Even as interest rates rose in the first quarter, U.S. bank margins dipped in the period.
The Fed kicked off highly anticipated rate hikes in mid-March and long-term rates rose notably ahead of the move, but the banking industry's aggregate, taxable equivalent net interest margin declined to 2.51% in the first quarter from 2.53% in the prior quarter, according to S&P Global Market Intelligence data. Several years of low rates and an abundance of excess liquidity have pushed margins 74 basis points below pre-pandemic levels.
Loan growth should offer margin relief
Bank margins should rebound later this year due to increases in short- and long-term rates, while stronger loan growth will allow banks to deploy more of their excess liquidity into higher-yielding assets. Loan growth slowed modestly in the first quarter, growing 1.0% from the linked quarter, and lagged deposit growth in the period, leaving the industry's loan-to-deposit ratio at 56.98%, down slightly from 57.10% in the fourth quarter.
Strength in commercial and industrial credits, which rose 3.1% from year-end 2021, remained the largest driver of loan growth. Loan growth is expected to continue in the coming quarters as high levels of employment and elevated inflation spark more borrowing activity.
In the Federal Reserve's latest Senior Loan Officer Opinion Survey published in April, banks reported that demand for consumer and commercial and industrial, or C&I, credits continued to increase, leading to stronger loan growth. The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that loans have risen 3.8% through the week ending May 11 since Dec. 29, 2021, while C&I balances have increased 3.0%. Deposits, meanwhile, have ticked up 0.3% during the same period.
Fed rate hikes will offer a boost to margins
While loans grew and interest rates rose, loan yields actually declined in the first quarter, falling 16 basis points from the prior period. Rate hikes by the Fed should drive C&I yields and yields on other credits tied to the short-term rates higher in the future, but notable gains might not occur until the second half of the year when the fed funds rate is materially higher.
Investors expect the Fed's efforts to combat inflation to drive the fed funds rate 200 basis points higher by year-end, beginning with a series of 50-basis-point increases at its next meeting in June.
Margins might even get a larger boost once institutions redeploy funds sitting in lower-yielding assets such as interest-bearing balances due — deposits at other banks. Those assets jumped during the pandemic but fell 5.8% in the first quarter from the prior quarter.
Securities holdings had grown at a torrid pace during 2020 and 2021 as well but essentially held steady in the fourth quarter of 2021. Bank managers now have more attractive opportunities to put cash to work in the bond market, with long-term rates having risen notably since the end of the first quarter. The average yield on the 10-year Treasury through mid-May had risen 87 basis points from first-quarter levels, offering further support for bank margins.
The promise of further increases in rates and signs of stronger loan growth suggest that margins will rise in the second half of 2022, with even greater increases in 2023.
