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Deep Dive | Funding Will Be Key As Yield Curve Flattens

The flattening yield curve is expected to continue pressuring industry profitability in coming months, even though the Fed has hit the brakes on interest-rate hikes.

Banks have averaged quarterly net interest income (NII) growth of 6% on a year-over-year basis since the Fed started raising rates in the fourth quarter of 2015. Needless to say, the moves greatly boosted the sector’s revenue and profitability.

If one were to peel the onion back another layer, however, it becomes apparent that approximately 70% of the growth over the past eight quarters was driven exclusively by rate increases. This leads to a natural question: what will happen to NII growth in a plateauing rate environment?

The simple answer: loan growth and funding-cost relief become much more important.

Regarding lending growth, banks outperformed alternative lenders in the fourth quarter of 2018 due to weakness in capital markets. This trend continued strongly into the first quarter, but H8 data for the second quarter indicates that momentum is slowing. While year-over-year consumer loan growth of 5% is providing some cushion, commercial loan growth has slowed from the annualized 10%+ rate in the first quarter to approximately 4% in the second quarter. One potential reason is that commercial customers may be raising money in the capital markets in order to pay off their loans.

As slowing loan growth weighs on NII, banks will likely continue to focus on building their securities books — a trend that has been occurring for the past three quarters. Over this period, banks grew their lending books by 2% while increasing their securities books by 3%. Additionally, as the yield curve continues to flatten, these securities will likely be reinvested at lower incremental yields than their current portfolio, providing yet another headwind to NII.


In this environment, banks will have an increasingly difficult time growing funding that is profitable at the margin. Surprisingly, total deposit growth has outperformed expectations at approximately 4% year-over-year, but that growth is coming entirely from CDs. In the first quarter, for example, retail CDs of all tenures grew at 32% year-over-year, according to Novantas data.
Banks have started curtailing the duration offered on CDs due to the flattening yield curve, but the incremental growth is still coming in at a marginal cost of funds (MCoF) rate in the range of 500 basis points. This makes profitable growth difficult at best, especially given today’s yields on earning assets.

An additional risk to profitability is the risk to any credit hiccup in the system. Overall, bank management teams are not pointing to any imminent credit issues on the horizon. Forward-looking data remains solid and Novantas believes that much of the riskiest lending has moved off-balance sheet to non-bank lenders over the course of this cycle.

While we are not calling for a catalyst to prompt credit normalization, we do believe that reserve releases — and their accompanying boost to earnings — have largely run their course. In the first quarter alone, banks experienced no less than 16 credit events of impactful size that were all described as one-time events. This begs the question of whether they are really one-off events or the beginning of a normalized credit cycle?

In prior years, investments in technology and growth put upward pressure on expense bases. Profitability on the balance sheet is becoming largely dependent on the macro economy, resulting in a difficult operating environment for banks. Therefore, they will be forced to look for efficiency programs to improve costs without sacrificing their technological competitiveness.

Over the past few quarters, several banks have announced that they expect to cut costs or see expense growth flatten. But most large banks already have picked the low-hanging fruit by refining their branch footprints and reducing headcount.

This will put additional pressure on the regional banks because they will need to continue to invest in technology and marketing. The nationals, on the other hand, are close to achieving scale necessary for balanced expense growth.

Novantas expects continued large-scale M&A to occur in this environment because it will be difficult to easily identify expense initiatives that don’t sacrifice investments in marketing and technology.

At this point in the cycle, profitability will be pressured at banks of all sizes, and we expect those banks that offer a distinctive value proposition to their clients to come out ahead. However, unlike previous cycles, the governing metric to outgrow competitors through the cycle will be their funding position.

Bob Warnock
Director, Chicago

For more information, contact Novantas Marketing

+1 (212) 953-4444

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