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Deposit betas exceed loan betas at US community banks

Deposit costs at community banks rose at a quicker pace than loan yields in the second quarter, and the trend is unlikely to change, causing margins to hold at current levels for the foreseeable future.

Lackluster loan growth will limit additional expansion in loan yields even as interest rates move higher while rising funding pressures should cause further deposit cost increases. That could spell bad news for margin expansion hopes, particularly at community banks that are running deposit specials to meet their liquidity needs.

S&P Global Market Intelligence's recently updated five-year outlook for the community bank group, which includes institutions with less than $10 billion in assets, suggests that margins will hold flat in the near term. We expect community banks to report modest margin expansion in 2020 and 2021, but that improvement will come alongside rising credit costs, causing earnings to decline.

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Deposit specials helping drive costs higher

Community banks saw funding costs rise more quickly in the second quarter. The group's cost of interest-bearing deposits rose to 0.71% from 0.51% a year earlier. That equates to a deposit beta, or the percentage of changes in the fed funds rate they passed on to customers, of 25% in the 12 months ended June 30, 2018, compared to a 36.6% beta recorded by the entire banking industry during that period.

A handful of banks have demonstrated less rate sensitivity in their deposit bases, with seven of the 100 largest community banks reporting single-digit deposit betas in the second quarter.

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Southern California's CVB Financial Corp. is in that group. President and CEO Christopher Myers said at a recent conference that CVB Financial has worked to retain operating accounts and business deposits while selling more relationship-based products focused on cybersecurity and fraud prevention. Most customers do not want to pay for those services, Myers said, but he requires them to maintain certain balances in noninterest-bearing accounts to support those offerings. At the end of the second quarter, noninterest-bearing deposits made up 61% of CVB's deposit base.

Meanwhile, some other community banks have seen their deposits reprice far more quickly. Many of them have reported higher concentrations of CDs in their funding bases. Among the 100 largest community banks, eight of the 10 institutions with the highest deposit betas in the second quarter reported a heavier reliance on CDs for funding than their community banking peers. Community banks have reduced their exposure to CDs over the last decade, with the balances falling from the peak of 34.8% of deposits in 2008 to 17.6% in 2017. However, after a decade of declining CD balances, the trend shifted early in 2018 and has since climbed to 17.72% of deposits.

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A number of institutions, including community banks, have grown their time deposits as a result of marketing CD specials, or promotional rates to attract new customers. Community banks' betas on retail CDs rose to 34.2% in the second quarter from 19.1% in 2017. Betas on retail CDs eventually rose to nearly 60% during the last rate-tightening cycle and are heading toward that level as banks put more of their excess liquidity to work and loan-to-deposit ratios rise.

We expect more customers to move their funds into such higher-yielding products over the next few years, causing interest-bearing deposits to rise. The growth in more rate-sensitive products supports our view that community banks' overall beta will rise to 34% this year — up slightly from our prior projection — as depositors become more accustomed to higher rates in the marketplace and banks' funding needs grow. We project an overall industry deposit beta of about 43% in 2018.

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 December and twice more in 2019. We expect the community banks' beta on interest-bearing deposits to rise to 41% in 2019.

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The flat yield curve threatens margins

The Fed's rate hikes have also driven loan yields higher, but the increases have failed to keep up with deposit costs. That trend seems unlikely to change as lackluster loan growth has led to fierce competition for quality credits, limiting the benefit of future rate increases.

Community banks reported a loan beta, or the percentage of the change in fed funds rate passed on to borrowers, of 22% through the 12 months ended June 30, 2018.

The outlook appears challenging for a number of community banks, particularly those with greater exposure to longer-dated credits like real estate loans, as the yield curve remains flat. And weak loan growth means that loan pricing pressures are unlikely to abate anytime soon.

S&P Global Market Intelligence expects loan betas to continue to lag deposit betas in full year 2018 and for that disparity to grow during the remainder of the year amid intensifying competition for credits as banks struggle to lever excess capital created by tax reform. We expect community bank net interest margins to finish 2018 at 3.65%, essentially flat with the level reported through the first six months of the year. Margins should hold nearly flat in 2019.

With margins holding steady, an expected jump in earnings in 2018 will come from the lower corporate tax rate as a result of tax reform. Earnings should decline 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 result in more problem loans.

Given the pressures from the flatter yield curve, community banks that buck the trend will be those with the stickiest deposit bases. As deposit costs march higher, the institutions with the best deposit franchises have shown an ability to lag the rest of the industry considerably. That gap should continue to grow during 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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