Interest rate curves are signaling that the market expects yields to remain low and flat across the maturity spectrum, and, consequently, that bank net interest margins will remain under pressure.
The industrywide net interest margin hit a recent peak of 3.83% in the first quarter. (An enormous 30-basis-point jump from the fourth quarter was fueled by the absorption of high-yield loans under new accounting rules for securitizations.)
But, while there has been some relief since late August, the spread between long term and short term rates has generally been narrowing since the beginning of the year, and the trend has been echoed in results at banks, which in a generic sense borrow short and lend long. Average net interest margins fell 7 basis points in the second quarter, to 3.76%.
Yield curves derived from forward rates suggest little change over the coming year, with the gap between the 10-year and the 2-year actually compressing a bit more (see charts).
Small-sounding moves in net interest margins can create substantial swings in earnings. For example, a 15-basis-point decrease for one bank to a net interest margin of 2.85% would represent a 5% drop, and, assuming that earning assets remain constant, net interest income hitting the bottom line would fall by an equal proportion.
In view of persistent weakness in the economy and the Federal Reserve's commitment to support a recovery by keeping rates low, analysts with KBW Inc.'s Keefe, Bruyette & Woods Inc. considered what might happen if the current yield curve prevails indefinitely in a note last month .
They concluded that net interest margins in their coverage universe would drop by a median 15 basis points compared with what they had otherwise reckoned for the long term, leading to a median 11% bite out of earnings per share. (KBW's estimates for individual companies varied widely. For example, the firm figured that Cathay General Bancorp's net interest margin would be 24 basis points better under the scenario, mainly because its borrowing costs would not rise as anticipated in an alternative environment of increasing rates, under which assets already subject to pricing floors would not produce better yields anyway.)
Of course, reality is unlikely to slot into the future projected by forward rates, which are calculated using current yields: with a rate for a six-month instrument and a three-month instrument, the market's sense for the rate on a three-month instrument in three months can be inferred.
Moreover, rather than the prospect that banks will be forced to grind out earnings at slimmer margins, perhaps a more pungent fear is that they will be caught flat-footed by the unexpected.
"Everyone is stuck in the moment on the assumption that interest rates are staying extremely low for the foreseeable future," said Andrew Freeman, the executive director of the Deloitte Center for Financial Services, who noted that net interest margins are still higher currently than they have been for years. He warned that rates might rise "more quickly than anyone is anticipating."
Kathryn Dick, a special adviser at Promontory Financial Group and former deputy comptroller for the credit and market risk department at the Office of the Comptroller of the Currency, said that anxiety is building about the ability of banks to handle a shift in the rate environment and predicted "steady messaging" from regulators against complacency.
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