Most banks' net interest margins declined in the third quarter, but the pace of contraction slowed from the prior period.
Funding costs rose at a far faster clip than earning-asset yields in the first and second quarters as banks' reliance on higher-cost funding like certificates of deposits grew, but the two metrics increased at the same pace in the third quarter. The dynamic resulted in a relatively small decline in margins in the third quarter. The median, taxable equivalent net interest margin of the banking industry dipped to 3.37%, down 3 basis points (bps) sequentially, after falling 5 bps in the second quarter and 15 bps in the first quarter, according to S&P Global Market Intelligence data.
Banks defend their deposit bases with higher rates
Banks continued to experience deposit outflows in the third quarter, with deposits falling 0.5% quarter over quarter, driven by declines in nonbrokered deposits. The decline marks the sixth straight quarter of decreases in nonbrokered deposits, but outflows slowed in the last two quarters as banks paid up to defend their funding, leading to notably higher deposit costs.
The banking industry's aggregate cost of deposits rose to 2.03% in the third quarter, up 32 bps from a quarter earlier. While the increase was smaller than the 38-bps sequential increase in the second quarter, the beta, or the percentage of change in fed funds passed on to depositors, was 117.9% in the period, compared to 79.4% 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. The gap between what banks paid on their deposits and the rates available in the market narrowed some in the third quarter and could continue to decrease as funding costs grind higher while the Federal Reserve holds rates steady. The latest consumer price index suggested that the Fed might have reached the terminal rate for fed funds, and the reading gave some hope in the market that the central bank could cut rates as soon as May 2024.
A pivot in rates would ease pricing pressure on deposits, but banks have also seen the mix of deposits change considerably as customers shifted funds out of noninterest-bearing deposits and into higher-cost products for institutions like brokered deposits and certificates of deposits. That mix continued in the third quarter.
Banks continue to prize liquidity and securities balances continued to shrink, while loans grew at a slower pace in the third quarter. In the third quarter, total loans rose 0.4% from the linked quarter, after growing 0.7% on a sequential basis in the second quarter. Modest loan growth and pressure on deposits caused the industry's loan-to-deposit ratio to rise further, increasing to 66.5% from just shy of 66% in the prior quarter and 62% a year earlier.
Bank lending remains tight
Banks continued to tighten lending standards on commercial credits in the third quarter while demand remained weak, according to the Fed's latest Senior Loan Officer Opinion Survey, published in October. The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that loans in the fourth quarter have held virtually flat through the week ended Nov. 8. Deposits have declined 0.4% during the same period.
While the Fed continues to engage in quantitative tightening, the narrowing gap between banks' deposit costs and higher-yielding alternatives should help limit future deposit outflows. If funding is not as fleeting, bank margins could soon find a floor for some institutions as they continue to see their loan yields move higher. Loan yields have received a boost from higher rates but have also increased as some fixed rate credits mature and refinance at higher rates. Loan yields rose 29 bps quarter over quarter in the third quarter after climbing 38 bps in the second quarter.
However, banks that struggle to grow loans notably while maintaining large, underwater securities portfolios are likely to see additional margin pressure. Those institutions could face a slow bleed from the presence of lower-yielding assets that fail to offset higher funding costs.
