Net interest income is an important source of revenue for banks. It consists of the interest income earned on a bank’s loans, investment securities, and short-term investments, minus the costs (interest expense) of the funds used to make the loans and investments. Deposits and both short- and long-term borrowings provide the funds for lending and investing. The net interest margin is an indicator of the profitability of a bank’s lending and investment activities.

Banks adjust the mix, maturities, and interest rates of their loans and investments, and deposits and borrowed funds, to maximize net interest income in whatever interest-rate environment they happen to find themselves. The process of coping with changing interest rates is very complex.

The bank industry currently is in a very difficult spot. Interest rates have fallen to extremely low levels, and the Federal Reserve Board has indicated that it doesn’t intend to raise them anytime soon. In the past year or two, many banks have been able to lower the interest rates that they pay for deposits sufficiently to offset declines in the yields on their loans and investments. But with short-term interest rates now approaching zero, banks are running out of room to reduce their deposit costs further. To be sure, a number of banks were able to expand their net interest margins in the June quarter, but the industry is not confident that it can continue to do so if interest rates remain at their current historically low levels. The following is a sampling of how banks have been coping with low interest rates.

Maturing high-cost time deposits are giving some banks a hand in managing through the very low interest-rate environment. Alabama-based Regions Financial (RF) experienced a decline in certificates of deposit in the June quarter, which allowed its net interest margin to expand by 10 basis points. As of mid-2010, another $8 billion of its CDs with an average interest rate of 1.71% were due to mature in the second half, and another $4.1 billion were scheduled to mature in the March quarter of 2011, including $1.5 billion that carry an average interest rate of 4.55% . Regions should be able to roll over a portion of these deposits at lower interest rates. The company has also extended its short-term hedge position to help offset the expected pressure on its margin if interest rates stay low well into 2011, which we now expect.

Some banks are altering the composition of their assets to counteract the margin compression. Fifth Third Bancorp (FITB), which experienced a little margin pressure in the June quarter, expects a reduction in its low-yielding liquid assets to support a 10 to 15 basis point expansion of its net interest margin in the September period. Thereafter, a pickup in the growth of loans, which have higher yields than liquid assets and most securities, may be necessary to sustain the margin improvement. 

Acquisitions have boosted the net interest margins of some banks. One of these is FirstMerit (FMER), which acquired Chicago-based Midwest Bank And Trust in a federally assisted transaction in May. The acquisition was the main impetus behind the 32 basis-point expansion of FirstMerit’s margin in the June quarter. The company also repaid or redeemed high-cost subordinated debt and trust preferred securities which, in addition to maturities of $1.1 billion of certificates of deposit yielding an average 1.45% in the second half, is expected to allow the company’s net interest margin to remain at the June-period level over the rest of 2010.

Finally, reducing the drag of problem loans can have a beneficial effect on a bank’s net interest margin. Marshall & Ilsley (MI), a bank with exposures to the depressed Arizona and Florida real estate markets, noted in July that nonperforming assets depressed its margin by 26 basis points in the June period. As the company works down these problem assets in the next several quarters, some of this margin pressure should be alleviated.

In the end, if interest rates remain at the current extremely low levels for an extended period of time, we think most banks will have a difficult time protecting their net interest margins.  But the net interest margin is only one of the factors influencing bank earnings, and how long the Federal Reserve will maintain its interest-rate stance remains to be seen. We think this timeframe will exceed another year.


At the time of this article’s writing, the author did not have positions in any of the companies mentioned.