Even if the Federal Reserve slows down on rate hikes, deposit costs will continue rising more quickly than loan yields at U.S. banks.
S&P Global Market Intelligence's recently updated five-year outlook for the U.S. banking industry suggests that further increases in deposit costs will prevent net interest margins from expanding further in 2019. We assume margins will rise again in 2020 and the following years but also expect credit costs to rise at the same time, as a number of economists predict that the next downturn could lie around the corner.
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Deposits wake up from hibernation
Rising short-term interest rates, changes in customer behavior and growing funding needs among a number of institutions caused deposit costs to rise at a quicker pace in 2018. Funds that were asleep in the years following the Great Recession woke up to higher rates available in the market, causing a considerable shift of dollars out of noninterest-bearing accounts and into CDs and online savings accounts advertising lofty rates.
The industry's cost of interest-bearing deposits rose to 0.81% in 2018 from 0.49% in 2017. Deposit betas, or the percentage of changes in market rates that banks pass on to their customers, jumped to 42% from 19.6% in 2017 and 12.2% in 2016.
The industry recorded deposit betas of 41% and 62% in 2005 and 2006, respectively. Betas returned to the level witnessed during that tightening cycle in the third quarter of 2018, rising to 44%.
Deposit betas held fairly steady in the fourth quarter, when fears over a global economic slowdown resulted in a broad sell-off of equities and a flight to quality in the bond market. Investors that harvested their portfolios may have brought cash back to their banks in the fourth quarter, but the markets have recovered since then and many of the same funds have likely been put to work elsewhere.
Deposit costs should continue to rise in 2019 even if the Fed pauses rate hikes for now. That pressure should persist as more customers become aware of the myriad deposit offerings with attractive rates, including those marketed by non-traditional players. Large regional banks and many small institutions will contribute to deposit competition as they seek to build their retail funding through CD specials — promotional offerings aimed at attracting new customers. In the fourth quarter of 2018, many of those products began carrying rates in excess of 2%, catching the attention of customers who had previously sat on the sidelines.
Betas on retail CDs jumped to 56.7% in 2018 from 24.7% a year earlier. 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 and institutions continue to aggressively market CD specials.
This likely will prompt additional funds to leave noninterest-bearing products, continuing a trend witnessed over the last few years. S&P Global Market Intelligence projects that noninterest-bearing deposits will decline to 22.8% in 2019 and eventually fall to 17% in 2023. We have argued that this shift would begin occurring since the fall of 2015. Since then, noninterest-bearing deposits have fallen from 26.2% of deposits at the end of the second quarter of 2015 to 23.7% at year-end 2018.
Flat yield curve, competition ending the rate party for banks
The strength of a given bank's deposit franchise will remain firmly in focus since that could serve as a true driver of profitability at this point in the interest rate cycle. Loan yields will receive some benefit from rate increases that have happened over the past year, particularly as credits with lower yields roll off banks' books. However, loan yields are unlikely to expand at their 2018 pace as banks continue to compete for business by offering loans with thinner spreads. Institutions face added pressure as long-term rates fell more than 50 basis points from the recent peak in November 2018.
The loan portfolios of the nation's largest banks have been better positioned for higher rates than their smaller counterparts. The top 25 institutions recorded a median loan beta of 61.24% in the fourth quarter, while posting a deposit beta of 44.45% in the period. The industry in aggregate, meanwhile, recorded a loan beta of 49.17% in the fourth quarter, while posting a deposit beta of 42.93%.
S&P Global Market Intelligence expects the industry's loan beta to decline further in 2019 due to the retrenchment in long-term rates and competition for quality credits. The industry's loan yield should rise to 5.45% in 2019 from 5.23% in 2018 and 4.83% in 2017.
While earning-asset yields will expand, the increases will fail to outstrip rising deposit costs, causing net interest margins to stabilize in the near term. Margins are expected to rise over the longer term, but that expansion will come as credit costs serve as a larger headwind to earnings.
This is the first article highlighting our recently updated outlook for the banking industry. Stay tuned for another article focusing on the impact of the new reserve methodology with which most banks must comply beginning in 2020, known as the Current Expected Credit Loss model, or CECL.
Scope and methodology
S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2005 through 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 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.