Striking a Balance: The Challenge of Preserving Net Interest Margins with a Flattening Yield Curve

Striking a Balance: The Challenge of Preserving Net Interest Margins with a Flattening Yield Curve

With four Federal Open Market Committee (FOMC) rate increases totaling 100 basis points (1.00%) implemented since December 2015, U.S. financial institutions find themselves in the first rising rate environment since 2006.

Rising Rate Environment – August 1, 2017 – Given the historically low rates in the interim, banks have experienced significant Net Interest Margin (NIM) compression as funding costs reached implicit floors and legacy higher-yielding assets gradually matured and were replaced at considerably lower rates and spreads due to a flattening of the yield curve. A flat yield curve impacts smaller banks in particular, due to the fact that they traditionally invest a greater percentage of their assets in longer-term investments. Because of this, they have not experienced the same NIM benefits as larger banks due to the rise in short-term rates: As of Q1 2017, more than half of all banks (53.7%) reported lower NIMs than at this time last year. Moreover, margins will come under further pressure if and when big banks boost deposit rates for consumers. Once that happens, the future pace of deposit-rate increases may occur faster than in previous cycles, according to RBC Capital Markets analyst, Gerard Cassidy. For now, the timing and magnitude of these events remain largely unknown.

While banks welcome these higher short-term rates, they are facing several key challenges. The first, as noted above, is when and by how much they should raise rates on their retail deposits. The second is that the longer end of the yield curve remains stubbornly moribund, resulting in a flattening curve at a time when bankers can least afford it. The traditional practice of funding short and lending long is not resulting in the spreads banks had experienced in the past. Third, with liquidity trends reflecting strengthening loans/deposits ratios the subsequent increase in wholesale funding reliance highlights the need for effective diversification and appropriate funding concentration limits. Discipline with respect to the pricing of core deposit bases is more relevant than at any time in the past 10 years. With regulators’ heightened focus on operating liquidity, the aforementioned concerns are at the top of most Asset/Liability Committee (ALCO) agendas. This must be optimally managed by implementing sound funding strategies that include effective cost management, diversification and preservation of asset liquidity, all while ensuring appropriate levels of deposit retention.

Download the complete article and read more about these challenges and recommendations for alternative funding scenarios in this current rate environment, including interest rate risk strategies that address both asset-sensitive and liability-sensitive balance sheets.