The era of unbridled deposit growth appears to be coming to an end as the Federal Reserve ratchets up interest rates and starts to shrink its balance sheet.

Industrywide deposits in the U.S. increased just 1.1% in the first quarter, well below the quarterly average of 3.8% since the beginning of 2020, according to data from S&P Global Market Intelligence. Weekly Fed data showed an outright decline over the first five weeks of the second quarter.

Curinos, a data company for financial institutions, expects both consumer and commercial deposits to be flat to slightly down over the next six to 12 months, said Adam Stockton, director of retail deposits. The company believes that loan growth would have to exceed 10% to offset money the Fed will drain from the system by cutting its bond holdings by $1.1 trillion annually once the reductions are fully phased in. Banks create deposits by lending.

Banks are flush with cash from the extraordinary growth in deposits during the pandemic, insulating them from the need to raise deposit prices quickly. Still, analysts say that outflows could produce strains and result in smaller pools of earning assets than investors are counting on.

"Deposit dynamics are likely to be where the next round of positive [and] negative surprises emerge," BofA Global Research analyst Ebrahim Poonawala said in a note on May 9, citing substantial differentials across banks in excess liquidity and the stability of the deposits they hold.

Growth tails off

The $191.52 billion increase in deposits in the first quarter compares with cumulative growth of $5.159 trillion since the end of 2019 as the Fed pumped money into the economy and federal pandemic aid helped fatten consumer and small business accounts.

Banks like JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. said in April earnings reports that they anticipate their deposits continuing to grow, though they acknowledged uncertainty. "This is a fun question," CFO Jeremy Barnum said, but "our base case remains modest growth." BofA said its deposits grew 5% in the 12 months preceding the last peak in rates and deposit costs before the pandemic.

But other banks described expectations for deposit outflows, with Regions Financial Corp. anticipating that $5 billion to $10 billion will leave its balance sheet, even though it projected that higher interest rates will help deliver a large boost to net interest income overall.

Industrywide deposits dropped 1.1% from March 30 to May 4, according to the weekly Fed data, although they were about flat after seasonal adjustments. The Fed first increased its target rate by 25 basis points on March 16, and then by another 50 basis points on May 4. The central bank will start trimming its bond holdings, and taking cash out of the system, in June.

Reductions in the Fed's balance sheet will tend to pull money directly out of commercial deposits as institutions absorb the bonds, Stockton said, though there is also pressure on consumer deposits from inflation that is outrunning wage growth and a rebound in spending as people make purchases for trips and other services that were deferred during the pandemic.

While primary checking relationships continue to give banks one of their most stable and lowest-cost sources of funding, such balances could also be vulnerable to outflows since that is where much of the pandemic surge wound up, Stockton added. "If we do see a massive wave of increased revenge spending, then that's going to come out of the banks who have built up the most in terms of cushion."

Wolfe Research analyst Steven Chubak screened banks for factors including jumps in percentages of noninterest-bearing deposits, lower liquidity and higher loan growth outlooks to identify those with weaker funding profiles in a report May 8.

"This should be the biggest driver of performance dispersion in the months ahead," Chubak said. "With the Fed poised to tighten aggressively we believe funding stresses will begin to emerge and those banks that did not manage their balance sheets conservatively will run into issues."

Inflection for deposit prices

Banks' aggregate cost of funds was flat from the fourth quarter at 0.15% in the first quarter, according to S&P Global Market Intelligence data. The period was the first quarter without a sequential decline since the second quarter of 2019, and funding costs appear likely to head higher from here.

Cullen/Frost Bankers Inc. said it raised deposit prices after the first rate hike to be competitive, and Bank OZK said its cost of interest-bearing deposits probably hit an inflection point in February.

Online banks, which generally did not see the same kind of pandemic surge in deposits that traditional banks did, have been raising rates faster than during the last hiking cycle, Stockton said. But "retail more broadly, we think is going to have a longer and deeper lag this time around because of the excess liquidity in the system."

Commercial deposit prices are typically "quite a bit" more sensitive to rising interest rates since banks frequently negotiate them individually with clients, said Peter Serene, director of commercial banking at Curinos. "They have customers that they're working on deepening relationships with and so they want to use prices as a lever to help with that."

Abundant funding should help on the commercial side too, but the rapid Fed hikes anticipated by markets will create a challenge, Serene added. "A slow pace of hikes is your friend if you're a bank because people are a little less attuned to the rate environment. … It gets harder if rates are moving very quickly."