Interest rate fluctuations plagued community bankers in 2013, but they managed — after a lot of complaining — to capitalize on rate trends.

Historically low interest rates in early 2013 pushed net interest income and profit margins well below year-earlier levels.

(For full Countdown 2014 coverage, click here.)

Margin "compression takes away much of the flexibility a bank can utilize when working with a customer in structuring his or her loan," says Rob Braswell, the chief executive of the Community Bankers Association of Georgia, echoing a lament heard throughout the year.

But the midyear spike in long-term interest rates provided some benefits that initially may have been underestimated. Though fee income from refinancings suffered, net interest income and margins turned upward later in the year (see related chart).

To be sure, the pain early in the year was acute.

For banks with between $1 billion and $10 billion of assets, net interest income bottomed out in the first quarter, at an average of 3.73%, according to the Federal Deposit Insurance Corp. For banks with less than $1 billion of assets, the margins were even worse: an average of 3.58% in the first quarter.

The compressed margins hit profits hard. For all banks with $10 billion of assets and under, net interest income hit bottom in the first quarter at $23.6 billion.

But net interest income immediately started to rise in the second quarter, about the time when long-term interest rates spiked. By Sept. 30, income had reached $24.2 billion for banks under $10 billion of assets, while margins rose to between 3.7% and 3.85% for this group.

However, the downs and ups reinforced how little control bankers have over their businesses right now.

Banks can only lower deposit costs so far, meaning a bankers' range of responses to low rates is very limited, says Whit Whitham, a banking attorney at Williams Mullen in Richmond, Va.

"There is just nowhere now for deposit costs to go," Whitham says. "You can't go below zero on deposit costs."

Community banks are hurt more than large banks by the situation, says Lee Sachs, chief executive of Alliance Partners, an asset management firm in Chevy Chase, Md., that operates the BancAlliance loan participation network.

"Fixed [deposit] costs impose an additional burden on community banks that wholesale-funded firms don't face," Sachs says. "Low interest rates clearly put downward pressure on returns for community banks."

The perceived funding advantage of big banks has also made it difficult for community banks to compete in certain lending areas, Sachs says.

"Large swaths of the loan markets have been pulled away from community banks by big banks due to the economies of scale of lending businesses," he says.

The Federal Reserve said Wednesday that it would begin tapering its bond-buying program, which should encourage higher rates. Lenders say it was past time.

"Quantitative easing appears, at this point, to be overdone and no longer effective," says Jim Blaine, president of the $27 billion-asset State Employees' Credit Union in Raleigh, N.C.

Plenty of other challenges remain, especially on the cost side.

Bankers complained about how in 2013 they were overburdened by regulations. The onslaught of mortgage rules were a source of worry for most community banks this year, Whitham says.

"The various mortgage rules that have been adopted take what used to be a pretty simple business and have made it pretty complicated," Whitham says.

The regulatory overhang put a crimp on dealmaking, too, says John Sorensen, president and CEO of the Iowa Bankers Association.

"There is still too much uncertainty surrounding monetary and fiscal policy, as well as the impact of Dodd-Frank and Obamacare," Sorensen says.

Other factors played into the level of mergers-and-acquisitions activity in 2013, most notably unrealistic expectations by sellers of how much they can get in a sale, says Kamal Mustafa, chairman and CEO of Invictus Consulting Group in New York.

"There is this unrealistic expectation they can get these absurd multiples," Mustafa says.

"Buyers are now being careful about how much they're going to pay, and the sellers aren't there yet," Mustafa says.

One ray of hope came from a measured rebound in loan demand, in certain areas. There was increased demand for business and auto loans in Iowa in 2013, Sorensen says. Agricultural lending continued to show strength, as commodity prices decreased while farmers' overhead costs remained high.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.