How deposit competition reignited — and why it should continue in 2023

December 28, 2022 11:25 AM

When the year started, deposits were one of the more boring parts of banks' balance sheets, as they had been for several years.

But then inflation took off, and the Federal Reserve hiked interest rates aggressively, which resulted in higher yields on a variety of safe investments, such as money market funds and U.S. Treasury securities.

Banks, in turn, felt pressure to pay more for deposits — to ensure that customers didn't park their money elsewhere. Suddenly the deposit market was no longer so sleepy.

The industry was comfortable with some level of deposit outflows, given the vast amounts of cash that had flooded into the banking system from pandemic-era stimulus funds and companies' larger cash buffers. And so far, the Fed's rapid rate hikes have generally helped banks by letting them charge more on their loans.

But the central bank is set to keep rates high for a while, and the ongoing reduction of its bond portfolio is also removing liquidity from the system. So analysts expect deposit costs to keep rising next year, dampening the industry's profitability by reducing the benefit of higher rates on loans.

The pressures are expected to be more muted at banks with higher-quality deposits, which are less likely to leave or be repriced upward.

"We believe the quality and type of deposits will begin to separate bank stock performance," RBC Capital Markets analyst Gerard Cassidy wrote in a note to clients.

What follows is a look at how the deposit picture shifted for banks in 2022, and how the industry is responding to the new landscape.

Pressure began with commercial deposits

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Some early signs of change came in late spring, when larger commercial clients started pulling some of their surplus funds out of banks.

The outflows came relatively quickly at trust banks such as State Street, Bank of New York Mellon and Northern Trust, which focus more on institutional clients and funds. Those early declines were expected, since institutional clients had vast amounts of surplus funds sitting at their banks waiting for more attractive options to emerge.

Other large commercial clients started waking up too, realizing they could put their extra money into higher-yielding alternatives. By May, some banks were already seeing deposits heading out the door.

Banks that had more "operational deposits" — those that companies need on a day-to-day basis for payroll and other expenses — had more luck with customer retention. Those with a larger base of non-operational deposits were forced to start paying more.

"You're starting to see material outflows at some banks," Peter Serene, director of commercial banking at the consulting firm Curinos, said in June. "You're seeing rate competition come back to the market a little bit sooner than we would have expected."

The competition accelerated later in the year as the Fed pressed on with its rate-hiking campaign, prompting some analysts to start cutting their expectations for bank profits in 2023.

The high-yield savings market quickly follows suit

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Rate pressures on consumer deposits, which tend to be stickier than commercial deposits, were generally more limited this year.

But the segment of the market that focuses on rate-seeking consumers quickly got competitive. Banks that offer high-yield savings accounts — including Synchrony Financial, Capital One Financial, American Express, Discover Financial Services and Goldman Sachs' Marcus, as well as several community banks — hiked the rates they pay.

Those banks had anticipated some pressure as the Fed signaled it was getting more aggressive. Several of them raised the rates they paid on certificates of deposit early in the Fed rate hike campaign, hoping it would lock in consumers' money for a long period of time before more hikes made offering CDs pricier.

"Banks and credit unions have a window of opportunity now to grow term deposits at bargain prices," Dan Geller, a behavioral economist and the founder of Analyticom LLC, said in May.

The rates that some banks pay on their online savings accounts, meanwhile, started rising soon after, as rate-seeking consumers started to seek more compensation.

By November, a DepositAccounts.com tracker of online savings account yields surpassed its pre-pandemic peak of about 2.23%. The tracker breached 3% this month.

In an effort to avoid some of that pressure, at least a couple of banks sought to attract new customers with higher rates while keeping rates for existing customers at lower levels.

"Unless the customer pays attention, he or she might never notice it," Ken Tumin, the founder of DepositAccounts.com, said in October.

Deposits at the center of policy fights

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Deposits were also the subject of policy debates in 2022, with industry groups pointing to a more competitive deposit environment as a key reason why an increase in their insurance premiums was unnecessary.

The Federal Deposit Insurance Corp. pressed ahead anyway, raising assessment rates on banks' deposits by 2 basis points starting next year. The FDIC estimates the higher premium costs will lower banks' income by an average of 1.2%, a decline that it says is needed to get its deposit insurance fund back to its minimum levels.

The spike in deposits during the pandemic had caused the FDIC's insurance fund — which pays for the guarantee it makes to depositors — to drop below its minimum requirements.

Banking trade groups criticized the FDIC for the premium hike, arguing that the problem was "likely to fix itself early next year" since deposits had already started falling. Several House Republicans also urged the FDIC to avoid raising banks' premiums, saying that the move "could pose real harm to consumers" by limiting access to credit.

FDIC Chairman Martin Gruenberg has rebutted those arguments, saying the industry's strong earnings mean it's "well positioned to absorb this modest increase" and that the move "should not impact lending or credit availability in any meaningful way."

Deposits also got some attention from Sen. Jack Reed, D-R.I., who questioned the country's biggest banks about why they've been slow to raise consumer deposit rates.

Banks eye other sources of liquidity

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The gradual decline in deposits has prompted some banks to take steps to ensure they have ample funding for their loans.

After sitting still for some time, certain banks have started to raise deposit rates in an effort to retain or attract new funds. Some banks are also tapping the brokered deposit market or advances from the Federal Home Loan banks.

Glacier Bancorp in Kalispell, Montana, turned to FHLB advances to "plug any gaps" that stemmed from the mismatch between "very strong" loan growth and soft deposit growth, Chief Financial Officer Byron Pollan said in July.

As deposit costs rise, banks will start getting a larger portion of their funding from wholesale sources like the FHLBs, PNC Financial Services Group CEO Bill Demchak predicted at a conference this month.

Demchak said that PNC and other larger institutions are in better shape than smaller banks that are struggling with a "liquidity squeeze" as deposits leave the system.

Some smaller institutions are at risk of being cut off from FHLB funding, given that large unrealized losses on their bond portfolios as interest rates rose are hurting their tangible equity. The Independent Community Bankers of America has asked regulators to give those institutions leeway.