Deposit price sensitivity tops earlier cycles, keeping pressure on margins

Deposit costs have been highly sensitive to surging interest rates in the current cycle, and analysts expect more compression in bank net interest margins (NIMs) before the key revenue metric levels out maybe early in 2024.

The cumulative deposit beta, or the change in deposit costs as a percentage of the change in underlying short-term rates since the Federal Reserve started lifting its target in early 2022, hit 33.9% for US banks combined in the second quarter, racing past the mark reached over an equivalent time interval in the two previous rate-increasing cycles, according to data from S&P Global Market Intelligence.

The Fed moved far faster this time in response to high inflation and a resilient economy, and many banks have been forced to periodically revise their forecasts for deposit price increases higher. Further increases in deposit costs are widely anticipated even if the Fed's target is at or near its cyclical peak; at 1.8% in the second quarter, industrywide deposit costs still have considerable room to catch up with wholesale overnight rates of about 5.3%.

Now, a surge in long-term interest rates that started in late September could add pressure. Higher-for-longer rates have the potential to challenge consensus outlooks, BofA Global Research analysts said in a note Oct. 4. "In particular, [a] consumer shift towards time deposits could lead to higher terminal deposit betas even if the Fed is done after one more hike."

Inflection postponed

Large bank deposit and net interest income outlooks did stabilize in intra-quarter updates in September.

"Virtually all the banks that touched on beta expectations reaffirmed their prior forecasts," Piper Sandler analysts said in a note Sept. 15.

Still, those outlooks incorporate further increases in deposit costs, largely driven by rotation into more expensive account types.

Consensus forecasts anticipate further declines in NIMs in the third and fourth quarters, followed by stabilization in early 2024, Janney Montgomery Scott analysts said in an analysis Sept. 28.

Moreover, share prices could reflect the belief that bank outlooks and analyst estimates are too high. Bank stocks are trading at roughly 20% to 30% below historical earnings multiples, Raymond James analysts said in a note Oct. 5. "While many management teams believe NIMs will likely trough at some point in [the second half of 2023 or the first quarter of 2024], we are concerned that the recent increase in rates and a higher for longer environment could result in further NIM pressure throughout 2024, which could further pressure estimates."

Loan yields are sensitive too

Loan yields have also jumped, initially outstripping increases in deposit costs and helping to fuel NIM expansion early in the cycle.

The industrywide yield on loans and leases reached 6.5% in the second quarter, according to data from S&P Global Market Intelligence, up from 4.3% in the fourth quarter of 2021 before the Fed started raising rates, and it has room to increase further particularly as banks tighten standards and become more selective about extending credit.

"New loan yields today are significantly better than a year ago, and discipline continues to strengthen at banks, given true 'credit scarcity,'" the Janney Montgomery Scott analysts said.

The BofA Global Research analysts also see an offset in the recent surge in long-term rates. "Banks with fixed rate assets or roll-off in prior fixed rate hedges ... could be better positioned to mitigate some of the funding cost squeeze over the next 12 to 24 months," they wrote.

Highest and lowest betas

To be sure, deposit and loan pricing dynamics can vary widely at individual institutions, largely reflecting differences in business models that carry over from cycle to cycle.

Banks that depend heavily on online deposits and have no or relatively small retail branch networks, like Synchrony Financial and Discover Financial Services, tend to have high deposit betas, for example.

Some of the same institutions tend to have high loan betas, however, reflecting factors like high exposure to variable-rate credit card loans.

Broadly, however, changes in NIMs reflect a race between loan yields and deposit costs, and lately betas for deposits have been increasing faster than for loans.