Fed's inflation conundrum brightens outlook for US community banks

U.S. community bank margins are poised to rebound in 2022 as the Federal Reserve works to combat inflationary pressures but the expansion will not offer a material lift to earnings until 2023.

Community bank margins will expand over the next few years as the Fed raises short-term interest rates and earning-asset yields rise more quickly than deposit costs. Normalizing credit trends in 2022 stemming from the lack of pandemic relief efforts and rising labor costs will create difficult year-over-year comparisons for community bank earnings in 2022, but margins will rise modestly and then increase far more the following year. While margins will fail to return to pre-pandemic levels for the foreseeable future due to the abundance of excess liquidity, the expansion in 2023 should help drive earnings nearly 8% higher from 2022 levels.

Fed action should offer community bank earnings some juice

The Fed is expected to soon tighten monetary policy to combat heightened inflation, ending its bond-buying program in March, with short-term rate hikes poised to follow soon after.

Economists expect the central bank to raise short-term rates three times by the end of 2022 as it works to temper rising prices. Inflation has tracked well above the central bank's 2% target rate for the last eight months, with the core consumer price index, or CPI, the Fed's preferred measure, which strips out food and energy, tracking at 3% or higher in every month since April 2021. The core CPI has increased in recent months, rising to 5.5% in December 2021 from 5% in November and 4.6% in October.

Rate hikes will offer a modest boost to community bank margins in 2022, with much greater expansion occurring in 2023. Economists expect three more short-term rate increases in 2023. If that occurs, community bank margins are projected to rise to 3.33% in 2022 from 3.28% in 2021 and then increase to 3.44% in 2023.

Those margin projections are up considerably from our prior outlooks in September and July 2021, when few short-term rate increases were expected during 2022 and 2023.

Community bank margins are now projected to rise even further in 2024 and 2025, but the massive growth in cash balances during 2020 and much of 2021 will continue to serve as a headwind to spread income. Borrower demand for loans remained weak through much of 2021, while forgiveness of loans made through the Paycheck Protection Program and early paydowns of other credits served as an additional headwind to loan growth. While that occurred, deposit growth remained strong, leaving community bank balance sheets sodden with an estimated $415 billion in excess liquidity as of Sept. 30, 2021.

That excess cash will remain on their balance sheets for the foreseeable future, leaving community bank margins below pre-pandemic levels for the next few years.

Excess liquidity should decline modestly by year-end 2021, with loan growth finally showing signs of life in the last month of the year. Excess cash balances should decline further in 2022 and 2023 amid stronger loan growth and weaker deposit growth but remain well above $300 billion even as the economic recovery continues.

We expect deposit growth to decrease significantly as the Fed tightens monetary policy and consumers utilize some of the nearly $2.7 trillion in excess savings accumulated through the pandemic. Slower deposit growth combined with stronger loan growth will allow loan-to-deposit ratios to improve.

A number of bankers have questioned if changes in relief programs and the Fed's tapering of its bond-buying program purchases could serve as a headwind to deposit growth or even result in some of the cash leaving their bank. Not every institution is in that camp though.

Bank of America Corp. Chairman and CEO Brian Moynihan noted on the company's fourth-quarter earnings call that deposits did not shrink during the 2017 to 2019 rate hike cycle. The executive said BofA grew deposits throughout that period and recorded higher growth than the industry.

Bankers should also have more attractive investment options in the bond market as rates move higher, encouraging them to deploy some of the dry powder sitting at the Fed into higher-yielding assets. We expect community banks to put more excess cash to work in their securities portfolios in 2022 and 2023, supporting margin expansion.

Credit risk remains low but costs to begin normalizing

Credit costs remain historically low for community banks but should rise modestly in the coming years as emergency relief efforts wane, interest rates rise and higher inflation and increases in wages negatively impact some borrowers.

Net charge-offs are expected to fall nearly 20% in 2021, down to 0.10% of average loans, from relatively low levels recorded in 2020 as the myriad government relief efforts to mitigate the blow of the pandemic and forbearance provided by banks offered borrowers a bridge into the economic recovery. Such a low level of credit costs will allow earnings to jump nearly 24% in 2021 from year-ago levels.

Credit costs should normalize in 2022, with net charge-offs rising notably, albeit to just 0.19% of average loans as borrowers operate in a world without the same support from deferrals on loan payments, expanded unemployment benefits and rent and foreclosure moratoriums. Companies also face higher labor costs, with wages through November 2021 having risen nearly 10% since February 2020 as several million people have left the workforce.

Higher wages could limit efficiency improvements as well. A number of large banks, including JPMorgan Chase & Co. and The PNC Financial Services Group Inc. told the Street during their respective fourth-quarter earnings calls that expenses would rise in 2022, in part due to the need to boost wages. Increases in labor costs could mitigate the efficiency improvement some institutions will gain through investments in technology. Such improvements might even be further out the horizon for smaller community banks who are further behind the curve in making necessary tech investments.

Given those expense pressures and the abundance of excess liquidity, many community banks likely will contemplate maintaining their independence in the coming years. While the prospect of higher rates has boosted bank stocks and a number of institutions are positioned to benefit from the change, others could find that earnings growth might be short of expectations and opt to partner with a larger institution to achieve the necessary scale to compete effectively in the current environment.

Scope and methodology

S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2004 through the third quarter of 2021. The analysis includes all commercial and savings banks and savings and loan associations, including historical institutions, as long as they were still considered current at the end of a given year. It excludes several hundred institutions that hold bank charters but do not principally engage in banking activities, among them industrial banks, nondepository trusts and cooperative banks.

The analysis divided the industry into five asset groups to see which institutions have changed the most, using historically significant regulatory thresholds. The examination looked at banks with assets of $250 billion or more, $50 billion to $250 billion, $10 billion to $50 billion, $1 billion to $10 billion, and $1 billion and below.

The analysis looked back more than a decade to help inform projected results for the banking industry by examining long-term performance over periods outside the peak of the asset bubble from 2006 to 2007. Market Intelligence has created a model that projects the balance sheet and income statement of the entire industry and allows for different growth assumptions from one year to the next.

The outlook is based on management commentary, discussions with industry sources, regression analysis, and asset and liability repricing data disclosed in banks' quarterly call reports. While taking into consideration historical growth rates, the analysis often excludes the significant volatility experienced in the years around the credit crisis.

The outlook is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment and economic growth. The projections can be updated or revised at any time as developments warrant, particularly when material changes occur.

^{This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.}