U.S. Commercial Banks May Directly Benefit from the Rate Cuts. Here's How

The banking industry is one of the sectors most directly affected by interest rate changes. Continuous rate hikes had triggered a regional banking crisis in early 2023, while Wednesday's rate cut may reverse many of these unfavorable factors. The impacts are multifaceted, including:

Although rate cuts can reduce commercial banks' deposit costs, loan yields also decrease. Companies like JP Morgan, which already have lower deposit costs than their peers (due to a sufficient customer base and no need for high interest rates to attract deposits), may not see as much elasticity in deposit cost reduction as smaller banks when rates are cut. Therefore, interest margins may gradually decrease.

However, interbank borrowing rates are expected to decrease, which could alleviate financing pressure for banks that are heavily reliant on interbank borrowing.

In addition, the overall US economy is still in the upward phase of the Kuznets cycle (with a typical duration of 20 years, driven primarily by investments in real estate and other construction), so credit demand remains strong, and interest income should be higher than pre-pandemic levels

Although credit card loans continue to reach all-time highs, mortgage applications, auto loans, and C&I loans (commercial and industrial loans) have been declining due to high interest rates.

Falling car prices, together with falling loan rates, are expected to reduce the burden on car buyers, thus allowing auto loans to return to growth. As for the housing market, lower mortgages are also likely to lure more buyers back to the market. Since the national housing inventory is still lower than in the pre-epidemic era, the tight supply can easily make potential buyers form rising expectations.

Major banks have responded to the Federal Reserve's action by lowering their prime lending rates on Wednesday. "The reduction by the Fed diminishes uncertainty regarding borrowing costs and the overall economy," stated Steven Alexopoulos, an analyst at J.P. Morgan. "We anticipate that a reduced funds rate will stimulate demand for loans among commercial borrowers."

The rising credit card interest costs and commercial real estate refinancing costs over the past two years have put pressure on residents and commercial real estate investors for repayment, leading to higher delinquency rate since 2022. Banks had to set aside deposit reserves as a buffer against loan defaults. Rate cuts are expected to reduce residents' repayment pressure (especially for those with floating rate contracts), thereby improving banks' asset quality.

The Fed's aggressive tightening cycle caused significant mark-to-market losses on the banks' available-for-sale (AFS) and held-to-maturity (HTM) portfolios. The soaring interest rates have caused the bonds previously held by banks, which were issued during an era of low interest rates, to continuously depreciate. These are paper losses that over time will mature at par, but could become real if the bank must liquidate the portfolio. Therefore, with the Federal Reserve cutting interest rates, the market value of these bonds will gradually recover, narrowing the book losses for banks, especially regional and smaller banks.

Overall, at this stage, the benefits outweigh the drawbacks. After the rate cut, smaller and medium-sized banks are likely to see a stronger rebound. For example, on Thursday, Capital One led with a 5.2% increase; KeyCorp rose 4.5%; while JPMorgan rose less than 1.5%.

However, banks are still operating in a delicate environment. If the economy further slows down in the future, smaller banks may have less ability to withstand an economic landing compared to larger banks.

Analysts at Jefferies explained, "The initial positive response from bank stock indices is logical, given that a 50 basis point cut alleviates concerns about high-end credit." They added, "(The rate cut) raises questions regarding the underlying economy and whether, in the Fed's view, the rate of economic slowdown is actually intensifying."