Banks’ Interest Margins Will Remain Under Pressure For Several Quarters

by Trefis Team
U.S. Bancorp
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Over the last few quarters, investors in the financial sector have kept a very close eye on net interest margin (NIM) figures at the country’s biggest banks because of the marked impact the metric has on revenues in the industry. And they have not been too happy with the trend of a steady decline in these figures over the last couple of years. Now, these shrinking NIM figures are a direct result of the prolonged low interest rate environment maintained by the Fed since the economic downturn of 2008. Now the Fed has decided to kick off the tapering plan in January, even as it maintains interest rates at current low levels until key economic indicators reach stable target figures. As a result, one can expect interest margins at banks to remain in a state of flux over the next few quarters. [1]

This is because the steps taken by the central bank will trigger changes to interest rates which will take some time to normalize. The resulting interest rate perturbations should affect top-line figures for banking giants Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB) the most, as they rely on the traditional loans-deposits model for a majority of their income. While the impact of this will also be seen on the three biggest U.S. banking groups JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Citigroup (NYSE:C), their substantially diversified models mitigate interest rate risks on their results to a large extent.

In this article, which is a part of our continuing series on the relative performance of the country’s five largest commercial banks on several pertinent measures, we detail how these banks’ NIM figures have changed over the recent quarters and what to expect over the near future.

See our full analysis for Bank of AmericaCitigroupJPMorganWells FargoU.S. Bancorp

The Federal Reserve set its benchmark interest rates at 0% to 0.25% in December 2008, and has maintained them at that level since. The rationale behind low federal fund rates is simple. When these rates are kept low, banks can afford to give out loans — be it personal loans, commercial loans or mortgages — at lower interest rates. This should coax individuals and companies looking for money to borrow, allowing the economy to slowly grow back to health. In order to sweeten the deal and ensure additional liquidity in the economy, the Fed also announced a series of “Quantitative Easing” (QE) measures, with the current one (QE3) diligently purchasing $85 billion worth of treasury and mortgage-backed securities from the market each month.

Over the recent months, there has been a change in the Fed’s stand though (see The Fed’s Plans To Taper Asset Purchases: Good Or Bad News?). While they intend to keep interest rates at the current low for the foreseeable future, they are looking to slowly do away with the asset purchase program beginning January. This in turn will create opposing market forces that will keep interest rates jittery over coming months.

Why do we believe that? To begin with, the low interest rates will continue to make it difficult for investors — retail and institutional — to find lucrative returns on their investments. Under such circumstances, deposits at banks grow at a fast rate, leading to higher interest expenses, even as their total interest income decreases or remains constant. This is what has largely contributed to shrinking NIM figures over recent years, and won’t change much until the Fed hikes interest rates again.

An additional factor that will temporarily increase pressure on margins stems from the Fed’s tapering plans, as the central bank will gradually work its way through the $40 billion in agency mortgage-backed securities it purchases each month.  This will slowly close off a lucrative source of interest income for the banks since the package was introduced in September 2012. But there is an upside to the tapering plans too as far as interest margins are concerned. The gradual reduction in liquidity should help ease interest rates.

Taken together, these factors are what lead us to believe that a period of interest rate uncertainty is soon to follow.

But while this is the expected future of interest rates in the country as of now, the past demonstrated a very clear trend:  shrinking net interest margins. The table below shows the NIM figures for the five largest banks for each of the last eleven quarters. The figures were reported by the banks in their respective quarterly SEC filings.

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013
U.S. Bancorp 3.69% 3.67% 3.65% 3.60% 3.60% 3.58% 3.59% 3.55% 3.48% 3.43% 3.43%
Wells Fargo 4.05% 4.01% 3.84% 3.89% 3.91% 3.91% 3.66% 3.56% 3.48% 3.46% 3.38%
Citigroup 2.88% 2.82% 2.83% 2.90% 2.90% 2.81% 2.86% 2.93% 2.88% 2.85% 2.81%
Bank of America 2.66% 2.49% 2.31% 2.44% 2.50% 2.20% 2.31% 2.34% 2.43% 2.43% 2.43%
JPMorgan 2.89% 2.72% 2.66% 2.70% 2.61% 2.47% 2.43% 2.40% 2.37% 2.20% 2.18%

As is evident from the table, NIM figures for all the banks have fallen over the period Q1 2011 to Q3 2013.

The largest decline was witnessed by JPMorgan with NIM figures falling 71 basis points (0.71%) over the period — a considerable decline — followed by Wells Fargo whose NIM figures sequentially fell 67 basis points (0.67%). Quite interestingly, the difference between the interest margins for both these banks for Q3 2013 is considerably large at 120 basis points (1.2%).

This is due to two factors: business model and capital structure. The business model directly affects the NIM figure as some types of loans and securities inherently draw more interest rates than others. No doubt the focus Wells Fargo and U.S. Bancorp have on the mortgage industry acts as a plus in this regard. Wells Fargo in particular earns a lot of interest income from its portfolio of mortgage-backed securities.

As for the impact of the capital structure on NIM figures, it is obvious that the more long-term debt a bank has on its balance sheet, the more it will pay as interest expenses; reducing its NIM figure in the process. JPMorgan has more than double the size of long-term debt compared to Wells Fargo and the debt burden clearly weighs against the former in the big way.

You can get a better understanding of the partial impact of changing net interest margins on the bank’s total value by making changes to the chart below, which represents U.S. Bancorp’s NIM on outstanding mortgages.

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  1. Federal Reserve issues FOMC statement, Dec 18 2013 []
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