Community bank margins are poised to rise but higher loan losses and reserve builds to cover them will stand in the face of earnings growth.

While funding cost pressures have likely peaked, institutions could still feel pain from customer balances repricing at current market rates when certificates of deposits mature. Absent notable declines in interest rates — which some market watchers expect given recent weakness in employment trends — deposit costs are unlikely to drop significantly in the near future, but net interest margins should still expand as fixed-rate assets reprice at higher rates. Some of those assets will not find lenders willing to refinance the credits, particularly in the commercial real estate segment, leading to higher loan losses. Community banks will incur some of that pain, but the loss content will not match the fears of some investors, who believe the credit deterioration will claim scores, if not hundreds of banks.

Community banks nearing peak funding costs

Deposits have remained firmly in focus for community banks even though liquidity pressures are not as acute as they were in 2023.

Community banks have grown their deposits over the last few quarters as they increased the rates they paid on their products and narrowed the gap with higher-yielding alternatives in the treasury and markets. That spread is evident when looking at the difference between the average fed funds rate and the industry's cost of deposits, which peaked in the second quarter of 2023. By the first quarter, the gap had declined 31 basis points from the peak to 315 bps, and we expect that spread to narrow further in 2024 and decrease even more significantly in 2025.

The pace of increases in deposit rates slowed in the second quarter as institutions believed their offerings were competitive enough to still attract and retain customers. However, 29 of the top 50 banks by assets reported quarter over quarter declines in deposit balances in the second quarter as they sought relief from pricing pressures in the marketplace. In the second quarter, six of those institutions — Citigroup Inc., PNC Financial Services Group Inc., Truist Financial Corp., State Street Corp., M&T Bank Corp. and Associated Banc-Corp — saw their deposits drop 2% or more from the linked quarter.

Beyond competition in the treasury and money markets, many banks and credit unions continue to market CDs at lofty rates. In fact, 2,004 banks and credit unions marketed one-year CDs with rates over 4% as of Aug. 2, while 265 institutions marketed one-year CDs over 5%. Those numbers compare to 1,856 depositories marketing CDs over 4% and 324 institutions marketing CDs over 5% as of March 29.

Competitive rates on CDs have played a role in funds moving out of noninterest-bearing deposits and into interest-bearing deposits. Heading into the second quarter, noninterest-bearing deposits had dropped 17.5% since year-end 2021, while interest-bearing deposits had risen 7.5%. The decline pushed the community bank aggregate's noninterest-bearing concentration down to 23.1% of total deposits at end of the first quarter from 27.3% at year-end 2022 and 28.1% at year-end 2021. We expect noninterest-bearing deposits to decline further in 2024, dipping to 21.5% of deposits.

Rate cuts by the Federal Reserve will offer modest relief in community banks' funding costs late in 2024, but more substantial rate cuts — which are expected to occur in 2025 but could come sooner — will be needed to drive deposits costs notably lower.

Deposit competition should persist amid regulatory pressures and higher-for-longer interest rates as banks place a higher value on deposits than other forms of funding. However, deposit costs should remain relatively sticky even as rates decline as banks continue to prize deposits and face regulatory pressure to do so.

Funding costs will drop in 2025, when we project betas, or the percentage change in fed funds that banks pass on to their customers, to reach 11%, well below the level witnessed in 2023 as community banks feel the sting of higher-cost CDs originated when rates were higher remaining on their books.

If the weakness in the July employment report is enough to spark a faster pace of rate cuts, deposit costs will decline more quickly. However, if rates drop sharply, community banks could face a double-edged sword because they may no longer receive the benefit of fixed rate assets acquired when rates were historically maturing and repricing at significantly higher yields.

Credit costs slowly moving higher but to manageable levels

Despite the fierce scrutiny and fear over the group's commercial real estate exposures, community banks continue to see minimal stress in their borrowing base. We do expect that stress to continue to build later in 2024 and become more pronounced in 2025, resulting in higher credit losses.

Banks have tried to prepare for slippage by tightening lending standards and building reserves for loan losses. Regulatory pressures to reduce commercial real estate concentrations have also discouraged some community banks from growing their balance sheets notably since the institutions have greater exposure to the asset class.

Regulators have reiterated the importance of banks maintaining strong risk management of their CRE portfolios, particularly for institutions with elevated CRE concentrations. In a number of cases, regulators have encouraged banks with elevated CRE concentrations to raise capital, particularly in the context of acquisitions.

CRE delinquencies have risen off historically low bases and banks have increased reserves against their CRE portfolios, particularly related to office credits. Delinquencies on owner-occupied CRE loans have only increased modestly, while delinquencies on non-owner occupied loans have risen much more, but performance has diverged between larger banks and community banks. The increase in deliquencies has been most pronounced at banks with more than $100 billion in assets, which have the balance sheet capacity to lend against high-rise office properties in center city areas that have garnered the most negative attention in the post pandemic era.

Community banks will feel some pain in their commercial real estate books, particularly as borrowers digest the impact of higher interest rates, less credit availability and lower occupancy since the pandemic. The test will come when many CRE credits mature and some borrowers struggle to refinance loans at significantly higher rates. Banks have offered extensions to those maturities in some cases.

We expect higher charge-offs, with losses peaking in 2025 and then lingering in 2026 due to extension of terms. However, even with net charge-offs in 2024 expected to jump 34% from 2023 levels, losses and the reserves required to fund them should prove a modest hit to earnings as opposed to the headwind that would occur during a severe downturn.

We expect provisions to rise to 16.0% of net revenue in 2024, up from just 11.5% in 2023 and then rise further to 20.7% in 2025. From 2014 to 2019, banks' provisions equated to 10.4% of net revenue on average.

Scope and methodology

The outlook discussed in this article is based on a proprietary S&P Global Market Intelligence model that utilizes the actual results of nearly 10,000 active and historical commercial and savings banks and savings and loan associations. The outlook is based on management commentary, discussions with industry sources, regression analysis, and asset and liability repricing data disclosed in banks' quarterly call reports. While taking into consideration historical growth rates, the analysis often excludes the significant volatility experienced in the years around the credit crisis.

The outlook is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment and economic growth. The projections can be updated or revised at any time as developments warrant, particularly when material changes occur.

^{This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.}