On the heels of the Federal Reserve’s two emergency rate cuts, banks are contending with a significant uptick in uncertainty coupled with the reality of operating in a lower-for-longer rate environment. One obvious strategy to deal with these challenges is the pursuit of non-rate driven growth. But it’s often the day-to-day tactics—providing line-of-business flexibility or unlocking new value in traditional bank-customer relationships—that matter most.
With its second emergency rate cut in two weeks, the Fed has effectively cut its benchmark rate to zero. The adverse impact this has on basic banking is well known, yet it’s causing many institutions to revisit and expand their traditional rate fighting playbook.
The existing low-rate era will be accompanied by lower levels of interest income and more margin pressure. Unfortunately, this also comes as returns in the banking sector begin to show signs of plateauing. Regional banks, which have about two-thirds of their revenue tied to interest income, saw overall return on equity slip in the second half of 2019 as interest margin fell.
One culprit is that bank balance sheets have been overly exposed to asset sensitivity, a situation in which assets, such as loans and investment securities, reprice faster than deposits, often driven by asset mix. Put simply, net interest income will decrease as assets reprice more quickly than liabilities in a falling rate environment. The wider the repricing gap, the more significant the impact. Making matters worse, as rates approach zero so do deposit betas, further increasing relative asset sensitivity.
The upward rate cycle that began in 2015 was accompanied by rising deposit betas, a measure of the change in funding costs. With the Fed’s rate reductions beginning in August 2019—and its two emergency cuts in March 2020—deposit betas will also likely reverse course as experienced from 2008 to 2009. In this last downward rate cycle, betas steadily fell as banks simply did not have enough room underneath their deposit rates to recoup the downward slide of asset returns.
In a period of low rates and a flat yield curve, institutions that take immediate steps to recalibrate and manage their deposit betas will be better positioned. This can be done by improving pricing discipline and expanding low rate-sensitive products such as prepaid cards or health savings accounts. But as the lower-for-longer rate environment is likely to continue, an expanded playbook is due.
Traditional loan economics don’t work in a near-zero rate environment.
There are a number of items that remain in your control even when market rates are not. Decisions about pricing and product type can shape balance sheet duration, and understanding which customers are more sensitive to rates can help you manage deposit growth, regardless of the direction that rates are headed.
An effective playbook should include 1) line of business flexibility to manage the balance sheet, 2) an understanding of price elasticity at the individual customer level, and 3) a focus on customer value to minimize repricing risk. As you search for incremental growth in a low-rate environment, these marginal decisions often matter more.
1) Enable line of business flexibility
Traditional loan economics don’t work in a near zero-rate environment. In this situation, banks can’t be adequately compensated for borrowing short and lending long due to a flat yield curve. Moreover, decisions on individual clients and products matter more than ever, simply because a flat yield curve doesn’t allow all clients to receive the same price in an efficient or profitable manner.
Strategies may include delegating more decision making to line-of-business leaders within the parameters of enterprise-level planning goals or a funds transfer pricing framework that accurately captures the net interest margin benefit of reducing asset sensitivity. Individual loan pricing decisions, for example, can help steer customers to particular maturities to better control asset duration. This is especially relevant in situations of excessive asset sensitivity.
Just as critical is extracting more value from your deposit portfolio. While most banks have honed their skill at optimizing deposit strategies, a low-rate environment provides more reason to reassess the deposit portfolio and the tradeoffs between deposit margin contributions, growth objectives and the costs of managing deposit products. Deposit volume has been a great equalizer in the face of lower rates but, particularly if loan growth slows, incremental deposit funding could feed growth of low-duration, low-return cash. A more balanced approach might be to accept deposit attrition if customer profitability can’t simultaneously be enhanced.
Bank and line-of-business treasurers who bring a sophisticated understanding of the balance sheet have a significant role to play in managing the multiple factors that can offset rate pressure. This starts with data-driven insight at the customer level to base decisions on customer lifetime value rather than simply having a blanket approach across the customer portfolio.
2) Understand price elasticity at an individual customer level
How customers behaved in past rate changes provides a blueprint for whether deposits might move quickly or stick around in the current environment. Banks have the data from prior rate cycles and transaction activity to help understand these trends. This will help determine which customers are more rate-sensitive to help manage deposit flows, in addition to harder decisions such as deposit attrition considerations for lower-margin and “hot money” customers.
Knowing how sensitive individual customers are to rate and fee changes is a critical ingredient in managing asset-liability needs and preserving profitability. Every customer reacts differently to different factors, and effective data-driven customer segmentation can help you understand which customers are more sensitive to rates or which customers value experience or service over price.
How institutions manage the response will vary by customer history and by customer segment. As commercial clients reprice faster and are equipped to leverage multiple relationships for the best rate, differentiation beyond price is needed. In addition to industry verticalization, some financial institutions may look to be more deeply embedded in customer operations that incorporate both intra- and inter-bank considerations. For example, bringing an ecosystem approach to a global supply chain solution involving procurement, manufacturing, logistics and real-time payments.
3) Focus on customer value to minimize repricing risk
As mentioned, every bank has customers who are more and less sensitive to rates, and effective ways to reduce repricing risk come with deep relationships. More and more, this will involve a portfolio approach that may extend beyond the traditional boundaries of banking—real estate or healthcare capabilities could easily become part of banking services. After all, these are really big financial issues.
In retail banking, the data shows that there’s a generational shift in how consumers define their primary bank relationship—and it’s increasingly moving away from deposit accounts and toward transactional services. The trick is knowing the tendencies of each consumer. Detailed customer segmentation to support high quality deposit growth or to offer other products for customer acquisition is key to having a better grasp on deposit quality and attrition.
An ongoing focus for banks should therefore be expanding the range of products you have to retain the customer even when they aren't paying the highest rate. A more strategic exercise should increasingly involve a focus on pulling customers in rather than pushing products out—something we can see in recent deal activity, as financial institutions begin to reimagine the crossover of financial services with ancillary areas. This may ultimately require an ecosystem approach or acquisitions, but it’s a consideration in expanding addressable opportunities, diversifying revenue and increasing customer lifetime value.
Banks have long sought revenue diversification to grow more predictable fee income. A more accommodating regulatory environment and the digitization of finance, which helps remove traditional industry barriers, are structural catalysts that can help you deliver more value for a fuller customer relationship. And achieving that may matter more than any rate-driven developments.
Financial Services Leader, PwC US
Principal, Financial Services Risk Practice, PwC US