Let’s face it: watching interest rates over the past decade is like watching paint dry. Following the Great Recession, the Fed moved rates to near zero and just 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, as the industry gets used to low stationary rates, product innovation takes a break. Low rates make it almost impossible for banks to make money on deposit accounts, so most banks find revenue by organizing and optimizing individual products – a strategy that ends up being siloed.
But all this is about to change. Interest rates and inflation are both rising. The industry is entering an operating environment not seen in many years. In our vibrant digital world, where yesterday feels like last week and last week might even be last year, higher interest rates can feel unprecedented. Banking’s youngest executives only experienced a world of higher rates in the history books.
Higher rates change the rules of the game. Deposit accounts have economic value again, which is pulling banks away from their focus on product niches and towards a holistic view of the customer again. This great resurgence will bring product innovation back into the spotlight at banks.
Here are three threads we’ve seen emerge from their efforts so far.
1. Breaking down product silos to address the holistic needs of customers
Near-zero interest rates have disrupted consumer markets, prompting banks to focus on individual products rather than customers as a whole. In a world of ever-increasing rates, the weaknesses of this approach are increasingly exposed. Tomorrow’s leaders are shifting their focus to unifying both sides of the customer balance sheet to create value.
Some banks are more advanced than others on this front. Bank of America, for example, has achieved a nearly 99% customer retention rate by packaging its products to customers with an integrated loyalty program that recognizes the total value of their deposits and credit products. Its customers get better rates and better value with the more deposits they keep with the bank. A smart combination of assets and liabilities allows the bank to find value for itself and its customers.
But this is still more the exception than the rule. Banking requires an Amazon Prime-like approach for today’s customers. Bankers should explore ways to tie their deposit products to other business areas, such as linking deposit quantities to greater rewards for spending, or lower mortgage rates or rewarding customers for the total value of their deposits and loans at the bank.
2. Create there is and there is no banking
The rate hike has reminded banks of the eternal truth that not all deposits are created equal. The general rule is that the more sticky deposits are the better, and the most sticky tend to be those linked to current accounts. These accounts have a lower deposit beta – which is the portion of changes in the federal funds rate that banks must pass on to their depositors.
The difference in beta deposits creates a set of haves and have-nots. Banks with sticky, low-beta branch deposits have less pressure to raise account rates when Fed rates rise. They also have great flexibility to create loyalty programs that combine deposits and loans to drive new value for banks and customers.
On the other hand, if you are a “hot money” bank with a high beta, you pay dollar for dollar every time rates go up. As a result, the top of Bankrate.com is the most dangerous place to be in banking right now. If your name is on that list, it means you have to pay money every day that the rate increases just to keep the deposit you have.
The average annual percentage yield (APY) for savings accounts in the US is 0.21% right now. The average APY for the top 10 hot money banks that offer short-term deposits for above-average interest rates is 3.16%.
The spread will force banks funded by hot money to start thinking in new ways. Look for a new emphasis on branches, deposit product innovations such as teaser rates, integrated rewards and more.
3. New opportunities (and risks) in M&A
The impact of higher rates on the mergers and acquisitions ecosystem could be their biggest strategic consequence. History shows that higher rates will unleash a wave of M&A, as it creates a once-in-a-decade opportunity for liability-rich banks to increase their long-term equity returns, balance their loan portfolios and reduce reliance on commercial loans.
For example, in the last significant rate hike cycle of the early to mid-2000s, Capital One used smart acquisitions wisely to transform itself from a monoline lender to a true multi-purpose bank. Some of its competitors, such as First USA and MBNA, are not and have been acquired.
Today’s ecosystem can be a huge opportunity for mid-market banks—those not facing the capital constraints of the big players—to consider acquiring monoline or fintech lenders that may struggle to operate and fund themselves in a rising rate environment.
The time is now to dig out your history books and put on your thinking caps. After a long absence, banking innovation is back in the spotlight. It was a dangerous, stressful time—and an exciting time.