Fed actions spell margin relief for US banks

Introduction

U.S. bank margins held steady in the fourth quarter of 2021 but should expand notably in 2022 as short-term rates move higher and institutions deploy some of their excess cash.

The Federal Reserve's efforts to combat elevated inflation will offer a significant lift to U.S. banks' net interest margins. Expected increases in short-term rates will boost loan yields, particularly yields on commercial and industrial loans, while stronger loan growth will allow banks to put more cash to work into higher-yielding assets.

^{This analysis includes updated projections for loan and deposit growth ahead of our annual U.S. Bank Market report, which will be published in March.}

Margins stabilize ahead of Fed rate hikes

Bank margins held steady in the fourth quarter as loan growth finally resumed. The banking industry's aggregate, taxable equivalent net interest margin was 2.53% in the fourth quarter, flat with the prior quarter and year-ago period. Several years of low interest rates and abundance of excess liquidity has left margins depressed and 71 basis points lower than pre-pandemic levels.

The Fed's efforts to combat inflation could spell relief for bank margins though, particularly over the longer term. Economists expect the central bank to raise short term rates five to seven times by year-end 2022 as it works to reduce inflation, which has tracked well above the Fed's 2% target levels since June 2021. The Fed's favorite inflation measure, the core consumer price index, which excludes food and energy costs, has met or exceeded 4% in every month from June 2021 to January 2022.

The Fed is expected to fight inflation by raising short-term rates beginning in March and then begin shrinking its nearly $9 trillion balance sheet not long after that. We expect the Fed's balance sheet reduction and utilization of some of the nearly $2.7 trillion in excess savings that consumers have accumulated through the pandemic to lead to slower deposit growth in the future, allowing loan-to-deposit ratios to recover from depressed levels.

Deposits are projected to grow 3% from year-ago levels in 2022 and climb 2.25% in 2023, falling well short of the 6.75% and 4.50% projected loan growth in the respective periods.

That outlook would mark a considerable reversal from the trend seen throughout much of the pandemic, when explosive deposit growth overshadowed loan growth, leaving banks sodden with excess liquidity and lackluster margins. Since year-end 2019, deposits have grown 35.4%, while loans have increased 6.7% during the same period.

The fourth quarter of 2021 offered signs that brighter days could lie ahead, with loans growing at a slightly faster clip than deposits. With the move, the industry's loan-to-deposit ratio inched higher to 57.09% from 56.98% in the third quarter and 60.95% a year earlier and 72.36% at year-end 2019.

Loan growth in the fourth quarter was driven by strength in commercial and industrial credits, which jumped nearly 7.5% from the linked quarter, when excluding loans made through the Paycheck Protection Program.

Banks reported in the Federal Reserve's latest Senior Loan Officer Opinion Survey published in January that demand for commercial and industrial credits continued to increase in the first quarter, with 21.7% of respondents reporting stronger demand for loans to large and middle market firms, while 9.2% of participants reported stronger demand for loans to small firms. Both measures are the highest level recorded in the survey since 2014.

The pick up in demand has yet to lead to stronger loan growth in 2022. The Fed's H.8 data, which tracks commercial bank balances on a weekly basis, shows that loans have risen just 0.2% through the week ending Feb. 2 since Dec. 29, 2021, while C&I balances have dipped 0.5%. Deposits, meanwhile, have ticked up 0.2% during the same period.

Higher rates offer promise of better loan yields

Loan yields held steady in the fourth quarter at 4.34% but are poised to move higher with increases in interest rates. Loan yields were under considerable pressure throughout 2020 when PPP loans were responsible for the bulk of loan growth in the period as those credits carried rates of just 1%. As PPP loans are forgiven, many lenders are able to recognize revenue from origination fees.

PPP forgiveness bolstered C&I yields through the first three quarters of 2021, but those yields dipped in the fourth quarter as the volume of forgiveness waned, causing yields to fall to 4.14% from 4.19% in the linked quarter.

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 the benefit might not materialize until after the first quarter since the central bank's March meeting will occur with just a few weeks left in the period.

Still, while higher rates will increase yields on many credits, loan growth would offer an even larger boost to bank earnings as it would allow institutions to redeploy funds currently sitting in lower-yielding assets such as interest-bearing balances due — deposits at other banks. Those assets jumped an additional 13.6% year over year in the fourth quarter, increasing off an already-high base.

Interest-bearing balances surged in the early days of the pandemic as banks parked the flood of deposits at the Fed. The low-yielding assets have continued to rise notably since then due to the lack of attractive opportunities to put cash to work. Since year-end 2019, interest-bearing balances due have jumped nearly 128.8%.

Banks have also continued to grow their securities holdings even before rates have risen materially, increasing those portfolios 4.9% from the prior quarter and 22.1% from year-ago levels. Historically low interest rates have left bank managers with few attractive investment opportunities in the bond market but yields improved slightly in the fourth quarter, with the average yield on the 10-year Treasury rising 21 basis points from the prior quarter.

Long-term rates have continued to rise in 2022 on the news of the Fed's plans to taper its bond buying program and rising inflation concerns. In 2022, the average yield on the 10-year Treasury through mid-February had risen 30 basis points from fourth-quarter levels, offering further support for bank margins.

The promise of further increases in interest rates and signs of stronger loan growth suggest that margins will rise in 2022, with even greater increases in 2023.