Banking

Net Interest Margin Performance in a Low-Rate Environment
Over the last few years, a great deal of regulatory, industry, and media attention has focused on bank earnings and the challenges banks face in generating net interest margin in a low interest rate environment. These concerns have been heightened by the extension of an "at or near zero" fed funds rate through 2014. In fact, as third quarter results have come in, many large bank stocks have been under pressure as net interest margin results were worse than the market had expected.

Attention to this issue is understandable, since net interest income typically makes up a large portion of a commercial bank's overall revenue, and reductions in this revenue decrease the funds available to cover credit costs (loan loss provisions) and returns and dividends available to shareholders. However, explanations for net interest performance have typically focused exclusively on declining interest income, which indeed has been negatively affected by low rates, but this explanation is only part of the story. Liability rates, primarily deposit rates, along with the banks' funding mix also play key roles in this story—and understanding how all these variables perform—will ultimately help explain net interest margin performance historically and in the current rate environment.

top

Net interest margin and interest rates: A historical perspective
Throughout the financial crisis, banks greatly increased the level of reserves in an attempt to absorb potential losses on loans. The provision expenses many of these banks took to build loan loss reserves were substantial and a key negative driver of earnings growth. Now that many of the most severe asset-quality issues have subsided, a lingering byproduct of the financial crisis is a slow-growing economy and a low interest rate environment designed to help spur economic growth.

While it is true that current rates are at historic lows, interest rates overall have been on the decline for many years. In fact, interest rates peaked in the early 1980s (as the Volcker Fed sought to stave off inflation) and essentially have been on a downward trend ever since (see the chart). Similarly, net interest margins have been on the decline for almost 20 years.

The trends in interest rate and net interest performance prompt several questions:

• Why was there an almost a decade lag between the peak of interest rates and the peak of net interest margin?
• Why have net interest margins only declined approximately 1 percentage point from their peak while interest rates have fallen around 18 percentage points from their peak?
• Why did net interest margins receive a bump in the late 2000s despite a dramatic fall in interest rates?
• Should rates continue at these levels, what is the potential impact on future net interest margin performance?

To answer these questions, net interest margin must be broken down into its various components.

top

Components of net interest margin (the Dupont method)
To truly understand what drives net interest margin performance, the Dupont Method decomposes it into its various components (see the chart):

As the Dupont Method shows, net interest margin is derived from a bank's yield/cost spread (yield on earning assets less the cost of interest bearing liabilities), plus its gain or loss on its net interest position. The gain or loss on net interest position is important because it adjusts the yield/cost spread to account for the degree to which earning assets are funded with interest-costing liabilities. This, then, is a result of a bank's asset/liability mix.

Now that the various net interest margin components are identified, we can see how they have performed over time.

top

Net interest component performance in an increasing rate environment
The charts below show aggregate U.S. commercial bank net interest margin, yield/cost spread, net interest position and gain or loss on net interest position from 1955 to 2011. During periods of increasing interest rates (1955–80), yields and costs trended higher. However, yield/cost spreads declined as increased liability costs offset any benefits gained on higher yields (see the charts). Net interest margins, however, expanded during this period as a result of increased gains on net interest position. These gains were realized even as net interest positions fell (reliance on interest-costing liabilities increased) because costs increased at a faster rate than the decline in net interest positions. When this happens, banks can decrease net interest positions and still provide support for net interest margin growth.

The charts above show that once rates peaked in the early 1980s and then begin to fall, net interest margins continued to rise all the way until 1992. The reason net interest margins continued to increase despite sharp declines in interest rates is apparent in the yield-versus-cost chart. Yields and costs peaked in conjunction with interest rates in 1980, yet when rates fell, costs fell at a faster rate resulting in an increasing yield/cost spread. In fact, we see the yield/cost spread increasing dramatically from 1981 to 1992, providing a great deal of support for net interest margin expansion.

top

Net interest component performance in a declining and zero interest rate environment
So far, this discussion has focused on how net interest margin and its components have performed during periods of increasing interest rates and/or expanding net interest margins. The charts below focus on net interest margin performance in a declining and low rate environment (here the focus is on median, quarterly, net interest margin performance for all U.S. commercial banks from the second quarter of 1990 to the third quarter of 2012, which provides a more granular look at industry-wide net interest performance).

Again, it is apparent that when rates fall suddenly, costs decline a bit more rapidly than yields, which increases the yield/cost spread. When this happens, any gains from net interest position are limited because the yield/cost spread is already benefiting from lower costs. However, as rates have declined, the longer-term trend shows that banks have been increasing their net interest position, which helps provide support for net interest performance. The combination of the yield/cost spread and net interest position help to provide a floor for net interest margin and explains why interest rates (fed funds) can fall dramatically while net interest margins decline only a few basis points.

top

Implications of continued low rates
As we have seen, net interest margin performance is determined by a combination of the yield/cost spreads and any gains or losses from net interest position. These two factors provide a cushion for net interest margin as yields fall in a declining interest rate environment.

The issue banks face now is that rates are near zero and interest costs are also bottoming out. Because of this, as evident in the chart below, net interest margin and yield/cost spreads are coalescing, and when—or if—these two equal, all the benefits of lower costs are gone and net interest margins become completely dependent on the performance of yields. With the cushion of low-costing liabilities gone, should yields continue to decline, net interest margins, along with net interest income, will fall much more rapidly than they had in the past.

This scenario will undoubtedly present challenges for banks in managing their net interest margins. One potential remedy could be increased use of non-interest liabilities, which have been on the rise over the last few years because of heightened depositors' risk aversion and economic uncertainties. However, this strategy presents potential issues, as those funds could easily be withdrawn once depositors become more confident in any economic recovery. Another solution may be to increase net interest positions further, yet it is doubtful that such an increase will provide much support for net interest margin and could also present potential risks should interest rates rise and the composition of interest-bearing liabilities favor shorter-term over longer-term maturities.

Historically, capital has been used to help fund earning asset growth, especially when rates were rising, yet the cost of equity—the required return demanded by investors—is higher in the current environment than in the past, so attracting investors when returns are so low is unlikely. Finally, a boosting of yields would be one of the most direct ways to increase net interest margins, but finding yields that provide an adequate risk/return profile has been difficult for most banks.

Because there seem to be limited solutions to boost net interest margin in a continued low-rate environment, does this then mean there is a paradigm shift in the reliance on net interest margin to fund bank operations? There is no clear-cut answer to this question, as data on how banks manage net interest margins and overall revenues in a multi-year, near-zero interest rate environment are nonexistent. However, what history does tell us is that banks find ways to adapt to the environments they operate in ways that are hard to predict. So whether it's the creation of new interest rate products or fee-generating services—or if rates simply rise and net interest margins expand as a result of increasing yield/cost spread—a healthy, profitable banking industry is important and necessary to help fuel economic growth.

By Dean Anderson, a senior technical expert in the Atlanta Fed's supervision and regulation division

top