Moody's Report: Fed Rate Cuts Favorable Long-Term for US Banks

A recent Moody's report anticipates that the Federal Reserve's potential rate cuts will benefit US banks in the long run. Despite short-term financial pressure due to slower deposit repricing, lower interest rates should eventually bolster net interest income, economic growth, and asset quality.

A recent report from Moody's ratings indicates that the Federal Reserve's expected interest rate cuts will, in the long run, benefit most US banks. "Initially, the rate cuts will be credit negative for most US banks. We expect their deposit costs to reprice downward more slowly than their loan yields, constraining net interest income, which is most banks' largest revenue source," the report states.

In the long term, however, reductions in deposit costs are expected to catch up, thereby strengthening net interest income for banks. This improvement is partly dependent on lower rates promoting prolonged economic growth, which will help banks maintain and improve their asset quality. The gradual decline in deposit costs compared to loan yields will compress net interest income (NII), impacting short-term profitability as banks adjust to the lower rate environment.

Looking ahead, the impact of rate cuts is expected to gain momentum over time. Analysts predict cumulative rate reductions of 200 basis points (bps) by the end of 2025. The report further explains that as deposit costs eventually align with the lower rate environment, banks' net interest income should stabilize and potentially improve. Furthermore, prolonged low rates are likely to support sectors like commercial real estate (CRE), aiding loan refinancing and improving debt affordability for borrowers with floating rates.

"Cumulatively, as rate cuts become more impactful, that will support commercial real estate (CRE) loan refinancing, a challenged asset class for many regional banks. Lower rates will also improve debt affordability for floating rate borrowers," the report added. On the downside, increased loan demand could put pressure on banks' liquidity as more funds are directed toward lending activities.

Another positive aspect for banks is the potential improvement in capitalization. A sustained decline in long-term interest rates will reduce unrealized securities losses, providing a boost to banks' economic capital. Overall, while US banks are likely to experience short-term challenges from rate cuts, the long-term outlook appears more optimistic.

The Federal Reserve is expected to cut interest rates for the first time since its aggressive rate-hiking cycle began in March 2022. On Wednesday night India time, according to Moody's report, the Fed is likely to reduce the federal funds rate by at least 25 basis points (bps), marking a reversal after cumulative increases of 525 bps between March 2022 and July 2023.

(With inputs from agencies.)