Five big questions as banks await Fed's rate cut

September 6, 2024 11:18 AM

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The Federal Reserve has signaled it will likely cut interest rates later this month, beginning the descent from a record-high level that has crimped banks' earnings for two years.

Although it's unclear whether the central bank will bring rates down by 25 or 50 basis points, Fed Chair Jerome Powell has sparked confidence about the likelihood of a cut when the Federal Open Market Committee meets two weeks from now.

The Fed's move could be the start of a new chapter for financial institutions whose deposit costs, loan growth and profit margins have been squeezed by high rates.

Still, while many banks' balance sheets have been showing scars from rate hikes, their executives have made clear that one small decrease won't have a meaningful impact on their earnings.

"Based on the current expectation on the rate cuts, I wouldn't think that the rate cut will be significant enough that it can really move that much of a needle," East West Bancorp Chairman and CEO Dominic Ng told analysts in July.

He said the Fed seemed to be driving toward a so-called soft landing — avoiding the high unemployment rates of a hard recession — but the industry isn't ready to chase new business yet.

On Friday, the Bureau of Labor Statistics reported 142,000 jobs were created in August, falling short of forecasts and a development likely to fuel the debate over how much the Fed should cut interest rates.

Here are five major questions about the impact of interest rate cuts, drawing on what bank executives said during second-quarter earnings calls about the likely impact on some of the ways they earn money.

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Will deposit costs take a long-awaited turn?

Banks anticipate getting some relief on deposit costs as the stiff competition to land customers' money over the last two years eases up. Lower interest rates should mean that people won't expect as much bang for their buck and may have less incentive to shop for high yields on their cash.

Although higher rates also allowed banks to charge more interest on loans, decreased borrower demand meant that interest income didn't keep pace with the price of deposits. That imbalance compressed net interest margins — the difference between what banks collect in interest and what they pay to depositors.

Financial institutions have steadily been making moves to fight high deposit costs, especially since abundant funding has become less vital amid tepid loan demand. Some companies, such as Ally Financial, Discover Financial Services and Goldman Sachs, began trimming high-yield savings programs earlier this year.

Still, most banks signaled that one, or even two, rate cuts wouldn't immediately put a lid on margin compression from deposit costs.

Ally, for example, isn't counting on rate cuts to start generating upside on the liability side of its balance sheet, according to Chief Financial Officer Russ Hutchinson. The $193 billion-asset bank is guiding for its net interest margin to tick up as its funding costs go down and it bulks up on higher-earning loans.

John Woods, the CFO at Citizens Financial Group in Providence, Rhode Island, said on the $220 billion-asset company's second-quarter earnings call that deposit pricing pressures will continue to "bump along" until the Fed cuts rates, adding that the first Fed rate would be "helpful."

JPMorgan Chase also offered a wary outlook on deposit costs. CFO Jeremy Barnum Barnum cautioned that deposit margins, which are "well above historical norms," would continue to compress profits going forward.

Bank of Marin, a $3.7 billion-asset bank in Novato, California, is managing its deposits by pulling out of the competition for "rate shopper money," said President and CEO Tim Myers.

"We will cautiously look to allow deposits to run off that are overpriced," Myers said.

How much will loan demand improve?

High borrowing costs have been contributing to the sluggish loan demand that bankers have been reporting in recent quarters. In the first quarter, the industry-wide year-over-year loan growth rate was 1.7%, according to the Federal Deposit Insurance Corp. — the lowest quarterly growth rate in two and a half years.

The question now is whether the Fed's first rate cut will make a significant difference.

David Antolik, the president of S&T Bancorp in Pennsylvania, expressed optimism about the likely impact of rate cuts. As commercial customers anticipate a decline in borrowing costs, "they're looking at the possibility of refinancing or moving forward with projects," Antolik said.

Similarly, Peter Sefzik, the chief banking officer at Comerica, said that the Dallas-based company's surveys of customers indicate that interest rates are the top driver of loan demand. But he also pointed to business owners' uncertainty about the outcome of the presidential election as another deterrent to borrowing.

"I think probably real demand doesn't pick up until you start to see interest rates come down and we get through the election," Sefzik told analysts in July.

Will mortgage refinancing regain steam?

Though mortgage rates are down a bit from their peak last year — the 30-year fixed-rate mortgage rate sat at 6.35% in late August — they are still higher than they were at any point between 2009 and mid-2022.

