Community Banks to Face Margin and Earnings Pressures in 2023 – Rising Rates and Liquidity Crunch Shift the Landscape for US Banks –
In the past months, a combination of swift rate increases and liquidity challenges has affected several banks, leading to major failures. This has created a heightened demand for deposits among US banks. While in 2022, community banks experienced slower increases in deposit costs compared to larger banks, the scenario is set to change in 2023. Customers are anticipated to swiftly transfer funds from noninterest-bearing deposits to higher-cost options such as certificates of deposits (CDs), narrowing the divide.
To cope with the liquidity crunch, banks, including community banks, will adopt measures like building reserves for potential loan losses, slowing down loan growth, and increasing their cash reserves. This shift in the composition of their balance sheets will inevitably impact the margins and earnings of community banks, presenting them with new challenges in the coming year.
Community Bank Margins Squeezed by Liquidity Crunch
In 2022, community banks experienced significant improvements in their margins, thanks to notable increases in interest rates, which resulted in higher yields on loans. During this period, funding costs also rose but remained relatively moderate. However, towards the end of the year, a shift occurred as more customers withdrew their funds from banks to seek better rates in Treasury and money markets. This trend intensified in the first quarter of the following year, leading to increased liquidity pressures for many institutions.
While these specific situations had unique characteristics, they raised concerns about funding challenges within the banking industry, considering they were among the second, third, and fourth-largest bank failures in US history. However, it’s worth noting that the majority of banks reported only modest outflows. This is positive news for community banks as well, as they, like larger institutions, hold bond and loan portfolios that may be underwater due to the sharp interest rate increase. Selling assets to meet liquidity requirements could cause them financial strain.
To address these challenges, some community banks are taking measures such as trimming their bond portfolios, selling securities at a loss, and reinvesting the proceeds into higher-yielding assets. Others are considering asset sales as a means to pay off higher-cost borrowings. For example, during the first-quarter earnings season, regional banks like Cadence Bank, First Interstate BancSystem Inc., Atlantic Union Bankshares Corp., and others announced securities sales in their efforts to strengthen future earnings.
However, the majority of community banks are likely to avoid selling securities and instead, increase their reliance on higher-cost funds such as certificates of deposits (CDs) and borrowings, while noninterest-bearing deposits decline. This shift will be driven by the significant spread between deposit costs and the fed funds rate, which remains wide. Consequently, deposit betas—the percentage of change in the fed funds rate passed on to depositors with interest-bearing accounts—will continue to rise.
In the fourth quarter, community banks saw a quarter-over-quarter interest-bearing deposit beta of 30.0%, a notable increase from 16.0% in the third quarter and 5.6% in the second quarter. The industry recorded an overall deposit beta, encompassing both interest-bearing and non-interest-bearing funds, at 20.7%, aligning closely with the 22% projection provided in our mid-December outlook.
The pressure intensified further in the first quarter as deposit outflows accelerated due to the liquidity crunch experienced by a few banks, eroding the confidence of shareholders and depositors in the viability of these institutions. In response, we anticipate community banks will be even more determined to protect their deposits by actively marketing accounts with higher interest rates.
In 2023, we anticipate betas to reach 30%, surpassing the level observed in 2022 by more than three times. This projection is primarily driven by liquidity pressures prevalent in the market.
As a consequence of the higher deposit beta, community bank margins are expected to contract significantly. We project a decline of 33 basis points in net interest margins for 2023. However, there is an optimistic outlook for 2024, as interest rates are predicted to decrease slightly, leading to more stable funding costs and liquidity pressures. As a result, net interest margins are anticipated to rebound significantly during that year.
Despite the dip in interest rates, community banks, which hold higher concentrations of longer-term loans, are likely to experience continued growth in earning-asset yields in 2024. This trend is expected to counterbalance the effects of lower rates, contributing to their improved financial performance.
Community Banks: Credit quality will begin to slip this year
In response to market stress and to maintain adequate liquidity, community banks will tighten their lending standards. This adjustment is expected to be ongoing, as indicated in the Federal Reserve’s latest senior loan officer survey in April 2023. Consequently, the pullback in lending is likely to contribute to higher credit costs for the group.
Over the past year, community banks, like larger institutions, have experienced substantial profits from credit activities due to historically low interest rates and the lingering effects of government stimulus provided during the pandemic. However, this favorable situation is expected to shift in 2023. Community banks will begin building reserves to prepare for the potential impact of significantly higher interest rates and elevated inflation on their borrowing base, particularly in the commercial real estate sector. This strategic move is aimed at safeguarding their financial stability in the face of changing economic conditions.
Credit trends in the US continue to show positive signs as unemployment rates remain historically low, household debt-to-income ratios are below the long-term average, and early warning indicators such as criticized loans are at low levels.
While there has been some attention on the increase in credit card delinquencies during the early months of 2023, the net loss rates for the six largest card companies have risen year over year but still remain significantly below pre-pandemic levels.
Investors are expressing concerns about banks’ exposure to the commercial real estate market, particularly in office and retail sectors, which have experienced reduced demand post-pandemic. The stress in the office market is evident as more companies adopt hybrid work models and remote work options, impacting office space utilization and property valuations.
Some banks have underwritten office properties with loan-to-values around 60% to 65%, but current market valuations suggest that the decline in property values could erode the equity cushion associated with these loans.
An inverted yield curve, often a signal of an impending recession, and higher mortgage rates have slowed housing market activity, leading to an increase in the inventory of homes for sale.
US consumers have maintained spending by borrowing more and using excess savings accumulated during the pandemic. However, bank lending has slowed following the liquidity crunch, potentially creating challenges for certain borrowers, like office landlords, to secure financing elsewhere.
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