As I've discussed in the past, the Boston-based regional lender Eastern Bankshares (EBC -1.68%) is one of my favorite mid-cap bank stocks, primarily because of its incredibly strong deposit base.
But after the Federal Reserve went on its most intense interest rate hiking campaign ever in 2022, banks really started to feel the pinch as customers sought higher yields. Additionally, the Fed has been pulling liquidity out of the economy by shrinking its balance sheet in a process known as quantitative tightening, which has also led to deposits leaving the banking system.
In the fourth quarter, these trends seemed to catch Eastern by surprise, with the bank seeing a significant rise in deposit costs and deposit outflows, showing that no bank is immune to the environment right now. Let's take a look.
Pressure on the margin
A good way to assess the profitability of banks, especially smaller ones that focus a little bit more on lending, is through the net interest margin (NIM). The NIM looks at the difference between what banks make on interest-earning assets such as loans and pay on interest-bearing liabilities such as deposits.
Image source: Getty Images.
In the fourth quarter, Eastern's NIM fell six basis points (1 bps = 0.01%) to 2.81%, largely due to the rise in funding costs. As I mentioned above, Eastern is known for its strong deposit base, which is largely composed of non-interest-bearing deposits the bank pays no interest on or accounts that it pays very little interest on. In the third quarter, 62% of Eastern's deposits were in checking account products, which are associated with sticky, low-cost deposits.
But in the fourth quarter, Eastern's total deposit costs rose 27 basis points to 0.37%. Furthermore, and perhaps even more surprising, Eastern saw its non-interest-bearing deposits shrink by $342 million in Q4, while interest-checking deposits fell by $479 million.
To continue to fund loan growth in the quarter and maintain customers, Eastern increased its higher-cost certificates of deposit by $1.26 billion and also brought on another $320 million of other higher-cost borrowings. Keep in mind this is a bank that prides itself on being deposit-funded, so this is certainly not what investors expected.
Big change to the outlook
The velocity at which deposit pressure accelerated forced Eastern to significantly revise its guidance for this year.
During its third-quarter earnings call back in October, management provided an early look at guidance for 2023. They told analysts and investors to expect commercial loan growth in the mid- to high-single-digit percentage range for the year. They also planned to make investments and said they expect the NIM to move into the low 3 percentage point range by early 2023.
Fast forward to today, and it's clear that management was caught off guard by the deposit pressure they saw in Q4. Now, management is only guiding for commercial loan growth in the low-single-digit percentage range for the year. NIM is expected to keep declining from the 2.81% level until funding costs stabilize, and the bank is lowering its expense outlook by $30 million and planning to tighten its belt until conditions stabilize. Basically, everything has changed in three months.
"It's been important for us to keep close to and respond to the needs of our customers with competitive pricing to attract and retain long-term customer relationships," Eastern's CEO Bob Rivers said on the earnings call. "We are watching our funding trends very carefully, but do not expect a reprieve from the more difficult competitive landscape over the near term."
Uncharted waters
It's important to remember that the Fed has never gone this fast before with rate hikes, and it's doing so while pulling liquidity out of the economy. These are uncharted waters for any bank management team, no matter how well their deposit base has responded in the past.
Plus, depositors really start to respond to rate hikes when they hit the 3% mark, especially on the consumer side. Hopefully, the Fed will be able to end its rate-hiking campaign soon, allowing deposit costs to stabilize.
I am certainly still confident in Eastern, given the moat it has built in the Boston market, but it's clear that right now, some of its customer relationships are not as sticky as perceived. The next few quarters will likely be tough, though, and the bank's struggles show that no one can really fight the Fed right now.
