Aggressive tightening by the Federal Reserve offered banks much-needed relief in their net interest margins in the second quarter.

Through a series of rate hikes between mid-March and mid-June, the Fed increased the target fed funds rate by 150 basis points. Deposit costs held fairly steady in the second quarter, but loan yields marched higher. The banking industry's aggregate, taxable equivalent net interest margin jumped to 2.74% in the second quarter, up 23 basis points from the prior quarter — the largest quarterly increase since 2010.

Rate hikes, loan growth boost margins

Bank margins should continue to rebound in the second half of 2022 as further increases in short-term rates and steady loan growth allow banks to deploy excess liquidity into higher-yielding assets. The Fed unveiled a 75-basis-point rate hike in late July and is expected to continue tightening in the remainder of 2022.

Loan growth accelerated in the second quarter, increasing 3.9% from the linked quarter, excluding loans made through the Paycheck Protection Program, while deposits declined 1.9% from the prior period. That dynamic lifted the industry's loan-to-deposit ratio above 60% for the first time in six quarters.

While consumer loans grew at a slightly faster clip in the second quarter, commercial and industrial credits, which rose 3.9% from the first quarter, remained the largest dollar driver of loan growth in the period.

The market is fearful that elevated inflation and the Fed's efforts to tame it will lead to a slowdown in economic activity and possibly a recession. Banks are preparing for a slowdown and reported in the Federal Reserve's latest Senior Loan Officer Opinion Survey, published in July, that they tightened underwriting standards on all loan products due to expected deterioration in borrowers' debt-servicing capacity and weaker collateral values.

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The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that loans rose 1.1% through the week ending Aug. 3 since June 29, while C&I balances increased 1.5%. Deposits, meanwhile, dipped 0.2% during the same period.

Loan yields rebound amid rising rates

Higher rates helped loan yields recover in the second quarter, rising 22 basis points from the linked quarter. Further rate hikes by the Fed should drive commercial and industrial yields, and yields on other credits tied to the short-term rates higher in the future.

Investors expect the Fed's efforts to combat inflation to drive the fed funds rate 125 basis points higher by year-end, which would leave the benchmark rate 200 basis points above the level at the end of the second quarter.

Margins have also been supported by institutions redeploying funds sitting in lower-yielding assets such as interest-bearing balances due — deposits at other banks. Those assets jumped during the pandemic but dropped again in the second quarter, declining 17.7% from the prior period.

Securities holdings grew at a torrid pace during 2020 and 2021 as well but dipped in the second quarter as excess liquidity waned.