How Are Net Interest Margins Going To Change For U.S. Banks Going Forward?

Last week, the Federal Reserve hiked the benchmark interest rate by 25 basis points – marking the second time the regulator has taken a step towards normalizing interest rates since it reduced them to record lows in the wake of the economic downturn of 2008. ^[1] The Fed maintained interest rates at near-zero levels from 2009 to December 2015, when it announced its first hike of 25 basis points. The second rate hike was delayed over the course of 2016 as the Fed was forced to exercise caution in the light of lukewarm economic conditions in the U.S. coupled with global macroeconomic uncertainty stemming from the U.K.’s vote to exit the EU and China’s slowing growth.

Notably, the Federal Reserve Board (FRB) conveyed a more optimistic outlook for the U.S. economy over coming years by projecting slightly higher growth in real GDP and slightly lower unemployment rates. ^[2] This in turn led to the FRB raising its estimate for the average benchmark rate in Dec 2017 from 1.1% to 1.4%. Given that the current benchmark rate is in the 0.5-0.75% range, the updated estimate points to three rate hikes of 25 basis points over 2017 (indicating a range of 1.25-1.5% then). This is good news for the yield-starved U.S. banking industry, which has seen profits come under considerable pressure since 2010 due to the low interest-rate environment. In this article, we quantify the impact of the proposed trajectory of Fed rate hikes on the net interest margin (NIM) figure for the U.S. banking industry as a whole.

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According to its latest projections, the Federal Reserve Board largely expects benchmark interest rates to be hiked by 25 basis points three times each year for the next three years (i.e. over 2017-19), with the figure stabilizing at 3% in the long run. ^[2] The table below summarizes the trajectory of benchmark interest rates at the end of each year as currently estimated by the FRB:

Now, the net interest margin (NIM) figures for banks are correlated with the Fed funds rate. As observed over recent years, low benchmark rates for an extended period of time shrinks the NIM figure, while an increase in the benchmark rate helps interest yield spreads in the long run. It should be noted that these trends only hold if the industry has had sufficient time to fully absorb the rate changes, as there will be sizable fluctuations immediately after a change in the fed rate.

Assuming that the NIM figure of ~3.35% seen in 2006-07 reflects the steady state level for Fed rates at the elevated figure of ~5.25% prevalent then, and using the average NIM figure of 3% seen in 2014-15 as the steady-state level for the average Fed fund rate of 0.1% for this period, we can assume that a ~500 basis point change in the Fed rate results in a ~35 basis point change in NIM for the banking industry. The Fed fund rates and NIM figures used here are as compiled by the Federal Reserve Bank of St. Louis.

If this sensitivity level were to hold, a long-term Fed rate of 3% would result in the NIM figure increasing by about 21 basis points over the base level of 3% seen in 2014-15 to around 3.2%. Using this, and assuming the three rate hikes the Fed is expected to implement each year are spread out evenly (i.e. there is a hike every four months) and that the NIM stabilizes a quarter after a Fed rate hike, we can expect the following trajectory for these two figures:

There are two important things to note here. Firstly, the NIM for all U.S. banks is expected to normalize at 3.2% in the long run – much lower than the 3.35% figure seen before the economic downturn – primarily because of the lower expected Federal funds rate (3% beyond 2019 compared to 5.25% in 2006-07). Secondly, the NIM figure for the U.S. banking industry is well above the figure for the country’s largest banks (something we highlighted in a recent article). This is because of the lower loan-to-deposit ratios for the largest banks compared to the industry average. However, this also makes these banks more sensitive to changes in the Fed rate compared to smaller banks, and gains to their individual NIM figure will be much more than what is estimated for the industry at large.

You can see how an increase in net interest margins impacts our estimate for BNY Mellon by making changes to the chart below.

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1. Federal Reserve issues FOMC statement, Federal Reserve Press Releases, Dec 14 2016 [↩]
2. Projections, Federal Reserve Website, Dec 14 2016 [↩] [↩]