During the pandemic, banks became the best deposit gatherers in history. Some say it was like the entire banking industry was completing a deposit-only acquisition. Waves of deposits came in at ultra-low rates and resulted in record low loan-to-deposit ratios.
There is a well-documented historical relationship between the movement in fed funds and the costs of our deposit base, but other factors can drive an institution’s need to adjust deposit pricing. While the Fed controls short-term rates, each institution controls their funding curve. Could an institution’s loan-to-deposit ratio or on-balance sheet liquidity ratio have an equally important impact on funding costs?
The loan-to-deposit ratio and the liquidity ratio, often inversely related, strongly influence deposit pricing. When liquidity gets tight, the supply of excess deposits is low, and thus funding costs increase to retain deposit supply. Traditionally, the equation for on-balance sheet liquidity is relatively straightforward: on balance sheet liquidity equals cash and equivalents plus Fed funds sold plus unincumbered securities. New to this rising rate cycle was the swift change in unrealized losses within the securities portfolio. In interest rate cycles of recent memory, institutions had been able to generate reasonable liquidity from security sales within the investment portfolio. Borrowing against investments is still a good option but can result in higher-than-desired wholesale funding reliance over time. This challenge has raised the bar on the importance of deposit pricing.
With industry liquidity tightening, deposit pricing focus has shifted towards retention at a tolerable cost. To accomplish this, institutions must take a deeper dive into their deposit base. Which accounts or customer types are the most rate sensitive? Who are we at risk of losing? Institutions must understand their unique deposit base. Going back to our initial eBrief (insert hyperlink) on this topic, we emphasized a top-down approach: starting with the most rate sensitive or the closest to market pricing.
Once we identify our rate sensitive account types, the next step is to understand where our depositors fall across certain dollar thresholds or tiers. Do we have a granular, small dollar account balance, or do we have a tilt towards large balances, over $150k for example. Do they require pledging or collateralization? For those institutions that cannot pinpoint the exact source of pressure, building deposit stratification reports can be helpful. Breaking down each deposit product by the dollar thresholds allows one to be targeted and defensive with deposit pricing. More information allows your institution to identify who is in need of a rate concession and who is at risk of moving to competition.
And if customers are lost, which competitor did they migrate to? What type of account and what branch is seeing the most outflows? Are institutions even tracking this information? The data is available, but first it must be identified and analyzed to empower ALCO to form and execute on the pricing strategies. Although strategies for each institution have shifted over time, one common theme is the importance of a defensive posture towards deposit pricing. At Taylor Advisors, we like to use a medical analogy to emphasize defensive deposit pricing. The Hippocratic Oath include the phrase “First do no harm” and your deposit pricing should reflect this as well. Continuing on this theme, we echo the concept of “Rate Adjustment Surgery”.
The Rate adjustment surgery
The Scalpel, the Saber and the Chainsaw
Financial institutions have often assumed which depositors are rate sensitive and which are satisfied. With the new growth in the deposit base since the pandemic, institutions may not have knowledge of who in the deposit base is rate sensitive. ALCO members may question if we should significantly increase rates on all products and tiers across the board to help retain deposits. With this approach the institution could be rewarding rate sensitive and non-rate sensitive depositors the same. What if you accelerated rate sensitivity in your deposit base if broad rate increases were not enough? Not only have you immediately shocked your interest expense higher overnight, but potentially attracted more attention to the rates you are offering across all your products and your competitors! Making broad tiered and posted rate changes and publicizing them is like doing surgery with a Chainsaw: It’ll be quick…It’ll be messy…but the patient may not survive!
The next level in the analogy moves to the Saber. Still a somewhat blunt instrument, the Saber can be used to enhance precision but still move quickly through the deposit base, like institutions publicizing attractive CD rates. This was intended to satisfy the maturing CD base, but it risks conversion from nonmaturity accounts into the CDs and potentially accelerated the increase. Still working through CDs as the primary product, institutions risk CD balances growing and core cost of funds accelerating. To mitigate this, some ALCOs started to raise rates on higher non-maturity product tiers but what if the current tiering system is inefficient and over-rewarded the bulk of the deposit base if tier structures topped out at too low a dollar threshold. This is like doing surgery with a Saber: Relatively efficient…less messy than a chainsaw…but still very painful!
A surgeon takes their time. The Scalpel requires effort, precision and finesse. The Scalpel approach forces defensive pricing, focusing on higher beta relationships and using the exception pricing and relationship pricing as key tools. While this approach requires far more effort, it enhances the likelihood of mitigating conversions risk and limiting parabolic increases in cost of funds. Further, institutions willing to accept some rate sensitive runoff actually saw weighted average costs come down compared versus conversion risk and marginal cost of funds related to Chainsaw and Saber pricing. With a Scalpel, the patient has the highest chance of survival and the surgeon avoids malpractice!
Taylor Advisors’ Take:
First Do no Harm! As you evaluate deposit pricing with this challenging liquidity and economic backdrop, remember that this is no silver bullet. Crafting strategies and pricing accounts requires time, effort, skill and precision to satisfy your goals and to ensure the patient survives the rate surgery! Don’t forget to listen to your balance sheet and remember what your institution is pricing for: Retention? Growth? Bragging Rights? All eyes will be on the deposit base over the coming quarters and the impact that rising cost of funds has on NIM. The pricing and funding strategies that you pursue today can impact your NIM and profitability for quarters and year to come. Deposit strat tools echoooo
If you’d like to hear more about Taylor Advisors and review your Institution’s Performance Snapshot at no cost, email Wes Taylor to schedule a brief conversation.
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