Most banks' net interest margins contracted in the second quarter, but the pressure was not as great as in the prior period.
Funding costs continued to rise at a faster clip than earning-asset yields as liquidity pressures persisted in the marketplace and banks increased their reliance on higher-cost funding sources. The median, taxable equivalent net interest margin of the banking industry dipped to 3.40%, down 5 basis points sequentially, after falling 15 basis points in the prior quarter, according to S&P Global Market Intelligence data.
Banks pay up to defend their deposit bases
Deposit outflows slowed in the second quarter, with deposits falling 0.5% from the prior quarter after falling 2.5% sequentially in the first quarter. While deposit outflows were not as large, banks paid up to defend their funding, leading to notably higher deposit costs.
The banking industry's aggregate cost of deposits rose to 1.78% in the second quarter of 2023, up 37 basis points from a quarter earlier. That equates to a beta, or the percentage of change in fed funds passed on to depositors, of 79.1% in the period, compared to 48.7% in the previous quarter.
Banks have competed for deposits not only with other depositories but also with attractive, higher-yielding alternatives in the Treasury and money markets. While the Federal Reserve has slowed the pace of rate hikes and could be close to the terminal rate for fed funds, the fallout from several large bank failures in March and May prompted institutions to prize their deposits and build liquidity. Banks have also seen the mix of deposits change considerably, as customers shifted funds out of non-interest-bearing deposits and into higher-cost products for institutions like brokered deposits and certificates of deposits.
Lending rebounded modestly from the first quarter, when higher interest rates, liquidity pressures and economic uncertainty slowed origination activity. In the second quarter, total loans rose 0.7% from the linked quarter, after falling 0.2% on a sequential basis in the first quarter. Loan growth and pressure on deposits caused the industry's loan-to-deposit ratio to rise further, increasing to just shy of 66% from 65.2% in the prior quarter and 60.2% a year earlier.
Loan growth improves but remains slow
Bankers say they are approaching new loans with caution as borrowers and the US economy digest higher rates. The Fed's latest Senior Loan Officer Opinion Survey, published in late July, offered credence to that notion and showed that banks continued to tighten standards on commercial and industrial and commercial real estate loans, while loan demand also weakened. The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that loans in the third quarter have barely inched higher through the week ended Aug. 16. Meanwhile, deposits have climbed modestly, rising 0.3% during the same period.
As deposit betas have increased with persistently higher rates, the gap between banks' deposit costs and alternatives in the Treasury and money markets has narrowed, mitigating deposit outflows. Higher rates also helped push loan yields higher in the second quarter, with yields rising 38 basis points sequentially after climbing 45 basis points quarter over quarter in the first quarter.
Expansion in bank loan yields could slow in the coming quarters as the Fed nears the end of its tightening cycle. However, bank funding costs should continue to rise as institutions continue to protect deposits by offering elevated rates, while customers move more cash out of non-interest-bearing funds and into higher-yielding products. The dynamic should lead to additional pressure on margins.