Facing Federal Reserve rate increases and intensifying competition for customers, more community and midsize banks have started offering high-yield deposit accounts to keep up, in a strategy that risks cannibalizing lower-cost deposits from existing customers.

The industry median cost of funds — calculated as total interest expense as a percentage of average interest-bearing liabilities and average non-interest-bearing deposits — was 0.95% as of March 31, up 32 basis points quarter over quarter and 66 basis points year over year, according to S&P Global Market Intelligence data.

Albuquerque, NM-based DSRM National Bank had the largest increase in its cost of funds of any US bank as of the first quarter, with a 400-basis-point rise sequentially to 5.60%. Houston-based Cornerstone Capital Bank SSB, Miami-based Newtek Bank NA and Eden Prairie, Minn.-based American Investors Bank and Mortgage were among the banks whose cost of funds rose above 3% in the quarter.

Banks' costs rose as the central bank hiked rates aggressively over the past year in an effort to tame inflation, and a string of bank failures in the first half of 2023 brought liquidity and deposits into sharper focus. Customers who might have stayed with a bank when rates were low are now "shopping their deposits," First Horizon Corp. CFO Hope Dmuchowski said during a bank industry conference in June.

"Recently, they have become hyper-aware, post-Silicon Valley, of the very highly competitive deposit industry," Dmuchowski said.

"Banks have not really had to compete aggressively for deposits since 2008, so that means that their playbooks are really very rusty," Kris Lazzaretti, head of data-driven marketing at payments and business technology company Deluxe, said in an interview.

Banks push deposit rates

California-based First Foundation Bank offers a high-yield savings account with an annual percentage yield of 4.85%, putting it in line with some of the highest offers in the industry.

The company's cost of savings accounts is 3.01% and its cost of interest-bearing transaction accounts is 2.69%, well above the industry medians of 0.73% and 0.41% respectively, according to Market Intelligence data. First Foundation's cost of savings accounts rose 284 basis points year over year and its cost of interest-bearing transaction accounts rose 241 basis points over the same period.

First Foundation aims to put out a competitive rate while remaining focused on customer relationships, COO Christopher Naghibi said in an interview. First Foundation's high-yield savings is bringing in a "healthy amount" of deposits, in part because of the ease with which customers can open accounts online, Naghibi said.

Columbus, Ohio-based Northwest Bancshares Inc. launched its high-yield savings account as a pilot to reach customers outside of its branch footprint, Chief Marketing Officer Devin Cygnar said in an interview. The pilot had already exceeded its deposit growth goals for the end of June by nearly 10%, Cygnar said, though he declined to say what the specific goals were.

Northwest's cost of savings accounts rose to 0.83% from 0.25% in the year-ago quarter, and its cost of interest-bearing transaction accounts rose to 0.21% from 0.05% over the same period.

Northwest's high-yield savings account currently offers an annual percentage yield of 4.2%. The company sets the rate based on what competitors were offering in order to stay near the top of rate boards such as Bankrate, Cygnar said.

Horicon, Wis.-based Horicon Bank launched its digital bank brand, KindMoney, to reduce its exposure to its certificate of deposit offerings, CEO Fred Schwertfeger said during Market Intelligence's 2023 Community Bankers Conference.

KindMoney's annual percentage yield on its money market account is 4.75% compared to just 0.95% for Horicon's. At 0.63%, Horicon's cost of savings accounts remains below the industry median but is still up 48 basis points year over year.

In order to build scale, community banks need to have a strong digital offering, Schwertfeger said. KindMoney was able to build scale quickly, and within six months, the digital bank has more in total deposits than eight of Horicon's physical branches, he added.

Deposit marketing strategies

While some banks are finding success in drawing in new deposits with high-cost products, they also run the risk of lowering their net interest margins by paying higher rates per customer, as well as by cannibalizing existing accounts when existing depositors switch to higher-yielding products.

To mitigate those risks, banks can target new rather than existing customers to avoid cannibalizing and can cross-sell lower-yielding products, such as checking accounts, to customers with high-yield savings accounts.

First Foundation tries to prevent its high-yield savings account from eating into its net interest margin by cross-selling other products — such as treasury management services, remote deposit capture, and checking or operational accounts — to depositors with high-yield accounts, Naghibi said.

Some of the largest financial institutions, such as JPMorgan Chase & Co. and Citigroup Inc., focus on acquiring core consumer checking households first, and then offering additional products such as high-yield savings and certificate of deposit accounts, Lazzaretti said.

"Once you win the checking relationship, you can then very effectively cross-sell into the high-yield relationship and have a much stickier relationship overall, so you don't end up with a single-service household," he said.

In a June 12 conference appearance, Aron Levine, president of preferred banking at Bank of America Corp., called the bank's base of checking accounts, in which customers typically are not focused on yield, "a very powerful engine" for maintaining stability.

Northwest is "very careful" with the marketing of its high-yield savings accounts, with most promotion coming through highly targeted ads on social media, Cygnar said. More than 75% of the balances in the bank's high-yield savings accounts are new, he added.

Horicon is targeting its digital marketing to new customers and could rein in its digital bank's growth by ceasing to advertise on Google, Schwertfeger said. Still, it is important not to be a "bait and switcher," cutting rates after onboarding customers, he added.

"You have to stick with it and be prepared that there's an audience that will be enjoying a high rate," Schwertfeger said.