Low interest rates pressuring US bank margins - Deutsche Bank ...

Research Briefing
Global financial markets
May 11, 2012
Authors
Jan Schildbach
+49 69 910-31717
jan.schildbach@db.com
Sarah Lantz, Robert Bosch Stiftung Fellow
Editor
Bernhard Speyer
Deutsche Bank AG
DB Research
Frankfurt am Main
Germany
E-mail: marketing.dbr@db.com
Fax: +49 69 910-31877
www.dbresearch.com
Managing Director
Thomas Mayer
Low interest rates pressuring
US bank margins
— With interest rates likely to remain at depressed levels for years
to come in most developed banking markets, the focus is on
the impact this may have on interest margins and banks’ net
interest income.
— Historical data for the US shows that with a flattening of the
yield curve, margins face significant pressure as long-term
rates draw closer to short-term rates. This margin compression
is exacerbated as funding costs approach the zero bound,
while asset yields continue to fall.
— Whether the recent uptick in US commercial lending volumes
will compensate for the negative price effect from lower interest
margins on overall net interest income remains in doubt.
The US banking industry in 2011 was a strongly profitable one: return on assets
rose across banks of all sizes and net income was close to pre-crisis levels. A
closer look, however, reveals this profitability was mainly a result of lower loan
loss provisions. Provisions declined year-over-year for the ninth consecutive
quarter, but now appear to be levelling off. Whether or not banks can continue
these profitability trends remains a key concern in the near term given sluggish
credit growth and a lingering low-interest rate environment.
Despite the growing importance of non-interest income sources such as fees,
much focus is currently on banks’ primary revenue driver, net interest income
(which, in 2011, represented more than 64% of total US bank revenues). Net
interest income is a reflection of banks’ traditional earnings strategy: the rate
spread between borrowing short and lending long, or more broadly the
differential between asset yields and funding costs. In previous recessions, bank
balance sheets benefited from lower interest rates as funding costs dropped
more quickly than asset rates. In fact, US banks expanded net interest income
by 7% p.a. between 2007 and 2010. As low rates persist, however, loan-todeposit
spreads fall as prices adjust, and longer-term securities, held as assets,
roll over to lower-yielding securities (the same holds true on the funding side, of
course, helping to extend the positive impact of falling interest rates into the
future). The net impact on banks’ net interest levels may be negative, though. In
previous recoveries, this effect has been offset by increased loan volumes,
allowing banks to return to sustainable growth levels. Furthermore, as an
economy recovers, banks may quickly benefit as short-term assets roll over at
higher rates.

Low interest rates pressuring US bank margins
The current banking environment is not conforming to history, however. The
initial benefit of low rates has waned without the concurrent growth in lending.
Although funding costs continue to decline, they may not be enough to offset
lower asset yields and they are approaching a limit of zero (see chart 1). With
the Fed announcing no intention to raise rates until the end of 2014, this limit
could quickly constrain bank profitability. Although there are indicators of a pickup
in lending across recent quarters, it may not be enough to make up for the
compression in net interest income. Furthermore, alternative revenue drivers
like non-interest income so far have not provided much support.
Funding costs on a downward trend, nearing zero bound 1
%
12
10
8
6
4
2
0
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Sources: St. Louis Fed, FDIC
Asset yields Funding costs of earning assets Fed funds rate
Net interest margins (defined as net interest income over average earning
assets) were 3.6% at year-end 2011, just 11% higher from the 20-year low of
3.2% in the last quarter of 2006 (see chart 2). After the initial benefit from low
rates, net interest margins are likely to continue to trend downwards as funding
costs bottom out and asset yields continue to fall. The chart below demonstrates
that net interest margins spiked not only after the most recent crisis but also
during previous recessionary rate environments, as evidenced during the US
recession in the early 1990s and again in 2001-02. In the second half of the
1980s, the decline in inflation and the reduction in the Fed funds rate led to a
corresponding surge in net interest margins.
More precisely, it may be the shape of the yield curve (which is heavily
influenced by the official interest rate) that largely determines the interest
margin. The spread between 10- and 2-year Treasuries demonstrates that as
the yield curve flattens or becomes inverted (indicated in chart 2 by near-zero or
negative values), net interest margins tend to fall. For example, at the recent net
interest margin low in late-2006, the yield curve was inverted. By contrast, as
spreads widen, net interest margins follow suit. The yield curve is likely to
continue its flattening trend as long-term rates draw closer to short-term rates.
The Fed’s recent “Operation Twist” is explicitly targeting lower long-term rates,
with the intention of boosting credit volume in products that track longer-term
Treasury yields such as mortgages and corporate bonds. As a result, further
compressions in net interest margins are likely in the near term.
2 | May 11, 2012 Research Briefing

Low interest rates pressuring US bank margins
Considering rates are likely to be sustained at low levels for the foreseeable
future, how long can lower provisions cover for the sluggish credit environment?
In recent quarters, banks have benefited from lower reserves to protect
profitability, but indicators show that this trend is levelling off. It is clear that loan
growth will be the critical factor to offset the negative impact of interest rates.
Lending, driven primarily by commercial and industrial loans, grew for the third
consecutive quarter through the end of 2011. Nevertheless, the housing market
remains sluggish and it remains unclear whether the increase in non-consumer
credit volumes will compensate for a lower net interest margin in the near term.
Jan Schildbach (+49 69 910-31717, jan.schildbach@db.com)
Sarah Lantz
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Interest margins follow the yield curve 2
%
15
13
11
9
7
5
3
1
-1
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Fed funds rate (left) 10-Yr over 2-Yr Treasury yields (left) Net interest margin (right)
Sources: St. Louis Fed, FDIC, DB Research
3 | May 11, 2012 Research Briefing
4.3
4.1
3.9
3.7
3.5
3.3
3.1
2.9
2.7