Banks' interest income bottoms out

Third-quarter results from the biggest US commercial banks show the windfall from high interest rates is fading. JPMorgan Chase raised its full-year net interest income guidance to $92.5 billion, but its executives said deposit earnings had peaked for this cycle now that the Fed has begun to ease.

How the windfall was made

The boom in interest income came from a simple mismatch. When the Fed raised its policy rate from near zero in March 2022 to 5.25-5.50 per cent by July 2023, banks repriced their floating-rate loans upwards almost immediately. Deposit rates followed slowly, because most retail customers leave money in current accounts that pay little or nothing and rarely move it. For more than a year, the gap between what banks earned and what they paid widened, and net interest income across the industry reached records.

That advantage eroded before the Fed began cutting. Customers eventually noticed the yields available on money-market funds and Treasury bills, and moved cash out of low-yielding accounts or into certificates of deposit. The share of deposits earning little or nothing fell, and the average cost of funding rose each quarter. September's half-point cut turns that slow squeeze into a faster one.

Loans reprice first

When the base rate falls, yields on floating-rate commercial loans and credit lines drop almost at once. Retail deposit costs come down far more slowly. Net interest margins will narrow as a result, and that will test bank profits over the coming year. The strongest balance sheets will still make plenty of money. The days of easy margin growth are over.

The lag works against the banks at this point in the cycle. Certificates of deposit reprice only when they mature, so banks that locked in funding at high rates last year will keep paying them for months. Banks can cut rates on large corporate and wealthy clients' deposits quickly, but those customers are also the quickest to move their money if they find the offer poor. The easiest deposit costs to cut, those on ordinary current accounts, are already close to zero and have little room to fall.

Offsets that will soften the blow

There are forces working the other way. Banks hold large portfolios of fixed-rate securities and mortgages bought when yields were far lower, and as those assets mature the cash is reinvested at today's higher rates. That repricing will support income for several years regardless of what the Fed does. Falling yields also reduce the unrealised losses on bond portfolios that caused so much alarm when Silicon Valley Bank failed in March 2023, which strengthens regulatory capital at banks that must count those losses.

A steeper yield curve would help too. If the Fed cuts short rates while long yields hold up, as they have since September, banks earn more on the spread between cheap short-term funding and longer-term lending. Fee businesses offer another cushion. Investment-banking income has been recovering this year as bond issuance and deal-making pick up, and the largest banks have trading desks that thrive on volatility.

A lesson from 2019

The last easing cycle offers a guide. When the Fed made three insurance cuts in 2019, several large lenders trimmed their forecasts for interest income within months, and the industry's margins narrowed even though the economy kept growing and loan losses stayed low. The difference this time is the starting point: policy rates are far higher, so there is more room for deposit costs to fall eventually, and banks have more fixed-rate assets still waiting to be reinvested at better yields. The squeeze should therefore be shallower than in 2019 but last longer.

Big banks and small ones

The squeeze will not fall evenly. Money-centre banks such as JPMorgan have the broadest fee income and the cheapest deposits, and they gained customers during the regional banking turmoil of last year. Smaller regional lenders depend more heavily on spread income and have larger exposures to commercial property, where falling office values have already forced losses. For them, lower rates are a mixed blessing: margins narrow, but borrowers struggling to refinance property loans get some relief.

Credit quality is the other variable. Charge-offs on credit cards have risen from their unusually low levels during the pandemic, and a softer labour market would push them higher still. Banks raised provisions for losses in the third quarter, which is prudent but also a drag on reported profits. If the economy slows sharply, the Fed will cut further, margins will compress more, and loan losses will rise at the same time.

The case against gloom

The bullish view is that a soft landing would give banks the best of both worlds. Loan demand, which has been weak for two years as companies avoided borrowing at high rates, could revive as rates fall, and higher volumes would offset thinner margins. A lighter regulatory touch may also help, after the Fed signalled that it would water down proposed increases in capital requirements for the largest lenders. Bank shares have risen this year on precisely this hope.

The trouble is timing, and the data to watch come in two speeds. Loan growth takes quarters to build, while deposit and loan pricing adjust within weeks of each rate cut. The fourth-quarter results in January, along with banks' first guidance for next year, will show how far margins have narrowed and whether lending has begun to recover. In the meantime, the Fed's weekly figures on bank balance sheets will reveal whether loan books are growing and whether deposits are still leaking to money-market funds, and management commentary on how much of each rate cut is being passed on to depositors will indicate how fast the squeeze is coming.

Bank earnings will probably grow more slowly over the next year as margins narrow. Investors who bought the shares for rising interest income will need another reason to hold them. Expect net interest income at the big lenders to dip next year from this year's peak, with fee income and a pick-up in lending doing the work that rate rises did in 2023.