End of cheap deposits

Implications for banks’ deposit betas, asset growth, and funding 

After a long period of cheap deposits, the sharp rise in the federal funds rate from a near-zero base, while boosting net interest margins, is creating distinct challenges for US banks. The uncertain timing of the Federal Reserve’s interest rate “pivot,” coupled with the possibility of a recession, adds additional complexities. This article explores the questions bank leaders should be asking now and presents key considerations for developing a resilient deposit funding and asset growth strategy.

Deposit pricing strategy in the midst of rate hikes

The US economy is experiencing the most aggressive rate hike cycle in recent memory (figure 1). In less than a year, the effective federal funds rate increased about 425 basis points (bps) by the end of December 2022. And there are more increases to come, with the target rate likely reaching above 500 bps in 2023. The sharpness of the rate increases, along with the recent hike cycle starting from a near-zero base, is creating some unique challenges for banks. And because we have lived through a long period of low rates, institutional memory of steep hikes like these is sparse in the banking industry.

Deposit pricing strategy considerations

Recent rate hikes indicate that the era of cheap deposits US banks enjoyed for more than a decade is over. For years leading up to this current rate cycle, banks could attract deposits at close-to-zero rates. For instance, the cost of interest-bearing deposits, including time, money market deposit accounts (MMDAs), and savings deposits, was only 0.26% at the end of 2020, compared to 0.75% at the end of Q3 2022.

Surplus deposits during the pandemic—fueled by more than $2 trillion of inflows—helped to reduce the cost of funding significantly but did not come without some headaches. Deposit growth outpaced loan growth. Deploying these funds in a tough macroeconomic environment with the pandemic still raging and low investment yields presented a challenge, so much so that some banks explored the idea of curtailing deposits from certain customers.

But how quickly the situation has changed. Multiple banks are already advertising higher yields on CDs, money market accounts, and commercial deposits. Even though rate hikes have boosted banks’ net interest margins, the pace of rate increases is beginning to affect customer behavior. Retail and corporate customers alike are demanding higher deposit rates. At the same time, there has also been a steady outflow of deposits.

Uncertainty about the Fed’s rate trajectory and the macroeconomy could make it challenging for banks—large and small—to manage their interest rate risk. This task is becoming more complex with the inversion of the treasury yield curve in recent weeks.

The current scenario raises several questions:

  1. How can banks manage interest rate risk in the current environment, especially with an inverted yield curve, and the possibility of a “Fed pivot” in 2023?
  2. How quickly should banks raise deposit rates? Which products (consumer vs. commercial or 5-year CDs vs. 3-month CDs) should get this boost first?
  3. How to rethink funding: Should banks borrow from the Federal Home Loan Banks (FHLBs), or should they pursue brokered deposits instead of growing deposits organically?
  4. In the current environment, how can banks sustain a favorable net interest margin? How high can these loan yields go without hurting loan growth and profitability?

Explore these questions and other key considerations below.

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