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Managing deposit costs in the rising rate cycle

Banks need to be vigilant about keeping a finger on the pulse of their customers’ pricing sensitivities, banking behaviors and switching triggers.

Aug 1, 2022 / Consumer Banking
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A unique mix of macroeconomic conditions and market dynamics is conspiring to make deposit cost management particularly challenging over the next 24 months. Interest rates are on a fast and furious climb. The target federal funds rate (currently at 2.25% – 2.50%) is expected to finish the year a full percentage point higher as the Federal Reserve battles rampant inflation. The pace of rate hikes is one of the fastest in history.

Economists expect tightening monetary policy to trigger a recession – a recent survey by the Wall Street Journal pegged the 12-month recession probability at 44%. As the Fed seeks to shrink its balance sheet, deposit growth will slow. For some banks, the combination of rising rates and a shrinking Fed balance sheet could translate to negative deposit growth.

We are amidst this rising rate cycle at a time when a new breed of banks is coming of age.  There are now 85 neobanks in the U.S., together servicing more than 100 million retail banking client-accounts, according to Simon-Kucher research. Of these, at least eight can boast a client base of 5 million users or more, affording them the ability to scale, make bolder strategic moves and pose a real challenge to incumbent banks. Younger bank customers are especially attracted to these digital attackers who first emerged following the global financial crisis seeking to establish primary, digital-only client relationships across multiple products.

The rate cycle will be full of unexpected twists and turns. There are higher levels of economic uncertainty and global shocks, competition for primary bank relationships will be fierce and intense, and traditional approaches like relying solely on higher rates or executing blanket marketing campaigns for acquisition and retention will have limited success.

To effectively manage deposit costs, banks will have to be vigilant about keeping their fingers on the pulse of their customers’ pricing sensitivities, banking behaviors and switching triggers.

They will also have to work to avoid common pitfalls, which include:

Showing up late to the game: Most banks are coming into the rising rate cycle flushed with deposits, and most are willing to let some of this excess run off. However, with inflation at record levels and an aggressive Fed, interest rates could rise faster and higher than previously predicted. Banks must be careful not to find themselves in the unenviable position of having to reacquire valuable deposits relationships at higher cost later in the cycle.

Banks that are not practicing customer-relationship optimization to retain their most valuable customers must begin to do so. As an example, one bank noticed that customers who have been with the bank for a year or less are most likely to move money externally when a deposit instrument’s term ends. Armed with this insight, this bank was able to orchestrate a multiproduct bundle offer featuring lucrative rewards, including a complimentary Netflix subscription, to convince these customers to consolidate their financial accounts with the bank.

Suboptimal pricing: Mastery over customer elasticities and precision pricing will determine the extent a bank can take surgical actions to meet portfolio goals while keeping deposits costs down.

During the last rising rate cycle, a large national bank built a deposit pricing-optimization engine that could output more than 5,000 price points for deposit products across regions and customer segments. This bank was able to realize more than $45 million in deposit cost savings while keeping deposit portfolio volumes unchanged.

As cloud-based pricing analytics become increasingly accessible, banks of all sizes can similarly factor in price sensitivity and other considerations to optimize deposit offers to meet volume goals without sacrificing margins.

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Blanket acquisition campaigns: Banks have traditionally operated along single product lines where knowledge, data and expertise were siloed. Deposit marketing campaigns and promotions tended to be product-centric and impersonal, and banks threw a wide net when it came to customer-acquisition efforts.

Banks now have access to data, analytics and cloud-based tools to enable personalization, so they can tailor offers to target the highest-value customers. By observing fund-movement behaviors of newly acquired customers over time, a large Canadian bank has been able to distinguish between loyal customers and rate chasers. These observations are currently being used to develop targeted and precise acquisition strategies.

Current market conditions will test traditional responses and stress net interest margins. Banks will have to challenge themselves to find ways to act with precision, speed and discipline to ensure margin expansion and growth.

David Chung is a partner, Betty Cowell is a senior advisor and Rohan Shah is a senior director at the consultancy Simon-Kucher & Partners.