The U.S. banks got a reprieve following the latest signals from the Federal Reserve of a rate cut. The Fed’s Chairman Jerome Powell said the central bank is ready to cut interest rates next month.

The development led the U.S. stock markets to rally with the S&P 500 rising over 0.2% and the tech-heavy Nasdaq Composite nearly 1.5%. The Dow Jones Industrial Average rose about 1.1%, and the interest rate-sensitive Russell 2000 small-cap index soared, rising almost 1%.

KBW Nasdaq Bank Index increased 2.6% on Friday. With this, shares of Citigroup C rose 2.9%, JPMorgan & Chase JPM rose nearly 1%, and Wells Fargo WFC rose 1.3% on Friday.

The long-awaited rate cuts are anticipated to benefit banks with a concentration on commercial real estate (CRE) loans by reducing some of their credit risk and increasing their potential for profits.

Hence, lenders with excessive real estate exposure attracted investors’ attention. Shares of Eagle Bancorp EBMT, and First Foundation Inc. FFWM rose 5.8% and 5.3% respectively on Friday. As of Jun 30, 2024, EBMT had real estate loan exposure of 53% of total loans while for FFWM, it stood at 71.5% of total loans.

The Fed has kept its influential lending rate at its highest level at 5.25-5.50% since 2001 to tame inflation. The inflation has been gradually cooling down.

Powell stated that the central bank has "ample room" to maneuver as policy enters its next phase. He stressed that the timing and speed of reduction will "depend on incoming data," but markets rapidly moved to price in four rate cuts of 25 basis points each by the end of 2024.

Following the development, the CME Fedwatch data showed rapid changes. Now the market participants are projecting a 38.5% chance of a 50-basis point cut in interest rates in September, a jump from a 24% chance a week ago.

Powell also recognized the recent weakness in the labor market and stated that the Fed does not "seek or welcome further cooling in labor market conditions."

Bureau of Labor Statistics reported that U.S. employers added only 1,14, 000 jobs in July, considerably lower than the 1,80,000 expected by the economists. The unemployment rate rose to 4.3% in July from 4.1% in June.

How the Banks are Likely to be Affected?

The banks reaped huge benefits in the form of higher NIM and NII during the initial phase of high rates. However, challenges related to slowing loan growth, increased funding costs, and decreased liquidity became more apparent by the first quarter of 2023.

In 2022 NII increased by almost 20% for banks compared to 2021 while the metric increased around 10% in 2023 from 2022. NIM also increased sharply in 2022 while the rate of increase fell in 2023. Further, during the first half of 2024, the high funding cost started to weigh on NII and NIM, and the lending scenario was muted. In the first half of 2024, both NII and NIM decreased compared with the prior level.

High rates have proven to be a major challenge for lenders struggling with the high costs of funding, lower-yielding securities, and their exposure to the weaknesses of commercial and consumer borrowers. The high rates have also reduced lending activity, making it more difficult for banks to sustain profits.

Lower rates would relieve some of the burden on borrowers who could otherwise find it difficult to make debt payments when their loans mature in a climate substantially more expensive than the near-zero interest rate period in which they were made. Also, it is expected to encourage consumers and businesses to borrow. Such increased loan activity can result in larger profitability for banks because they earn more interest on these loans.

However, lower interest rates can narrow the spread between what banks pay on deposits and what they make on loans (i.e., the net interest margin), possibly reducing bank earnings in the near term. Furthermore, banks frequently keep huge amounts of fixed-income securities, which give lesser profits when interest rates are reduced.

Even though the rate cut offers hope to the U.S. banks that the lending scenario could improve it will take a longer time to reflect the benefits of the same to be visible in their financials.

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