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Margin expansion ends for US banks

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Margin expansion ends for US banks

After years of increases, the U.S. banking industry saw net interest margins come under pressure in the first quarter.

Bank margins declined 4 basis points in the first quarter of 2019, with the industry's taxable equivalent net interest margin falling to 3.40% from 3.44% in the fourth quarter of 2018.

The linked-quarter decline came after the key profitability metric expanded for three straight quarters. Margins had risen over much of the last three years, rebounding from years of pressures stemming from persistently lower interest rates and fierce competition for loans. But that expansion halted as deposit costs rose at a quicker pace than loan yields in the first quarter and that trend could continue in the future.

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The loan yield for the banking industry posted a sequential decline in the first quarter, falling 3 basis points to 5.49%. Yields were still materially higher than year-ago levels, but the flattening of the yield curve in 2019, punctuated by sharp decreases in long-term rates, led to pressure on longer-dated credits.

Loans tied to short-term rates received a lift in the first quarter, with the average effective fed funds rate and three-month London interbank offered rate increasing by 95 basis points and 76 basis points, respectively, from a year earlier. Meanwhile, the yield on the benchmark 10-year Treasury rose just 10 basis points from the year-ago period.

Accordingly, in the first quarter yields on longer-dated credits such as one- to four-family mortgages dipped 3 basis points from the prior quarter, while yields on commercial real estate loans declined 6 basis points from the previous period.

The yield on the 10-year Treasury surpassed 3% in the third quarter of 2018 and traded well above that level for several months, but has fallen close to 75 basis points since the peak in early November. The average yield on the 10-year Treasury was 2.75% in the first quarter, compared to 3.04% in the prior quarter.

Banks with greater exposure to longer-dated credits might not see much rate relief soon either. Economists expect an average 10-year Treasury yield of 2.68% in 2019, down 24 basis points from the prior year. That stands in stark contrast to the 59-basis-point year-over-year gain in 2018.

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Increases in short-term rates did offer a lift to yields on commercial and industrial loans. The expansion in C&I yields still failed to match the increases in short-term rates, in part due to competition. For C&I loans, the beta — or percentage of changes in fed funds over the last 12 months that banks passed on to borrowers — was 67%. This was up from 51% in the fourth quarter of 2018 and 56% in the third quarter.

Spreads on C&I credits have been under pressure for much of the last nine years and contracted again in the most recent quarter. In the Fed's most recent quarterly senior loan officer survey, bankers said spreads on C&I credits to larger and middle-market firms contracted relative to their cost of funds. That marked a reversal from the prior quarter, when spreads expanded, ending 35 straight quarters of weakening. The most recent survey focuses on changes in lending standards and terms and featured responses from 73 domestic banks and 21 U.S. branches and agencies of foreign banks.

In the survey, a net 27.5% of banks responding reported weaker spreads on C&I loans to large and medium-size firms, relative to the lenders' cost of funds. That compares to 4.2% of respondents reporting stronger spreads in the previous quarterly survey, from January.

Banks in the survey also reported weaker demand for C&I loans from large and middle-market firms for the third consecutive quarter.

While yields on C&I loans help boost earning asset yields, banks also felt additional pressure on deposit costs. The deposit beta, or the percentage of changes in market rates that banks pass on to their customers, rose to 50% in the first quarter from about 44% in the fourth quarter of 2018 and the 30% level experienced in the year-ago period.

Meanwhile, the beta on total loan and leases was lower than the deposit beta in the first quarter. The overall loan beta was 46% in the first quarter, compared to 51% in the prior quarter and 45% in the year-ago period.

Loan yields are not expected to receive the same boost from rising interest rates in the future, with the Federal Reserve seemingly putting further rate hikes on hold. Deposit costs, meanwhile, remain elevated as customers react to higher rates being available in the marketplace, begging the question of whether margins can rise from current levels.

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