Banks started the year thinking they could hold off on raising the deposit rates they pay to customers, but a more aggressive Federal Reserve is starting to change that calculus.
The thesis that deposit costs will stay subdued for a while mostly remains on track — since, with loan-to-deposit ratios near historic lows, banks have little incentive to pay more to retain depositors. But the Fed is raising interest rates rapidly in response to soaring inflation, and those moves have reset expectations about when banks will start feeling pressure on deposit costs.
The Fed raised short-term rates by half a percentage point last week, its largest hike since 2000, and signaled it is likely to do so again at its next two meetings. The central bank will also begin slimming down its $9 trillion bond portfolio in June, and will be pulling about $95 billion out of the financial system each month when the reductions reach their full pace.
“The expectations now, compared to where they were three months ago, are vastly different,” said Adam Stockton, director of retail deposits at the consulting firm Curinos.
In their recent quarterly earnings calls, bankers expressed optimism that deposit costs will stay muted for a while. But they also acknowledged that a more aggressive Fed could lead to a more rapid withdrawal of deposits, which would force banks to raise the rates they pay to retain depositors.
“I do think there’s a risk, particularly if interest rates start moving up at 50 basis points at a crack,” KeyCorp Chairman and CEO Chris Gorman said during an April 21 call, though the bank still expects deposits to rise slightly this year rather than decline.
The first signs of pressure would come at the trust banks — Bank of New York Mellon, State Street and Northern Trust — because the Fed’s balance sheet cuts have an outsized impact on their deposits, and their institutional clients are more sensitive to rate movements than many other depositors.
The next step, market observers predict, will be some outflows of commercial clients’ non-operational deposits. Companies keep that spare cash at banks on top of what they need for payroll and other operational payments.
For much of the pandemic, corporate treasurers have had limited ability to make a bit of interest from non-operational deposits, whether at a bank or elsewhere. But rising short-term interest rates mean that companies can now invest excess cash in money market funds and other safe short-term investments — rather than parking it at the bank.
“You look around and you go: ‘Hey, it’s now worth my time to invest a little bit, to manage this cash flow a little bit more actively,’” said Brian Foran, a bank analyst at Autonomous Research.
Because many banks have excess liquidity, they will likely welcome at least the exit of some non-operational, rate-seeking deposits. But at some point, the outflows are expected to prompt banks to offer more competitive rates.
The industry is in the “first inning” of that process, Foran said, pointing to Dallas-based Comerica as an example. The $89.2 billion-asset bank relies more heavily on commercial deposits than many others.
In the first quarter, Comerica’s average deposits fell to $79.1 billion, which was $5.4 billion less than the prior quarter. The decrease was largely attributed to seasonal factors, but Comerica executives said they expect modest declines for the remainder of the year.
Comerica anticipates that deposit rates will “adjust slowly as rates rise,” Chief Financial Officer James Herzog told analysts on April 20. But he also cautioned that the Fed’s hawkish turn may put “a little bit more pressure” on deposit costs.
“The Fed actions will cast a shadow over deposit growth, and those will continue over the next couple years most likely,” Herzog said, adding the caveat that there’s “no exact equation for this” as the Fed pulls back its massive amount of support to the economy.
At Regions Financial, where deposits were a bit stickier than expected in the first quarter, executives last month predicted that funds would probably start flowing out once the Fed opted for a half-point interest-rate hike, which happened two weeks later.
“When that happens, we believe we’ll start to see deposits start to decline,” David Turner, chief financial officer at the Birmingham, Alabama-based bank, said in an April 22 interview.
Consumers are usually less likely to chase higher deposit rates, but this cycle will be different, Morgan Stanley analyst Betsy Graseck predicted in a note to clients Monday.
The Fed is reducing its balance sheet at a faster rate than it did last time, putting downward pressure on deposit volumes, Graseck noted. The central bank is also raising rates far faster than in the last cycle, making rate changes more noticeable to consumers.
Then there’s the competition from online banks, which had a smaller market presence when the Fed last hiked interest rates between 2015 and 2018. Those banks, which save money by operating with few or no branches, pay relatively high rates on deposits.
Consumers are “primed and ready to respond to higher rate offers,” and increased comfort with digital banking during the pandemic made it “more frictionless than ever before” to open an account, Graseck wrote. A national survey by Morgan Stanley found that 57% of consumers thought opening a new account in order to get a higher savings rate is “simple and worth the effort.”
Rates on high-yield savings accounts have been ticking up in recent weeks. Ally Bank raised its annual percentage yield for its online savings account to 0.60%, matching the rates offered by Goldman Sachs, Discover Bank and Synchrony Bank, according to DepositAccounts.com. Citizens Financial increased its online savings rate to 0.75%.
Two institutions offer annual percentage yields of 1.25% on online savings accounts: Bask Bank, a unit of Texas Capital Bancshares that recently launched its high-yield product, and the online lender SoFi Bank.
Banks that pay lower rates are likely comfortable with some level of customer attrition, said Curino’s Stockton, offering as an example customers with a certificate of deposit but few other products at a particular bank.
Other customers, however, have deeper relationships with their banks or have the potential to be a long-term customer for auto loans, mortgages and other products.
“That’s the trade-off that banks are going to really have to carefully weigh: How much do I pay to try and retain deposits or retain customers now?” Stockton said. “And how do I make sure that I’m spending that money in places where the longer-term payback is going to be there?”