Where will margins go from here?

Short-term and long-term rates have been through some amazing changes since December 2000. The most dramatic shift was the 475 basis point drop in short-term rates. By December 2001 the Fed had lowered its discount rate from 6.00% to 1.25%. Long-term rates have shifted significantly as well. After briefly rising in first quarter of 2002, long-term rates have now reached historic lows. The average conventional mortgage rate for third quarter 2002 was 6.289%, the lowest it has been in thirty years.

Another big change has been the erosion in consumer confidence. The aftermath of the tech-stock boom coupled with the questionable accounting practices of some large public companies, has driven the average investor away from mutual funds and the stock market, back to more traditional savings vehicles.

Impact on the balance sheet…
Over the past two years consumers have run for cover, many parked their funds in NOW and Money Market accounts. This trend is continuing. The FDIC reports that money continues to flow into savings deposits. Domestic deposits continued to grow very strongly in the third quarter of 2002. Deposits in domestic offices of commercial banks grew by $120.7 billion (3.2%), led by a $92.0 billion (4.5%) increase in savings deposits.1

Impact on IRR position…
Banks measure short-term interest rate risk (IRR) by examining their Net Interest Income at Risk (or Margin-at-Risk). Margin at Risk is the greatest negative change to net interest earnings given a one-year forecast of interest income and a parallel shock to the yield curve. In other words, take a one-year forecast of interest earnings, and use it as a base amount. Then run two additional simulations: one shocking rates up and the other shocking rates down. The simulation, up or down, that produces the most negative change to the base net interest earnings, defines the amount of potential risk.

Normally an increase in the level of core deposits helps a bank stabilize its Margin at Risk. These types of deposits typically have administered rates (rather than market rates). Therefore banks can more easily control their level of exposure. As rates rise a bank may not raise its core deposit rates as quickly thereby limiting the increase to its interest expense. If rates fall, banks generally drop their core deposit rates to match the changes in the market. In either case, a bank usually has a good tool to mitigate their short term IRR.

The problem is that rates are already at historic lows. Institutions are having a much harder time lowering these administered rates, which are already close to zero. So while many banks have an abundance of core deposits, their ability to reduce the price of these funds to protect their margin is limited.

Since December 2000, the number of banks at risk to fallings rates has increased from 51% to 62%. Over that same time frame, the magnitude of risk has worsened as well. In December 2000, the average Margin at Risk was -4.71%. For third quarter 2002 the average margin at risk is -5.64%.

Surprise!
In March 2002 if someone said that the Fed would again lower rates by 50bp within the next eight months, most people would have been quite skeptical. The conventional wisdom was that rates couldn’t go lower. By March 2002 the market had already been though some very remarkable changes. Most of the industry believed that after a short period of stabilization, rates would begin to climb before the end of the year. However, during the first week of November, the Fed, in an effort to combat declining consumer confidence and stimulate the economy, again lowered the discount rate by 50 basis points.

While it is hard to predict what effect the rate drop will have on the overall economy, we can expect many banks’ net interest income to decline during the last quarter of this year. The impact will likely be greater on smaller institutions since they rely more on retail (core) deposits. How long will this last? Will rates fall further, or begin to rise? Most community banks are positioned to take advantage of rising rates, how long will it be before this position pays off?

¹ FDIC Quarterly Banking Profile, Commercial Banking Performance, Third Quarter 2002

This A/L BENCHMARKS Industry Report article was published
and is ©2004-2005 by Olson Research Associates, Inc.