Small Banks Brace for Deposit Wars as Interest Rates Rise

By Rachel Louise Ensign and Allison Prang

Rising interest rates were supposed to help banks. They are hurting many of them instead.

Three years after the Federal Reserve began raising rates from near zero, bank customers are starting to demand more interest on their deposits, particularly at small and regional U.S. banks. Many of these same banks ramped up lending after the financial crisis by adding long-term, low-rate loans. Now, as they pay out more to depositors, the rates they are earning on loans are barely moving.

Pinched banks can be found across the country. They include 34-branch Banc of California Inc., where interest costs rose 68% over the last year as it paid up to attract depositors; Southern National Bancorp of Virginia Inc., which is now paying 2.25% interest on certain checking accounts while national lenders continue to pay effectively 0%; and New York Community Bancorp Inc., whose deposit costs are rising faster than the yields on its loans for city apartment buildings.

Overall, profit margins from lending are still rising at banks of all sizes. But at many small banks, the metric has started to go in the opposite direction. Net interest margin, which is a key profit metric, fell at nearly half of a sample of small U.S. banks in the third quarter from a year earlier, according to an analysis from investment bank FIG Partners LLC.

It is the latest sign of a growing divide between large and small financial institutions. Big banks have spent billions of dollars developing mobile apps and other technology to attract and keep customers without paying higher rates. They also added loans to their balance sheets that benefit when rates go up.

Smaller banks face a more immediate need to raise deposit rates. These banks use more of their deposits to make loans, meaning a loss of customers could jeopardize their ability to cheaply fund that lending. Their depositors often skew toward business accounts and consumers with certificates of deposit, two groups that tend to keep a close eye on rates.

The pressure to raise rates to retain deposits has become much more profound in the last six months or so, said Scott Siefers, an analyst at Sandler O'Neill.

When rates were near zero, many small banks used plentiful interest-free customer deposits to grow loans aggressively, often in the area of commercial real estate. In the process, many of these banks tacked on a record number of loans that carried low, fixed rates for long periods. The Fed moves have thrown a wrench into that approach.

Pinnacle Financial Partners Inc. more than quadrupled its assets to $24 billion over the last eight years and went on a hiring spree, enticing bankers with the promise of less bureaucracy than bigger institutions.

But in the last year, the Nashville-based bank's profit margins from lending have started to shrink due to higher deposit costs. Its shares have given back all of their gains since Donald Trump's 2016 election sparked a broad rally in bank stocks.

Pinnacle is trying to reverse the slide. It is hiring bankers who specialize in gathering deposits and, though it has eschewed advertisements in the past, launched a campaign to tout a money-market account paying 1.69%.

"These customer wars are new," said Christopher Marinac, director of research at FIG Partners. "I'm not sure it gets better unless the Fed changes gears."

Smaller banks still have above-average net interest margins, but the gap is narrowing, according to the Federal Deposit Insurance Corp. That is because bigger banks continue to benefit from the Fed raises as they tend to have more floating-rate loans such as consumer credit-card debt and corporate loans.

Banks of all sizes are grappling with slowing loan growth, while a flattening yield curve threatens to crimp the margins they earn from borrowing short term and lending longer term. Over the last three months, the KBW Nasdaq Regional Banking index is down 20%, compared with 18% for the big-bank KBW Nasdaq Bank index.

Over the last four years, New Jersey-based Investors Bancorp nearly doubled its book of loans for apartment buildings to $8 billion. Some 62% of the bank's loans are for commercial real estate, largely in New York and New Jersey.

Rates aren't budging on many of those loans. Commercial real-estate loans typically have fixed-rate periods from three to 10 years, a span that often got longer in recent years due to fierce competition for borrowers.

Investors Bank's average loan yield barely rose over the last year, from 4.10% to 4.20%. Meanwhile, the rate the bank paid on interest-bearing deposits increased from 0.90% to 1.39% in the third quarter from a year earlier. The bank recently hired Keefe, Bruyette & Woods to look for a potential buyer, The Wall Street Journal reported last month.

Write to Rachel Louise Ensign at rachel.ensign@wsj.com and Allison Prang at allison.prang@wsj.com

(END) Dow Jones Newswires

December 16, 2018 11:14 ET (16:14 GMT)

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