Thursday, May 30, 2024

We Need a New Funding Strategy

In December 2021, when the Fed Funds Rate stood at 0-25 basis points and prior to the Fed's tightening beginning in the first quarter of 2022, there were $18.2 trillion in domestic deposits, according to the FDIC's Statistics at a Glance. In December 2023, a full three quarters after the Fed paused its tightening of the Fed Funds Rate (QT continued), domestic deposits stood at $17.3 trillion. Nine hundred billion dollars, or 5% of deposits... gone. 

What happened?

Money market total financial assets, according to the St. Louis Fed, went from $5.2 trillion in total assets at December 2021 to $6.1 trillion in December 2023. Not so coincidentally, a $900 billion change.

Read this comment from M&T Bank Corporation's (MTB) fourth quarter earnings release:

"Net interest margin of 3.61% in the recent quarter narrowed from 3.79% in the third quarter of 2023 reflecting the higher costs paid on deposits amidst a continued shift of customer funds to interest-bearing products."

And indeed, MTB did grow deposits during this period. But the industry as a whole, not so much. Nationwide, depositors did switch to interest bearing accounts. But money market mutual funds seemed to be the benefactors of the switch. 

As far as community banks, I look to data gleaned from all of the banks where my firm does profitability outsourcing because we have a level of granularity that the FDIC and most readers do not have. Look at the two average balances per account charts below courtesy of The Kafafian Group.

It is true that the average balance per retail (non jumbo) CD account was higher in the fourth quarter 2023 than the fourth quarter 2021. But it was not materially so. In fact, if I multiplied the change in CD balances per account times the average number of CD accounts for all of our outsourcing clients, it would equate to a positive aggregate change in CD balances per bank of $65.7 million. For retail money market deposit accounts alone, the same math equates to an aggregate decline in those balances of $105 million. Of note there were 11% more CD accounts and 8% more retail money market deposit accounts. 

The outflow of deposits was not driven by a decline in the number of accounts. It was driven by the decline in the average balances of those accounts. The story is similar regarding business deposits (see chart above).

Although financial institutions cost of funds are now stabilizing yet still slightly increasing, it has been one year since the Fed paused its Fed Funds Rate tightening. This was similar to the tightening cycle between 2004 and 2006 when Fed Funds rose again to 5.25%-5.50%. But since the financial crisis came quickly on that cycle's heals, banks cost of funds rose two or three quarters after the Fed paused. Because the Fed then precipitously dropped the Fed Funds Rate to offset the negative economic impacts of the financial crisis. For this tightening cycle, the tail of increasing cost of funds amidst a Fed pause is lasting much longer. Higher for longer.

Most of our deposits are immediately callable. We believe we established relationships with our customers so they won't flee with every rate increase. A relationship is built on trust. And if our deposit strategy was to keep rates as low as possible so long as our depositors didn't notice, we have broken that trust. And they fled. Or we had to apologetically raise their rates to be closer to the market to keep their money. Something we continue to do.

What we can learn from this is there is value in a relationship, if we truly have a relationship where our depositors know our bankers and have someone to call to discuss banking matters. Some self-reflection might be needed here.

And secondarily, we have to assess the value of that relationship or other differentiated value we deliver. And by value I mean how much less than market deposit rates they will accept for that perceived value, which appears to be what they can earn in a money market mutual fund. Maybe it's 50 basis points. Maybe 100. But as we found out, it's not 300 or more.

Our cost of deposits will have to be managed by the strength of our differentiation and the mix of our deposits. Because this cycle proves that customers will flee. They may not close their account. But they will drain it. And we may not even notice it.

~ Jeff


  1. The challenge here is that there is a potential for an increase in unprofitable customers while at the same time, the most profitable customers become less profitable. These two behaviors can create significant downward pressure on overall profitability. Banks will need to do significant work at reducing the costs to serve their customers and find additional ways to improve income not directly related to loan and deposit balances. Thankfully, there are many opportunities for data-savvy banks to achieve this.

  2. Dave, you are correct about looking hard at the costs to originate and maintain an account. And that includes the 80-90 basis points of direct branch cost as a percent of deposits if branching is part of your distribution strategy. Additive to that is knowing exactly which accounts are price sensitive and not price sensitive and having customers in the right product or at least have an identifier to know that this is Customer A's vacation account and they are not price sensitive, and here is their family emergency fund and it is price sensitive. Seems a combination of proper onboarding and AI could be helpful here.