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Deposit betas are catching up with loan betas at US banks

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Deposit betas are catching up with loan betas at US banks

Deposit costs have risen notably across the U.S. banking industry and are poised to rise more quickly than loan yields during the remainder of 2018, threatening margin expansion for some banks.

Stabilization in long-term rates will limit further increases in loan yields this year, while continued rate hikes by the Federal Reserve should cause deposit costs to rise at a faster pace. That scenario could limit additional margin expansion at a number of banks, particularly those with less-sticky deposit bases and exposure to longer-dated credits such as real estate loans.

S&P Global Market Intelligence's recently updated five-year outlook for the U.S. banking industry suggests that most banks will report strong results in 2018 and 2019, buoyed by margin improvement. However, the increase in margins will not be enough to drive earnings higher in 2019, 2020 and 2021 in the face of rising credit costs. While returns will remain healthy in the near term for most institutions, the situation could be even worse for some banks whose balance sheets have already proven to not be as well positioned for the rate cycle after several years of rate increases.

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Fed rate hikes test balance sheet positioning

Short-term rate increases pushed the industry's cost of interest-bearing deposits to 0.68% through the first six months of 2018 from 0.49% in 2017. Deposit costs have increased faster over the last six months as more banks have marketed deposit specials to satisfy their funding needs and meet customer demands.

Deposit betas, or the percentage of changes in the fed funds rate that banks pass on to their customers, rose to 36.6% in the 12-month period ended June 30, 2018, compared to 30% in the prior 12-month period and 19.6% in full year 2017.

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Four of the top 10 banks by assets, excluding less-traditional bank holding companies such as Goldman Sachs Group Inc., Morgan Stanley, Charles Schwab Corp. and American Express Co., posted a higher deposit beta than the industry aggregate during the 12 months ended June 30. Two of those institutions — HSBC North America Holdings Inc. and Capital One Financial Corp. — offer higher-yielding deposits through digital accounts and recorded deposit betas in excess of 50%.

Deposit betas across the industry should increase further as higher rates and funding needs intensify competition. Economists and the futures markets suggest a high likelihood of the Fed raising rates in September, possibly again in December and twice more in 2019. We expect the industry's beta on interest-bearing deposits to rise to 43% in 2018 and 52% in 2019.

The Fed's rate hikes have also driven loan yields higher. Through the first six months of 2018, the banking industry's loan yield rose at a faster clip than deposit costs, allowing margins to expand considerably. That trend seems less likely to continue due to the stabilization in longer-term rates and competition for quality credits, limiting the benefit of future rate increases.

The industry reported a loan beta, or the percentage of the change in fed funds rate passed on to borrowers, of 47.1% through the 12 months ended June 30, 2018.

Among the 10 largest banks in our analysis, Citigroup Inc. recorded the lowest loan beta of 31.3%, even though repricing disclosures show that about 75% of loans at its lead banking subsidiary were set to reprice or mature in less than 12 months as of the end of the second quarter.

Meanwhile, JPMorgan Chase & Co. reported a loan beta of 79.3% during the period, the highest among the top 10 banks. The bank's deposit beta was lower than the industry aggregate, helping the institution's margin rise 19 basis points from year-ago levels. When compared to the industry, JPMorgan's lead banking subsidiary had greater exposure to loan types that tend to be priced off shorter-term rates.

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The flatter yield curve could spell bad news for some banks

The picture could turn grim for the banking industry as the yield curve remains flat and loan growth stays weak. Loan growth rebounded in the second quarter but seems unlikely to pick up materially in the final two quarters of 2018, suggesting that competition will not ease.

S&P Global Market Intelligence expects loan betas to lag deposit betas modestly in full-year 2018 and for that disparity to grow in 2019 amid intensifying competition for credits as banks struggle to lever excess capital created by tax reform. We expect net interest margins to finish 2018 at 3.31%, up 3 basis points from the level reported through the first six months of the year. Margins should climb another 3 basis points in 2019 to 3.34%.

The expected margin expansion and a lower corporate tax rate should cause earnings to jump in 2018. Earnings growth should slow in 2019 as deposit costs increase at an even quicker pace and credit costs begin to rise. We expect credit quality to deteriorate further in 2020 as the impact of easing underwriting standards, waning stimulus related to tax reform, slower economic growth and a higher debt service for borrowers results in more problem loans.

We continue to believe the banks that outperform before credit slides will be those that can best hold the line on deposit costs. The gap between the best deposit franchises and the rest of the industry has grown, and that divide will widen through the remainder of 2018.

Scope and methodology

S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2005 through the second quarter of 2018. The analysis includes all commercial and savings banks and savings and loan associations, including 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 divided the industry into five asset groups to see which institutions have changed the most, using key regulatory thresholds to define the separation. The examination looked at banks with assets of $250 billion or more, $50 billion to $250 billion, $10 billion to $50 billion, $1 billion to $10 billion, and $1 billion and below.

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 from 2006 to 2007. S&P Global Market Intelligence has created a model that projects the balance sheet and income statement of the entire industry 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 2021 and 2022 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 is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment and economic growth. The projections can be updated or revised at any time as developments warrant, particularly when material changes occur.

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