Thinner competition and rate floors help margins jump
By Bill Streeter, editor-in-chief,
Uptick in net interest margins results from reduced competition, a normal yield curve, and ability to set a floor. “We’re still lending”
Combine low-cost funds with an influx of de novos and nonbank lenders plus a booming economy and it’s not surprising that net interest margins have been squeezed.
Actually, margins for the industry as a whole have been trending downward since the end of the last big banking downturn (see nearby chart), reaching their nadir early this year. Now that the ranks of lenders have been thinned, and borrower demand cooled off, margins have turned back up.
Was that the bottom? Several bankers interviewed believe it was. But when it comes to margins, industrywide figures are not always relevant. Much depends on balance sheet composition, deposit pricing, local market conditions, and more.
One thing all agreed on, however: higher margins are better!
Furthermore, net interest income is still the key to bank performance, and has become even more so with increased pressures on service charges and less-than-stellar success in building noninterest income from other sources, such as Trust or securities brokerage. The latter point applies mainly to community and midsize banks. Large banks generally speaking have been more successful building fee-based businesses.
Arthur Johnson, newly elected ABA Chairman and CEO of United Bank of Michigan, Grand Rapids, commented recently that the upward movement of margins is particularly important right now. “Every other element of our revenue stream is under extreme pressure, and we’ve got to make money at something.”
In rural Missouri, John Klebba reports that margin pressure has been much less than in urban markets. Of the eight communities where Legends Bank operates, only one—on the western fringes of St. Louis—saw extreme pricing behavior, says Klebba, who is chairman and president of the $235 million-asset bank, based in Linn, Mo. That behavior was driven in part by a large number de novo banks and branches, he says.
“We saw deals [priced] far below where they should have been, just to get the business,” says Klebba. Now, he adds, “we’re starting to see pricing there based more closely on risk.”
“I have a real sense it’s going back to the old models,” says Klebba. By “old models,” he means traditional intermediation-based banking, which is what Legends Bank does. “We never really transformed ourselves into a fee-based bank,” says Klebba. The bank’s net interest margin, in contrast to the industry average, has stayed pretty close to 4% for years. It’s a little under that now because with Fed funds below 20 basis points, it’s difficult to keep the margin at 4%.
In south central Ohio, Park National Corp. Chairman and CEO Daniel DeLawder likewise sees more rational pricing of late. As a general rule, the big banks are not lending that much in his markets, he notes. Community banks like the 12 banks that comprise the $7 billion, Newark-based holding company he heads are still lending, however. With less competition, rates can be set higher.
Return of the rate floor
Like several banks contacted, Park National has instituted a rate floor to compensate for the unusually low prevailing rates.
“When rates fell to 3.25%, we understood what the Fed was doing,” says DeLawder, “but we said to ourselves, ‘We don’t have to lend at that rate’.” The bank set a floor at 5%, with some exceptions. Some existing customers who were at prime, stayed there, but new customers come in at the floor. With large banks not lending, Park was able to grow its loan portfolio at the higher rate and improve its margin, which at 4.22% is 75 basis points above its peers among $3-$10 billion banks. That margin was up from 4.16% for all of last year, but down from the 4.50% range in 2006-7, according to DeLawder.
Cost of funds, of course, is part of the equation and Park National enjoys a 36 basis point edge there over peers, as well.
The traditional model for community bank commercial loan pricing has been a floating rate above prime (or LIBOR). For Houston’s Omnibank, that was typically prime plus 1, depending on the business, according to Julie Cripe, president. She says many banks in Texas have now put a floor in place. These range from 6% to 8%, she said. For Omnibank it’s 6%, or a little lower for customers that have a deposit relationship. The bank’s base rate is now prime plus 2, but the floor gives Cripe leeway to keep her margin stable and keep lending.
“We hear some minor complaining,” she says, “but we’re still loaning money and 6% is not that high.”
Most of the comments so far have been related to business lending and commercial real estate. The two banks belonging to Arrow Financial Corp., Glens Falls, N.Y., do a large consumer lending business, indirect auto lending, in particular (31% of the combined portfolio is auto). As a result the banks tend to be liability sensitive, says Thomas Hoy, chairman and CEO. When the Fed was rapidly dropping rates last year, the banks enjoyed an immediate positive impact on their margins. But Hoy expects some compression by the end of the year.
“Margins used to be in the 4-5% range,” he says, “but we haven’t seen 4% in some time.” The bank suffered when the yield curve was flat under Alan Greenspan.
On the commercial side of the loan portfolio, Arrow competes mainly with banks in the $1 to $5 billion asset-size range, and Hoy says that generally they’re in pretty good shape and still very competitive.
“Pricing is pretty thin and everyone is awash with liquidity, looking for a place to put it to work,” he observes.
Founders Bank, likewise, is awash in deposits. The $112 million-assets, five-year-old startup in San Luis Obispo, Calif., recently changed its deposit policy, letting CDs roll off and focusing on demand deposits and savings. Although San Luis Obispo is an oasis of relative prosperity in California, Founders Bank is having trouble generating good quality loans. As a result, says President and CEO Thomas Sherman, the bank is parking funds in short-term, low-yielding bonds. Its net interest margin, normally over 5%, is just above 4% currently.
Founders has established a rate floor for loans—currently 6.5%. Sherman says a floor was first used in the last credit cycle and was much higher—8%. The new floor is more accepted, he says, not only because it’s lower, but because customers are used to the concept this time.
Question mark for noninterest income
The community and mid-size banks interviewed for this article are a conservative bunch when it comes to service charge income, and none are particularly outstanding in developing other forms of noninterest income.
Park National Corp., for example, despite its otherwise stellar numbers, is below peer on noninterest income. Dan DeLawder agrees service charge income is under pressure from both political and economic forces. He also says he’s noticed a decline in overdraft checking fees.
“That’s heartening,” he says. “It shows consumers are being more responsible.”
John Klebba observed that on a recent trip to Washington, D.C., “everybody—regulators and legislators—said that that train [restricting service charges] is coming down the tracks and will be hard to stop.”
Says Julie Cripe, whose bank’s overdraft income is much lower than its peers, “for a bank our size, noninterest income is ATM fees, overdraft fees, and checking service charges. If they do away with all that, we won’t have any noninterest income.”
Several of the banks do generate some noninterest income from trust services, securities brokerage, and sales of insurance, but the amounts relative to net interest income are modest.
Still, Arrow’s Tom Hoy offers this caution: “Net interest income,” he says, “will be easier to grow short term, but it would be foolish not to grow other income so that we are not so dependent on net interest income, being mindful of the past when we had a flat yield curve.” He believes that selling insurance has the potential to be a major component of income. BJ
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