US banks are unlikely to see relief from compressed net interest margins before the end of 2024, even if the Federal Reserve cuts interest rates.
Net interest margins (NIMs) are a key bank profitability measure that weighs a company's interest income from credit products against the outgoing interest it pays depositors. The NIMs of US banks compressed over the last year as the Federal Reserve increased interest rates and competition for deposits intensified. If the Fed follows through on plans to cut rates in 2024, NIMs are unlikely to improve and may even shrink before 2025 due to high funding costs, which tend to lag rate moves, McQueen Financial Advisors President and CEO Charley McQueen said in an interview.
"That lag in deposit costs coming up really started to hit hard in the second half of 2023," McQueen said. "Nice yields on loans really popped up, and that will continue to improve asset yields, but I still think there's a little bit more of the deposit costs coming up right now."
Analysts predict further NIM compression in 2024
Analysts expect NIM compression for 16 of the 20 largest US banks in 2024 with a median decline for the group of 14 basis points, according to S&P Global Market Intelligence data. The group median of consensus estimates were 3.07% for 2023, 2.93% for 2024 and 2.98% for 2025, as of Dec. 18.
In contrast to analysts, bankers at some of the country's largest banks said they do not expect further NIM compression in 2024.
U.S. Bancorp has "great confidence" that its NIM will bottom out in the fourth quarter of 2023 and has the flexibility to reprice deposits as needed when the Fed cuts rates, CFO John Stern said during an industry conference in December. Huntington Bancshares Inc. expects a flat to rising NIM through 2024, CFO Zachary Wasserman said during the same conference.
Hedging for lower rates
Banks with excess funds can protect their NIMs by extending the duration on their investments and refraining from buying option-based investments, mortgage-backed securities or anything with negative convexity, McQueen said.
"That's going to allow us to keep our assets out there yielding a higher level in a downward rate environment," McQueen said.
Banks are increasingly selling low-yielding securities and reinvesting the proceeds into higher-yield securities to protect their margins. The industry recorded its highest level of realized losses on available-for-sale securities in three years during the third quarter as more banks repositioned their bond portfolios to improve their NIMs and other profitability measures. In the fourth quarter, several banks executed securities sales.
Hedging against falling rates is significantly more expensive now than it was just two months ago for asset-sensitive banks because the yield from converting floating secured overnight financing rate assets to fixed has declined by about 115 basis points in that time, said Isaac Wheeler, head of balance sheet strategy at Derivative Path.
"If you're a bank that's exposed in that way, you're not welcoming this move at all," Wheeler said in an interview. "It's actually no longer possible to hedge the first 150-basis-point move lower in rates because the market is already priced in."
Unlike asset-sensitive banks, the downward movement in swap rates and treasury yields has made hedging strategies cheaper for liability-sensitive banks, which have experienced substantial margin compression as the Fed has raised rates, Wheeler said.
"If you're an institution that's exposed to higher rates as a whole still, this is a nice entry point maybe to establish some funding hedges or even to swap fixed-rate investment securities to floating," Wheeler said.
Ultimately, the shape of the yield curve will be more important than the level of rates in terms of NIMs, Wheeler said. Banks would welcome rate cuts if they are accompanied by a significant steepening at the five-to-10-year part of the curve because the standard inversion of the last 18 months has put a lot of pressure on NIMs, Wheeler added.
On the lending side, banks should balance their loan books to make sure they have higher-yielding loans that will not refinance as soon as the Fed cuts rates, McQueen said.
Banks can also ladder short-term borrowings from the Federal Home Loan Bank, McQueen added.
"It's not a bad way at all to lock in some funding, although at an adjustable rate effectively," McQueen said. "If rates do come down as the world is predicting, we can definitely improve that cost of funds for that borrowing capacity."