The impacts of quantitative tightening need to be considered in the context of the broader rate cycle. The current economic climate marks an end – at least temporarily – of the bullish run of lower rates since the onset of the 2008 Global Financial Crisis, and of the accommodative policy measures enacted during the COVID-19 pandemic. Quantitative tightening and other contractionary monetary policy measures are intended to normalize economic conditions following this accommodative period, and to mitigate the risk of persistent inflation in the economy.

Central Banks are in the process of removing liquidity from the financial system at a time when general price levels are significantly elevated, and this will reduce deposit creation in the banking system. Combined with the higher levels of household and business expenses due to inflation, and the increases in debt servicing costs, it is plausible that excess deposit levels (that were added to the banking system to mitigate the societal impacts of the COVID-19 pandemic) would be removed by the summer of 2023. The extent of the reduction will remain dependent on the speed of monetary policy adjustments, combined with the propensity of households and businesses to reduce their spending and leveraged borrowing.

How has the changing environment impacted the way deposits are modelled?

Asset-liability management has become inherently more challenging in the last couple of years. On one hand, we experienced a rapid rise in the deposit base that was outpacing credit origination; to absorb it, financial institutions increased their holdings of securities, often with a hold-to-maturity view and under an amortized cost accounting election. These investment portfolios were reflective of the views of individual institutions of the value that they could derive from the surge in deposits over time, with the caveat that rapidly rising interest rates would make it economically disadvantageous to outright reduce portfolio holdings. However, the unprecedented velocity of rate hikes needed to combat inflation has also introduced uncertainty around the weighted average life and the rate sensitivity of client deposits.

While the general statistical modeling approaches remain largely unchanged, institutions are being more deliberate with their modeling granularity and in stress testing their deposit assumptions. We have seen an increase in the frequency of term profile adjustments, with additional capabilities to differentiate pricing responses based on client profiles. Furthermore, the complexity of the current operating environment requires a well-balanced and strategic approach to measuring and monitoring deposit levels at the individual client and the aggregate level. With the primary drivers of the current rate cycle being exogenous to financial institutions, it is paramount that macroeconomic variables are appropriately amplified in modeling approaches – these factors are likely to provide the leading indicators of system-wide deposit levels.

How can banks effectively measure and monitor deposit outflows?

Banks can effectively measure and monitor deposit outflows by assessing the behavior of deposits under different economic regimes and stages of economic cycles using historical data and statistical analysis. Given the speed and magnitude of policy rate changes, machine learning and artificial intelligence capabilities should be leveraged to better understand client level behavior, and the drivers for migration of funds between product types and institutions. This would help supplement existing deposit measurement and monitoring efforts.

What are some of the challenges banks face acquiring core deposits?

The primary binding constraint for core deposit growth is the aggregate level of deposits in the financial system, which is dependent on the economic cycle and level of monetary policy rates. Empirically, when aggregate deposit growth is lackluster, institutions focus on retaining and attracting deposit clients through product pricing. Trying to capture market share by pricing alone, however, inevitably leads to price matching by competitors, and declines in net interest margins for the system as a whole. These dynamics limit the opportunities to grow through market share acquisitions.

Financial institutions are further impacted by the differences in the demographic characteristics of their client bases, their geographic footprints, and their ability to sustain accretive asset-liability management practices. Institutions with stronger capital positions will likely continue to pursue reinforcement of their balance sheets through mergers and acquisitions, leading to further consolidation within the industry. Ultimately, the financial institutions that are in a position to offer well-differentiated products and to deepen institutional loyalty through proactive client engagement would be able to withstand the upcoming challenges related to retaining and growing their deposit base.

Why should banks assess the transfer of rate increases to clients?

In most simple terms, financial institutions have the ability to derive franchise value from actively managing deposit pricing in support of both increasing the size of their balance sheets and improving net interest margins.

At any point of time, several deposit product offerings are available to clients. These have distinct characteristics. Low interest bearing customer accounts, for example, serve to provide instantaneous access to liquidity, whereas term deposits are more or less an alternative to fixed income investments. Deposits that are less sensitive to the levels of interest rates and to the prevailing economic cycle are deemed to be inherently stable, and enable a bank to conduct maturity transformation in their role as a financial intermediary. This maturity transformation is a necessary prerequisite for credit creation, and further supports economic growth. Correspondingly, increased price sensitivity of deposits can erode the ability of the bank to effectively perform this maturity transformation and therefore hinders its ability to adequately intermediate liquidity, credit and duration risks.

An assessment of client rate pass-through enables banks in appropriately classifying its deposit segments and in identifying stable deposits that can support credit-creation and maturity transformation. Through their funds transfer pricing processes, financial institutions can therefore provide the necessary repricing incentives for their salesforce to ensure a more agile market place response, enabling more effective asset-liability management practices.