Net interest margins across the U.S. banking industry expanded in the third quarter but some members of the investment community are beginning to question how beneficial further increases in short-term rates will be as deposit costs migrate higher.

Bank margins rose 3 basis points in the third quarter, buoyed by increasing loan yields. The industry's taxable equivalent net interest margin rose to 3.40% from 3.37% in the second quarter of 2018 and 12 basis points from 3.28% a year earlier.

Margins for the industry have rebounded considerably after coming under pressure in the first quarter of 2018. That compression marked a break from the consistent expansion reported at the recent low point sustained in the first quarter of 2015. Margins fell early in 2018 as lackluster loan growth sparked fierce competition for quality credits, limiting the expansion in loan yields. Increases in short-term rates have propelled loan yields higher since but the moves seemed to benefit banks' loan portfolios less in the third quarter.

The banking industry's yield on loans and leases increased to 5.38%, up 13 basis points from the linked quarter and 42 basis points from a year earlier. Yields expanded as the three-month London interbank offered rate and the 10-year Treasury yield increased 102 basis points and 68 basis points, respectively, from the year-ago quarter.

Yields on commercial and industrial loans continued to rise the most in the third quarter, given that those credits are usually tied to short-term rates such as Libor or Prime. While C&I yields rose, they still lagged the increases in short-term rates, in part due to competition. The beta on C&I loans, or the percentage of changes in three-month Libor over the last 12 months that banks passed on to borrowers, equated to 55%, down from 62% reported in the prior quarter.

That trend could continue, with bankers saying in the Fed's recent quarterly senior loan officer survey that spreads on C&I credits remained under pressure. They noted that spreads on C&I credits to larger and middle-market firms, relative to their cost of funds, contracted for the 35th consecutive quarter. That survey featured responses from 70 domestic banks and 22 U.S. branches and agencies of foreign banks and focuses on changes in lending standards and terms.

In the survey, a net 26.5% of banks responding reported weaker spreads on C&I loans to large- and medium-sized firms, relative to the lenders' cost of funds, down slightly from 31.9% in the previous quarterly survey, published in July.

S&P Global Market Intelligence found in a separate analysis of the nonsyndicated commercial loan market that spreads contracted modestly for some lower-rated loans and higher-rated credits. The average spread above Libor for higher-rated credits fell 2 basis points to 204 basis points in September. The average spread for a lower-rated borrower dipped to 269 basis points, 3 basis points lower than a year earlier.

Banks with exposure to longer-dated loans have felt even greater pressure as the yield curve has flattened. The yield on the 10-year Treasury surpassed 3% in the third quarter and continued to trade above that threshold for several months, the first sustained period above that level since 2011.

Despite notable increases in long-term rates, yields on longer-term credits such as one- to four-family mortgages and some commercial real estate loans failed to increase substantially. In the third quarter, the yield on commercial real estate loans rose 36 basis points from a year ago, while the yield on one- to four-family mortgages climbed just 15 basis points.

Loans priced along the long end of the yield curve might not receive as big a boost next year, with economists expecting an average 10-year Treasury yield of 3.38% in 2019, up 42 basis points from 2018, compared to the 63-basis-point year-over-year gain expected this year. Further increases in rates will no doubt lead to higher yield, but deposit costs are beginning to rise at a faster pace.

The deposit beta, or the percentage of changes in market rates that banks pass on to their customers, rose to about 39% through the first nine months of 2018, up from the nearly 20% level experienced in 2017.

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