In a recent article we published on Where Your Deposit Balances Are Going, we might have underplayed the looming competition for deposits particularly from money market mutual funds (MMF) and online-only banks. Our article failed to highlight an important signal that has only been present since April of this year. As such, our use of second-quarter data, in retrospect, didn’t adequately capture the risk that many community banks are and will be facing. In this article, we take another look at what this signal is and why it matters.
The Sensitivity of Money Market Mutual Funds
Money market funds are much more correlated to rising rates than bank deposits. In April of 2016, the average MMF eclipsed the rate on the average one-year bank CD. In March of this year, the average MMF rate surpassed the rates the online or Internet-only banks were paying. This is a problem. Historically, there is an inverse correlation between balances in MMF and bank deposits. No surprise that as the spread between money market funds and banks rates rise, more money is attracted into MMFs from banks.
Another way to look at this is as rates rise, savings and money market accounts average around 40% for community banks and 80% for internet-only banks, MMFs are closer to 100%. Thus, as rates go up, more and more money is expected to flow from banks to MMFs increasing bank interest rate sensitivity in the process.
The Problem For Community Banks
The huge advantage that community banks have is that we are local. The disadvantage we have is that we don’t pay the rates that the MMFs and internet-only banks pay. We also often lack the technology online account opening, enhanced mobile banking, and digital cash management tools. As rates rise and the technology difference between community banks and national/internet-only banks increases, there is reason to believe that community banks will lose deposits at a faster rate than before.
Consider that all bank deposit rates had similar growth rates for several years before 2016. At that time, low rates rarely motivated consumers or businesses to actively manage their liquidity. However, this began to change in 2017 when interest-bearing accounts, including CDs, grew at a faster pace than non-interest bearing and lower yielding deposit accounts.
When Rate Difference Matters
After a period of low rates, retail customers have traditionally been accepting of earning 40 to 80 basis points on time deposits. Now, it appears that the 90 to 100 basis point difference of online banks over community banks will continue to drain some deposits from community banks. Further, MMFs have averaged a 25 basis point spread to online banks over the past six months, a difference that is set to increase. As this difference increases, banks should prepare to lose deposit balances first from their corporate clients, then by their high net worth individuals and finally from there retail base.
When Technology Matters
National banks, with their investment in technology, have had a slower increase in cost of funds, particularly in savings and MMDA accounts. Community banks don’t have that advantage at the moment plus don’t have the net interest margin or low-cost structure like many of the internet-only banks.
As a result, expect deposit betas to increase at a faster rate in the future. Community and regional banks hold approximately 50% of all retail deposits, an estimated $2.5T. When we reported only a slight change in MMF and internet-only bank balances last article, this large spread difference was only present for a couple of months. Now, we are afraid we will be seeing more of a runoff in the 3rd quarter and an even larger deposit run-off in the coming two quarters.
Putting This Data Into Action
Money market funds and internet-only banks will keep increasing rates and are next expected to do so in December. Community banks have not had to compete against money market funds for the past ten years so that this competition will be new for many younger bankers. These internet-only banks have never been around at the size and scale they are now so this is a brand new competitor that banks will have to track and battle.
As banks develop their strategic plans, understanding the role of deposit technology on liability interest rate sensitivity is important. Technology that allows the gathering of deposits from a wider geographical area and at a lower cost will not only give community banks a structural advantage against banks that don’t make that investment but will also do a better job at both retaining current customers and acquiring new customers.
Marketing also plays a role. While 4Q is a horrible time to market deposit products, we strongly suggest banks ready campaigns to hit during the first two weeks of January. As we have discussed before, our data shows that this is a key decision time for both households and businesses to invest their liquidity and to open new banking products such as health savings accounts, retirement accounts and similar.
Finally, the first quarter would be a good time to also introduce new products that limit the outflow of funds. Interest checking, a money market fund sweep account, prepaid cards, payroll, and many other products can help slow balance run-off.
If we don’t invest in technology that supports our high-service ethos and we don’t provide the products our customers want, then price will be one of the only levers left to pull in order to protect our current balances.
Submitted by Chris Nichols on October 24, 2018