An unexpected drop in funding costs may have widened net interest margins at community banks in the second quarter.
For most of 2011, small banks have slowly reduced interest rates on deposits enough to stabilize or perhaps lift margins, some analysts say. It remains unclear whether banks will be able to sustain wider spreads.
Christopher Marinac, an analyst at FIG Partners LLC, said a number of banks, particularly those with less than $10 billion of assets, realized earlier this year that reducing deposit prices was "the one card they had not played yet."
Those banks "had a lot of momentum left" in the second quarter for reducing what they paid on money market accounts and certificates of deposit, he said.
The average one-year CD rate hit an all-time monthly low in June of 0.44%, according to Bankrate.com. The average five-year CD yields tapered off to 1.67% in June compared with a 1.71% average for the previous three months. (Analysts said funding costs for the second quarter could edge down from the 1.07% median of a quarter earlier, as determined by SNL Financial.)
"Funding costs came down a lot faster than anyone anticipated," said Mark Fitzgibbon, the director of research at Sandler O'Neill & Partners LP. "People will be surprised by the net interest margins" when community banks report second-quarter results this month.
Fitzgibbon estimated that the median margin would be a few basis points higher than the 3.63% reported in the first quarter for banks and thrifts with less than $20 billion of assets. (The first quarter margin was virtually flat from the two prior quarters.)
The research team at FIG Partners wrote in a July 5 note that investors who have become accustomed to presuming the worst will be surprised by the second quarter, as reduced funding costs will likely boost spreads and earnings.
Some analysts disagreed. They predict lending woes will offset any benefit on the funding side.
"What, are they on drugs? We've been hearing that [margins] will continue to be under pressure," said Paul Miller, an analyst at FBR Capital Markets. "Loan growth is coming at the expense of yields, and deposit prices are not [falling] quick enough for various reasons to offset the yields."
Jeff Davis, an analyst at Guggenheim Securities LLC, expects more of the same from the second quarter. "We're looking for flat to down nominally," he said. "We're talking about a couple basis points, and that's basically flat."
Naysayers argue that competition for good loans, largely through the offering of low rates, will overshadow any slashes in deposit rates.
"In theory, loan yields are somewhat stable, but it's only a matter time before loan yields start to ease" due to competition, Davis said. "If we stay in a really low interest rate environment for another year or two years … no one's going to escape" margin pressure.
Fitzgibbon said the most margin pressure is in the Southeast and Pacific Northwest. Margin expansion will likely occur at thrifts that had higher deposit rates than banks and recently lowered their cost of funds, as well as in markets with more commercial loan growth such as New York.
"It is going to get harder. You can't take everybody's deposit rate to zero so your funding has limited ability to continue lowering rates," Fitzgibbon said. "The longer we stay in a lower rate environment, the harder it is going to be to hold margins."
Marinac agreed that slashing deposit rates does not remedy the greater problem of lagging loan demand, but it may "soften up" investors with a negative bias toward banks. "People forget that there are a lot of [banking] companies making the trade-off between cash and getting more proactive in earning assets," he said.
With lending weak, many banks have invested in securities and Treasuries that are low-yielding but may pay enough to preserve margins for a while. However, most analysts agreed that locking into such investments will not compensate for a prolonged soft lending market. Regulators have also expressed concerns about banks that rely too much on such investments.
"Fundamentally, the yields are pathetic compared to history and inflation rates" and "loan demand is going to stay very soft for years," Davis said. "The industry may have to rethink its [negative] view of corporate bonds."
