The Federal Reserve raised rates four times last year, making it nine total adjustments over the past three years, when the Fed first began raising rates from near zero. Despite favorable economic indicators and a strengthening economy, these rising rates, coupled with ultra-competitive loan markets, created more margin compression for community banks and credit unions. That was 2018.
This year, while the Fed says it plans to slow down rate hikes, there still remains uncertainty on the rate environment over the next 12 months. Regardless of the environment, community financial institutions still need to evaluate core deposits to determine how best to spur growth and profitability. With a highly flexible strategy, banks and credit unions can battle margin compression despite ongoing economic volatility.
Dangers of Driving Solely by ‘Cost of Funds’ Thinking
Anyone who went to banking school likely learned the acronym “COF” on their very first day — and for good reason. Without a sharp eye on cost of funds (COF), banks and credit unions can expose themselves to interest rate risk (among many other pitfalls), with detrimental long-term effects likely.
If the 2008 financial crisis taught the industry anything, it is that net interest margins can compress quickly — and stay compressed much longer than anyone expects or most models predict. These periods of extended margin compression revealed how little control institutions have over their return on earning assets versus market forces. That said, there remains significant opportunity on the deposit side that ultimately enables greater control of that critical margin.
“Basing strategic funding decisions on cost of funds analysis alone is like driving down the highway with blinders on.”
Unfortunately, COF will always fall short when assessing the true cost for the most common deposit products in a bank or credit union today: checking accounts. This remains the core component of any consumer’s relationship with their primary financial institution, and the most likely means for attracting new relationships, which are vital for long-term sustainability.
For instance, a group of qualification-based, high-interest checking accounts at one institution has a median of $9.76 in monthly interest expense, which translates to a COF of 2.11%. That is high enough to send any CFO running, but those same accounts generate a median of $28.31 in monthly net non-interest income (NII). A complete examination reveals these accounts generate $39.25 in median marginal profit per account (monthly).
Clearly, basing strategic funding decisions on COF alone is like driving down the highway with blinders on, leaving you in danger of making a costly mistake.
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‘Cost of Deposits’ Metric Can Outperform COF Measure
The cost of funds approach works well for many deposit products like savings, money market deposit accounts and CDs because there is little non-interest expense or income involved in these accounts.
Transaction accounts may carry interest expense, for which COF adequately accounts. Yet those same accounts also come with non-interest expenses and generate non-interest income. Both can be easily lost elsewhere in the balance sheet and not properly attributed to these deposits.
Consider a free checking account. While it has a 0% cost of funds, there are a number of marginal expenses that must be considered — processing checks (people still write them), sending statements (especially if they’re paper), core fees, etc. — along with whatever club account features or incentives the institution may add in to differentiate their offering. On the flip side, there are sources of non-interest income, mostly debit card interchange and overdraft revenue.
By taking a holistic approach and looking at the full picture —interest expense, non-interest expense and non-interest revenue — you are now looking beyond COF and seeing an under-reported (and grossly under-utilized) metric referred to as Cost of Deposits, or COD.
A significant amount of revenue and expense flows through checking accounts that never impacts the COF for these deposits. Unfortunately for many institutions, there is little visibility to these numbers as a function of the individual account type, because most (if not all) of these sources are reported and tracked en masse across the entire deposit suite. This makes it virtually impossible to assign marginal expenses and revenues to individual product types and can ultimately lead to poor strategic decisions.
Going Beyond Deficient COF
Accurately measuring such factors into cost of deposits just hasn’t become mainstream — yet. As we find ourselves in the midst of historic times in banking, now is the time to change that.
“Community banks faced the result of understandable hesitancy to adjust loans rates up for fear of losing business, while deposit products commanded higher rates.”
Over the last few years, the Fed funds rate has been on a steady upward trajectory. Unfortunately, a more competitive loan market left many community financial institutions facing a unique type of compression — the result of understandable hesitancy to adjust loans rates up for fear of losing business, while deposit products commanded higher rates.
Typically, executives would consider the following options in response to this compression:
• Increase loan rates. Regrettably, the continued challenging loan market and onslaught of new forms of competition makes this next to impossible, except for institutions who find ways to compete on some basis besides rate.
• Decrease deposit rates. While many financial institutions have left their deposit rates untouched from historic lows, this is simply postponing the inevitable. The continued rise of Fed funds and the subsequent rise of deposit markets everywhere will eventually force upward repricing of all deposits. Down isn’t an option.
• Decrease non-interest expense. Despite the economic recovery, few financial institutions have loosened their belts beyond the absolute minimum — any more cost cutting is likely to handicap growth.
• Increase non-interest revenue. Traditionally, this has meant new and higher fees or other strategies that draw intense consumer ire. But it doesn’t have to be that way.
If we continue looking through COF blinders, the only choice is to raise loan rates and hope that the competition quickly follows suit. That’s clearly not a desirable or winning strategy in today’s market.
So let’s examine some non-traditional means to increase non-interest revenue.
Using COD to Position Your Institution for Growth
Through the holistic cost of deposit (COD) lens, an institution can accurately allocate the non-interest expenses and revenues to the accounts generating them. As a result, the true value of transaction accounts as a lower cost/higher margin source of funding becomes apparent. With all data points exposed, the strategy for maximizing that revenue, and attracting the most valuable account holders becomes clearer.
An increasingly popular method to do just that has emerged over the last decade: reward-based checking accounts. They are attractive to consumers because they are not only free — which consumers demand — but include the potential to earn rewards, such as high interest.
On the surface, reward checking can look like an unjustifiable expense — increasing liability and giving little in return. This appearance is deceiving and COD helps to unmask it.
First, profitability per account is much higher than the standard “free” checking account most institutions rely on. For instance, the median monthly profit-per-account for reward checking is $33.16 compared to $20.71 for standard free checking. The impact of this success in profit-per-account is magnified by the ability that reward checking accounts have to attract new account holders. Our studies indicate that institutions launching reward accounts typically see an average 50% increase in annual account openings in the first year offered compared to the year prior.
This approach can increase revenue while decreasing expenses. Consider the cash back account. Across 700 banks and credit unions in our study, these accounts generate 81% more net interest income compared to free checking accounts. Another example is a high-interest rewards checking account, which generates 16.5% more net interest income, compared to free checking accounts.
More importantly, the median COD of these cash back accounts is -8.34% and -0.27% on high-interest rewards accounts. Where COD appears as a negative value, it indicates the opposite of cost, or in plain terms, profit, net of interest and non-interest expense, before the deposits are invested or loaned. Some institutions see even higher levels of profit.
Combined with the profit margins on each account before reinvesting the deposits, it is clear to see (thanks to a COD perspective) how high-yield checking accounts can generate significant revenue while attracting engaged consumers.
Improving Position Regardless of Rate Environment
As opposed to the past period, economists are only predicting one rate hike for the entire year, as the Fed takes into account fears of a new recession. Fully understanding what the rate trajectory will mean for institution-wide COF, net interest margin, and ultimately income will be very difficult.
In the end, capitalizing on lowest overall COD better positions every institution in any environment, and rewards checking programs can help. They can also help attract more young consumers and help build share of wallet.
Of course, nothing is ever as simple as one measurement, like COD. Focusing on the benefits of low-cost deposits, for example, could lead to the extreme conclusion that funding an institution’s entire deposit portfolio with free checking makes sense. But the extraordinarily high attrition rate of free checking begins to cancel out its COD advantages. Additionally, institutions would find it almost impossible to obtain the sheer volume of account holders necessary to fund a significant portion of an institution’s portfolio with commodity-like free checking.