U.S. banks' net interest margins expanded in the fourth quarter of 2022 even as deposit costs increased at a much faster clip during the period.

Net interest margins increased during the quarter as the benefit of higher interest rates boosted earning-asset yields, while excess liquidity continued to decline. The median, taxable equivalent net interest margin of the banking industry rose to 3.60%, up 12 basis points sequentially and 43 basis points year over year, according to S&P Global Market Intelligence data.

Fed tightening pressures deposit costs

Swift rate hikes by the Federal Reserve, including in the fourth quarter of 2022, began to drive deposit costs notably higher during the period, casting doubt on how much longer margins can expand.

The banking industry's aggregate cost of deposits rose to 1.02% in the fourth quarter of 2022, up nearly 49 basis points from a quarter earlier. That equates to a beta, or the percentage of change in fed funds passed on to depositors, of 32.7% in the period, compared to 23.9% in the previous quarter.

Deposit betas are expected to remain elevated this year as liquidity pressures grow. The Fed's 50-basis-point rate hike in mid-December came with just a few weeks left in the fourth quarter of 2022, so it should have a bigger impact on funding costs in the first quarter of this year. The central bank raised rates again this February, and the futures market pegs a nearly 40% probability of 75 basis points in additional hikes by December 2023.

Loan growth picked up slightly during the 2022 fourth quarter, with total loans going up 1.9% on a sequential basis, compared to the 1.0% linked-quarter increase in the third quarter.

Deposits continued to decline in the fourth quarter of last year, but the decrease was not as great as in the previous quarter. Deposits dipped 0.7% on a sequential basis after posting a 1.6% linked-quarter decrease in the third quarter of 2022.

The industry's loan-to-deposit ratio rose to 63.6% but remained 9 percentage points below the pre-pandemic level recorded at year-end 2019.

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Loan growth likely to slow

A number of banks have viewed new loans with greater caution with the potential for a recession lying on the horizon.

The Fed's latest Senior Loan Officer Opinion Survey, published in early February, 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 first quarter dipped 0.4% through the week ended Feb. 15. Meanwhile, deposit outflows accelerated, with deposits falling 1.6% during the same period.

Loan yields in the fourth quarter of 2022 climbed 70 basis points sequentially, the largest quarterly increase in the last decade. Additional rate hikes by the Fed should drive yields on credits tied to the short-term rates higher in the future. However, those increases might not be enough to offset the acceleration in deposit costs.