For all banks, the flattening yield curve is impacting profitability. The difference between the Two-Year swap and the Ten-Year swap rate is around 12 basis points. For banks over $15B, this flattening moves net interest margin (NIM) lower and then improves past the one year mark. However, for community banks under $15B, the flat curve not only moves net interest margin down, but this lower profitability becomes worse over time. Ironically, not knowing this relationship, many of these same community banks are forecasting greater profitability in the future contrary to this historic relationship. The Federal Reserve Dallas just released their research on the topic which can be found below.
Community banks tend to have less diversified balance sheets with more relative income generated from interest income from loans. The duration of most community bank's loan portfolios has increased over the last decade so not only is NIM compressed due to the flat curve, but it is not resetting at the same rate as deposits. As deposit beta continues to increase, NIM moves lower.
We look for this trend to continue and believe the market continues to lag the economic forecasts by about 60% of major bank economists (see below). Major bank economists are more aligned to the Fed's projections and have been more accurate than the Libor futures market over the last several years. As such, we expect a continuous rise in rates and the flat yield curve environment to maintain for the foreseeable future.
How To Counteract This Effect - Loans
To combat this effect, community banks need to shorten asset duration, while increasing profitability from both risk-adjusted NIM and fee income. At CenterState, we are doing this through use of our ARC Program and through better targeting of profitable relationships. For community banks, ARC allows banks to lock in a profitable borrower for ten or more years while a receiving floating interest rate. This Program helps remove competition and generate 1% or more in upfront fees. For a small increase in monthly payments, borrowers get the certainty of a fixed rate loan and the portability of an ARC hedge - all without a derivative on the bank's balance sheet.
How To Counteract This Effect - Deposits
On the deposit side, banks need to be careful how they raise funds and reprice their current deposit base. While many banks will just track their cost of funds, in an environment with a flat yield curve where rates are rising, banks need to be hyper-focused on not only their cost of funds but their deposit rate sensitivity. This makes Treasury management, goal-oriented accounts, health savings accounts, and similar longer duration products more valuable. Community banks should allocate more sales time and marketing expense to expand balances in these products.
To see, and download, the Fed's NIM forecast, check out the research below:
Submitted by Chris Nichols on July 06, 2018