U.S. banks' deposit costs rose far more quickly than loan yields in the first quarter. That trend will persist amid a flat-to-inverted yield curve, creating a headwind to bank profitability.
S&P Global Market Intelligence's recently updated five-year outlook for the U.S. banking industry suggests that net interest margins have peaked and will remain under pressure over the foreseeable future as liquidity pressures persist even in the absence of further rate hikes from the Federal Reserve. While funding costs continue increasing, loan yields will receive only a modest boost, in no small part due to the recent decline in long-term interest rates.
Liquidity pressures, hungry depositors pushing funding costs higher
Bankers hoped that deposit betas had stabilized in the fourth quarter of 2018. But that proved not to be the case as liquidity needs grew at some banks, while many others felt pressures from customers demanding higher-yielding products. The industry's cost of interest-bearing deposits rose to 1.09% in the first quarter of 2019 from 0.62% in the year-ago period.
Deposit betas, or the percentage of changes in market rates that banks pass on to their customers, rose to 49% in the first quarter from 43% in the fourth quarter of 2018. Betas had nearly stabilized in the fourth quarter as fears over a global economic slowdown led to a broad market sell-off and flight to quality. As investors took cash out of the markets, many likely brought those funds back to their banks. The markets recovered notably in the first quarter, and deposit betas once again rose.
The amount of reserves parked at Federal Reserve banks also declined in recent quarters as the central bank has shrunk its balance sheet. The Federal Reserve Bank of Boston predicted in the fall of 2017 that reductions in reserves would lead to considerably wider spreads in the repo markets, or more expensive short-term borrowing, adding to liquidity pressures.
In a survey earlier this year of senior financial officers at banks that collectively held close to 75% of the reserves in the system, the Fed found that institutions would take actions to bolster liquidity if reserves fell to their lowest comfort level. At the time of the survey in February, respondents said reserves would need to decline by 43.5% before reaching that point.
Since that time, total reserve balances at the Fed, including reserves held by foreign banking organizations, had fallen 6.4% as of May 29. Through the end of the first quarter, total reserves had fallen 23.2% from year-ago levels.
Looking at just U.S.-based banks that make up our industry aggregate, reserves at the Fed fell 29.1% in the first quarter when compared to year-ago levels.
Banks in the Fed survey said they would look to replenish the reserve balances in the short term by increasing advances from Federal Home Loan Banks. Few said they would seek to increase their retail deposit base through higher rates or through other attractive, nonrate offerings, at least in the short term. But about 60% said they would borrow in the unsecured lending market, including negotiable CDs, in tenors less than 30 days, while nearly 40% would consider similar strategies in tenors greater than 30 days. Negotiable CDs have a minimum value of $100,000 and can be sold in the secondary market.
CDs have already become a larger portion of banks' funding bases, growing to 14.0% of deposits from 12.5% a year ago. The cost of CDs has climbed during the same time period, with deposit betas on retail CDs jumping to 69.3% in the first quarter of 2019. That is above the level witnessed during the last tightening cycle, when the beta on retail CDs reached 55.6% in 2006.
Betas seem poised to rise again this year as banks put more of their excess liquidity to work, while customers continue to move funds out of noninterest-bearing products and into higher-yielding accounts.
Rates now stand as a headwind for margins
While short-term rates have held steady this year, long-term rates have fallen considerably, with the yield on the 10-year Treasury dropping more than 100 basis points since the recent peak in November. The yield curve has actually been inverted over the last week, with the 3-month Treasury bill trading at a higher yield than the benchmark 10-year Treasury.
That change has been recent, but the yield curve was quite flat during the first quarter, and the decline in long-term rates weighed on banks' loan yields and resulted in margin pressure. Banks recorded a loan beta, or the percentage of changes in the fed fund rate that banks passed on to borrowers, of 43.7% in the first quarter, well below the 49.3% deposit beta in the same period.
Of the top 100 banks by assets in the first quarter, 44 institutions reported a year-over-year decrease in their net interest margins. The 25 banks in that group reporting the greatest margin compression recorded a median loan beta of 27.2% and median deposit beta of 68.1% in the first quarter.
S&P Global Market Intelligence expects the industry's loan beta to rise during the remainder of 2019, but the metric will still lag deposit betas. The industry's loan yield should rise to 5.53% in 2019 from 5.23% in 2018. If long-term rates remain under pressure, there could be downside risk to that forecast. The challenging rate environment will keep a lid on earning-asset yields over the remainder of 2019, while deposit costs will continue to rise, holding down net interest margins.
As net interest margins fall from the recent peak, credit costs will begin to rise late in 2019 and even more materially in 2020, weighing on earnings in the future.
Scope and methodology
S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2004 through the first quarter of 2019. 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 2022 are based on a two-point average of the WSJ survey and estimates from the Congressional Budget Office's annual outlook. Figures for 2023 are based on CBO estimates. 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.