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Deposit costs hit inflection point, but demand for funds could limit relief

A long-awaited turnaround in funding costs arrived in the third quarter, but questions remain about how much relief U.S. banks can expect in the coming months.

Overall increases in funding costs had been tapering since the Federal Reserve shifted from raising rates to taking a wait-and-see approach near the end of 2018. Now, with three rate cuts — the first two of them were in the third quarter — and drops in longer-term rates over fears about the economic outlook, funding costs appear to have entered a descent.

The cost of interest-bearing transaction accounts for U.S. banks fell four basis points from the previous quarter to 1.62% in the third quarter, according to S&P Global Market Intelligence data. That is the first quarterly decline in more than four years.

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The cost of savings accounts edged up less than a basis point to 0.62% while the overall cost of funds edged down less than a basis point to 0.96%. The fall in overall funding costs, while incremental, was the first quarterly decline since the beginning of 2016.

Many banks have forecast that funding costs will continue to ease, providing a crucial if not complete offset to a rate environment that is also pressuring asset yields. Citizens Financial Group Inc., for example, has forecast that the decline in its deposit costs will accelerate in the fourth quarter from the third quarter as lower benchmark rates flow through its portfolio.

But many factors might inhibit the magnitude of the adjustment to benchmark rates relative to previous cycles: growth in a moderately healthy economy that is driving bank demand for funding; rates that never increased that much on enormous pools of core deposits; and ongoing churn into accounts priced at aggressive "acquisition" levels from cheap "back books" in an era where digital banking has made it easy to move money.

"There's really only one way for [overall deposit costs] to go down materially faster, which is if we see further decreases in" rates offered to new customers, said Peter Gilchrist, executive vice president at bank analytics and advisory company Novantas.

Data on a pool of about $2 trillion of retail deposits that Novantas tracks has shown that savings account acquisition rates have fallen sharply so far: by about 25 basis points for the 50 basis points in cumulative Fed cuts in July and September.

But "the biggest factor that's going to drive acquisition rates down [further] is if the industry doesn't have an appetite for outside deposit growth," Gilchrist said, which would require a broadly undesirable softening in macroeconomic conditions.

Meanwhile, deposits from long-term bank customers that never experienced price increases when rates were rising continue to flow into accounts with more competitive offers.

"The back book at most institutions is very, very low, generally under 25 basis points and often under 10," Gilchrist said. "There's only so far you can go down."

The churn dynamic could be particularly powerful in isolation, if no further rate cuts are forthcoming. Fed officials have indicated that they are likely to stand pat after the cut in October unless there is a major change in the economic outlook.

Declines in funding costs so far have been broad-based. Fifteen of the 20 largest banks by domestic deposits posted quarterly drops in cost of funds, although the median for the group was a decline of just 1 basis point. Nine of the banks posted quarterly declines in their cost of interest-bearing deposits, although the median move was an increase of 1 basis point. Ten of the banks posted quarterly declines in the cost of savings deposits, and the median change was close to zero.

Future results will vary based on factors including how well individual banks controlled deposit costs when rates were rising — determining the room they have to reduce costs now — and the structure of their certificate of deposit portfolios. Some banks have also said that they are having success reversing increases in prices on commercial deposits, which had shot up particularly fast when interest rates were rising.

"CDs are complicated, and a bank-by-bank issue," Gilchrist said. "Some banks certainly have CDs that were long-enough term that they are renewing into rates that are higher than they were when they were originated."

While banks that maintained low deposit costs when rates were rising have less room to maneuver now, they are in the enviable position of having strong through-the-cycle funding bases. In terms of deposit mix, institutions like Bank of America Corp. stand out for their success in building up core transaction account balances.

From the third quarter of 2016 to the third quarter of 2019, the share of Bank of America NA deposits held in transaction accounts increased 4.9 percentage points, while the shares represented by savings and time deposit accounts fell, according to S&P Global Market Intelligence data.