Since 2008 the U.S. has experienced a prolonged period of low interest rates, which has created headwinds for bank performance. The flattening of the yield curve has put significant pressure on most banks’ net interest margins.
As lending has improved, the competition for deposits and other sources of funding has increased, further reducing spread. Given the challenges faced in a low interest rate environment, many bankers are hoping that rates will soon begin to rise. They’re hoping for higher rates to alleviate pressure on their balance sheet and improve profitability
Sounds good on the surface. However, rising rates could be a mixed blessing. There is certainly the potential that the yield curve will steepen and improve spreads, but there is also danger in how consumers and competitors will respond.
Given the extent of the opportunities and dangers, I’m surprised that the question I hear most often is, “When will rates begin to climb?”
Instead, I believe the question that should be asked, is “What should we be doing now to prepare for rising rates?”
Rate, rate … Don’t tell me!
Just like National Public Radio’s weekly quiz program “Wait Wait ... Don't Tell Me!,” where you can test your knowledge against the best and brightest in the news and entertainment world, bankers have the opportunity to test their knowledge against experts, in predicting the future of interest rates.
Of course, bankers are playing this game with real money.
What is the consensus of these experts? Upon entering 2015, it was for rates to begin rising in the second half of the year. The Congressional Budget Office predicted, in February 2013, that the 10-year Treasury rate would hit 3.2% in 2015 and rise further to 4.1% in 2016.
However, recent performance has called that into question. Consider that on Jan. 2, 2015, the 10-year rate was 2.12%. Before rising to its current level of 2.02% on Feb. 13, it had dropped as far as 1.68% (reached on Feb. 1 and 2).
This trend has resulted in diverging expert opinions. For example;
• Jonathan Rick, interest rate derivatives strategist at Crédit Agricole, said he has no plans to lower his estimate that the 10-year yield will rise to 3.25% by January 2016.
• In a recent interview with Barron’s, Jeffrey Gundlach, the King of Bonds, stated that he could see rates falling below 1.38%, the modern-era low, last reached in 2012.
Which prediction will hold true?
Recent movement certainly seems to support Gundlach. However, Federal Reserve Board Chair Janet Yellen still seems to be intimating that rates will rise later this year as she recently told reporters that “rates won’t rise for at least two meetings [of the Federal Open Market Committee]”, meaning we might see rates increased as early as June 2015.
It’s not just whether rates are rising or falling. Adding to the complexity of the problem for banks is the expected volatility of rates—driven by both the lack of inflationary pressure and external factors such as the recent election in Greece— expected in the coming months.
Given such uncertainty, how should banks respond?
Regardless of where you feel rates are headed in 2015, it’s important to begin preparing now for their inevitable rise and for the potential of a sustained period of high volatility. Under both scenarios, banks will need internal processes for monitoring rates—both macro-trends and the rates of competitors; for projecting the impact of rate changes; and for quickly changing offered rates, as required.
An important component in this process is tying in the discussions and actions of your bank’s Asset-Liability Committee (ALCO) with those of the bank’s implementers, the in-market actions of the product, marketing, and sales teams.
Benefits gained by preparing now and setting yourself up to be successful when rates ultimately do rise could be substantial. As you develop your response plan, here are some items to consider:
1. Core deposits are king.
As rates inevitability rise, generating funding through low-cost DDA (core) deposits will become critical. Add to this their more favorable treatment under Basel III and you have the recipe for significant competition between banks.
To clarify the point above, the goal isn’t to simply get consumers or businesses to open a checking account, but more exactly, it is to get them to open their primary checking account—their main transaction account—with your bank.
It is only once they’ve established their primary checking account that you have the opportunity to develop a sustainable relationship.
2. Hold them close and never let them go.
Many banks will conclude that the path to growth will be through stealing market share. Design your on-boarding and on-going service model to ensure you are stealing from someone else.
Building deep relationships, in which the consumer or commercial client utilizes multiple products and services, is the most effective method for retaining core deposit customers.
How do you build deep relationships?
The formula is simple: great service; concerted and aligned effort to engage with your clients; and offering value-added products and services at the right time, through the right channel.
Simple, yes. It’s the execution on this formula that is difficult.
As added inducements for undertaking this challenge, there are the diversification of revenue through fee-based services and the opportunity to take advantage of the expected growth in consumer lending (especially in the near-term, once rates begin to rise).
3. Make time (deposits) work for you.
While core deposits are indeed king, time deposits will still play a key role in the funding mix for banks. In an environment where rates are rising and expected to continue to rise, consumers will typically opt for shorter maturities, while banks would prefer longer durations.
Resolve this dilemma by offering incentives to extend-out maturity dates. For example, provide existing customers the opportunity earn additional basis points on their rate based on the value of their relationship.
A watch-point to note is maturity date concentration. Carefully monitor and adjust your CD program as necessary, to avoid having a high percentage of your time-deposits maturing during any given time period.
4. Remain relevant in payments.
More and more consumers and small businesses are selecting banks based on their digital capabilities. One 2014 study, by Alix Partners, reported that 65% of consumers who switched banks cited mobile banking as a top two consideration in selecting a new bank. [See “Mobile In Motion: Consumers’ Digital Orientation”, p. 29.]
Offering a competitive rate and having convenient locations isn’t enough anymore. Relevance comes by providing consumers and businesses robust digital tools.
This is especially true with the dramatic growth in digital payments. Providing safe, simple access to the payments system is a fundamental function of banks. It began with the checking account and remains just as important, even with the move towards digital payments.
So seek opportunities—Apple Pay, mobile remote deposit, P2P payments—that will extend the relevance of core deposit account relationships.
Don’t compete with crazy
There will always be crazy.
Avoid the temptation to react to short-term, unsustainable rates being offered in your markets. I don’t suggest ignoring aggressive pricing, but there is a difference between aggressive (when you must respond) and crazy (which you can ignore).
Understanding the reasons behind the crazy (e.g., competitors facing liquidity challenges) can help you both resist the instinct to react and determine how best to capitalize on the inevitable failure of a crazy competitor’s approach.
The time to being ready for rising rates is now.
Use the time now to understand how rising rates will impact your balance sheet; map out the approach that makes sense for your bank; and put yourself in a position to take advantage of the opportunities always present in volatile and stressful times.