Academic journal article Economic Review (Kansas City, MO)

What Explains Low Net Interest Income at Community Banks?

Academic journal article Economic Review (Kansas City, MO)

What Explains Low Net Interest Income at Community Banks?

Article excerpt

A vibrant and strong system of community banks is critical for the health of local and regional economies across the country and, therefore, for the health of the national economy. The 2007-08 financial crisis and ensuing Great Recession led to the worst banking conditions in more than two decades, and community bank health declined commensurately. Community bank failures rose sharply and profitability plummeted, bottoming out in 2009 with the first aggregate net loss since the current reporting system began in 1959.

While performance has improved significantly over the four and a half years since the end of the recession, commentary from bankers and industry analysts suggest community banks are still struggling. While profitability has largely recovered, the quality of earnings largely has not. In particular, net interest income--the difference between interest income and interest expense as a share of average assets--rose early in the recovery but has since turned down and is near a 40-year low.

Weak net interest income is of particular concern for the long-term viability of community banks. The heart of the community bank business model is lending to local businesses and households, which makes net interest income the largest source of core operating revenue. According to many commentators, including community bankers, it has been difficult to earn an adequate spread on loans in the current recovery because of the low interest rates and flat yield curve resulting from the Federal Reserve's accommodative monetary policy. In addition, bankers say weak lending opportunities have contributed to reduced interest income. Thus, after more than four years of economic recovery, it is important to know whether low levels of net interest income is "normal" after accounting for factors such as low interest rates, reduced lending, and other cyclical factors, or is it cause for alarm due to other factors that are unlikely to be reversed when the economy improves.

This article examines the historical behavior of net interest income for community banks, focusing on how it compares in the current recovery to four previous recoveries starting in the mid-1970s. The data show low interest rates, a flat yield curve, and a decline in lending are important reasons why net interest income still has not recovered. In fact, compared to the recoveries from the relatively severe 1973-75 and 1981-82 recessions, net interest income is somewhat stronger this far into the recovery. Thus, as monetary policy normalizes and the economy recovers, community bank net interest income should be expected to rise toward pre-recession levels.

Section I reviews the recent performance of community banks, focusing on net interest income. Section II discusses primary economic factors that drive net interest income and compares its behavior in the current recovery to the four previous recoveries. Section III conducts a statistical analysis of community bank net interest income, accounting for interest rates, bank balance sheet factors, and macroeconomic conditions, to determine whether the current recovery is different from previous recoveries.


Community bank profitability has rebounded sharply from the depths of the financial crisis and Great Recession, but it has stalled over the past two years below pre-crisis levels. The improvement is largely due to declining provisions for future problem loans, which can only support net earnings until problem loans are wound down. In contrast, core operating net revenue--the largest and most important component of which is net interest income--remains weak, which raises concerns about the longer-term sustainability of profitability.

The decline in community bank profitability and subsequent rebound from 2007 to the third quarter of 2013 is shown in Chart 1. Community banks are defined in this article as banks with total assets of $1 billion or less in 2012 dollars. …

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