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Headwind from mix shift to time deposits lets up

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Headwind from mix shift to time deposits lets up

When interest rates were rising, a rotation into pricey time deposit accounts added to the funding cost pain for U.S. banks.

Now, with cuts to short-term rates and an even steeper drop in intermediate-term rates, that particular headwind appears to have dissipated, and some banks say they are poised to reap the benefits of maturing certificates of deposit.

Time deposits represented just 16% of industrywide domestic deposits at the end of the second quarter, but almost half of domestic deposit growth since the third quarter of 2017.

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But as medium-term rates slid below short-term rates in the second quarter, and the Federal Reserve embarked on the first of two cuts to overnight rates so far at the end of July, the shift toward CDs appeared to peter out. Across the industry, domestic time deposits were nearly flat with the first quarter at $2.088 trillion in the second quarter, while domestic transaction balances grew 1.65% to $2.174 trillion and domestic savings balances edged up 0.28% to $8.485 trillion. The flows mean that banks' reliance on time deposits fell for the first time on a quarter-over-quarter basis in more than a year.

Banks "tend to look at equivalent duration in the wholesale markets" to price CDs, Adam Stockton, a director at the advisory firm Novantas, said in an interview. As wholesale rates dropped, "banks really started to price down" time deposits, particularly for longer-term maturities.

CD prices do not precisely track the wholesale yield curve, a concept that customers typically do not understand. Instead, depositors generally expect to be compensated with higher rates for tying up their money for longer periods — in technical terms, they demand high term premiums. Once premiums over liquid accounts flattened, CDs ceased to be attractive for most depositors. Customers made the calculation that "if CD rates are only five basis points better than what I could get in a savings account, I would rather keep my money in a savings account," Stockton said.

When rates were going up, banks used time deposits to capture rate-sensitive balances without increasing yields on a broader portfolio of accounts, Stockton said. "The alternative would have been to increase rates substantially on savings accounts, which would have involved pricing up a much larger tranche of customers."

As a result of these dynamics, and since CDs reprice with a lag because of their nature as term instruments, time deposit funding remains expensive overall. In fact, the interest expense on time deposits as a percentage of outstanding balances increased 11 basis points from the first quarter to 2.10% in the second quarter, outpacing increases in the same measure for savings deposits and interest-bearing transaction accounts. The cost of savings balances, which form the core of banks' funding, increased four basis points from the first quarter to 0.62% in the second quarter.

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Another factor slowing reductions in funding costs is that large amounts of deposits remain priced well below market benchmarks, despite recent declines in rates across the curve. This is creating upward pressure on prices even in an easing cycle.

Nevertheless, some banks say that CDs coming up for renewal in a lower rate environment are providing an important cushion in otherwise adverse conditions for net interest income.

In September, Huntington Bancshares Inc. CFO Howell McCullough III said the "biggest piece" behind his bank's guidance that it will keep its 2020 net interest margin about stable with 2019 is the ability to reprice deposits, including about $8 billion subject to promotional rates that are expiring or in CDs that are maturing in the third and fourth quarters.

BB&T Corp. Chairman and CEO Kelly King also underscored maturing long-term CDs when reiterating his bank's NIM projection at an investor conference in September. "Deposit rates are declining because we've worked through the cycle," he said.

In a presentation for his bank in September, Morgan Stanley CFO Jonathan Pruzan said that CD prices are dropping in "lockstep" with market rates as the company tries to diversify its deposit portfolio.

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Broadly, time deposit maturity data suggests that banks are relatively well positioned to take advantage of lower rates in the coming quarters. The proportion of time deposits across the industry with a remaining maturity of one year or less has increased from 66% in the third quarter of 2017 to 71% in the second quarter of 2019.

For the largest institutions, the figure is typically even higher, with a median 73% for the 20 U.S. banks with the most deposits.

"Ultimately the mix shift out of CDs over a longer time period will prove to be a net benefit," Stockton said.

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