Pressure from commercial depositors is arriving faster than expected

With interest rates rising quickly, banks are starting to face pressure from business clients to pay more on their deposits.

The landscape for commercial deposits has been changing rapidly since the Federal Reserve hiked rates at its most aggressive pace since 1994, according to bank consultants. The shift raises the risk that banks’ funding costs could rise in the coming months, eroding their profits.

For much of the pandemic, companies have parked their spare cash at the bank, since low interest rates meant that other safe options typically didn’t offer much yield. Recently, that flood of deposits has made banks comfortable with some of the cash heading out the door.

But the outflows also mean that banks may need to start playing defense sooner — by paying companies more for their deposits rather than see them exit for better-paying options.

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

Deposit pricing pressures are still far from widespread. Commercial deposit volumes remain slightly elevated from last year, though some banks are seeing significant year-over-year declines. Banks that were in the bottom quartile for commercial deposit growth saw a 9% decrease in those deposits from a year earlier, according to a Curinos study of 21 regional, super-regional and national banks.

In addition, the average interest rate on commercial customers’ demand deposits jumped to 26 basis points in May, up from 16 basis points a month earlier, according to Curinos. The average rate remains below its pre-pandemic level of 88 basis points.

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Meanwhile, the rebates that banks pay on commercial clients’ non-interest-bearing deposits have stayed flat, though a Curinos survey found that about 90% of bank liquidity managers expect them to increase this year. 

Some banks are in a better spot than others, Serene said, noting that certain depositories have done a better job of becoming companies’ primary bank for payroll, supplier payments and other ongoing cash needs. As a result, they have a larger amount of “operational deposits,” which companies need on a day-to-day basis and are less likely to move elsewhere.

Other banks rely more on non-operational corporate deposits — the hot money that companies were always likely to shift to safe investments, such as money market funds, as soon as those options started paying more.

Banks with “lower-quality deposits” are starting to lose them in favor of higher-yielding options, according to Serene. Such banks are starting to “backfill those deposit outflows with additional deposits,” he said, but they’re attracting that cash by paying higher interest rates.

Other banks have been touting what they describe as their advantage in operational deposits. For example, Huntington Bancshares’ focus on growing “high-quality, sticky commercial operating accounts” means that it is seeing fewer outflows, according to Chief Financial Officer Zachary Wasserman.

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That leg up will help the Columbus, Ohio-based bank manage its deposit costs throughout the cycle, Wasserman said at a Morgan Stanley conference last month. Still, he noted that the Fed’s more rapid rate increases will push up deposit costs more quickly than gradual moves would.

At the end of last year, Fed officials were projecting they would tighten monetary policy gradually, and that the benchmark federal funds rate would finish 2022 at just below 1%. But as inflation continued its climb to a 40-year high, the Fed shifted gears and started to raise rates at a more aggressive pace.

The central bank hiked rates to between 1.5% and 1.75% last month, and its latest projections showed that rates are likely to end the year above 3%. The Fed’s pace of tightening has prompted some analysts to take a more cautious view of deposit costs.

Bankers started the year confident that deposit betas — the amount of each rate hike that banks pass on to their depositors — would be low for the first 100 basis points of Fed rate hikes. But the central bank has “already eclipsed this mark,” and banks will likely now have to raise deposit rates faster, eating into their profit margins, according to David Chiaverini, an analyst at Wedbush Securities.

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“Given how quickly rates have already risen, combined with stagnating deposit growth, we are now concerned that betas will actually be higher than what was seen in the 2016-2018 period,” Chiaverini wrote in a note to clients.

So far, banks haven’t made major moves in reaction to Fed rate hikes and are waiting to see what their competitors will do, said Anand Shah, a partner at KPMG. The tricky part will be figuring out what types of deposits they’re more comfortable seeing leave.

Banks seek long-term relationships with commercial clients, and they will need to analyze whether they should be offering a slightly higher rate on some companies’ deposits if doing so helps the lending side of the business.

“I think the reality is that they have to monitor this very closely to fend off any attrition ⁠— any unwanted attrition,” Shah said.

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