The recent flattening of the yield curve and competition for quality credits has dashed hopes for considerable expansion in U.S. community banks' net interest margins in the near term.
S&P Global Market Intelligence expects net interest margins at community banks, which have less than $10 billion in assets, to stay flat in 2017. Margins are still poised to rise in 2018, aided by only modest increases in deposit costs, particularly when compared to larger banks.
Community bank net interest margins are expected to rise by 7 basis points to 3.71% in 2018, down considerably from our prior expectations, largely due to a more bearish outlook for loan yields. Community bank earnings are still poised to rise by 6% in 2018, with margin expansion and an extra boost from a lower corporate tax rate driving results higher.

Persistent pressure on yields tied to longer-dated credits has negatively impacted community bank margins more than those of larger banks. Institutions with more than $10 billion in assets — which hold nearly 80% of the industry's loans — have seen yields rise with the Federal Reserve's rate hikes. The situation has been different for community banks because of their higher concentrations of credits such as commercial real estate loans and mortgages, which are based on long-term rates.


Long-term rates have failed to rise in step with increases in short-term rates. Meanwhile, loan growth has remained relatively weak, spurring pricing competition for newly originated credits. Community banks have tried to offset some of that pressure by reaching further out the yield curve. Those efforts helped loan yields find a bottom in 2017, but the moves seem to have also mortgaged some of the benefits that would come from further rate increases since loan portfolios will now take longer to reprice or mature.
At the end of the third quarter, the amount of loans expected to reprice or mature in excess of five years rose to 30.4% of community banks' loans, up from 28.8% at year-end 2016 and 26.5% at year-end 2015. The banking industry, meanwhile, has not reached quite as far out the curve, holding the amount of loans expected to reprice or mature in excess of five years at roughly 25% over the last few years.
The greater exposure to longer-dated loans and the flattening of the yield curve should put a cap on community bank loan yields over the next few years.
Community banks have also mitigated pressure on loan yields by reporting only minimal increases in deposit costs. The deposit beta, or what percentage of changes in market rates institutions pass on to their customers, has remained considerably lower at community banks than at the nation's largest institutions through the first nine months of 2017.
Betas among larger regional banks and a few institutions with greater exposure to online deposits such as Goldman Sachs Group Inc. and HSBC North America Holdings Inc. began to separate from the pack in the third quarter. Deposit costs at community banks, however, have fallen short of our expectations thus far. The community bank group actually saw its deposit beta decline through the first nine months of 2017 when compared to the first half of the year, with the number falling to 9% from 10% at June 30. The banking industry as a whole saw the deposit beta climb to 17% from 14% during the same time frame.
Community banks boast strong customer loyalty and seem to be benefit from having greater exposure to more rural markets, where they face less competition.

Still, funding pressures will grow at community banks, and their deposit costs should not lag larger banks as significantly next year since they have higher loan-to-deposit ratios. At some point, community banks are also likely to face greater competition from credit unions, which often promote attractive rates on deposit products for their members. Those institutions held deposit costs nearly flat through the first nine months of 2017 even as their banking counterparts began lifting rates. As short-term rates move higher, it seems likely that credit unions will take a harder look at keeping their customers happy and moving upward with market rates.
Increases in deposit costs will come against higher credit costs, though the slippage in asset quality should prove manageable over the next few years. Community banks weathered hurricanes Harvey and Irma in the summer of 2017 with minimal impact to their balance sheets. Delinquencies in some lending categories are rising from relatively low bases but overall continue to decline from year-ago levels.
That trend will soon change, and credit costs will emerge as a headwind to earnings, but in the near term, it seems that more prudent underwriting in the years following the credit crisis has prevented true cracks in the armor.
As the credit environment remains relatively benign in the near term, community banks returns will improve modestly before both funding and asset quality pressures stand in the way of further expansion.

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Scope and methodology
S&P Global Market Intelligence conducted an analysis highlighting community banks' core balance sheet and income statement metrics as well as key capital, asset quality and performance ratios.
The analysis of community banks, which focused on institutions with less than $10 billion in assets, stems from a larger examination of nearly 10,000 banking subsidiaries, covering the core banking industry from 2005 through the third quarter of 2017. The analysis includes all commercial and savings banks and savings and loan associations and historical institutions as long as they were still considered current at the end of a given year. It excludes several hundred institutions that hold bank charters but do not principally engage in banking activities, among them industrial banks, nondepository trusts and cooperative banks.
The analysis looked back more than a decade to help inform projected results for the banking industry by examining long-term performance over periods outside the peak of the asset bubble. S&P Global Market Intelligence has created a model that projects the balance sheet and income statement for all banks below $10 billion in assets and allows for different growth assumptions from one year to the next.
The outlook is based on management commentary, discussions with industry sources, regression analysis, and asset and liability repricing data disclosed in banks' quarterly call reports. While taking into consideration historical growth rates, the analysis often excludes the significant volatility experienced in the years around the credit crisis.
The projections assume future fed funds rates and 10-year Treasury yields based on a monthly survey of more than 60 economists conducted by The Wall Street Journal. Interest rate assumptions for 2020 and 2021 are based on the Congressional Budget Office's annual outlook. S&P Global Market Intelligence does not forecast changes in interest rates or macroeconomic indicators and aims to project what the banking industry will look like if the future holds what most economic observers expect.
The outlook incorporates a new lower corporate tax beginning in 2018 but does not account for other changes coming from tax reform, including write-downs to deferred tax assets that a number of banks will report in the fourth quarter of 2017 or increases in expenses stemming from one-time bonuses to employees.
The outlook is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment and economic growth. The projections may be updated or revised at any time as developments warrant, particularly when material changes occur such as the implementation of the Financial Accounting Standards Board's impairment model, which is known as the current expected credit loss model, or CECL. The provision will drastically change the way banks reserve for loan losses. S&P Global Market Intelligence intends to make periodic updates as circumstances warrant.

