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Net Interest Margin Performance in a Low-Rate Environment
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.
Net interest margin and interest rates: A historical perspective
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:
To answer these questions, net interest margin must be broken down into its various components.
Components of net interest margin (the Dupont method)
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.
Net interest component performance in an increasing rate environment
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.
Net interest component performance in a declining and zero interest rate environment
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.
Implications of continued low rates
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