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Rates have been low for an extended period of time now; it was back in December 2008 when the target fed funds rate was lowered to a range of 0-25 basis points. As this period of low rates has continued for over three years, a sense of resignation seems to have set in due to the pressure on the net interest margin from the flood of liquidity, combined with low loan demand and historically low investment yields. On the other hand, there is a sense of cautious optimism about the future, with the view that rates will either stay at current levels or rise, with a corresponding increase in loan rates. This article will discuss the potential challenges to the return to higher rates.
While loan rates may rise, deposit rates will lag in both timing and amount. The thinking, therefore, is that interest rates on loans will increase faster than interest rates on deposits, which will contribute to increased margins. However, as rates rise, the road to higher margins could be a rocky one that should be navigated with care. To begin, one should examine the assumptions that both assets and liabilities will benefit from rising rates.
A major plank underlying this view is that rising rates will be accompanied by, if not actually caused by, an economic recovery. Loan rates have been low for a long time. As rates begin to rise, the expectation is that loan pricing will also improve, resulting in higher than current spreads over cost of funds. For example, consider a loan priced at prime plus 100 basis points. As prime increases from the current 3 percent to 3.50 percent, there would be a 50 basis point increase in the loan rate as well, so the new loan rate would be 4.50 percent. In addition, an institution's management may be able to increase the spread, since economic conditions have improved, and borrowers are eager to borrow and take advantage of opportunities. Thus, the market could bear an increase of 10 basis points in the spread, so that the new yield on the loan would be 4.60 percent.
Overall loan demand is also expected to rise because of increased economic activity. Businesses have identified opportunities for investment, but they are currently holding back because of the slowdown. Once the economy picks up, borrowers will be enthused about the prospects and eager to start projects that have been on hold, driving up loan demand for financing such projects. Increased loan yields and higher loan demand together will result in higher interest income, helping the margin as well as net income; this is the expectation.
Consider the deposit side of the balance sheet. As rates rise, bank management becomes reasonably confident that it will be able to lag deposit rate increases to a pace slower than increases in loan rates. In addition, it is possible that management will pass on only a portion of the rate increase to deposit holders, with the balance remaining to boost the margin. Thus, if loan rates increase by 50 basis points, deposit rates may actually rise only a fraction, perhaps 20 basis points. In case the deposit rate increase can be delayed up to 90 days beyond the increase in loan yields, an additional boost to the margin and income would be realized.
Based on this reasoning, it would appear that banks should anticipate rising rates. In fact, some managers have informally expressed that they are now waiting for rates to start rising so that they can see their margins and performance improve. These conclusions are based on a very plausible set of assumptions and reasoning. However, prudence requires a look at some additional facts and alternative assumptions.
Consider loan yields first. The line of thinking outlined above applies to rates for new loan originations and to portfolio loans that are floating rate. In these situations, the new loans are booked at the new (higher) pricing, and the floating rate portfolio reprices immediately to the higher rates. However, fixed rate loans will behave differently. Even though new fixed rate loans are originated at the new, higher rates, the portfolio of loans on the books will not reprice. In fact, since there has been an extended period of declining and low rates, the older (and higher priced) loans will run off before the newer, lower-rate loans as illustrated in the chart. For instance, a loan booked in the second quarter of 2009 (when the 10-year bond averaged 3.52 percent) will run off before a loan booked in the third quarter of 2011, when the 10-year bond averaged 2.43 percent.
A second factor that may restrict even floating rate loan yields from rising immediately is the very factor that prevented them from falling too far: floors. As rates continued to decline over the last three years, bank managers began to modify loan terms to be, for example, prime plus 100 basis points with a floor of 5 percent. Floors were not common prior to this extended period of declining rates. The floors served their purpose, since these loans continued to yield 5 percent when the terms without the floors would have dropped the yield to 4 percent (current prime rate of 3 percent plus 100 basis points). Looking forward to a rising rate environment, however, these floors will prevent an increase in loan yields, since the yields already are higher than the index plus spread. For loans with those terms, a 100 basis point increase in prime would translate to a zero increase in loan yields. Prime would have to increase more than 100 basis points for these yields to start increasing.
Finally, the scenario of higher loan demand also may not play out quite as quickly as anticipated. Loan demand may remain weak, as borrowers are wary of incurring debt with the experience of recession still fresh in their minds. It is true that as rates and economic activity increase, loan demand should eventually increase as well. However, the economy has been in an extended downturn. It may take three or four quarters of sustained growth before borrowers feel comfortable taking on debt and before loan demand shows a robust and sustained increase.
As described above, loan portfolio yields may take a few quarters to start reflecting the increase in market rates. Traditionally, one of the tools bank management uses in more “normal” (higher) rate environments to help the margin for two or three quarters is to slightly reduce deposit rates, for example 15-20 basis points. This action can provide some breathing room as other initiatives (in this case, increased loan demand and rates) with longer lead times kick in. Deposit rates can be boosted back up once the new initiatives start making a contribution. The hope is that the temporary nature of the reduction will not jeopardize depositor relationships. This option is not available in the current environment. Most industry observers and participants are in agreement that deposit rates have no further room to fall. Not being able to use this tool reduces the options management has to keep margins steady.
Another assumption in the view that rising rates will help margins is that management will be able to not only delay (lag) increasing deposit rates while loan rates increase, but will also be able to keep deposit rate increases significantly lower than loan rate increases. In practice, this strategy has some limitations. As noted above, it may take a few quarters for sustained loan demand to take root, especially if loan rates are also higher. This effectively translates to an unplanned lag in benefit derived from higher loan rates and volumes. This lag could partially offset the benefit expected from the planned lag in deposit rate increases as deposit customers see increases in market rates and expect to see those increases passed on to them without too much delay.
An additional factor is that rising rates may be accompanied by a rapid evaporation of liquidity in the system. This scenario is very plausible. Rising rates in an environment of recovery could lead to the liquidity currently parked in bank deposits flowing back into the stock market and other asset classes. This flow could lead to more competition for the liquidity that remains in bank deposits, eroding management's capacity to lag deposit rates.
It is clear that many factors are at play in this environment. Some factors point in the direction of higher loan rates, better spreads, and better overall interest income. Other factors could dampen, or even overwhelm, the effect of these beneficial factors—effects of the extended low rate environment and cautious borrower behavior. On the interest expense side, the positive effects of traditional tools like managing deposit rates may offset liquidity drying up and competition for remaining liquidity. The impact on a specific institution will depend on the institution's balance sheet dynamics and local market conditions.
It is possible for management to quantify the probable effects of these scenarios. ALCO meetings are a good forum to develop a set of alternative assumptions regarding loan growth, loan pricing, and deposit pricing. Once management is comfortable with the specifics of the assumptions, these scenarios can be run through the simulation models to determine possible results. This exercise can more precisely quantify what otherwise remains only an educated guess about the impact different scenarios can have. Results from this simulation can be discussed at ALCO meetings to develop strategies to address institution-specific exposures.
Scenario planning and analysis can be done without an inordinate amount of effort, but they can provide very valuable insights and help navigate the rocky road to higher margins. If management keeps a cautiously optimistic view and considers the assumptions discussed here, that road might feel just a bit smoother.
If you have any questions regarding this article, please contact Senior Analyst Atul Dholakia at (215) 574-4360.