Where Do Net Interest Margins Go from Here?

In June 2004, the Fed increased the federal funds rate by 25 basis points, the first of many rate increases to follow. Over the next two years, the Fed increased rates from 1.00% to 5.25%, a quick and aggressive tightening cycle when compared to today’s cycle that has seen nine Fed rate increases over the span of 43 months. In the third quarter of 2007, the average net interest margin for all U.S. banks was 3.39%, very close to today’s average margin of 3.36%. However, the Fed started cutting rates rapidly in late 2007 and found themselves zero bound by the end of 2008. Net interest margins took an initial decline throughout 2008, but then when the Fed hit zero bound in late 2008, average margins actually increased from 3.15% in the fourth quarter of 2008 all the way to 3.83% in the first quarter of 2010. Subsequently, over the next five years, margins compressed while rates remained near zero until the Fed started its current tightening cycle in December 2015.

What was the main reason for the year-long run of margin expansion from 2009 to 2010? Cheap and abundant deposits! Banks saw their cost of funds fall to historically low levels by quickly cutting their deposit rates. Even though deposit rates were being cut, that didn’t stop the flow of funds into the banking system seeking the safety of the FDIC insurance during uncertain economic times. Cost of funds peaked out in late 2007 at a level approximately 55% of the then fed funds rate of 5.25%. Today’s cost of funds is approximately 30% of the current fed funds rate of 2.50%. Yes, bank’s cost of funds has steadily risen over the last few years; however, we are still at a historically low overall cost of funds.

Where do we go from here? Many anticipate the Fed to cut rates two to three times before the end of 2019. It is possible that we could see margins expand several more quarters, but then what? We have already seen a 100+ basis point drop in the intermediate to long end of the yield curve in less than a year. This movement, along with the inverted yield curve, has put immediate pressure on our asset yields. Loan yields have crept up slowly over the last few years; however, they haven’t exploded as competition for loans has been intense. Many loans are priced off Wall Street Journal Prime, which will move downward with the Fed rate cuts. In preparation for lower rates, bankers may already be implementing interest rate floors and making more fixed rates loans as their customers and markets allow. Lastly, we won’t have the benefit of dropping our cost of funds from a significantly higher level (55% of the fed funds rate) like we did in 2007 and 2008, which spurred initial margin expansion. We will find the floor on our cost of funds much more quickly this time around.

How do you fight off margin compression?

  1. Review your current asset liability management strategy. Ask yourself if your bank is well positioned for a decline in interest rates. Today, the majority of banks are positioned for a rise in interest rates, as this was the focus for many years.
  2. Resist the urge to stay short as inverted yield curves are often followed by falling rates, especially on the short end.
  3. Protect the yield of your portfolio by deploying funds into the longer parts of the yield curve. The investment portfolio is a great tool for managing interest rate risk, as the investment portfolio “doesn’t talk back.” Today’s treasury yield curve is inverted, but in order to find the best relative value, you must seek out investment yield curves that are not flat/inverted. Don’t chase yield by sacrificing credit quality.
  4. Shorten your liabilities by utilizing a healthy level of wholesale funding. Utilize brokered deposits or FHLB advances to shorten up your liability structure as needed.

Don’t find yourself saying the four most dangerous words in investing: “This time is different.”

The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.

Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.

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For More Information

Dale Sheller

Senior Vice President
Financial Strategies Group
The Baker Group LP


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