The Struggle With Growing Income At Banks Given Rising Rates

Most community banks are eagerly anticipating rising interest rates. The banking industry has historically fared well when interest rates rise, and banks’ cost of funding lags - net interest margin expands and banks’ profitability increases. However, in this particular rate cycle, there are a few unusual industry and market developments that community banks must consider. From analysis shown below, and anecdotal discussion with CFOs and CEOs, banks must be mindful of their strategic and balance sheet positioning for the next few years.

Interest Rate Normalization

It has been 13 years since interest rates increased because of monetary tightening. During that period the industry has changed in many ways, and customer behavior has adapted on numerous dimensions. In fact, a sizeable percentage of bankers have either not worked in banking when interest rates last rose or had substantially different banking roles at that time.

We recently had two separate meetings, one with the CFO and one with the CLO of a bank. The bank has been adding substantial loan and security duration on its balance sheet. Surprisingly the CFO indicated to us that he anticipates higher income and EVE in a rising rate environment. Although the bank’s loan duration has extended, he believes that the bank’s floating rate assets and non-maturity deposits will help the bank increase profitability as interest rates normalize. 

The CLO had another interesting view. He has been meeting with his borrower clients who have seasoned fixed rate loans and are interested in extending those durations. The CLO understands that the bank does not want to fix anything beyond five years and is struggling to maintain that business. Further, the CLO is surprised that many borrowers on floating rate loans believe that they actually have a fixed rate coupon. The floating rate loans are on floors which have not moved in years and borrowers are surprised to learn that their coupon rate will increase as interest rates rise. Once rates increase and floors are bumped, the CLO believes that many borrowers will awaken to want to fix their rate. The result is that the CFO will be surprised to learn that the bank’s floating rate loan portfolio will shrink as interest rates rise.

Data on Assets

Banks have been steadily increasing their balance sheet asset duration since 2007. The graph below shows Long-Term Assets as a percentage of Total Assets (as reported by the FDIC) for banks under $1B in assets (banks under $10B also show similar trends). Balance sheet asset duration has never been higher, and this is not a good sign for banks’ NIM in a rising interest rate environment.  

Community banks have been extending asset duration of their securities portfolio. However, the major source of asset duration extension is loan repricing. The graph below compares loan repricing for banks in three asset bands (under $1B, $5-$10B, and over $25B). The differences are substantial – smaller banks have been increasing loans that reprice three to 15 years. In contrast, larger banks have been increasing their variable rate loan portfolio and decreasing loans that reprice three to 15 years.

Data on Liabilities

Much debate continues over the stability and correlation (or beta) of bank deposits in today’s age of the internet and quick and efficient fund transfers. Community banks have increased the percentage of non-maturing deposits to total deposits (extending liability duration). However, the graph below shows that since 2000, banks under $1B in assets have seen a decrease in the percentage of Non-maturing Deposits to total Long-term Assets. Banks under $5B in assets show similar numbers.  

The largest liability-side protection for any bank against rising interest rates is large and stable non-interest DDA balances. The graph below shows that community banks currently have a lower percentage of their non-maturity deposits in non-interest DDA than larger banks. While non-interest DDA balances at small banks have been growing modestly, all banks will be challenged with maintaining these DDA balances as interest rates increase.

Explaining The Data

Why are banks exhibiting a duration gap? It is not always useful to use general data to explain specific bank performance. However, there is one powerful driving force that may explain this phenomenon. Income growth at banks under $1B has substantially lagged income growth at larger banks. The graph below shows income growth from 2000 levels to today for banks under $1B and banks over $5B in assets. Smaller banks have struggled to maintain profitability. The easiest way for management to increase NIM and net income when the yield curve is upwardly sloping (as it has been for the last business cycle) is to mismatch duration of assets and liabilities. We see this consistently in the data and anecdotally with many bankers that we talk to.

Conclusion

This next interest rate tightening cycle may impact banks differently than previous cycles. The banking industry has seen monumental consolidation since the last tightening cycle, and the internet has made deposits more fungible, more easily transferable and, most importantly, price discovery is transparent and instant. True long-duration deposits with positive convexity will become more difficult for banks to attract and maintain. Those banks that can increase non-interest DDA and can maintain stable and rising loan yields will have the best chance of growing income over the next interest rate tightening cycle.  

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