Community bank customers across the country are pushing for higher rates on their deposits, and institutions in the Mid-Atlantic and Midwest regions are feeling the greatest pressure.
Community banks in those areas could see their net interest margins come under pressure in the not-too-distant future as deposit costs rise faster than loan yields. This should be a trend for U.S. community banks in aggregate, resulting in lower returns in 2019 and 2020, particularly as credit costs begin to rise.
Higher rates may no longer benefit many community banks
Community banks are unlikely to experience significant asset quality deterioration in the near term, but they are already feeling pressure from rising funding costs and changes in deposit composition. While their deposit costs have not risen as quickly as those of their larger counterparts, the increase has been material in recent quarters.
Community banks in aggregate saw their cost of interest-bearing deposits increase to 0.72% through the first nine months of 2018 from 0.53% in 2017. Deposit betas, or the percentage of changes in the fed funds rate that banks pass on to their customers, rose to 28% through the first nine months of 2018 from just 11% in 2017.
Community banks in the Mid-Atlantic region, where many institutions have sought to increase their presence due to the prevalence of high-net-worth customers, have recorded the highest deposit beta at 31% over the last nine months. Community banks in the Midwest, which is home to more institutions than any other region, recorded the second-highest deposit beta through the first nine months of 2018 at 28%.
As deposits have repriced higher at a faster pace, customers have also actively shifted funds out of noninterest-bearing accounts, reversing a trend that persisted for nearly nine years after the Great Recession. Noninterest-bearing deposits peaked in the fourth quarter of 2017 at 22.82% of community banks' deposits but have steadily become smaller portions of their funding bases since then, falling to 22.26% of deposits at the end of the third quarter.
Meanwhile, many community banks have marketed CDs to attract deposits. The strategy has become popular again and caused CDs to grow to 27.03% of deposits at the end of the third quarter from 25.73% a year earlier.
Some banks have reported even greater changes in their deposit composition. Among community banks with between $500 million and $10 billion in assets, seven institutions saw their noninterest-bearing deposit concentration fall by 10 percentage points or more year over year during the third quarter. Meanwhile, 21 banks in the $500 million-to-$10 billion group saw their CD concentration rise by more than 10 percentage points, with Seattle-based Seattle Bank, Los Angeles-based State Bank of India (California) and Coral Gables, Fla.-based Marquis Bank leading the way.
Flattening of the yield curve spells bad news for community banks
Deposit costs have moved while the yield curve has flattened further, which is not good news for community bank margins. The institutions have much greater exposure to loans tied to the long end of the curve than their larger counterparts. That could mean loan yields only rise modestly, while funding costs increase at a quicker clip.
Long-term rates have fallen nearly 40 basis points from the recent peak, leaving the spread between the 2-year and 10-year Treasury at the lowest level in more than a decade. Short-term rates are expected to continue rising, meanwhile, which could cause deposit betas to exceed loan betas in the coming year.
Community banks reported a loan beta, or the percentage of the change in fed funds rate passed on to borrowers, of 35% through the first nine months of 2018, above the deposit beta of 28% reported during the same period.
S&P Global Market Intelligence expects that trend to reverse in 2019 as competition intensifies and the yield curve remains flat. Loan growth is expected to remain relatively weak, which will exacerbate loan pricing pressure as community banks struggle to lever excess capital created by tax reform.
We expect net interest margins to finish 2018 several basis points higher than the level reported through the first nine months of the year. Margins should fall the following year as deposit costs increase faster and competition limits further expansion in loan yields. The expected margin compression will come as credit quality begins to slip due to higher interest rates and weaker economic growth, resulting in pressure on construction and development lending. That in turn should cause community bank earnings to decline in 2019.
Credit quality should deteriorate further the following year as the impact of easing underwriting standards, waning stimulus related to tax reform, slower economic growth including weakness from housing, and higher debt service for borrowers result in more problem loans.
Community banks that outperform the group will be those that find ways to build customer loyalty through certain product offerings, allowing them to better hold the line on deposit costs.
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 third 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.