Lessons In Deposit Mix From Last Rate Cycle

Deposit Management

Banks have smartly used the low rates of the last ten years to restructure their liabilities so that they are much less interest rate sensitive than they were during the last tightening cycle. The fear is that as we face the next tightening cycle, banks will relax and give themselves carte blanche to add more time deposits. This happens every rate cycle, and in this article, we review what happened during the last cycle and point out ways that banks can avoid becoming more interest rate sensitive.


The Last Cycle


During the last cycle of interest rate increases from mid-2004 thru early 2006, banks changed their deposit mix that served to increase the industry’s deposit sensitivity. The median non-interest bearing deposit (NIB DDA) made up 15.3% of total deposits. By the end of the cycle that percentage fell to 14.5%. By the same token, time deposits jumped from 35.8% to 41.2% (graphic below). This mix change served to increase the interest rate sensitivity at the average bank cause the average bank to lose franchise value as rates rose.  


Change in Deposit Mix


While this might seem like a small change, consider that most deposit products increase their interest rate sensitivity as rates increase. Certificates of deposits, for example, started the last cycle with a 62% beta, before increasing to close to 80%. Below are the weighted medians during that period.


Median Core Deposit Beta


As can be seen, certificates of deposits are more than six times more sensitive to interest rates, so for the average bank to add 5.4% of total deposits to their time deposits, that ends up being a material increase in beta for the balance sheet. During the last cycle, the beta at banks increased some 60% over the cycle.


This Cycle


We have now seen a 1.0% increase in Fed Funds rate increases since the start of this cycle back in December of 2015. With each rate increase, deposit betas increase. Back in late 2015, there was very little rate pressure on deposits, and so the first rate increased moved deposit betas up by 6%. However, this last rate increase moved deposit betas up by 24%. If you project the sensitivity forward based on the last rate cycle but apply it to our lower, more benign starting point, you get an increase in betas of about 55% for the industry. New liquidity requirements for larger banks should serve to make them a little more interest rate sensitive than before, but those changes likely may increase betas another couple percentage points.


Since community banks tend to be more interest rate sensitive than their larger brethren over the cycle, we expect our betas to increase by closer to approximately 90% by the end of the cycle.


Putting This Into Action


Measure Often: Keep in mind that deposit sensitivity isn’t a linear relationship. As detailed above, during this cycle, betas have increased incrementally for each increase. This is to say that the first 100 basis points of every rate cycle are more muted than the second 100 basis point increase. This means that bankers need to pay particular attention to their moves with each cycle and plan on deposits becoming more competitive in the future. Like last time, there is always a large group of banks that get complacent and find themselves behind the deposit raising curve.


Protecting Your Core: The biggest mistake banks made during the last cycle was to panic. Many banks let their loans outstrip their deposits and had to increase deposit rates in their local markets. In doing so they cannibalized their existing deposit base. During this time in 2006, many banks did an excellent job training their depositors to be rate sensitive, much to their determent. If and when you need to raise deposits, how you do it matters. When in doubt, wholesale funds, such as brokered CDs, are excellent short-term solutions that permit more time to figure out how to raise long-term, low-rate sensitive deposits.


Manage Loans-to-Deposits: Banks are now averaging 85% loan-to-deposits. That is a red flag as it doesn’t give banks too much room for organic loan growth, draws on existing lines of credit and normal liquidity fluctuations. Loan growth comes at a cost and many times bankers are not cognizant of the net incremental change to franchise value. Once banks get above 85%, it becomes more likely that the value they create on the loan side is less than the value destroyed on the liability side. Having to shift your mix to more CDs can come at a material cost to the value of your liabilities.


Have Intent on Deposit Sales and Pricing: Design and market deposits with low beta early in order to build up a reserve of deposits that can be used in pro-growth times. Banks that have a high amount of checking accounts, goal-oriented accounts, health savings accounts, retirement accounts and cash management services in addition to a 70% loan-to-deposit ratio may be in the perfect position to excel during the back end of our current cycle.