The upshot is that the math of refinancing doesn't work for most homeowners. And bankers are warning that a 25-basis-point cut by the Fed, or even a 50-point cut, won't revive the refinancing business.

William Furr, the chief financial officer of Dallas-based Hilltop Holdings, said on a recent earnings call that the largest block of the company's customers currently have mortgage rates below 5%.

"So the first 25 basis points — even the first 100 basis points of reduction by the Fed — we don't actually see, or aren't actually projecting internally, that we're going to have a material rebound in refinance activity," Furr said.

KeyCorp CFO Clark Khayat gave the same assessment, saying that rates will "have to come down quite a bit, frankly," to spur a lot of refinancing activity.

There is a silver lining for banks that offer home equity lines of credit. Brendan Coughlin, vice chairman and head of consumer banking at Citizens, said that high rates and high levels of mortgage equity on homeowners' household balance sheets have contributed to "very strong HELOC growth."

Will lower rates protect banks from commercial real estate losses?

Banks may feel some relief from rate cuts in their commercial real estate portfolios, which have been under the microscope lately. The central bank's next move could boost the earnings potential for banks with outsized exposure to property loans, especially in the office sector, while also reducing their credit risk.

As fixed-rate loans made in the zero-rate days mature, especially in conjunction with high inflation, fears that borrowers will strain to make higher payments have percolated across the industry. Additionally, work-from-home trends have dragged down property values and deterred loan sales, narrowing the opportunities for banks to get troubled notes off their balance sheets.

The double whammy of credit concerns and weak income from the lower-rate loans has left many CRE-heavy banks feeling the burn on their stock prices.

After Powell's signal that the Fed would cut rates, the stock prices of several CRE-focused banks, including Eagle Bancorp, shot up.

Eagle, in Bethesda, Maryland, has lost nearly 30% of its value in the market this year due to concerns about its CRE concentration. The $11.3 billion-asset bank has taken losses on some of its properties in Washington D.C., which have bruised its earnings. Its stock price rose some 11% as the market digested the Fed's rate signals last month.

"Economic and interest rate uncertainties, particularly regarding office loans and other CRE exposures, have presented challenges," Eagle President and CEO Susan Riel said on the bank's second-quarter earnings call.

When will M&A rebound?

Lower rates should also give banks more room to weigh the benefits of mergers and acquisitions.

After a spate of deals in the zero-rate era of 2020 and 2021, M&A sputtered to a near-standstill as rising rates brought margin compression, unrealized losses on bond portfolios and uncertainty. Now, those factors are starting to level out. Investors are also more bullish on bank stocks — the KBW Nasdaq Bank Index is up nearly 20% year-to-date — which is providing some currency for transactions.

Still, banks are short on details about any M&A plans, often using terms like "opportunistic," and pointing to the upcoming presidential election as another roadblock to inking deals.

Tyler Wilcox, president and CEO of Peoples Bancorp in Marietta, Ohio, said he expects more M&A in 2025. He's encouraged by the increasing amount of conversations about deals but noted that it has yet to translate into more transactions.

"There is a lot of discussion going on," Wilcox said. "But from what I see, there are a lot of management teams and boards that are playing a little bit of a wait-and-see. Wait and see what happens with rates. Wait and see what happens with the election."

Home BancShares in Conway, Arkansas — which has been an avid acquirer of banks in the last 20 years — is looking to 2025 for opportunities. Chairman and CEO John Allison said he wants to get a clearer view of how rate cuts will shake out. He's also likely to hold off on deals until the maturation of loans from the Fed's Bank Term Funding Program — which offered loans to banks looking to shore up their liquidity amid last year's banking crisis.

Allison said he was cautious about striking too soon on a deal that leaves Home with a bank that is below its performance standard.

"I don't want to have my hands tied up in the middle of a deal when real opportunities come up," Allison said. "And I don't mean this [disrespectfully], but if [management teams] run their bank in the ground, [if] I'm going to buy their problem, it's going to come on our books."

Chicago-based Byline Bancorp also pointed to rate cuts as a tailwind to underwater bond portfolios, which have been a major impediment to bank M&A recently, though Byline President Alberto Paracchini said smaller banks like his face fewer regulatory hurdles than $100 billion-plus-asset institutions with respect to unrealized losses.

Paracchini said he thinks M&A activity will stay relatively level for now, but is likely to pick up in the future. He said the $9.6 billion-asset bank has the capital flexibility to jump on a deal.

There have been some 70 bank deals announced in 2024, per S&P Global Market Intelligence data, versus 100 total transactions in all of 2023.