How to predict deposit betas, avoid betting too much on rate hikes

While most banks are positioned for higher rates, institutions might be wise to consider the possibility that rates could turn the other way in the future, according to Darling Consulting Group President and CEO Matt Pieniazek.

The Federal Reserve began raising short-term rates in mid-March and is expected to continue tightening monetary policy at a rapid pace during the remainder of 2022. Most banks have positioned their balance sheets to benefit from rate increases, but Pieniazek said in the latest "Street Talk" podcast that banks should not overextend their hand. He noted that the industry has negative exposure to lower interest rates since there are implicit floors on how low funding costs can go but yields on earning assets continue to grind lower when rate falls.

Pieniazek said banks should remember George Costanza from "Seinfeld" fame and encouraged them to not be afraid to do the opposite of their instincts. He noted that in 2018 when most institutions thought rates could only go up, the conventional wisdom was to lengthen liabilities and shorten assets. But the banks that did not lose sight of their greatest risk and did the opposite by extending duration and purchasing call protection were the best positioned for the eventual turn in rates. He said the institutions that took that approach gave up some yield at the time but purchased insurance for a song.

"The best time to buy insurance is when nobody thinks you need it," Pieniazek said.

In the episode recorded April 20, Pieniazek discussed balance sheet positioning ahead of the rate hike cycle, the potential for securities portfolios to move further underwater as rates move higher, and how banks should evaluate how sensitive their deposit bases will be to the Fed's tightening cycle.

We've made the case, along with others, that deposit betas, or the percentage of changes in the fed funds rate that banks pass through to depositors, will be lower in the upcoming rate hike cycle when compared to other periods because banks remain flooded with excess liquidity.

Pieniazek disagreed, suggesting that the pressure on deposit rates will become "more acute" in the current rate cycle because the pace of tightening is expected to be much quicker. The futures market suggests the fed funds rate could reach 275 basis points by year-end 2022, topping the peak level the benchmark rate reached during the 2015-2018 rate hike cycle but in just a fraction of the time.

"If you were to ask bankers, if rates go up 100 basis points tomorrow morning, do you think that you would have different conversations about deposit pricing than if they went up 100 basis points over the next year. I think it would be hard-pressed to find anybody who would answer, well, it doesn't matter," Pieniazek said.

Pieniazek noted that it took 24 months for the fed funds rate to rise 125 basis points during the last rate hike cycle, while it took just six months for such an increase to occur during the 2004 rate hike cycle. He further noted that deposit betas for that first rate increase of 125 basis points in the last tightening cycle were about half the level of the 2004 cycle. Given that rates are expected to rise quickly during the remainder of 2022, Pieniazek expects betas in the current cycle to be somewhere in between the last two rate cycles.

"Street Talk" is a podcast hosted by S&P Global Market Intelligence.

Listen on SoundCloud, iTunes and Spotify.

Banks have provided different predictions for deposit betas in the current rate hike cycle during their first-quarter earnings calls. JPMorgan Chase & Co. and Huntington Bancshares Inc. expect deposit betas to be similar to the last rate hike cycle. Bank of America Corp. said it hopes to perform a "little better in this cycle" regarding the betas it reports, while The PNC Financial Services Group Inc. said deposit betas might be a "little bit less" in the current cycle than the last rate hike cycle. BankUnited Inc. and Hope Bancorp Inc. expect lower deposit betas will be lower than the last time the Fed raised rates. Meanwhile, Regions Financial Corp. is assuming lower betas for deposits in its core portfolio and then much higher betas for surge deposits that moved into the financial system during the pandemic, with an additional expectation for some of those funds to flow off its balance sheet.

Pieniazek said the explosive growth in deposits since the pandemic raises the question about the stickiness of deposits. He recommended institutions take deep dives into their deposit bases and examine whether the growth has come from new accounts or existing customers holding far larger dollar amounts. He said banks should also break out deposit balances between business and consumer accounts because the former is much more likely to shop for higher rates on their accounts once they become available in the marketplace. He said banks might not lose deposit relationships but could see deposit balances decline as rates move higher.

"I think a lot of banks are going to be faced with the prospect that they're probably not going to lose relationships, but you've got this unbelievable commingling now of operating and discretionary balances that are lumped into accounts," Pieniazek said.