The net interest margin (NIM) of most banks has been compressed in recent years. This is largely due to a flatter yield curve and a growing reliance on funding sources that are more sensitive to changes in interest rates. If conditions persist, then NIM compression will continue to dampen near-term earnings prospects. Regulators are concerned about how bankers respond to this added margin pressure. Some may pursue higher yielding, but potentially riskier, lending to compensate, while others could be tempted to relax underwriting standards in order to sustain loan volume or attract new borrowers.
Yield Curve Influence
Over the last ten years, the banking industry's record profitability and strong return on equity has often overshadowed a declining NIM. In recent years, bankers have been presented with an exceptionally challenging environment as the yield curve remained flattened or inverted for a prolonged period. As of September 29, 2006, the six-month Treasury rate (5.02 percent) was 25 basis points higher than the 30-year Treasury rate (4.77 percent). While the NIM has shown recent signs of stabilizing, it still remains low by historical standards.
Financial results indicate that small banks have experienced less of an impact from NIM compression. Deposit costs are administrative, as opposed to market-based, and they adjust more gradually, lessening the compression effect typically on small banks that utilize deposits as their main funding source. Large banks tend to have a greater reliance on wholesale funding, and as a result, their margins are more sensitive to changes in interest rates. However, as the flatness of the yield curve persisted, the compression effect became more widespread. For example, between December 2002 and December 2005, NIM declined at nearly two-thirds of the Third District commercial banks, with the greatest changes occurring mainly at large banks, credit card banks, and de novos.
Shift in Funding Sources
Changes in the funding mix have also pressured the NIM. In recent years, loan growth outpaced core deposit growth. Bankers now rely more heavily on more expensive noncore funding sources. Brokered deposits, measured as a percentage of total assets, grew from approximately 1 percent to approximately 3 percent. The use of FHLB advances became commonplace after membership opened to commercial banks in 1989. The level of FHLB borrowings grew from near zero percent in 1990 to around 3 percent in 2005.
Many Third District bankers say they have been experiencing increased difficulty obtaining and retaining core deposits. Released in early 2006, Grant Thornton's annual survey of bank executives found this to be a common sentiment throughout the industry.1 The survey found that while almost all bankers (96 percent) identified retaining deposits as critical to their bank's success, only half (51 percent) felt confident in their ability to do so.
Furthermore, the deposit mix has also changed. Between 2000 and 2004, customers typically held their money in MMDA deposits, preferring liquidity to the marginally higher yields offered on certificates of deposit. This changed when the Fed began increasing short-term rates in mid-2004. Customer preference has shifted from savings accounts to time deposits as yields become more meaningful. Many banks now have higher interest expenses on the same underlying deposits.
Looking to the future, there are potential consequences if current conditions persist. Some additional compression is likely to occur if the yield curve remains flat. Smaller banks that have benefited from delays in the re-pricing of core deposits may need to reassess their strategy. As market conditions reach an equilibrium point, some may find it necessary to raise deposit yields in order to prevent attrition.
Although the current asset quality environment appears relatively benign and charge offs are near historic lows, regulators remain concerned that banks may be turning to higher yielding, but potentially riskier, lending to offset the earnings effects of NIM compression. Stretching for yields and relaxed underwriting standards can lead to poor lending decisions that ultimately translate into credit problems as portfolios mature.
The April 2006 Beige Book noted that for the Third District, "Banks and other lenders in the region reported that competition for loans continues to be strong and net interest margins remain thin."2 For example, there has been sizable and rapid growth in the volume and concentrations of commercial real estate (CRE) loans, a historically volatile asset class. Financial interagency guidance that reinforces sound lending principles and emphasizes the need to adjust risk management practices as CRE concentrations increase is expected to be released by year-end.
At the same time, there are signs that underwriting standards are being relaxed. It is apparent from the Federal Reserve's Senior Loan Officer Survey3 that more lenders are relaxing their underwriting standards on commercial and industrial loans. The number of respondents that were tightening their underwriting standards reached an all-time low in 2005 before improving in recent months. Another indication is that examiners are reporting more frequent concessions to borrowers, lengthened maturities, and fewer loan covenants. As supervisors we want to ensure that loan to value standards remain high and the number of exceptions is not increasing.
Bankers and regulators face a variety of challenges ahead. A number of potential scenarios could unfold. The supervisory community will monitor how lenders respond to these heightened performance pressures. In the end, sound risk management practices, prudent decision making, and strong internal controls will help ensure the continued stability and prosperity of the industry.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.