A funding squeeze has cranked up an already heavy pressure on bank deposit costs, raising expectations for further price increases and crunching down net interest margin forecasts.

Deposit competition among banks, which had already intensified leading up to the pair of large bank failures in mid-March, has since entered a significantly more challenging phase. Price performance at about one-third of the largest US banks was already worse at 2022-end, well before the current cycle finished playing out, than in the previous interest rate tightening cycle.

The deposit picture "was hard before [Silicon Valley Bank] failed, and it's only gotten harder," said Christopher McGratty, head of US bank research for Keefe Bruyette & Woods. "Banks are scrambling to retain deposits."

Analysts said the heightened pressure could hit small banks disproportionately as some depositors move to big banks deemed too big to fail. Although flows appear to have stabilized from a spike at the outset of the turmoil, bank balance sheet positioning is under scrutiny, and the potential for deposit shifts to reignite persists.

Even more competition

Average deposit costs across the industry increased by 90 basis points from the fourth quarter of 2021, just before the Federal Reserve started increasing rates, through the fourth quarter of 2022, according to S&P Global Market Intelligence data.

Before the bank failures in March, Matt Pieniazek, president and CEO of Darling Consulting Group, said his firm's models anticipated another increase of about 85 basis points. Darling, which helps banks manage their balance sheets, also estimated that about 25% of peak nonmaturity deposits represented an abnormal pandemic surge, and of that surge, about 30% had already left the system and another 30% was at risk.

Now the failures "threw everything into a tizzy," Pieniazek said in an interview. He expects that outflows will be larger. The "fear factor" is also "going to accelerate funding costs even more because now the banks are nervous."

The industrywide cumulative beta, or the change in deposit yields relative to underlying rates across the cycle, already rivaled the 25.4% for the last cycle — from the 2015 third quarter to the 2018 fourth quarter — at 25.2% in the 2022 fourth quarter. Those figures are for total deposits, including those that do not bear interest.

Five of the 15 largest banks have already posted higher betas than the previous cycle, though that tally includes First Republic Bank, which has come under intense funding pressure, and First Citizens BancShares Inc., whose portfolio changed considerably since the last time because of the addition of a large direct bank through its merger with CIT Group Inc.

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Some banks continued to raise beta forecasts in guidance through March. Fifth Third Bancorp said March 8 that deposit costs would drive a miss to its net interest income forecast, as did KeyCorp the day before. For KeyCorp, the price pressure that lurched higher in the 2022 fourth quarter intensified again in February. KeyCorp increased its forecast for the peak cumulative beta to a mid- to high 30% range, from the mid- to high 20% range before.

Those March updates came as interest rates were peaking after hawkish remarks by Fed Chairman Jerome Powell, but the bank failures have since lowered expectations for the path of rates.

Even though the forward curve ended the first quarter looking closer to where it was at the end of 2022, banks and analysts expect lagged pricing increases on deposits to persist.

"Whenever the Fed is done, there's still going to be residual deposit pricing [pressure] because rates are still high until they cut them," McGratty said in an interview. "I wouldn't expect the pressure on funding costs to go away anytime soon."

Expensive flows

Some of the cost pressure is coming from accelerating shifts into higher-yielding accounts and out of non-interest-bearing ones.

Cumulative betas for interest-bearing deposits are naturally higher than for deposits overall. For interest-bearing deposits, the industrywide figure was 34.4% through the 2022 fourth quarter, already higher than the full-cycle figure of 32.9% last time, according to Market Intelligence data.

Commercial deposit outflows have stabilized to levels about the same as before the Silicon Valley Bank failure, after a spike driven by safety concerns and a recognition of the need to diversify payment options at small and medium-sized businesses, Adam Stockton, director of retail deposits at Curinos, a consulting and data firm, said in an interview.

There appears to be a "longer tail" in the acceleration of wealth outflows, Stockton added, as individuals with large balances assess their positioning. "A wealthy customer has other options that aren't zero risk, but are fairly low risk" like Treasurys and money market funds, Stockton said. The failures "may have spurred people on the wealth side to look more proactively at their overall cash allocation strategy."

Stockton noted that many banks still have considerable deposit resources. He expects that the recent turmoil will broadly put pricing on a higher trajectory, but "the change isn't going to be extreme and it's not going to be overnight."

Uneasy calm

While flows have steadied, banks and their advisers are keeping their guard up.

"We are looking pretty steady and stable right now," Stockton said. "One thing that's in the back of all bankers' minds, though, is things can change more quickly these days than they did in the past. With social media, there is the potential for a crisis to spread quicker than it did historically."

Pieniazek said the vast majority of his clients experienced "very manageable outflows, and they have stabilized" as banks have raised deposit rates to become more competitive with alternatives.

The most flighty money "heads for the hills first," he said. "Those who are going to move and react to this already did."

Nevertheless, if "regulators allow another bank to fail because of liquidity," Pieniazek added, "I think this thing starts round two."