The Federal Reserve has just cut interest rates. Again. For the third time since July. Meanwhile, the Dow Jones is above 27,000, the S&P 500 is over 3,000, and US unemployment rate is at a historic low of 3.7%. What is happening, and what are banks doing about it?
Third quarter data showed that GDP in the United States has cooled off and business investment has backed off. One could argue the softening of economic metrics signals the beginning of a business cycle decline, others will argue that we are just returning to “normal” after the tax cut sugar-rush of 2018. What the Fed is up to, publicly, is trying to prevent a downturn and recession and spur some inflation (currently at 1.7% vs. 2.4% in 2018) to match or exceed their 2% target. The other reality is that relative to the rest of the world, US interest rates are quite high at the new range of 150bp to 175bp.
The Reserve Bank of Australia is expected to move from a 75bp to 50bp target rate and is now considering quantitative easing. Bank of Japan is already in negative yield territory at -0.1%, as is Europe at -0.5%. The international pressure to lower rates to keep the US competitive is strong, as is the political pressure coming from the White House. Additionally, debt servicing on the US debt gets more expensive as the national debt grows, and with the US already running budget deficits at a 7-year high, the Treasury has some incentive to keep rates low.
Though the US is not in a recession, and it doesn’t appear that a recession is imminent (probability within the next 12 months stands at 27% according to Bloomberg), banks are moving quickly to trim budgets in the coming year. The primary headwind to bank earnings is Net Interest Margin (NIM) compression. As variable rate loans reprice immediately and repricing on term deposits comes down more slowly, the squeeze will be felt across the industry. Already banks have announced layoffs and have frozen budgets in response to the falling rate environment. Across the industry, we are hearing executives ask their teams to “do more with less” next year to make sure their banks stay lean and competitive.
The uncertainty about exactly where we are in the business cycle is certainly presenting a set of challenges banks have not had to address for several years. There is broad consensus that economy has cooled, but there is less alignment on whether the future of the economy will be up, flat, or down. Banks are now re-evaluating their capital levels, credit policy, and expenses in preparation for whatever is next.
So what should banks be doing right now given the Fed’s move downward?
Many banks and credit unions still have high loan-to-deposit ratios (>75%), limiting their ability to reduce deposit rates, and consequently, their total interest expense. To reduce your overall cost of funds while staying competitive, consider this simple solution: increase the number of price points on your deposit rate sheet. Take a moment to evaluate the number of pricing cells you offer to your clients. How many tiers are available on your CD, Money Market, and Savings accounts? If you aren’t limited by your core system from offering additional price points, then take steps to increase the number of price points and reduce the gap between tiers. For example, if you currently have a MMA tier that pays the same rate on balances between $25,000 and $100,000, then break that into tiers at $25k-$50k, $50k-$75k, and $75k-$100k. Only pay the most competitive rate on one tier and reduce the rate on the other two. With additional pricing cells in place, rate sensitive customers will adjust balances to maximize their rate, while non-rate sensitive customers will stay put. If you are using rate optimization software like Nomis Price Optimizer, the movement in customer balances will generate an observable data signal that can be used to further refine pricing and reduce the overall cost of funds. For a financial institution with a $15B deposit portfolio, every basis point of movement is worth $1.5MM in reduced interest expense.
While you and your Treasury department are probably already aware of what the cost or value of one basis point of interest is worth to your financial institution, it may not be immediately clear how to reduce that cost without increasing customer attrition. Increasing the quantity of pricing cells is a relatively easy method for reducing expense.
If your pricing cells are already maxed in your core system, or if other constraints prevent you from increasing the number of pricing cells, consider introducing a more robust relationship pricing structure. Using tools like Nomis Price Manager, you can layer more advanced relationship pricing schemas that cannot be supported by your core system. An advanced relationship pricing engine will allow you to offer more aggressive pricing to customers willing to bring deeper relationships and balances, while reducing aggressive pricing on transient or “hot” money to customers with little or no loyalty to your financial institution.
Whether this is the end of the rate easing cycle, or just another step on the path of a longer rate reduction strategy, managing cost of funds will be critical to maintaining profitability and managing expenses in 2020.