Slippery Slope

By Gamble, Richard H. | Independent Banker, February 2002 | Go to article overview

Slippery Slope


Gamble, Richard H., Independent Banker


Falling interest rates strain net interest margins, but bankers are keeping their balance

Community bankers learned a thing or two about asset-- liability management years ago. Now their match-funding and gap control skills are being stress-tested in a yo-- yo economy that brought, in 2001, the steepest decline in interest rates that many have ever seen. Now these bankers are bracing for the upswing.

"The rate cuts of 2001 are unprecedented in U.S. history, and they have squeezed community banks pretty hard," observes Cam Fine, president and CEO of Midwest Independent Bank, a banker's bank in Jefferson City, Mo. Fine also serves on the Federal Advisory Council of the Federal Reserve Board of Governors (see story, page 42).

This predicament of extraordinarily low interest rates has tightly ratcheted down on community bank's net interest margins just as the recession has put pressure on their loan portfolios. The one bright spot for bankers has been the strong growth of deposits, although extremely low fed funds rates give bankers few options to invest those deposits. The plunge has thrown community bankers into uncharted waters. "We haven't seen comparable conditions [in several decades]. Bankers need to be very cautious, especially on the funding side," Fine warns.

Good asset-liability management is supposed to protect net interest margins, but bankers were not prepared for such a dramatic rate drop, which accelerated sharply after the events of Sept. 11. Since then, margins have indeed been squeezed as community bank assets repriced faster than liabilities.

Over four quarters, ending Sept. 30, 2001, the gross yield on earning assets plunged 80 basis points-from 8.63 percent to 7.83 percent-for banks under $100 million in assets, according to the most recent FDIC statistics. Still, that was less than the 120-basis-point drop for the banking industry as a whole (from 8.45 percent to 7.25 percent). Large banks disproportionately influence those weighted averages, Fine says. But on the funding side, the industry's average liability costs also dropped 120 basis points, while community banks saw only a 50basis-point decline in the cost of their liabilities.

Aside from asset-quality concerns, margin compression is the number one concern the FDIC has been hearing from community bankers in the past few months, reports Michael J. Zamorski, the newly named director of the FDIC's division of supervision (see graph above).

Over the six quarters ending Sept. 30, 2001, net interest margins at banks under $100 million in assets eroded from 4.64 percent to 4.26 percent. Then they seemingly bottomed out, with no further decline from the second to the third quarter. Larger banks hit bottom earlier, in the first quarter of 2001, and then began to improve, notes Donald Inscoe, associate director of the FDIC's division of research and statistics. "Many community bankers have put a priority on defending their deposit base and thus have given up some earnings rather than lose deposits," he notes.

Banks entered the current recession with historically low net interest margins but historically high capital ratios-the highest since 1940, Zamorski notes.

CAPITAL MATTERS

Community banks rely more on their net interest margins for revenue. Any contraction in spreads hurts community banks more because they, by often lacking access to the capital markets, have fewer sources of noninterest income to bolster profits.

Banks under $1 billion in assets, for example, get 73 percent of their pre-tax revenue income from spreads earned on lending, compared with just 56 percent for banks larger than $1 billion, Inscoe points out. "With more sources of noninterest income, larger banks have more flexibility." That's one reason banks under $100 million in assets lag behind industry aggregates in return on assets (0.95 percent versus 1.08 percent) and return on equity (8.48 percent versus 12.

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