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Introduction | Spotlight: Banking Outlook Conference | Spotlight: Net Interest Margin Performance, Part II | State of the District | National Banking Trends

Spotlight: Net Interest Margin Performance, Part II

As we discussed in last quarter's "ViewPoint," U.S. banks are operating in an environment where net interest margins are becoming more and more compressed. We discussed how this compression is the result of two forces: (1) declining earning-asset yields as new loans and securities are put on the balance sheet at lower rates of return, and (2) the realization of lower incremental benefits of lower interest payments on deposits and other interest-bearing liabilities.

Now, let's turn our attention to how banks are managing their businesses in this low-rate environment, and what this may mean for banks interest rate risk exposure.

Impact of low net interest margins on bank operations
The impact of lower net interest margins on bank performance is fairly straightforward—lower net interest margins mean lower returns on earning asset balances. However, it is important to note that net interest margin is a measure of return and not a measure of absolute profitability (see chart 1). In fact for many banks, dollar levels of net interest income have steadily risen over the past several years.

Because of this conflicting picture of declining net interest margins but increasing net interest incomes, we can look to the degree to which net interest income is covering bank operating expenses to help gauge how beneficial or severe net interest performance really is.

Chart 2 provides four measures of net interest performance (amounts are shown by bank asset size and as a quarterly annualized rate of average assets): (1) interest income; (2) breakeven, which is the amount of interest income needed to cover interest expense, salary expense, and occupancy expense; (3) actual report net interest income; (4) operating adjusted net interest income, which is interest income minus breakeven.

We see in the fourth quarter of 2012 that total U.S. commercial banks generated an average 3.99 percent of interest income and needed 3.20 percent in interest income to cover interest and operating expenses. Banks reported an average net interest income of 3.39 percent, but once operating expenses were accounted for, they were only left with just 0.78 percent of operating adjusted net interest income (not included in these calculations are provision expenses, which averaged 0.29 percent in the fourth quarter of 2012).

When we take a look at these measures by bank asset size, we see a very different picture present itself. For example, the smallest banks—those with assets of $100 million and less—averaged 3.86 percent of interest income but needed to generate 4.18 percent to cover interest and operating expenses. This discrepancy resulted in an average quarterly loss on operating adjusted net interest income of 0.31 percent. The largest banks (those with assets greater than $10 billion) generated 3.84 percent to 3.75 percent in interest income but only needed to generate 1.90 percent to cover interest and operating expenses.

While the use of averages to measure bank performance by asset size does potentially leave the results susceptible to outliers—and there were several smaller banks that reported very large losses on operating adjusted net interest income—what these numbers do tell us is that the impact of net interest performance on a bank's operating results is highly influenced by the degree of operational efficiency at the bank. The smallest banks generate about the same level of net interest margin as the largest banks, but because they are on average less efficient, they need to generate a greater amount of interest income to cover interest and operating expenses.

Changing balance sheet compositions in a changing interest rate environment
The need to generate larger interest incomes, or reduce interest expenses, has led many banks to reorganize their balance sheets. Some of this reorganization can be seen in the type of earning assets a bank is investing in. For example, many banks have increased their holding of certain securities, particularly agency mortgage-backed securities, while reducing their exposure to many loan categories. However, another large change is in the duration of earning assets and interest-bearing liabilities on a bank's balance sheet. So in addition to the risks associated with lower net interest margins, changes in asset and liability durations present another interest rate risk challenge banks will have to manage as the industry eventually moves from operating in a low interest rate environment to operating in an increasing-rate environment.

Charts 3 and 4 provide a snapshot of the current profile of balance sheet duration for U.S. commercial banks for the fourth quarter of 2012. The first chart shows average loan and securities duration, by maturities bucket, and how the duration profile has changed since 2006. Similarly, the second chart shows the average deposit and borrowings duration, and change in duration, of U.S. commercial banks.

