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Net interest margins continue to climb, but deposit competition a concern

Commercial bank net interest margins continued to climb during the second quarter of 2017, but some industry experts are warning of rising deposit competition and a flattening yield curve.

The industry's net interest margin rose 5 basis points to 3.18% during the second quarter, up from 3.13% in the first.

In a research note, Raymond James analysts wrote deposit betas were generally lower than projected but several companies are indicating an increase in competitive pricing. The impact of rising deposit costs on NIM expansion is "among our concerns," they wrote.

Keefe Bruyette & Woods analyst Christopher McGratty said that for the past couple of quarters, banks have benefited from the Federal Reserve's series of short-term interest rate hikes.

"From afar, deposits costs seem pretty low, meaning they haven't really moved that much relative to the change in Fed funds," he said in an interview. "The one mitigating factor is that the yield curve is starting to flatten quite a bit. It's actually flatter today than it was before the election. So that will temper some of the enthusiasm on the pace of expansion for margins."

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In an interview, KBW CEO Thomas Michaud said he is optimistic NIM will continue to increase, at least on some level, despite deposit competition and a flattening yield curve.

“We think that deposit betas in the first quarter were about 8%, and in the second quarter they were about 19%, so they're building,” he said, "which means that banks are being competitive in that they are offering higher rates to their depositors.” He expects more deposit price movement during the second half, stickier deposits and a greater focus on acquisitions.

While he is predicting continued NIM expansion, Michaud said industry observers should keep in mind key variables.

"Not all banks are the same, and I think over time you're going to start to see differentiation," Michaud said. "If you have a loan to deposit ratio [of] about 100%, it's going to make it more of a challenge for you. If you are a retail bank more than a commercial bank, you may have a better margin improvement story because your deposit costs may be a little bit stickier."

He said NIM may also be impacted by geographical advantages and the influence of financial technology on deposit pricing.

"It doesn't take much to see what the online rates are that Ally, that Synchrony, that CIT, that Pure Finance are offering," he added. "And it'll be interesting to see their impact on depositors and if they really do see a rush of deposit flows."

He also pointed to concerns that the shape of the yield curve could eliminate the benefits of higher rates.

“When we have [a] flat yield curve, it may slow down the improvement, but I think the key point is we still have improvement … and that's after several years of continuous decline in the margin. The industry gets at least 65% of its revenues from net interest income, and the margin is critical." During the second quarter, Michaud said there was concern that the shape of the yield curve would eliminate the benefits of higher rates.

As interest rates continue to increase, he said there will be more talk of deposit betas.

Piper Jaffray analyst Matthew Breese wrote that while NIMs improved, "increasing deposit betas garnered a lot of attention," especially in the Northeast, where he said median loan-to-deposit rations are approaching "2007-2008 levels."

"Several management teams also indicated that given the current shape of the yield curve, barring any additional rate hikes, margins could starting contracting again as soon as 4Q17," he wrote.

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Click here for a template that models the impact of earnings at risk from anticipated deposit mix shifts.

Click here to view a video training session on net interest margin analysis.