To avoid repricing deposits at higher rates, banks, and credit unions have attempted to simultaneously use "relationship pricing" and "new money only" offers to manage their book of funding. Fear of funding costs rising may ultimately result in much higher funding costs, and lost profits and franchise value, all while alienating the people who've banked with them for years.
There’s a lot of irony in banking institutions’ deposit strategy right now. Some are using what one banker called a “delay and decay” approach. The idea is to hold out on raising rates for current account holders, allowing those who want a higher rate to decay while hoping the overall volume of the departing deposits will be slight.
Bank and credit union executives say they want to develop deep and broad relationships with account holders. They also proclaim loyalty to depositors who use them as their primary institution. Yet, many offer their highest rates in “new money only” deposit campaigns. Will longtime account holders still feel like they are valued when those with no prior relationship with the institution can obtain a higher rate?
With the Federal Reserve raising interest rates to a 16-year high, the flawed notion of preference for existing relationships has been clearly exposed. Large banking organizations categorically excluding anyone residing in their branch footprint from being eligible for their most aggressive pricing has been documented. In a February article, for example, American Bankers covered how “Big Banks Pay Up for Online Deposits, But With a Catch.” It’s part of a bolder “new money only” approach: Rather than quietly outsource funding to a broker network, many are openly promoting that they pay new people more.
Offering Higher Interest on Deposits Is Doable
Not long ago, the duality worked. Interest rates were so low that banks and credit unions could easily show a preference for valued depositors through a slight and mostly insignificant bump in rate. The cost of relationship pricing was modest. And institutions didn’t need new money in large volumes yet.
Now, many choose to let depositors shop. If the institution can’t match the rate offered elsewhere, it lets them go. Then, the institution competes for new money with every deposit marketplace and competitor campaign. We’re making clients into shoppers, or we’re attracting shoppers. Wasn’t everyone worried about repricing the book higher?
Some suggest that competition paying rates over theirs must be using a loss-leader approach to win business. But banking executives know they can invest newly acquired short-term funds at the Fed Funds rate. Today any short-term deposit offer below 5% needs no subsidization. Not only are the most aggressive deposit rates out there generally under wholesale funding costs for banks, there is typically the opportunity to invest these funds in a modest but attractive risk-free spread to Fed Funds.
Banks between $300 million and $100 billion of assets had average loan growth of between 12% to 14.5% from March 2022 to March 2023, depending on the peer cohort. The ratio of loans to deposits across the banking industry has also jumped, as shown in the chart below. Though avoiding an increase in the cost of funds benefits the margin, the challenge is finding a strategy that’s not self-defeating.
Master the Art of Negotiation to Retain Deposits
New money offers create an elephant in the room. Why couldn’t the institution offer longtime depositors the same rate as new money? This is how financial institutions end up alienating people.
The trouble is, the staff often lacks the skills and tools needed to negotiate with account holders. That’s because rates were at historic lows for a decade and a half.
Lenders know structure can be everything in winning a loan. But banks and credit unions simply haven’t needed the same organizational excellence for deposits. On the funding side, relationship banking is about mastering the value of deposits to the depositor.
Depositors know their preferred financial institution — the people, processes, technology and locations. Changing institutions makes all of that new. It’s against human nature to depart from what’s known, but only to a point. How much compensation in the form of an interest rate would they need to try the unknown? This is the game of chicken that results from the delay and decay mindset.
Pricing is a logical tool for bankers who want to respect their claim to relationship banking. It can be used to negotiate with rate shoppers, but it should only be used sequentially for those with a relationship. The rate should not be the first and only component of the deposit pricing toolkit. Depositors care about why they have invested their money, how much they will make relative to the work required to move it elsewhere, when their funds can be withdrawn, and the penalty to access it early.
The key is to let sleepers sleep, show respect to the curious, and negotiate skillfully with rate shoppers whether a current or prospective client. What are the depositor’s reasons for visiting the branch? What are their goals for their deposits? Are the savings for a son or daughter graduating next May? Are they aware of the relatively small difference in earnings — in dollar terms — between institutions? Could the funds be needed early for a surprise expense?
Term, penalties — and yes interest rate — must all be customizable. Then institutions can stop playing the game of chicken.
Reconsider Assumptions About Hot Money and Sticky Money
A dollar from one depositor is no more or less valuable than a dollar from another in terms of its potential to be invested or loaned out. The goal of any deposit strategy is profit maximization. It’s pricing differentiation that maximizes profitability in banking because it achieves an oversized portfolio simultaneously with an oversized margin.
While institutions are wise to differentiate in terms of size of account because there are cost efficiencies in getting larger relationships, large depositors are not necessarily more rate sensitive; assuming they are all rate shoppers is a major miss. In fact, many institutions report that smaller depositors may be as rate sensitive as the largest ones.
The banking industry is also fond of repeating the untested dogma that term deposits are hot money, a euphemism for volatile funding. On its face, how can a deposit with a maturity date be more volatile than on-demand funds? The recent bank closures, where tens of billions of dollars in on-demand deposits fled in a flash, certainly tell a different story.
Executives worry about how much interest depositors will demand, and yet they believe low-interest or no-interest accounts — from which funds can be withdrawn at a moment’s notice — are “cold” money.
Even if demand deposit accounts remain open, are the balances in those accounts sticky? There is little evidence these balances are durable. Silent attrition is a growing challenge. Open banking technology enables depositors to effectively sweep funds every day to the highest bidders and people can change where their direct deposits go in about 90 seconds now. We should consider our assumptions carefully.
Playing ‘Chicken’ Isn’t a Deposit Strategy
It is becoming less likely that banks and credit unions will win the game of chicken that they now play with depositors. Rates have made some depositors into adversaries on the opposite side of the negotiation table. Serious margin, profitability, and reputation risk result from assuming everyone is a rate shopper or that no one wants a term deposit at a competitive rate compared to their near-zero priced savings account. Most dangerous of all is forgetting that depositors care about their loved ones and their life goals first, and the value of financial products is framed in those terms.
Money is the ultimate commodity. Institutions can have all they need at a margin they want if they deploy flexible options, competitive pricing, and the best tools to display value to all participants, existing relationships and prospects alike. ?
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