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Banks face 'wall of worry' when it comes to net interest margins peaking


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Banks face 'wall of worry' when it comes to net interest margins peaking

Banks have seen their net interest margins jump, but higher funding costs and looser monetary policy have the potential to put pressure on those gains.

Higher interest rates have helped boost the NIMs of the banking industry as deposit betas have lagged the Federal Reserve rate hikes. But funding costs are expected to increase, and signs of cooling inflation have some speculating that the Fed could cut rates as soon as 2023.

Against that backdrop, analysts expect only four of the largest 20 U.S. banks to expand net interest margins beyond 2023, according to S&P Global Market Intelligence data that excludes targets of M&A deals.

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Investor concern about NIM pressure was evident when M&T Bank Corp. saw a roughly 8% stock sell-off after it provided disclosures relating to funding trends, Hovde analyst David Bishop said in a report.

"The wall of worry regarding peak NIMs and potential funding pressure and accelerating deposit betas continues to build," Bishop said. "Typically, we have associated this type of volatility with issues related to asset quality or material regulatory issues."

Advisers believe banks should start anticipating a changing environment. The current streak of rate hikes is the most aggressive in modern banking history and many bankers have never experienced such an environment, but they should not hesitate to protect their margins now, said Matt Pieniazek, president and CEO of Darling Consulting.

"Don't wait until the Fed stops raising rates and begins to ease because the best time for banks to be thinking about this is now," Pieniazek said.

Next steps

Banks can protect their net interest margins from declining rates by buying longer-term fixed rate assets and shorter-term floating rate liabilities, Pieniazek said. He added that the last rising rate cycle of 2018 and early 2019 can serve as a cautionary tale, and noted that many banks chose to shorten assets and lengthen liabilities, not expecting rates to go down in the near term. Pieniazek noted that banks need to understand how their balance sheet will react and protect it if rates "go the other way."

As of now, many banks are asset sensitive and positioned to benefit from rising rates, but they will need to be ready to protect their margins against falling rates by sometime between the midpoint of 2023 and early 2024, said Todd Cuppia, a managing director at the financial risk management company, Chatham Financial. Clients of Chatham are heeding this advice. About 80% of the hedging activity Chatham has facilitated for clients in recent months has been against potential falling rate exposure using such instruments, he added.

Banks are using "vanilla" hedging strategies to protect themselves if rates fall, including interest rate collar transactions, interest rate swaps and purchasing floors, which will allow them to replace some of the lost income from falling rates, Cuppia said.

Depending on the structure they use, it is even possible for banks to benefit if the Fed lowers rates without mitigating exposure to rising rates, Cuppia said.

"That gives banks a way to sort of protect themselves as rates fall, but continue to benefit if that forecast turns out to be incorrect and rates continue to rise or don't fall as anticipated," Cuppia said.

Look out below

Every bank will eventually face net interest margin compression when the Federal Reserve is lowering rates, Pieniazek said.

Since declining rates are typically correlated with a weakening economy, the probability of credit issues rises and banks tend to increase reserves and provisions for delinquencies and defaults, Pieniazek said. Growth also becomes more difficult for banks as loan growth slows down in a tougher economy, he added.

"The irony is the regulatory community seems to be so fixated on rising rates when it's declining rates that are the greatest concern for the industry," Pieniazek said.