In science class, we were taught that pressure is the application of force against an object. As bankers, we are constantly experiencing this phenomenon with our depositors and rates. Today presidents, CFOs, and other risk managers across the country are sharpening their pencils and focusing on how their institution's deposit rates impact net interest margin and the bottom line. In Asset Liability Committee (ALCO) lingo, the term "beta" is used to describe the relationship between deposit rates versus their sensitivity to the change in short-term interest rates.
It's been a while, but since December 2015 the Federal Open Market Committee (FOMC) has increased the federal funds target rate nine times, totaling 225 basis point, to the current level of 2.5%. Up until last year, the general feeling was that deposit betas were much lower when compared to previous rate cycles. Those feelings were in large part confirmed as banks calculated deposit rates ranging less than 20% on their deposit rates versus historic cycles usually ranging from 30-45%.
Many industry experts have studied why deposit betas have been subdued this time versus past cycles. Some reasons include: the massive amount of bank reserves versus historical levels, increased regulation, higher non-interest cost, and management's desire to maintain margin levels consistent with what they've experienced over the last two decades. Customers are starting to pay more attention since the four hikes last year and the fact that competitive rates are now above inflation rates around 2%, implying a pickup in real earning. Toss in growing funding needs and changing customer demand competition (think fintech) and that gives you the perfect recipe for higher deposit betas.
The review and analysis of deposit rates and their projected betas is never a one-size-fits-all approach. Variables such as geography and market competition heavily weigh on the sensitivity of these rates. New York and the Southeast region tend to have the highest deposit betas while areas in the Midwest have the lowest. In more competitive markets, we're beginning to see certain products being tied to short-term interest rates (for example 50% of prime rate). By tying your non-maturity deposit rates to short-term rates you remove flexibility to manage these rates, which can be challenging in a rising rate environment. Another factor is institution size; community banks have been slower than regional and big banks, but will likely have to play catch up if they lagged over the last three years.
One interesting trend we are seeing is banks spending more time improving and incentivizing their deposit operations department. While it's long been the norm to establish programs like this in the lending area, these individuals at the bank are vital in providing low-cost funding, which can then be deployed in earning assets such as loans or securities. ALCOs are rolling out new customer loyalty programs and improving customer relationship-building training with office administrators and controllers at their commercial accounts. Below are some other useful ideas to help manage your betas.
Ideas to Lower Your Deposit Betas
- Limit rate advertisements, focus on quality of service and products offered
- Tier certain deposit products and manage their rate changes separately, creating some low beta products (most often with lower balance tiers)
- Focus on certain demographics that exhibit low deposit beta behavior
- Increase duration of client relationships through training/education/incentives
- Cross-selling strategies and customer loyalty programs
If your bank experienced higher betas earlier in the cycle, how much will it take for competition to catch up? If your bank is smaller than market competition, will it lose market share? If loan demand is picking up, how long can the bank support these growth levels with these higher funding costs?
As you and your bank think about these questions, remember that there are many reasons other than interest rate why customers choose to deposit their funds at the bank. Studies have determined that consumers place higher value on attributes like convenience, service, availability, and technology over deposit rate pricing. Also keep in mind that assumptions by definition have limitations since they can vary from what actually occurs in reality. That's why as prudent risk managers we should always periodically stress test our assumptions with worst-case scenarios. If your bank hasn't been talking about implementing these concepts, now is definitely the time to do so! Taking time to revisit these interest rate risk concepts, making adjustments to your ALM model, and stress testing are all the right ingredients to a successful exam visit from your regulators.
Harris, CFA, is senior vice president at The Baker Group, a WBA Bronze Associate Member. He can be reached at 405-415-7251 or via email.