Among the many channels through which the Federal Reserve's near-zero interest rate policy has supported the economy, the steep yield curve has fattened bank net interest margins, funneling much-needed capital into the industry.
But the boost has not been as potent as the last time the gap between short-term and long-term interest rates was nearly as wide (see charts), and the medicine may be wearing off.
The Fed began slashing its target overnight rate in September 2007, ultimately lowering it from 5.25% to a range of 0% to 0.25% in December 2008, where it remains. From the second quarter of 2007 to the fourth quarter last year, the spread between two-year Treasuries and 10-year Treasuries increased from about nothing to about 260 basis points, and the industrywide net interest margin gained 20 basis points, to 3.53%.
A nice lift, to be sure, but net interest margins were about 20 basis points higher in 2003 when the spread was big but lower.
The apparent decrease in sensitivity to the yield curve could reflect long-term trends where banks have shied away from the carry trade — borrowing short and lending long — in order to reduce interest rate risk, and the impact of securitizing high-yielding loans. (In a reversal of the latter factor, the Federal Deposit Insurance Corp. attributed most of a 30-basis-point jump in the industrywide net interest margin in the first quarter, to 3.83%, to a handful of large credit card issuers that were forced to bring securitized loans back on to their balance sheets under new accounting rules.)
But the slackness has also been the consequence of mountains of nonperforming loans — many "earning assets" have not lived up to the name.
Of course, it takes time for the rate environment to filter through, and, in second-quarter earnings reports, banks frequently said that improving credit trends helped margins.
On the other hand, with the industrywide cost of funds having fallen 247 basis points from the second quarter of 2007, to 1.03% in the first quarter, the cycle of favorable repricings of liabilities may be close to its end, while repricings of assets (which typically lag liabilities) may take longer to play out. Moreover, the challenge of producing assets with attractive yields in an era of shrinking loan portfolios could add further pressure.
The data shows that large banks have soaked up most of the benefit from the steep yield curve. Excluding the first quarter and the securitization accounting change, yields on assets at banks with assets of $100 billion or more have generally fallen more than at smaller banks. But the relative drop in large banks' cost of funds more than made up the difference, likely reflecting in part smaller banks' greater reliance on time deposits. Overall, in fact, net interest margins at banks with assets of $15 billion or less were lower in the first quarter than in the second quarter of 2007.
Indeed, net interest margins are subject to a welter of countervailing forces and performance at different institutions can vary greatly.
Bank of America Corp., however, is one bellwether whose margin took a sizable bite in the second quarter, falling 16 basis points from the first quarter, to 2.77%. The company attributed the drop primarily to lower-yielding assets replacing higher-yielding ones amid the low-rate environment, but it said its asset-liability mix was poised to benefit from a rise in rates.
In a July 19 research note, analysts with KBW were skeptical, writing that "banks have traditionally been very price competitive," which could undermine their ability to draw out increases in "deposit rates on the way up."
In any event, in recent months yields on two-year Treasuries and 10-year Treasuries, and the spread between them, have all been falling.
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