Here Is The Future For Your Bank’s Cost of Funds

Deposit Management

For any bank not convinced that we face a period of inflation and rising rates, last week was an eye-opener. The 10-year Treasury jumped 21 basis points and the probability higher rates increased. Since rates began to rise in December of 2015, we have now seen a 1.50% increase in rates with four more increases currently built into the market. Outside of the market, the Fed’s Open Market Committee (FOMC) expects another three to four increases in 2019. In this article, we look at the current state of the cost of funds, provide our effective deposit beta projections and use what the markets are telling us to project an average bank’s cost of funds.


Fed Funds Futures


Bank cost of funds currently sits around 50 basis points or about 33% of the current Fed Funds target. Since a bank’s cost of funds is correlated to Fed Funds, Libor, and the swap rate, we will use the current futures market as a starting basis. It is important to note that the futures markets have lagged major bank economists and FOMC expectations. However, to remain unbiased, we will build our projections just on market indicators. Below, you can find the expected Fed Funds Effective rate based on where Fed Funds futures are trading. As can be seen, another 1% is expected in the near term.



Expected Fed Funds rate


Deposit Beta


Back in 2016, an increase in Fed Funds and Libor barely moved a bank’s cost of funds. Few banks raised their deposit rates when Fed Funds and Libor moved up. Now, a slight majority of banks are adjusting their rates. Soon, most banks will be forced raise deposit rates less they will face a deposit runoff.


Currently, we are at about a 17% beta. That is to say that when rates rise, about 17% of the increase gets translated into a higher cost of funds. We looked back over the last rate hike cycle back in 2004 to 2006 and used that data to estimate forward-looking deposit sensitivity quantified in the form of beta (our research HERE). More than a year ago, we predicted the deposit beta would remain muted as rates have been so low for so long that interest rate sensitivity has been “squeezed” out of the market. However, we also predicted that this should change once rates rise between 1% and 1.5%. We are now at that level and see evidence that deposits are, in fact, becoming more interest rate sensitive.


Below, is our current expectations for deposit beta that banks can use in their asset-liability systems.  


Predicted Deposit Beta


We feel these betas are fairly conservative as, during the last rate cycle, technology, specialized banks, and regulatory policy had less of an impact on a bank’s interest rate sensitivity. Now, with higher mobile use, online account opening, more deposit focused banks such as Goldman Sachs, Discover, and American Express, and more restrictive liquidity/deposit regulation, banks are expected to be more sensitive during this upcoming cycle.


Mobile Online Customer Change


 Cost of Funds Projections


By combining the two datasets, we derive our base case version for the average bank’s cost of funds projections. Please keep in mind that the data below is for an average bank that currently has a 0.53% cost of funds, a 72% loan to deposit ratio, and about 6% loan growth. As we discussed in the past, deposit beta is heavily influenced by deposit size (HERE), loan growth (HERE) and deposit mix (HERE). Banks should adjust our projections below to their situation as some banks may experience much higher deposit sensitivity which could result in costs being two to three times higher. 


Projected bank cost of funds


Putting This Into Action


As rates go up, we expect more and more money to come out of banks and into the capital markets which will further put pressure on deposit costs. Consider that during the last rate cycle, corporate accounts had about 30% of their liquidity at banks and about 70% in commercial paper, money market mutual funds, Treasury notes, and other short-term investments. Now, about 65% of commercial cash is at banks. In 2007, 31% of corporate cash was managed using a sweep product that moved cash balances into higher earning money market mutual funds. Now, only 8% is managed via sweep. As rates go up, these trends will revert to the mean. That is about $1T in deposits that are at risk of leaving the banking industry.


Last week’s rise in rates was yet another wake-up call that caused us to revise our projections upward. Each increase in the expected cost of funds means banks should be devoting more resources to stabilizing their deposit base and attempting to lower their beta. Further, last week sent a clear message that making fixed-rate loans comes at a material disadvantage and banks need to be confident in their pricing or be conversant in hedging. 


The battle for deposits will continue to heat up, and 2018 will likely mark the year where the majority of a bank’s franchise value shifts from loans back to deposits – a place where it hasn’t been since 2009.