US banks' margins contract at faster pace in Q1 2024

Most banks' net interest margins declined at a quicker pace in the first quarter than in the prior quarter as deposits remained precious.

Funding costs continued to rise in the first quarter, while loan yields actually dipped from the prior period, leading to additional margin pressure. Deposit costs ground higher as funds shifted into higher-cost deposit products. The median taxable equivalent net interest margin of the banking industry dipped to 3.28%, down 7 basis points sequentially, after falling 1 basis point in the fourth quarter of 2023 and 4 basis points in the 2023 third quarter, according to S&P Global Market Intelligence data.

Banks pay up to defend deposit bases

Deposits grew again in the first quarter for the second consecutive quarterly period, rising 1.0% from the prior quarter. The two periods of growth reversed six straight quarterly declines as institutions increased what they paid for deposits and narrowed the gap with rates available in the Treasury and markets.

The banking industry's aggregate cost of deposits rose to 2.37% in the first quarter, up 6 basis points from a quarter earlier. The increase was smaller than the 21-basis-point sequential increase in the 2023 fourth quarter, but it stood in stark contrast to the 2-basis-point decline in loan yields in the period.

Deposits costs continued to rise as banks faced ongoing regulatory pressure to maintain ample liquidity while expectations for rate cuts by the Federal Reserve were pushed out later in 2024. In December 2023, the futures market projected as many as seven rate cuts by the Fed in 2024 but now assigns a 30% probability of two rate cuts and a 43% probability of just one cut in 2024.

A pivot in rates would offer some relief from deposit pricing pressure, though banks have also seen the mix of deposits change considerably, as customers shifted funds out of non-interest-bearing deposits and into higher-cost products for institutions, like brokered deposits and certificates of deposit. That mix shift continued in the first quarter and will likely continue in the absence of rate cuts.

Loans shrink but fewer banks tighten lending standards

Banks continue to prize liquidity, and loans actually contracted in the first quarter. In the period, total loans dipped 0.3% from the linked quarter, after growing 0.9% on a sequential basis in the fourth quarter. Pressure on deposits and relatively slow loan growth caused the industry's loan-to-deposit ratio to increase in 2023, but bank liquidity has not been as levered in the last two periods. The industry's loan-to-deposit ratio dipped to 65.4% from 66.2% in the fourth quarter and 66.5% in the third quarter.

Banks have restricted credit in recent quarters by tightening lending standards, while demand has remained weak, but the pace of tightening slowed in the most recent period, according to the Fed's latest Senior Loan Officer Opinion Survey, published in April. The Fed's H.8 data, which tracks commercial bank balances weekly, shows that loans in the second quarter have dipped 0.4% through the week ended May 15. Meanwhile, deposits have fallen as well, declining 0.3% during the same period.

Broad deposit outflows appear to be in the rearview mirror as the gap between banks' deposit costs and higher-yielding alternatives have narrowed. Deposit growth in recent quarters has come at a cost, particularly as banks continue to see more funds move into higher-cost certificates of deposit. The number of institutions marketing certificates of deposit above 4% has continued to grow through mid-May despite hopes for Fed rate cuts on the horizon; institutions will have to eat the rates on many of those products that carry one-year terms even if the Fed begins lowering rates.

Further increases in deposit costs should be relatively small and pricing pressure would ease if the Fed does lower rates later in 2024. However, funding costs might need to stabilize for margins to bottom, given the weakness in loan growth and the related pressure on loan yields. Loan yields may be challenged as banks could seek to attract new borrowers with fixed-rate loans that carry lower yields while offering institutions some protection against rate cuts by the Fed.