The rise of digital banking and fintech platforms has transformed depositor behavior, making it increasingly important for community banks to adapt their strategies to manage the cost of funds and remain competitive. This challenge has been a top concern for community banks in recent years, as rising rate sensitivity, digital banking adoption and evolving depositor expectations continue to reshape the industry. To stay ahead, community banks must understand these structural shifts and develop sustainable funding strategies.

The Growing Cost of Funds and Deposit Competition

Nearly 90% of community banks identified cost of funds as a very or extremely important issue, according to the Conference of State Bank Supervisors’ (CSBS) 2024 Community Bank Survey. This proportion has nearly doubled since the 2022 survey, reflecting both rising funding costs and heightened deposit competition.

The cost of funds has more than tripled since 2020, increasing from 0.74% in December 2020 to 2.85% by March 2024. As rates increased, depositors became more rate-sensitive, leading to greater money movement between banks and non-bank financial institutions.

Shifting Depositor Behavior: A Structural Change

Historically, deposit rates followed a slow, predictable cycle, with customer movements largely driven by bank-led pricing decisions. However, since 2022, digital tools and fintech’s have accelerated deposit flows, making customer behavior more dynamic and unpredictable.

• A growing proportion of deposit outflow events involved instant transfer apps like Zelle or Venmo, enabling same-day transfers.
• Deposit beta surged from 0.25 before the 2022 Fed funds rate hikes to 0.5-0.6 in 2023, meaning rate hikes are passed to depositors much faster.

This represents a fundamental shift in how depositors behave  — community banks must adapt by offering competitive products and leveraging customer relationships for retention.

Three Critical Questions Before Raising Deposit Rates

While higher rates may seem like the easiest way to compete for deposits, community banks should consider three strategic questions before making pricing decisions:

1. Does your bank need additional deposits?
   There’s only one fundamental reason to spend money on attracting deposits: because your bank has profitable ways to deploy them. Assess your overall funding strategy, including:
   
   
   • How much funding is needed for loans and other profitable uses?
   • How much of your current deposit base is at risk of outflow?
   • What alternative funding sources exist, such as correspondent banking services, liquidity lines or structured funding solutions that may provide flexibility while maintaining deposit pricing discipline?
     
     
2. Are you reacting to market data or individual complaints?
   Some institutions feel pressured to raise rates when a competitor does or when a single high-value customer demands higher returns. However, with today’s digital landscape, high-rate depositors are the most likely to move their money elsewhere at the next opportunity. Instead of chasing rates:
   
   
   • Use data to determine competitive but sustainable pricing.
   • Explore diversified funding options that align with long-term profitability and risk management strategies.
     
     
3. How can you optimize your deposit strategy?
   Attracting large-balance customers with premium rates is tempting, but these customers are more likely to move their funds quickly when rates shift. A more sustainable strategy is to:
   
   
   • Reward customers who use multiple products, such as treasury management services, commercial loans or wealth planning.
   • Incentivize relationship-based deposits over rate-driven accounts.
   • Consider requiring a depository account with every lending relationship. Breaking down silos between different departments can help identify your best customers and create a strategy that looks at the entire customer relationship.
   • Ensure deposit gatherers are being appropriately incentivized through product pricing and funds transfer pricing.

Strategic Takeaways for Community Banks

1. Cost of funds has risen significantly, and depositors are more rate-sensitive than ever. Community banks need a clear funding strategy before aggressively pursuing new deposits.
2. Digital banking and fintech platforms have made deposit flows highly dynamic. Offering niche digital banking solutions and real-time payments may help retain customers.
3. Rather than chasing rate-sensitive funds, community banks should focus on relationship-based deposits. Encouraging client engagement and establishing primacy with them as their main financial institution can increase the client’s net value.

By adapting to this new deposit environment, community banks can optimize their balance sheets while maintaining a competitive edge in an increasingly volatile financial landscape.