Let’s face it, monitoring interest rates over the past decade has been like drying paint. During the Great Recession, the Fed raised interest rates to near zero and let them dry there for years.
The recession and subsequent regulatory changes rightly prompted banks to focus their efforts on risk and compliance. More importantly, product innovation took a vacation as the industry adjusted to low in-person fees. Low interest rates made it almost impossible for banks to make money on deposit accounts, so most banks sought revenue by organizing and optimizing individual products – a strategy that eventually deepened into silos.
But all of that is about to change. Both interest rates and inflation are rising. The industry is entering an operating environment not seen in years. In our volatile digital world, where yesterday feels like last week and last week could be just as good as last year, higher interest rates can feel unprecedented. Recent banking executives have seen a world of higher interest rates only in the history books.
Higher rates change the rules of the game. Deposit accounts have economic value again, pushing banks away from a niche product focus and towards a holistic customer view. This grand reawakening will put product innovation back in the spotlight for banks.
Here are three threads we see emerging from their efforts so far.
1. Break down product silos to address the holistic needs of the customer
Near-zero interest rates distorted the consumer market, causing banks to focus on individual products rather than the customer as a whole. In a world of rising interest rates, the flaws in this approach are exposed. Tomorrow’s leaders are shifting their focus to bringing both sides of the customer balance sheet together to create value.
Some banks are further along this front than others. Bank of America, for example, has achieved a customer retention rate of nearly 99% by wrapping its products around the customer with an integrated loyalty program that recognizes the total value of their deposits and lending products. Your customers get better interest rates and value the more deposits they keep with the bank. The intelligent bundling of assets and liabilities allows the bank to find value for both itself and its customers.
But that is still the exception rather than the rule. Banking needs an Amazon Prime-like approach for today’s customer. Bankers should explore how to link their deposit products to other lines of business, such as B. Linking the amount of deposits to higher rewards for spending or lower mortgage rates, or rewarding customers for the total value of their deposits and lending at the bank.
2. Creation of advantages and disadvantages of banking
Rising interest rates have reminded bankers of the timeless truth that not all deposits are created equal. The general rule is that the more loyal the deposit the better, and the most loyal tend to be those associated with checking accounts. These accounts have a lower deposit beta — also known as the fraction of federal funds rate changes that banks are required to pass on to their depositors.
Differences in the deposit beta create a range of possessions and have-nots. The banks with sticky, low-beta branch deposits have less pressure to raise account rates when the Fed rate rises. They also have tremendous flexibility in creating loyalty programs that combine deposits and lending to create value for banks and customers.
Conversely, if you are a high beta “hot money” bank, you pay dollar for dollar every time interest rates rise. As a result, the top of Bankrate.com is the most dangerous place in banking right now. If your name is on this list, it means you have to pay money every day interest rates go up just to keep your deposits.
The average annual return on investment (APY) on a US savings account is currently 0.21%. The average APY for the top 10 hot money banks, which offer short-term deposits at above-average interest rates, is a staggering 3.16%.
This spread will force banks funded with hot money to start new ways of thinking. Look for a new focus on stores, deposit product innovations like teaser rates, built-in rewards and more.
3. New opportunities (and risks) in M&A
The impact of higher interest rates on the M&A ecosystem could be their biggest strategic implication. History shows that higher interest rates will spark a wave of mergers and acquisitions, as they offer highly-debt banks a golden opportunity to improve their long-term returns on equity, balance their loan portfolios, and reduce reliance on commercial loans.
For example, during the last significant rate hike cycle in the early to mid-2000s, Capital One used slick acquisitions to transform itself from a monoline lender into a true multipurpose bank. Some of its competitors, like First USA and MBNA, didn’t and were acquired.
Today’s ecosystem could be a tremendous opportunity for mid-market banks that don’t face the capital constraints of large players to consider acquiring monoline lenders or fintechs that may struggle to operate in a rising interest rate environment to finance themselves.
It’s now time to dig out your history books and put on your thinking caps. After a long absence, banking innovation is back in the spotlight. It’s a dangerous, stressful time – and an exciting one.