While U.S. banks' funding costs have only risen modestly since the Federal Reserve began raising rates, the market will soon be reminded that not all bank balance sheets or products will prove equal. Even though deposit costs only inched higher in the second quarter, the liability side of bank balance sheets is coming back into focus. The investment community is watching closely for any changes in banks' deposit business, and the FDIC recently reminded community banks to be mindful of potential funding issues that could arise in stress situations.
Funding costs continued to rise in the second quarter amid rebounding loan growth and two rate hikes by the Federal Reserve in March and June. The banking industry's cost of interest-bearing deposits rose to 0.42% through the first six months of 2017 from 0.36% in 2016 and 0.33% in 2015, but there are signs of customers becoming more price sensitive as banks experiment with CD specials and raise rates on other products.
Deposit betas, or the percentage of changes in market rates that banks have to pass onto their customers, have lagged the levels seen during the last interest rate tightening cycle across most product lines, and are particularly lower for savings and money market accounts. Funds flocked into those accounts during the credit crisis, pushing them to 62% of banks' deposit bases at-year 2016 from 41.5% in 2007. Now as rates rise, many market watchers believe customers could shift those funds to other products or demand higher rates from banks.
As liquidity has yet to become stretched, however, the cost of money market accounts has not risen materially. That will change as loan-to-deposit ratios continue to rise and banks with the greatest funding needs offer higher rates on their deposits to attract customers. More banks have already begun offering CD specials with the hopes of attracting blocks of funding. CD rates are rising at many institutions, particularly at larger community banks and smaller regional institutions that managed higher loan growth rates in recent years. The rates on those products seem poised to move even higher, with more than half of retail CDs set to mature in less than one year as of June 30, compared to just 35.5% in 2016.
Funding costs have varied even among the nation's largest banks. The five largest banks by deposits, which collectively held 49% of the nation's accounts at the end of the second quarter, have reported deposit betas in the range of 9% to 25% over the last year.
Bank of America Corp. boasts the lowest beta and perhaps the strongest retail deposit franchise in the country. BofA has invested close to $3 billion in technology annually over the last three years and recently topped our mobile bank app rankings. BofA now reports that 21% of deposit transactions come through mobile channels, which we have argued helps build customer loyalty beyond the price tied to an account.
Wells Fargo & Co., meanwhile, reported the highest beta among the largest banks over the last year. The San Francisco-based bank has seen its cost of deposits increase more than its counterparts while it has battled fallout from its fake account scandal.
The nation's largest banks are often considered rate setters, but have experienced higher betas than the industry as a whole over the year. The industry recorded a deposit beta of 13.5% in the 12 months ending June 30, 2017, while seeing loan yields expand meaningfully across virtually all loan types. Loan yields should continue to rise with further increases in interest rates, although expansion could be limited if long-term rates do not rebound to the levels that most economists expect.
The industry has positioned loan portfolios to benefit from further rate increases. Banks' asset repricing disclosures show that close to 38% of loans were set to reprice in the next 12 months at the end of the second quarter, compared to nearly 27% at year-end 2005, when the last tightening cycle was underway. Rising loan yields should outstrip increases in deposit costs, allowing bank margins to expand.
Net interest margins should improve while credit quality remains fairly clean in the near term, resulting in notable earnings growth. There are some early warning signs on the horizon, such as higher credit card delinquencies, the potential for some spillover from problems in the beleaguered retail sector, and possible losses stemming from Hurricane Harvey. But early stage delinquencies across bank portfolios remain low, and the U.S. economy has shown no real cracks in the armor yet.
S&P Global Market Intelligence expects bank earnings to grow 12.6% in 2017, 7.1% in 2018 and 2.8% in 2019. We expect earnings to hold steady and then decline thereafter as credit quality sours.
The strong earnings growth in the near term should push bank returns to double-digits this year, eclipsing that mark for the first time in the last decade.