Bank profits set to disappoint amid tougher deposit competition

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The panic that gripped the banking industry this spring has faded, but that doesn't mean the bad news is over.

Many banks, particularly regional lenders, are expected to report a large squeeze in profits as the second-quarter earnings season kicks off on Friday. The culprit: a sharp increase in funding costs after this year's turmoil. 

Some banks lost deposits in the spring and had to raise cash by borrowing at higher interest rates. Others hung onto deposits but had to pay customers more in interest to do so. Even those whose deposit trends have been positive are finding that liquidity isn't as cheap as it used to be.

It all adds up to higher expenses for banks, whose depositors want more compensation now that short-term interest rates are above 5%.

"You're going to see higher deposit costs as banks start to play catch-up," said Tim Coffey, an analyst at Janney Montgomery Scott.

The good news is that those profitability concerns are quaint compared with the upheaval that upended the industry earlier this year, claiming three regional banks and threatening at least a couple more. Wild cards are always possible, but analysts say worries over additional banks failing have eased.

Even so, deposit competition "may rage on for the foreseeable future," according to David Chiaverini, an analyst at Wedbush Securities. 

The result will be pressure on net interest income, as banks' interest expenses rise faster than their revenues do, Chiaverini wrote in a note to clients. 

And though loan books remain healthy, office building loans may see trouble in the next year. So may certain other consumer and commercial lending segments.

Plus, over the coming months, large and regional banks will face tougher rules following the failures of Silicon Valley Bank, Signature Bank and First Republic Bank.

"The underlying fundamental and structural backdrop remains tough for banks, and we continue to believe that the next few quarters could be challenging," Chiaverini wrote. 

Four big banks will kick off earnings season on Friday: JPMorgan Chase, Wells Fargo, State Street and Citigroup. A slowdown in investment banking activity may prompt some setbacks at some big banks, but analysts expect the bigger disappointments to come next week, when regionals start reporting their results.

Brandon King, a regional and community bank analyst at Truist Securities, expects a 14% drop in quarterly profits among the midsize banks he covers.

Regional banks have been more vulnerable to deposit outflows following the recent bank failures. Those that were forced to borrow heavily from the Federal Home Loan Bank System — and those that tapped the brokered deposit market — should see the biggest expense hits, King said.

But banks' core deposits have also gotten more expensive, as lenders compete for customers' cash. Even the biggest banks in the country aren't immune. Bank of America CEO Brian Moynihan said last month that the $3.2 trillion-asset bank is part of the "dogfight."

Typically, banks' net interest margins rise when the Federal Reserve is hiking interest rates, since banks profit from higher rates on their loans outstripping the increases in what they pay to depositors. But the current cycle is unique, according to King.

"We've gotten to the point where the Fed has hiked rates so fast, so soon, that banks are seeing NIM compression at a point where rates are still rising," King said.

Elevated inflation has prompted the Fed's rate-setting committee to raise rates from near-zero at the start of 2022 to more than 5% today. Though the central bank hit pause at its last meeting, officials have penciled in a couple more rate hikes this year.

The higher rates have not gone unnoticed. Consumers are increasingly demanding bigger returns on their cash, forcing banks to raise rates on savings accounts and certificates of deposits.

Some banks have been able to keep their deposit rates lower, but even for those institutions, "pricing catch-up continues to accelerate," according to Jefferies analyst Ken Usdin. Google searches for "CD rates" and "saving account interest" remain elevated, he wrote in a note to clients, in a sign that consumers are alert to the issue.

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Companies are also rethinking their deposit options. Treasurers are increasingly eyeing alternatives such as money market funds, or they're shifting the funds at their bank away from noninterest-bearing accounts toward those that offer a return.

The so-called mix shift in deposits will be the "key differentiator" for banks this quarter, Truist Securities' King said. Banks with more stable noninterest-bearing deposit bases will fare better, while those with a bigger shift toward interest-bearing accounts may see their stock prices falter, he said.

Analysts are also watching for any early signs that individual banks are seeing troubles in their loan books. 

Late payments and charge-offs on credit cards and other consumer loans have risen in recent months, hitting 2019 levels after benign years during the COVID-19 pandemic. The lackluster return to in-person work has also prompted concerns over the health of loans tied to office buildings.

In their earnings calls, bankers will show they've been "vigilant and monitoring their credits," and that they've taken a more cautious approach on new loans, Janney's Coffey said. But the continued strength of the U.S. economy has thus far kept credit concerns subdued, as the vast majority of bank borrowers remain healthy.

"We're not seeing a broad deterioration in any specific asset class … but you're starting to see cracks," Coffey said.