Low Betas: While your bank is marketing CDs, your competition is likely creating and marketing products that grab deposits without resorting to rate. Health savings accounts, prepaid cards, 401k, lockbox, sweep, long-term goal-oriented savings accounts, and emergency fund accounts all have very low betas, attract higher than average deposit balances, have positive convexity and can differentiate your bank.
- Target Customers With Low Betas: Not all customers are rate sensitive. By targeting homeowners associations, trade associations, law firms, sports leagues, municipals, healthcare and thousands of other industries that are known to have higher balances and low-interest rate sensitivity your bank can perform better than average in a rising rate environment.
- Increase the Duration of Client Relationships: For decades, banks have touted relationship banking but did little to measure and extend the lifetime value of clients. Longer relationships lead to more stable interest-bearing deposits and more non-interest bearing deposits. This means increasing loan (see our recent article on how to execute the Tactical Refinance) and deposit terms for existing products a customer might have as well as increasing the cross-sell ratio. Cross-sell not only increases revenue but tends to extend life while lowering interest rate sensitivity.
- Manage Collateral: Many bankers don’t connect collateral and deposit performance. For example, banks think of loans attached to collateral. However, most collateral is frequently substituted, sold or transformed by borrowers creating unnecessary client churn. Instead, banks must connect their products to the client’s balance sheet in addition or instead of pieces of real estate.
- Price to Win Quality Owner-occupied CRE: Owner-occupied commercial real estate (CRE) often affords banks non-interest bearing or low-interest bearing accounts. This client segment is highly sought after, partly, for this reason. Furthermore, these commercial deposits have positive convexity – increasing balances in rising interest rate environments. Be sure to structure loans and operating plus reserve accounts together with bundled pricing.
- Interest Checking: While it is counter-intuitive, paying interest on retail and commercial checking makes clients less interest rate sensitive. Competition is less intense for interest checking than it is for money markets or CDs. Pay a competitive rate on checking and banks often find that they reduce the anxiety and need for a client to worry about rates on other products.
- Model The Relationship: Finally, all of the above pieces are difficult to measure, analyze and assess. Management’s decision on pricing, strategy, and product offering becomes frustrated without a commercial loan pricing model that can capture the benefit of deposits, cross-sell opportunities, retention estimates and lifetime measure of cash flow on an instrument and product level. Community banks must identify and implement robust pricing models to help them make decisions that can lead to lower cost, lower beta, and longer-term deposits.
- Train: Many lenders only tangentially know how to go after and close deposit sales. It is critical that relationship managers learn to ask the right questions to uncover deposit goals, interest rate sensitivity, and deposits at other banks. In addition, bankers need to learn the sales and structure techniques that motivate the customer to move deposit balances without focusing on rate.
- Incent: Incent the behavior you want. Since deposits often create more value than loans, it is always funny to us when a bank complains about having too much loan growth and not enough deposit growth yet they don’t compensate on deposits. Compensate your product people for low-cost deposits, and they will design low-cost deposit products. Compensate your relationship managers for low-cost deposits, and they will bring in low-cost deposits. If you want your team to execute each of the tactics above then compensate for it.
Banks should be positioning their deposits, loans and overall strategy to a flattening yield curve with an anticipated cost of funds rising faster than loan yields. Controlling deposit betas for the next two years will become a crucial strategy for community banks. For community banks, the ability to retain, or grow, NIM will take a multifaceted approach involving deposit and loan strategy.
Submitted by Chris Nichols on October 03, 2018