Net interest income--the difference between what a bank earns on its loans and investments and what it pays for its funding--remains under pressure because of:
• Weak loan demand in a lethargic economy.
• Aggressive competition for qualified borrowers.
• Unattractive investment yields in the current low-rate environment.
• Inability to lower funding costs to offset lower yields on assets, as many of a bank’s deposit rates approach their floor of zero.
The Jan. 25 announcement by the Federal Open Market Committee (FOMC) that it intends to keep rates low until late 2014 will place additional stress on bank margins and profitability. Immediately following the FOMC announcement, the five-year U.S. Treasury yield dropped over 10% (from 0.92% to 0.81%) to end the day only one basis point above its all-time low. Bankers will be inundated with requests from their best borrowers for modifications of their current loan agreements to both reduce rates and lengthen maturities.
At the same time that loan yields are falling, the yields on most bank investment portfolios are also dropping precipitously. The Federal Reserve Bank’s “Operation Twist” has driven investment yields down to levels at which it is impossible for a bank to safely invest cash at income levels that will allow for coverage of a bank’s overhead. Most banks’ overhead approaches 3% of assets and the spread on invested cash without excessive credit or interest rate risk is only 1.5% to 2%.
Historically, the response to lower yields on a bank’s assets would be to lower rates paid on deposits. Unfortunately, with deposit rates approaching zero, there is minimal ability to offset lower revenues from assets with reductions of interest expense.
In the current environment, this strategy would require aggressive loan pricing if the growth were to come in the loan portfolio. However, it might not end there.
Aggressive pricing could lead to more modifications in the current portfolio as existing borrowers discover (as they will) the pricing on loans being “pirated” from other banks. If the growth focuses on the investment portfolio, the bank will probably need to add duration or credit risk to the portfolio (see below) to realize acceptable yields. In either case, a growth strategy in today’s environment will require the use of a bank’s capital at historically low returns.
Many bankers are opting to hold qualifying mortgage loans that they might ordinarily sell in the secondary market as an alternative to purchasing mortgage-backed securities at significant premiums. Bankers are also tending to extend maturities on commercial loans beyond their traditional five- year maturities. Investment portfolios are also being used to extend maturities through the purchase of longer-term callable agency and municipal securities.
Bankers contemplating any type of extension strategy need to fully understand their current exposures to changes of interest rate and the ability of their balance sheet to carry these securities should rates rise.