Banks brace for more margin tightening despite lower funding costs

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Declining interest rates resulting from a recent rate cut will likely put more pressure on net interest margins.

A large number of community banks reported that their margins were squeezed in the second quarter as competition increased deposit prices and a market-driven dip in certain loan rates spurred refinancing.

The median margin at roughly 170 banks covered by Keefe, Bruyette & Woods compressed by 5 basis points from March 31, to 3.64%. About a quarter of banks that KBW follows had not reported as of the firm's July 26 note to clients.

There is a concern that, in a declining rate environment, banks will struggle to lower funding costs fast enough to offset lower loan pricing. The impact could be more pronounced for smaller banks that rely less on fees to offset lower spread income.

“Most banks are now asset sensitive, and so after a rate cut, it could take a couple quarters to adjust,” KBW analyst Damon DelMonte said. “In that time, you could see margin pressure on the asset side.”

KBW had cut earnings estimates for nearly half of the small-cap banks in its coverage, with an average reduction of 3%.

While several bankers said during quarterly earnings calls that they would lower deposit pricing after a rate cut, they also warned that floating-rate loans could reset quicker than deposits.

Brookline Bancorp in Boston is bracing for 5 to 7 basis points of margin compression over the next two quarters, Carl Carlson, the $7.6 billion-asset company’s chief financial officer told analysts on a quarterly call. Higher funding costs were a big reason why Brookline’s margin compressed by 9 basis points from a quarter earlier, to 3.55%.

At Opus Bank in Irvine, Calif., the margin narrowed by 27 basis points, to 2.88%. The $7.9 billion-asset bank was pinched by higher funding costs and a lower yield on earning assets.

Opus is “hopeful” that funding costs will ease over time, CFO Kevin Thompson said on the bank’s earnings call. Still, Opus is bracing for continued pressure on loan yields.

“Multifamily loan rates, in general, have [declined] quickly in this current rate environment, while the customer deposit rates have … held fairly strong,” Thompson said.

Executives at larger regionals and megabanks also expressed concern about the direction of rates.

“The interest rate environment has become more volatile than at any point in recent memory, impacting our outlook for net interest margin and spread revenues,” Darren King, CFO of M&T Bank, said during the Buffalo, N.Y., company’s earnings call.

The $122 billion-asset M&T’s margin contracted by 13 basis points, to 3.91%. Higher deposit costs were a factor, King said, along with lower market rates on loans, primarily from Libor moving down ahead of the most recent rate cut.

Many floating-rate loans are tied to Libor.

King, anticipating the rate cut, estimated that each 25-basis-point reduction would result in 5 to 8 basis points of margin pressure over the next 12 months.

Wells Fargo painted a comparable picture. The $1.9 trillion-asset company’s margin narrowed by 9 basis points, to 2.82%.

For the San Francisco company, the most pain will be felt in the next “couple of quarters because Libor assets, or prime assets for that matter, price down right way and deposit costs take a little bit longer,” CFO John Shrewsberry said during a quarterly earnings call.

Those forecasts leave some investors concerned about margin pressure negatively impacting bank earnings.

The bigger concern should be the reason why the Fed is cutting rates — the potential for the first recession in a decade, industry experts said. That could mean issues with credit quality as borrowers adjust a change in the economic cycle.

“If we see two, three rates cuts, then we have a whole lot more to worry about,” said Sam Pappas, president and CEO of Mystic Asset Management in Providence, R.I.

“One move on rates will affect bank earnings, but I think they can absorb that,” Pappas added. “Multiple cuts would likely happen only if the economy is clearly weakening, and that kind of environment opens things up to worry about elevated loan losses, declining loan demand and possibly really difficult challenges to earnings.”

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