Earlier this month, the Federal Reserve slashed interest rates by 50 basis points at its September Federal Open Market Committee meeting, lowering the federal funds rate in the range of 4.75%-5%.

The Fed also hinted at the potential for additional cuts in the coming months, with the updated dot plot revealing a more aggressive rate-cutting trajectory than forecasted in June.

Morgan Stanley economists anticipate an additional 150 basis points of rate reductions by mid-2025, with the U.S. economy steering clear of a recession.

Morgan Stanley highlights the banks expected to see the greatest net interest margin (NIM) expansion or compression through the end of 2025, based on the projection that short-term rates will decrease by 200 basis points.

Midcap banks are in a stronger position as they experienced greater pressure on deposit costs (higher deposit betas) when interest rates increased. They anticipate this pressure to ease at a similar pace as rates fall.

Also, midcap banks hold more fixed-rate assets that were issued when rates were much lower in 2021 and 2022, allowing for higher repricing even as rates decrease coupled with lower liquidity requirements.

For midcap banks, the analyst identifies Prosperity Bancshares Inc. (PB  ), rated Overweight, as offering the best risk-reward profile. The firm is expected to experience one of the largest net interest margin (NIM) expansions through the fourth quarter of 2025, driven by the upward repricing of fixed-rate loans and securities.

Similarly, Cadence Bank (CADE  ), newly rated Overweight, is projected to benefit from a significant rise in NIM as deposit costs decline. It has minimal exposure to floating-rate loans and net cash, which tend to weigh on earnings when interest rates drop.

While M&T Bank Corp (MTB  ), the analyst's top pick, ranks in the middle of the group, Morgan Stanley writes that future rate cuts will slightly boost NIM-a view that contrasts with the broader market consensus, which sees rate cuts as a long-term negative for margins.

Rate cuts are advantageous for the seven major large-cap banks sensitive to liabilities. These money center banks also have significant revenue exposure to capital markets, likely boosting fee income growth in a low-rate, soft-landing scenario.

Morgan Stanley expects this environment to strongly support M&A and Equity Capital Markets (ECM) activity. Additionally, lower rates are generally a credit positive for the banking sector.

For large-cap banks, Morgan Stanley holds an Overweight rating on Citigroup Inc (C  ), Goldman Sachs Group Inc (GS  ), and Bank of America Corp (BAC  ), citing expectations for a rebound in capital markets revenues amid a lower-rate environment and a sharp increase in buybacks following the Basel Endgame reproposal.

Regions Financial Corp (RF  ) and U.S. Bancorp (USB  ) are favored due to their liability sensitivity and commercial and industrial loan growth potential to accelerate post-rate cuts.

Meanwhile, Wells Fargo & Co (WFC  ) is highlighted for its strong excess capital levels and the possibility of progress on lifting its asset cap, which could favorably tilt the risk-reward outlook.