The Fed’s rate hike on Tuesday served as a stark reminder for many banks that a return to strong, broad-based business loan demand can’t come soon enough.
That’s because the era of rock-bottom funding costs that banks have enjoyed is rapidly coming to an end.
The Federal Open Market Committee on Tuesday raised its benchmark lending rate by a quarter percentage point to a range of 1.25% to 1.5%. Meanwhile, banks’ funding costs have risen to their highest level in four years, according to Federal Deposit Insurance Corp. data.
The situation is likely to continue in 2018, as the Fed projected Tuesday that there will be three rate hikes next year, as Federal Reserve Gov. Jerome Powell is expected to succeed Janet Yellen as Fed chair. (Powell's nomination has been approved by the Senate Banking Committee but is still pending in the full chamber.)
The rate hike highlights the need for loan demand from businesses to rebound, analysts and bankers say, as growth in commercial and industrial loan balances has slowed considerably this year. Otherwise, it will be difficult for banks to take advantage of the higher loan rates they are charging.
Take the case of the $1.2 billion-asset Evans Bancorp in Hamburg, N.Y. In a narrative that’s repeated at hundreds of banks across the country, Chief Financial Officer John Connerton described his bank’s one-step-forward, one-step-back situation in managing net interest income.
“The bank's loan yields have benefited from a variable loan repricing due to an increase in the prime rate” after the Fed’s recent rate hikes, Connerton said during an Oct. 30 conference call. Evans’ loan yields improved six basis points to 4.6% in the third quarter from the previous quarter, and 23 basis points on a yearly basis.
But here’s the rub: “The company’s core funding costs have risen due to consumer preferences returning to maturity deposits [such as CDs], as the cost of interest-bearing deposits for the third quarter” increased on both a quarterly and yearly basis, Connerton said.
It’s a situation that only certain banks can avoid, namely those institutions located in rural areas or those with little loan demand, said Josh Siegel, chairman and CEO of StoneCastle Partners, which provides deposit and liquidity services to community banks.
“Those banks aren’t rushing to raise deposit rates because they are still flush with cash,” Siegel said.
For banks located in competitive markets, or who have too few deposits to fuel their lending, they have little choice but to pay higher deposit rates, Siegel said. Otherwise, they run the risk of losing valuable deposit customers.
With each successive rate hike since the financial crisis, banks have increasingly paid higher rates to depositors and passed on the rate hikes sooner, Siegel said. When the Fed first raised rates in December 2015, only a small portion was passed along to depositors in the form of higher CD or savings account rates and it took a few months for it to happen, Siegel said.
Ever since, the size of deposit account rate hikes has increased, and banks have moved faster.
“The second hike was passed through within a couple of weeks” to depositors, he said. “The third hike was in a matter of three days.”
Indeed, commercial and consumer deposit rates continue to rise, although online banks are leading the charge on higher consumer rates more so than traditional banks.
The picture isn’t as bleak for banks with vigorous consumer lending, as credit cards, personal loans and home equity loans are typically tied to the prime rate, said Tendayi Kapfidze, chief economist at LendingTree.
“Typically, we see the prime rate is much more responsive to the Fed’s rate hikes,” Kapfidze said.
Otherwise, most bankers have accepted that the Fed’s plan to keep raising rates is going to increase their own funding costs. If only commercial loan demand can cooperate.
“Pricing pressure to starting to build on funding costs,” said Mark Turner, chairman and CEO of the $6.8 billion-asset WSFS Financial in Wilmington, Del., during their third-quarter conference call. “As we expected it would.”