Competition will hold back loan betas, but margins will still expand

Introduction

Banks looking to deploy enormous stockpiles of idle liquidity will compete aggressively for borrowers, but loan yields will still be considerably more sensitive to short-term interest rate increases than deposit prices, helping net interest margins recover off record lows.

Higher interest rates will offer a material lift for loan yields, but competition for new credits will mitigate the benefit. Loan betas — or the percentage of changes in the fed funds rate that banks pass onto borrowers — will be lower in the upcoming rate hike cycle when compared to other periods, as the abundance of excess liquidity in the banking industry should spur greater competition for credits. However, deposit rates will increase more slowly than the rise in fed funds might suggest due to the excess cash on bank balance sheets, resulting in notable margin expansion.

The Fed began raising short-term rates in mid-March and is expected to continue tightening monetary policy through further rate increases and by shrinking its nearly $9 trillion balance sheet. S&P Global Market Intelligence projects loans to grow 6.75% from year-ago levels in 2022, but that growth will not be great enough to put the trillions in excess cash sitting on bank balance sheets to work.

Due to strong competition for new loans, we projected an industrywide loan beta of 25% in 2022 and 31% in 2023, substantially ahead of projected deposit betas of 6% in 2022 and 17% in 2023, as excess liquidity reduces the need to pay up for funding.

Expectations for future rate hikes have risen considerably over the last month, and if the Fed does aggressively increase short-term rates in 2023, loan yields and deposit costs would be substantially higher than we initially forecasted. However, loan yields should still rise at a quicker pace than deposit costs, continuing the trend witnessed during the last tightening cycle.

The industrywide yield on loans and leases made a relatively steady ascent across the gradual series of rate hikes that took place from late 2015 through late 2018, rising from 4.59% in the third quarter of 2015 to 5.51% during the second quarter of 2019, according to data from S&P Global Market Intelligence. That meant that loan yields rose about 92 basis points across an increase of 226 basis points in fed funds, resulting in a beta of 40.9%.

Meanwhile, the cost of deposits rose 65 basis points over the same time to 90 basis points, for a beta of 28.9%.

The data fit a historical pattern, where bank net interest margins have typically expanded when short-term interest rates are rising and declined when they are falling. There were just two exceptions across 10 tightening or easing cycles since the 1980s, according to researchers at the Federal Deposit Insurance Corp.

Banks are asset sensitive

Loan yields should once again prove to be more sensitive to interest rates than deposit prices during the current tightening cycle, helping to undo some of the damage to net interest margins during the pandemic.

As interest rates plunged over the last few years, loan yields and deposit costs fell in tandem, with a sharper drop for loans. The industrywide yield on loans and leases tumbled 118 basis points from the second quarter of 2019, just before the most recent easing cycle began, to 4.34% in the fourth quarter of 2021. Over the same time, deposit prices fell 78 basis points to 0.11%, using up most of the room available above the zero lower bound.

However, movements in loan yields over interest rate cycles have not always been straightforward, reflecting factors like interest rate floors that can mute rate sensitivity, maturity profiles and sometimes intense competition for borrowers.

For example, loan betas were negative through the first two calendar quarters after an initial rate hike in June 2004, a period of intense competition for new loans. Average loans and leases increased 10.2% from the first quarter of 2004 to $6.022 trillion in the fourth quarter of that year, as yields fell from 5.09% to a bottom of 4.60% in the third quarter before recovering to 4.93% during the last quarter of the year. Loan and lease yields ultimately reached a peak during that cycle of 7.21% in the fourth quarter of 2006.

Commercial loans set for a big boost

For individual banks, loan betas will be heavily influenced by portfolio composition, with categories like commercial and industrial, or C&I; and consumer, excluding mortgages, tending to encompass floating-rate loans.

The C&I yield across the industry increased 137 basis points from the third quarter of 2015 to 5.08% in the second quarter of 2019, compared with an increase of 92 basis points for loans and leases overall. The industrywide consumer loan yield, including credit cards, increased 224 basis points over the same period to 10.74%.

A number of banks with heavy concentrations of C&I loans, like Comerica Inc., posted strong loan betas during the last tightening cycle. Capital One Financial Corp. and American Express Co., with large credit card portfolios, did too. Both also operate large online deposit platforms, however, and have reported relatively low overall sensitivity to changes in interest rates.

Broadly, banks with the highest betas during the last tightening cycle tended to have above-median concentrations of C&I and consumer loans, and banks with the lowest betas tended to have below-median concentrations.

To be sure, loan portfolio concentrations are not static, and much will depend on where banks pursue growth, and where they seek to trim. Broadly, however, liquidity deployment is likely to be a force that lifts many boats.

^{IHS Markit is now part of S&P Global.}

^{This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.}