Most banks' net interest margins contracted in the first quarter and could face additional strain as liquidity pressures accelerated in the last few weeks of the period, pushing funding costs higher.
The liquidity crunch that emerged in March put a far greater premium on deposits and forced many banks to rely on higher-cost funding sources such as certificates of deposits (CDs), brokered deposits and borrowings from the Federal Home Loan Banks. The median, taxable equivalent net interest margin of the banking industry dipped to 3.45%, down 15 basis points sequentially, according to S&P Global Market Intelligence data.
Fleeting liquidity drives funding costs higher
Elevated deposit outflows, in part due to broad concerns over bank liquidity in the aftermath of several large bank failures, helped push deposit costs significantly higher in the first quarter and weighed on bank margins.
The banking industry's aggregate cost of deposits rose to 1.40% in the first quarter of 2023, up 38 basis points from a quarter earlier. That equates to a beta, or the percentage of change in fed funds passed on to depositors, of 44.9% in the period, compared to 32.7% in the previous quarter.
Deposit betas are expected to remain elevated this year as liquidity pressures persist. 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 April accelerated deposit outflows and prompted institutions to build liquidity.
Deposits fell 2.5% on a sequential basis after posting a 0.7% linked-quarter decrease in the fourth quarter of 2022. While deposits declined, more customers shifted funds out of non-interest-bearing deposits and into higher-cost products for institutions like brokered deposits and CDs.
Meanwhile, as economic uncertainty and liquidity pressures increased, lending slowed, with total loans falling 0.2% on a sequential basis, compared to the 1.9% linked-quarter increase in the previous quarter. With the contraction, the industry's loan-to-deposit ratio rose to 65.1% and seems poised to increase further in the coming quarters as deposits remain under pressure.
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Banks hunker down to offset funding pressures, prepare for a downturn
Most bankers presenting at the annual S&P Community Bankers Conference seemed hesitant to grow their loan portfolios at this point. Executives said they have reduced their loan growth expectations and in some cases are working to only serve existing customers as they try to preserve liquidity to prepare for a potential recession in the future.
The Fed's latest Senior Loan Officer Opinion Survey, published in early May, supports that commentary and shows that banks continued to tighten underwriting standards on virtually all loan products, while loan demand weakened. The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that loans in the second quarter have risen 0.5% through the week ended May 10. Meanwhile, deposits have dipped further, falling 0.4% during the same period.
Deposits continue to decline as customers move cash into higher-yielding alternatives in the Treasury and money markets. Higher rates have also helped push loan yields higher in the first quarter, which rose 45 basis points sequentially after climbing 64 basis points quarter over quarter in fourth quarter 2022.
Bank loan yields are unlikely to receive the same boost from higher rates in the coming quarters as interest rates seem poised to stabilize with the Fed nearing the end of its rate hikes. However, funding costs should continue to grind higher as the rates banks offer on deposits rise further while customers move more cash out of non-interest-bearing funds and into higher-yielding products. The juxtaposition could lead to additional pressure on margins, at least in the near term.
