Well, it finally happened. After increasing short-term policy rates at the fastest pace in modern history and holding them there for more than a year, the Federal Reserve reduced the federal funds rate by 50 basis points (0.50%) in September to kick off an eagerly anticipated rate-cut cycle.

According to the FDIC, community bank net interest margin (NIM) rose by seven basis points in the second quarter of 2024, but profitability pressures clearly remain. Both return on assets (ROA) of 0.95% and return on equity (ROE) of 9.60% increased only modestly versus the previous quarter.

Given the liability sensitivity exhibited by the industry over the past year and a half, one might think that the directional change in short-term policy rates—and an associated re-steepening of the yield curve—might be a boon for bank profitability. However, there are a couple of reasons this may not be the case.

Takeaways from previous cycles

Though a steeper yield curve is better for bank profitability over the medium to long term, asset yields may be more responsive to reduced policy rates than liability costs in the near term. This seems somewhat counterintuitive but is primarily driven by two factors. 

The first is that a greater percentage of assets than liabilities are indexed. That means that once the index declines, coupons reset lower at the next reset date. This is a boon when interest rates rise, but it will work in reverse as rates decline.

Second is the migration of non-maturity deposits into CDs. While most CDs feature relatively short tenures, this movement lengthens the average maturity of liabilities and will limit banks’ ability to reduce deposit rates in lockstep with policy rates. This delay is amplified for institutions in competitive markets, as your ability to lower deposit rates may be limited if others in your footprint are reluctant to do so.

Both factors will course-correct over time, but a review of asset and liability betas from previous easing cycles suggests that it may take two years or more before the cumulative decline in funding costs meaningfully outpaces the cumulative decline in asset yields. 

During the transition period, strategies geared toward increasing asset yields become the best defense against continued margin pressure. Remixing the balance sheet, purchasing loans to supplement organic originations or repositioning a portion of the securities portfolio are several strategies that can be employed to drive incremental movements as a stopgap measure.

What could be different this time?

To paraphrase the saying, history often rhymes but never repeats. So, recognizing that previous rate-cut cycles may provide useful guidance, how might the current cycle differ?

First and foremost is the economy. To date, the economy has weathered a restrictive policy stance remarkably well. There are still several pockets of concern that need to be monitored—low levels of housing turnover, credit performance in commercial real estate and the effects of higher interest rates on consumer credit, to name a few. 

That said, absent a material deterioration in economic performance, the pace and depth of policy adjustments may be somewhat lesser in this cycle than in the past. This is especially true when recognizing that inflation readings remain above the Federal Reserve’s longer-run target of 2%, which may limit its ability to move to an accommodative policy stance.

As a reference point, it seems important to note that the easing cycles since the turn of the century have averaged nearly 350 basis points of cuts over the 12 months following the initial move lower. At the time of writing, Fed Funds futures project a decline of roughly 240 basis points over the 12 months beginning in September 2024. If realized as expected, this would place the current cut cycle among the shallowest of modern monetary policy and would likely limit the amount of relief for bank profitability.

Second is the impact of technology. The development of technologies allowing consumers to quickly compare deposit rates nationwide means that your competition isn’t just across the street anymore. Furthermore, those same consumers can just as easily place their funds into other short-term products, such as money market funds.

Indeed, data from the Federal Reserve show that retail money market fund balances ended the second quarter of 2024 at $1.89 trillion, an increase of roughly 67% over the previous peak of $1.17 trillion. While difficult to quantify the precise impact on deposit pricing, the sizable increase has undoubtedly affected the banking industry. 

That growth will almost certainly slow or reverse as policy rates move lower, but a mass migration into the banking system seems unlikely outside of a crisis scenario where return of principal becomes more important than return on principal. Unless that occurs, depositors will likely remain more rate-sensitive than in the past.

Wait, prepare and see

Each rate cycle is unique, but previous reductions in short-term interest rates have taken time to meaningfully improve profitability across the banking industry. Complicating matters further, the relatively shallow market-implied path of policy rates and increased competition due to technology developments may create additional setbacks even if the yield curve normalizes. 

As such, management teams hoping for the first Fed cut to provide near-term relief may not get all they want, but those who plan appropriately will be in prime position to benefit when the environment improves.