Rising Rates: It’s Time to Implement a Marginal Cost Culture in Your Bank

Rates are on the rise. Banks are watching what their competitors are doing with their deposit rates. Richard H. Thaler, Behavioral Economist and recipient of the 2017 Nobel Prize for Economic Sciences, once summed up the human gut-level emotion of peer pressure and competition: “An especially good way to gain weight is to have dinner with other people. On average, those who eat with one person eat about 3% more than they do when they are alone; members of a group of four eat about 75% more; those in groups of seven or more eat about 96% more.”

Being Mindful of Decision-Making Biases

The current rate environment stirs up the competitive juices of many a bank, causing deposit pricing decisions to come from error-prone biases as: availability (this just happened), outcome (that’s never happened), confirmation (that’s what I thought would happen) and salience (fear factor) and even the ostrich effect (that can’t possibly happen). To temper decision-making biases, now is a good time to pull out your college microeconomics textbooks and instill a marginal cost of funds culture within your bank.

The Role of Marginal Cost in Deposit Pricing

You remember the marginal cost equation, right? In any profit-seeking enterprise, it’s the relationship between the change in a firm’s total cost relative to the change in the quantity of goods produced. If your marginal cost exceeds your marginal revenue, you’re out-of-the-money. In the case of banking, the same concept would apply, especially in the areas of deposit pricing and promotion. Economic theory would dictate that if you are able to attract deposits at an incremental rate that is less than your marginal cost, you will attract funds below your marginal cost. The worst thing you can do is attempt to attract deposits at a rate that is higher than your marginal cost.

When it comes to deposit pricing, especially when you’re launching defensive strategies, it’s critical to get your bank to understand the concept and adopt a marginal cost culture. You’ll see that shifting to a marginal cost of funds mindset will help you minimize the cost of obtaining funding and force you to think about how your rate-sensitive members might impact any incremental deposit growth, as well as how varying degrees of rate sensitivity might alter your cost of obtaining funds in a rising rate environment.

Building an Effective Defensive Marginal Cost of Funds Strategy in a Rising Rate Environment

You’ve likely seen an inordinate degree of deposit growth in recent years. It’s been a tough environment in which to invest your low-cost source of funds. What will break the snap? The end of the zero-interest-rate policy? A decline in the savings rate? Reallocations of deposit dollars? Either way, you’ll need to assess your cost of funds not by gut or based upon what the competition is offering but by looking at how much it costs to fund your bank at the margin. Again, you need to consider the impact on your total funding costs for each increment of funding. Like many banks, it’s becoming more difficult to obtain non-interest income. It’s tough to cover expenses now that many banks are supporting loan-to-asset ratios well below 70%. Growing competition is placing stress on your asset and liability pricing. It’s time to adopt a data-driven deposit pricing decision-making culture in order to mitigate margin and earnings, and capital erosion.

Defensive funding strategies involve not having to unnecessarily pay for deposits that would have left your bank anyway, had you decided not to raise deposit rates. Paying up for deposit balances that you were never at the risk of losing can be very expensive. If not now, you may soon be asking yourself the question, “If my competitors are raising rates on their deposits, should I respond in lock-step?” As competitors raise deposits rates, do you “stand pat” and let the rate-sensitive depositors go elsewhere? Or, do you simply match the competition? In the “stand pat” scenario, it’s important to model the impact of letting rate-sensitive depositors leave and replacing the foregone funding with readily available wholesale alternatives.

In order to address that pivotal choice, you’ll need three basic ingredients: 1) Organization-wide discussion of segmenting rate-sensitive depositors from non-rate-sensitive depositors. That means treasury, lending, retail, and other pillars of your institution working together. 2) A just-in-time funding alternative for accurate comparative benchmarking. An example would be comparing the marginal cost of funding a deposit relative to an FHLB advance of comparable duration. 3) Data analytics that can assist you in quantifying your marginal cost of funding analysis and pricing campaigns. These analytics would include the marginal cost of funds, calculators, and tools that can help you assess the competitive product and market landscape.

Deposit betas are now low but can turn on a dime. We’re all watching for that first sign of a competitor’s deposit rate hike. Some are looking no further than the online banks to move first. You never know when deposit loyalty becomes more transient, and you’ll be focusing on preserving exiting funding levels. At the beginning of a rate tightening cycle, it’s important to develop defensive pricing strategies to avoid paying unnecessarily for deposits that would not have left anyway. Marginal cost of funding is not just about modeling various cannibalization and pricing scenarios. It’s about instilling a marginal cost culture within your bank. Eleanor Roosevelt had a great answer to the question of whether or not you should match a competitor’s deposit rates: “You wouldn’t worry so much about what others think of you if you realized how seldom they do.”