For community banks, net interest margin pressure looms large

Community bankers are increasingly concerned about the downsides of rising interest rates — notably, weaker economic conditions and upward pressure on deposit costs.

That's according to the Conference of State Bank Supervisors' annual survey of community bankers. The CSBS polled 470 bankers between April and July of this year and found that 35% labeled net interest margins as "extremely important" and another 53% said NIMs were "very important."

Banks collectively grew loans and net interest income in the first half of this year, as customers borrowed more to invest following the worst of the pandemic. At the same time, interest rates started to climb, making loans more profitable. This helped many lenders expand their margins.

Bankers, however, worry the good times can last only so long. Rising rates impact adjustable-rate loans almost immediately, while customers tend to gradually demand higher rates on their deposits. As such, after months of rising rates, bankers expect deposit costs will soon begin to climb and NIM pressure could mount.

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In all, 88% of bankers surveyed ranked the potential for narrowing margins as their top external concern — a risk they cannot fully control through internal processes.

Bankers view the lagging deposit cost factor as "problematic," particularly as it may come just as the economy slows and loan demand ebbs, said Meredith Covington, a senior manager at the Federal Reserve Bank of St. Louis who worked on the CSBS survey.

Indeed, bankers' second-most pressing external concern is the economy and the likelihood it could buckle under the weight of lofty inflation and high interest rates.

Economic conditions were named by 33% of bankers in the CSBS survey as an "extremely important" external risk and by 51% as "very important."   

"Inflation rates are at their highest level in more than 40 years. Economic growth is stagnant," said Tom Fite, chair of the bank supervisor group.

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Price inflation eclipsed 9% this year and reached the highest level since the early 1980s, squeezing consumers. Fed policymakers have boosted interest rates several times to make borrowing more expensive, further slow spending and tamp down inflation.

Last week, the Fed voted to increase its benchmark rate by three-quarters of a percentage point to a target of 3% to 3.25%. The hike puts the Fed's interest rate above 3% for the first time since 2008. 

The Fed has raised its interest rate by 75 basis points in three consecutive meetings and by 3 percentage points overall since March. Policymakers signaled additional rate hikes are likely yet this year.

Historically, when the Fed moved with haste to ramp up rates, spending grinded to a crawl and the economy tilted into recession. During economic downturns, credit demand typically slowed and loan growth tapered.

That explains why loan demand ranked third among bankers' concerns. The survey found 30% of bankers described pressure on loan demand as "extremely important," and 48% labeled it "very important."