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US bank margins crushed in Q2, falling to record lows

U.S. bank margins plummeted in the second quarter of 2020 as institutions found few opportunities to put excess liquidity to work outside of the low-yielding credits associated with the government's small-business rescue program.

Bank margins took a nose dive in the period, dropping 41 basis points in the second quarter, with the industry's taxable equivalent net interest margin falling to 2.74% from 3.16% in the prior quarter.

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Bank margins fell sharply as higher-yielding assets originated before interest rates moved to historic lows moved off banks' books and were replaced by loans and securities with lower yields. While the swift drop in rates earlier in 2020 put pressure on many earning-asset yields, the situation was exacerbated in the second quarter by the inflow of many loans originated through the Paycheck Protection Program, which carry rates of just 1%.

The program offered small businesses low-rate, forgivable financing, provided that borrowers use a majority of the funds for payroll. While the loans carry low rates, the credits are expected to bring fees of about 3% on average once loans are forgiven. That is not expected to occur until the third or fourth quarter or possibly 2021.

In the meantime, the roughly $520 billion in PPP loans banks originated in the second quarter weighed on the industry's loan yield. Loans originated through the government's small-business rescue program were responsible for the industry's entire loan growth in the period. When excluding PPP loans, loans declined 4.1% from the prior quarter.

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Yields on total loans and leases dropped to 4.46% in the second quarter from 5.11% in the prior quarter and 5.51% a year ago, with the decline in commercial and industrial loan yields leading the way. Yields in that asset category, which included the low-yielding PPP loans, plunged to 3.63% in the second quarter from 4.44% in the first quarter and 5.08% a year earlier.

While loan yields dropped, in part due to the inflow of PPP loans, bank margins came under pressure as deposits flooded into the banking system and left institutions with excess liquidity. Deposits continued to grow at a fast clip in the second quarter, increasing 7.5% from the prior quarter and 20.8% from year-ago levels. Banks parked many of those funds in low-yielding interest-bearing balances due — deposits at other banks— which jumped nearly 22% from the prior quarter.

Institutions also took the excess cash and put it to work in their securities portfolios, growing those positions 7.3% from the prior quarter. While those investments offer higher yields than keeping funds at other banks, the sharp decline in long-term interest rates and the support in the credit markets offered by the Fed have kept a lid on yields of many bonds.

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Most economists do not expect interest rates to rise or the Fed support to abate anytime soon, meaning that banks are unlikely to find many new higher-yielding opportunities to redeploy funds held in short-term assets. However, there are some questions about the surge in deposits and whether some of the growth was temporary.

Stimulus checks from the government offered a large boost to consumers' incomes and sent savings rates to 33.5% in April, the highest level on record. In May and June, the metric remained above the previous highs recorded over the last 60 years, coming in at 24.2% and 19.0%, respectively.

Deposit balances have also benefited from efforts by many corporates to bolster their own liquidity, drawing on outstanding credit lines and issuing debt in the capital markets to prepare for the unknown. The PPP might have supported deposit growth in the second quarter as well, as some borrowers likely deposited large portions of the funds they received but planned to utilize those funds over the following weeks and months.

The buildup in deposits helped banks cut deposit rates pretty substantially in the second quarter. Banks' cost of interest-bearing deposits dropped to 0.45% in the second quarter, down 40 basis points from the linked quarter and 57 basis points from a year earlier.

Even with the substantial declines in deposit costs, earning-asset yields dropped at a quicker pace, leading to margin pressure.

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