For average U.S. banks, earning assets that mature or reprice from zero to five years make up 66 percent of all loans and securities; however, those assets have fallen 15 percent from their levels six years ago. The largest growth has been in loans and securities that mature or reprice in five to 15 years, as these loans and securities now make up 23 percent of the overall loan and securities duration profile.

A shift has also been seen in liabilities. Nonmaturity deposits (transaction accounts, money market deposit accounts and other savings accounts) have grown around 10 percent since 2006, now equaling 59.54 percent of all deposits and borrowings. Short-term CDs, time deposits with maturities less than or equal to one year, which were the largest deposit category approximately equaling 35 percent of all deposits and borrowings in 2006, have seen the largest decline, falling to 24.62 percent of all deposits and borrowings.

Duration profile by bank asset size
So we see that U.S. banks, on average, have increased the duration of their earning assets and reduced the duration of their interest-bearing liabilities. In general, given low interest rates, reduced net interest margins and lower net interest operating profits, the changes in durations are a strategy by banks to boost yields on earning assets (as higher duration loans and securities typically offer higher rates of return) and reduce costs of interest-bearing deposits (as the rates paid on nonmaturity deposits are typically less than other deposit products). However, the incentive to undertake these duration changes varies because, as we previously discussed, banks that are less efficient, where lower net interest margins have an outsized impact on operational profitability, are more motivated to extend asset duration in search for higher yields and capitalize on lower-cost deposits and increase their levels of nonmaturity deposits.

The charts below show the change in balance sheet duration mix from the fourth quarter of 2006 to the fourth quarter of 2012 by bank asset size. Chart 5 shows the change in short-term vs. long-term assets. Chart 6 focuses on nonmaturity deposit growth along with costs of interest-bearing deposits.

The changes in asset duration appear highly correlated to what we previously saw with the operating adjusted net interest income. The smaller banks, who on average need anywhere from 2.80 percent to 4.18 percent in interest income to cover interest and operating expenses, have increased their exposure to longer-term duration assets by over 11 percent since 2006. Similarly, short-term assets have declined for these banks. The largest banks, however, have decreased their holdings of long-term assets by 0.76 percent, while short-term assets have grown 6.07 percent.

On the liability side, all banks have increased their exposure to nonmaturity deposits. We see this increase as a combination of factors such as depositor risk aversion as a result of continued concerns about the economy and banks' participation in the TAG (Transaction Account Guarantee) program, which we discussed in last quarter's "ViewPoint." Still, the growth in these deposits also appear correlated to bank size. Large banks have seen the largest growth, around 20 percent, with smaller banks growing from 9.33 percent to 12.66 percent. An interesting note is that large banks are paying rates that are anywhere from 10 to 25 basis points below those of smaller banks. The market dynamics that are driving the varying costs of nonmaturity deposits go beyond the scope of this article, but it is apparent that higher deposit costs help contribute to the lower operational adjusted net interest margins seen in smaller banks.

Persistent interest rate risk challenges
The low interest rate environment has presented a challenging operating environment for most banks. Banks have seen net interest margins fall to multi-year lows, and these lower margins are providing less net interest income available to cover operational expenses. In response, many banks are changing their balance sheet durations by extending asset durations in an attempt to capture additional yields, while decreasing their liability durations in an attempt to reduce costs of interest-bearing deposits. These responses, however, are not uniform across all banks and appear, at least partially, correlated to a bank's size and a bank's operational efficiencies.

Moving forward, whether it is continued margin compression as interest rates remain near all-time lows, or potential asset-liability mismatching once interest rates rise, interest rate risks have grown and will continue to persist for the banking sector in the foreseeable future. What ultimately will determine how well banks manage their interest rate risks is how proactive bank managers are in monitoring and measuring their exposures, and how willing they are to take the necessary steps to mitigate those risks.

This article was written by Dean Anderson, a senior technical expert in the Atlanta Fed's supervision and regulation division.