Funding costs at U.S. banks are beginning to diverge significantly, setting the stage for more considerable deposit rate increases next year.
A pair of rate hikes by the Federal Reserve in 2017 has driven deposit costs higher across the banking industry, whose cost of interest-bearing deposits rose to 0.46% through the first nine months of 2017 from 0.36% in 2016. Some banks are seeing this expense rise even more quickly, and there are signs of customers, particularly high-net-worth individuals and commercial depositors, becoming more price-sensitive and demanding better rates on their accounts.
Deposit betas, or the percentage of changes in market rates that banks pass on to their customers, climbed to 17.4% through the first nine months of 2017 from 13.5% in the first half and 12.2% in 2016. Betas remain well below the range witnessed during the last tightening cycle across most product lines, but we expect the industry's overall beta to exceed 50% in 2018.
Savings and money market accounts are one deposit product that could bear watching. Certain large institutions including Bank of America Corp. reported notable increases in deposit costs in the third quarter, largely due to higher rates on money market accounts with high-wealth clients.
Betas on money market and savings accounts have roughly doubled this year but remain under 10%. Betas on those accounts eventually eclipsed 40% during the last rate tightening cycle and seem poised to move again in that direction as banks put more of their excess liquidity to work and loan-to-deposit ratios rise.
Not all deposit franchises are created equal, and we have already seen divergence among the nation's largest institutions. The 20 largest banks by deposits, excluding trust and custody banks, have reported deposit betas in the range of 3% to 54% over the last 12 months. Those institutions collectively held close to 60% of U.S. deposits at the end of the third quarter. Goldman Sachs Group Inc. and TD Group US Holdings LLC, the U.S. banking division of Toronto-Dominion Bank, tied for the highest beta among the top 20 banks over the last year. More than a third of the deposits at TD's U.S. banking unit, TD Bank NA, are brokered deposits, which are more sensitive to rate changes.
Brokered deposits account for close to 45% of deposits at Goldman's banking unit. The firm has worked to build its consumer deposit base and improve its liquidity profile, adding more than $100 billion in deposits since year-end 2007. Much of the recent growth has come from the online retail channel that Goldman acquired from GE Capital Bank in the spring of 2016, but at a cost. Goldman offers some of the highest rates on savings accounts and 12-month CDs, currently marketing them at rates of 1.30% and 1.65%, respectively.
Other institutions, including some nontraditional players, boast much lower deposit betas. Charles Schwab Corp. has managed the third-lowest beta among larger institutions even though it lacks a significant bricks-and-mortar branch network. Schwab's largest funding source is a bank sweep product, which it considers most comparable to basic checking accounts at traditional banks. Schwab often prefers its brokerage clients to have a separate deposit account at another institution from which they can transfer marginal dollars into their Schwab account at the end of each month. Executives say that dynamic keeps Schwab from having to compete with higher-priced online-only deposits.
Regions Financial Corp.'s deposit base has proven to be one of the least sensitive to rates among the top 20 banks thus far, with a beta of just 11%. The Birmingham, Ala.-based bank has touted its conservative pricing approach to deposits in recent years that it believes pushed away any "hot deposits." Regions has also worked to reduce brokered and collateralized deposits while focusing on growth of smaller-dollar consumer deposits. That approach appears to be paying off, as the bank boasts not only a low beta, but a cost of interest-bearing deposits of just 0.28%.
M&T Bank Corp. has the lowest deposit beta among the top 20 banks, having seen little change in its cost of interest-bearing deposits over the last year. Nearly 98% of deposits at the Buffalo, N.Y.-based bank are considered core, and more than 40% of its deposits are transaction accounts. M&T also stands out because it has slowly run off a sizable portfolio of high-cost CDs that it inherited when acquiring Hudson City Bancorp two years ago.
Banks like these that can hold the line on deposit costs will benefit the most from further rate increases since most of the banking industry has positioned loan portfolios for rising rates. We do, however, expect loan yields to rise more quickly than deposit costs in the near term, allowing net interest margins to expand. Loan yields have rebounded from years of pressure, but competition has mitigated some of the increases. That pressure should ease somewhat in the coming year due to stronger loan growth.
Many bankers contend that uncertainty over potential policy changes in Washington, D.C., has overshadowed improvements in the economy and limited loan growth. Some policies and appointments of the Trump administration are beginning to take shape, and the market should have greater clarity into the potential passage of any legislation next year. Greater certainty, whether or not changes come to pass, should bring more borrowers to the lending table and help foster origination activity.
Loan growth and the expected margin expansion will drive earnings higher, particularly as credit costs remain relatively benign in the near term. Earnings are poised to grow 12.6% in 2017 and 5.7% in 2018. Earnings growth should slow in 2019 before higher credit costs serve as a true headwind to bank earnings.
The banks that outperform those expectations will be those with genuinely stable deposit franchises. Those funding bases have not been tested by a rate cycle in more than a decade, but the early signs suggest that not all banks will enjoy the same level of benefits from further rate increases.
Scope and methodology
S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2005 through the first nine months of 2017. The analysis includes all commercial and savings banks and savings and loan associations, including historical institutions as long as they were still considered current at the end of a given year. It excludes several hundred institutions that hold bank charters, but do not principally engage in banking activities, among them industrial banks, nondepository trusts, and cooperative banks. The analysis divided the industry into five asset groups to see which institutions have changed the most, using key regulatory thresholds to define the separation. The examination looked at banks with assets of $250 billion or more, $50 billion to $250 billion, $10 billion to $50 billion, $1 billion to $10 billion, and $1 billion and below.
The analysis looked back more than a decade to help inform projected results for the banking industry by examining long-term performance over periods outside the peak of the asset bubble from 2006 to 2007. S&P Global Market Intelligence has created a model that projects the balance sheet and income statement of the entire industry and allows for different growth assumptions from one year to the next.
The outlook is based on management commentary, discussions with industry sources, regression analysis, and asset and liability repricing data disclosed in banks' quarterly call reports. While taking into consideration historical growth rates, the analysis often excludes the significant volatility experienced in the years around the credit crisis.
The projections assume future Fed funds rates and 10-year Treasury yields based on a monthly survey of more than 60 economists conducted by The Wall Street Journal. Interest rate assumptions for 2020 and 2021 are based on the Congressional Budget Office's annual outlook. S&P Global Market Intelligence does not forecast changes in interest rates or macroeconomic indicators and aims to project what the banking industry will look like if the future holds what most economic observers expect.
The outlook is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment, and economic growth. The projections can be updated or revised at any time as developments warrant, particularly when material changes occur such as the implementation of the Financial Accounting Standards Board's impairment model, the current expected credit loss model, or CECL. That provision would drastically change the way banks reserve for loan losses. S&P Global Market Intelligence intends to make periodic updates as circumstances warrant.