The ABCs of how inflation hurts bank profits

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Inflation reached a 40-year high in 2022, topping 9% in the aftermath of the pandemic and the supply chain snarls it created. This set in motion a range of unique challenges for banks — from rising deposit costs to weaker loan growth to fresh threats to credit quality.

Prices have since been largely tamed — the Consumer Price Index increased at a relatively modest 3.2% rate in July — but this was due to aggressive interest rate hikes that have weighed on banks' profitability in 2023.

The Federal Reserve has boosted rates 11 times since March 2022, driving borrowing costs higher, curbing consumer spending and helping to curtail overall prices. However, the Fed's actions also pushed up the interest rates that banks pay for deposits. When this happens, the margin between what banks pay for deposits and earn on loans — known as net interest margin — contracts. Shrinking margins tend to hurt banks' bottom lines because most of them rely heavily on the income they earn from lending.

The median NIM for the U.S. banking industry fell to 3.40% in the second quarter, down 5 basis points from the prior quarter and down 20 basis points from the start of the year, according to S&P Global Market Intelligence data. The firm said banks' aggregate cost of deposits rose to 1.78% in the second quarter, up 37 basis points from the prior quarter and more than offsetting the impact of higher rates on loan yields. 

"No question in a high-rate environment, the pressure on margins becomes a challenge," said Robert Bolton, president of bank investor Iron Bay Capital.

When NIMs dwindle, banks tend to scale back lending. They do this to reduce their need for high-cost deposits to fund loans and to minimize exposure to sectors vulnerable to an economic downturn. Historically, when spiking rates combine with inflation, the U.S. economy goes into a downturn. When lending slows, so does banks' collective revenue.

For example, Optimum Bank in Fort Lauderdale, Florida, is methodically easing back on lending this year after strong growth in 2022. It still expects to expand this year, but investors should expect a noticeably slower pace, Moishe Gubin, chairman of the $622 million-asset bank, told shareholders in a second-quarter letter.

"I, for one, am in favor of slowing growth during this strange time in the world with interest rates being as high as they are," Gubin said.

As Gubin suggested, lenders also grow more selective to avoid recession fallout — namely, souring loans and the losses that accompany them. In the current market, bankers are concerned about commercial real estate broadly and urban office properties in particular, given enduring remote-work trends and high vacancy rates.

With recession concerns, an increasing number of lenders boosted reserves for potential future loan losses during the first half of 2023. 

Several community banks that cater to local businesses also said during second-quarter earnings season they were closely monitoring those customers' ability to absorb both higher expenses imposed by inflation and increased borrowing costs.

Citizens Financial Group said its index of national business conditions worsened in the second quarter. It dipped to 48.5 from 53.9 the prior quarter. A reading below 50 indicates weakness.

Eric Merlis, managing director at Citizens, said that while the overall labor market remained strong in the second quarter, new business applications decreased in most states and manufacturing activity slowed. The Citizens index results show "a business environment where activity has slowed as interest rate hikes seem to be working to curb inflation," Merlis said.

Bankers also are tempering fee-income expectations because of anticipated pullbacks in consumer spending and card use — on top of an already sharp drop in residential mortgage demand after interest rates spiked. Banks earn fees on home loan originations.

Against that backdrop, many banks are looking for ways to become more efficient to offset high deposit costs and falling revenue should lending recede in an economic downturn. Several have closed branches and laid off staff this year.

"I do think you see some urgency to rein in expenses," said Michael Jamesson, a principal at the bank consulting firm Jamesson Associates.