By James Gethings, Senior Manager, and Oliver Peacock, Manager, Simon-Kucher & Partners
The Bank of England (BoE) raised interest rates again by 0.25 percent to 1 percent on May 5. With the United Kingdom’s CPI (Consumer Prices Index) report showing annual inflation at 7 percent in March, the highest point since 1992, we will likely see continued rate rises throughout the year. High inflation and accompanying market conditions are strong areas of concern, but banks have clear opportunities to profit in a rising-rate environment.
Mortgage-margin growth possible—worries about volume shrinkage
If you had told bankers that they were getting higher interest rates a year ago, they would have been pleased with the prospect of additional margins. While this effect still holds true today from solely a margin perspective, there is a real concern about how rising rates will affect the mortgage market. So far, the market has remained strong through base-rate increases. The number of new prospective buyers increased 47 percent in the first week of March versus the five-year average1. UK mortgage-approval numbers stayed high throughout 2021 but are showing signs of reverting to pre-2020 levels in the early months of 20222. This could be due to buyers trying to lock in rates before they rise and continued delaying of post-COVID purchasing rather than a strong market.
Regardless, rising short-term rates leave bankers with real decisions about how to react with their mortgage pricing. The mortgage market saw a price war when rates were on the way down. Hiking mortgage rates intelligently (selectively, to minimise volume loss) across the product portfolio is much trickier.
Consumer sentiment indicates uncertain times ahead. The Building Societies Association’s (BSA’s) “Property Tracker” report in March found only 18 percent of people consider now a good time to buy a property3. Forty-nine percent of respondents said the affordability of monthly payments was a barrier to purchase, up from 39 percent in their report three months earlier4. It’s all very well to have the higher margins, but it’s not much use if you can’t get the volume. This makes it crucial for mortgage-pricing teams to understand customers’ price sensitivities across product portfolios to try to generate margins in a more targeted manner.
Average SVRs (standard variable rates) are also similar to what they were shortly after the financial crisis, so there may be limited headroom to extract margin from customers remaining at the end of their fixed terms. In addition to this, banks need to be cognisant of the broader economic environment when applying rate increases to their current portfolios. For instance, mortgage profit models need to account for potentially higher default probabilities.
To maximise the benefits of the increasing-rate environment, banks will need to consider the key trade-off of margin versus volume and optimise for mortgage NPVs (net present values) across the product portfolio. A competitive response will also be key since the single most important factor influencing a customer’s decision is the total amount payable on his or her mortgage.
As mortgage-pricing teams look to optimise their rates to meet their portfolio goals, they must be able to respond with precision and speed. Any change in rates across their portfolios should be supported by a clear understanding of customer elasticities, competitive behaviours and any other constraints under which the bank is operating (for example, market share, risk and cost to serve). Developing an intelligent, data-driven system that takes all these factors into account will allow bankers to optimise their responses to future rate changes and ensure they increase their margins.
Increased rate competitiveness in deposits
On the deposit side, it’s likely to become a much more interesting market. Recent entrants led the way in pushing rates higher, even before the Bank of England began its interest-rate hikes. At the time of writing this piece, the four highest rates on the market for large deposit sizes were all non-traditional UK market participants: JP Morgan Chase, Cynergy Bank, Zopa and Tandem Bank. Savings can be notoriously sticky, but High Street banks are having to and will continue to have to respond to keep their more price-sensitive savings customers. This will be especially tricky since banks have not had to consider this aspect of customer behaviour in several years and may have lost some muscle memory in the process.
Banks will need to consider whether to take the lead and increase interest rates, taking advantage of being at the top of the market to attract customers early and then relying on the customers’ stickiness as other banks raise their rates. If interest rates keep hiking past 2 percent in the next year, getting customers in at 1.5 percent and then increasing rates more slowly than competitors whilst retaining the stickier customers could be a good strategy. Although the banks that do push higher savings rates in the near term could be in a sticky situation if the mortgage market shrinks.
To make the best rate decisions, banks need to understand the rate sensitivities of their customer segments. All will have groups of customers who won’t leave their savings products regardless of the rate offered, and all will have customers who will leave as soon as the rising-rate environment makes a competitor’s offer look attractive enough. Differentiating approaches by customer groups will allow banks to have (part of) their cake and eat it, too.
Changing relationships between customers and their financial products
Banks have increasingly tried to differentiate product features to drive customer acquisition—with functionality for free accounts in the UK seeing tremendous growth in the past few years (the trick banks have missed here is probably giving away too much functionality for free). This is unlikely to change; however, the benefits may decrease. Over the past decade, customers who liked their current accounts likely used the accompanying savings accounts, even if the difference in rate between their savings accounts and competitors’ savings accounts was nominal. Customers in a high-rate environment are more likely to decouple their current and savings accounts. A savvy customer may keep a High Street bank’s current account for familiarity and a challenger bank’s current account for functionality but switch his or her savings account to whichever provider is offering the most attractive rate.
To combat this, banks need to consider how their products interact. By linking benefits in everyday banking functionality—for example, travel insurance and personal finance advice to savings and mortgage usage—they can combat the trend of customers increasingly using multiple providers. High Street banks already do this, but their functionality and feature propositions aren’t strong enough for their “premium” offerings to drive mortgage and savings behaviour when challenger banks’ functionality and feature propositions are so strong. High Street banks need to examine what their customers really want in their everyday banking relationships if they are to use it as a carrot to drive savings and mortgages. Driving customer primacy has to be the north star for banks.
Another trend that has impacted customers’ relationships with their banks is the accelerated digital adoption driven by the COVID-19 pandemic. Over the last two years, customers have developed higher expectations for digital interactions and personalisations. Traditional marketing within banks has historically been very product-centric and has often not considered the broader relationship with customers. This has been driven by the siloed structure of product lines and data within banks. To remain competitive and drive increased customer stickiness, banks will need to not only rely on functionality and strong rates but also deepen their relationships with customers through personalisation. Delivering a tailored message that includes the next-best offer to the right customer at the right time is a very effective way to encourage retention and drive engagement. If banks can develop this level of personalisation, they will create a loyal customer base and ensure that they remain competitive into the future.
The opportunity for which bankers have been waiting
Bankers have been presented with an opportunity through a rising interest-rate cycle. They face multiple challenges in driving margin expansion and growth. Bankers will need to develop disciplined, data-driven strategies that allow them to act with agility and precision to understand the price elasticities of customers across various cohorts and make volume-versus-margin trade-offs across product portfolios (on both sides of the balance sheet). This will enable them to optimize their responses to ensure they can fully capture the opportunities that such an environment presents.
1 BuyAssociation: “Will base rate rise hinder the fast-moving UK housing market?” March 18, 2022.
3 Building Societies Association: “BSA Property Tracker,” Simon Rex, March 17, 2022.
Oliver Peacock is a Manager in Simon-Kucher’s Financial Services practice in the UK. Oliver is an expert in dynamic pricing strategies and has helped banks optimise pricing for mortgages.