Low Interest Rates Hurt Or Help

October 9, 2002
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GRAND RAPIDS — Lower interest rates can enhance some bank’s earnings and erode other’s.

What impact interest rates have on a bank’s earnings depends on the bank’s asset-liability mix and how successful it is at generating loans and deposits.

It all depends on the mix of the balance sheet — the mix of variable rate loans and deposits vs. fixed rate loans and deposits.

In a low-interest rate environment, banks are forced to charge lower rates on loans while offering higher interest rates on savings accounts in order to attract and retain deposits.

Movements in interest rates impact nearly all banks, and the dramatic decline in rates has put pressure across the board on the margins of all institutions, said Michael Moran, chief of capital markets for Lansing-based Capitol Bancorp, a bank holding company that operates as a bank development company.

To date, Capitol Bancorp has established 29 community banks in eight states, 11 of them in Michigan.

“What happens is that you hit a point where you can only push the cost on your deposits down so far, but your loan yields continue to drop. So therein lies the pressure.

“I think that’s probably why you hear people say that smaller banks, or the community banks, are impacted more,” Moran noted.

Though he admitted that’s a broad-brush statement, he said there is a level of accuracy to it in that typically, traditional-spread lending is the driving force behind the community banks, whereas bigger banks often have a multitude of fee income sources upon which interest rates have very little impact.

“For the community banks that primary product is making loans, so they feel it more than bigger banks that have access to fee-income sources.” 

But asset liability management techniques have grown ever more sophisticated over the years, Moran pointed out, and banks of all sizes have access to those sophisticated models.

According to Russ Daniel, banks look at their deposit base, they look at the loans they’re making and the length of time they’re making the loans for, and try to manage that interest rate margin. Daniel is the senior vice president for Independent Mortgage Co., West Michigan

“It’s more how good you are at asset liability management as opposed to where interest rates are,” he said. “We, as a bank, try to match up our interest rates all along so we don’t have that risk.”

The thing that confuses a lot of people, Daniel said, is that for a bank, loans are assets and deposits are liabilities. A bank’s net interest margin is the difference between what it earns on loans and what it pays for deposits.

Every bank has someone who manages asset liability and tries to position the bank to take advantage of either rising, falling or steady interest rates, said Mark Kimball, president and CEO of Select Bank.

He said those officers make projections on what impact rates will have on their bank if rates go up or down by a certain percent.

“We go through all kinds of financial modeling, and what our particular strategy is at Select Bank is that we want to stay interest-rate neutral; we don’t really want to speculate on what interest rates are going to do. So we just try and match up our assets, which are our loans, and our liabilities, which are our deposits.

“If you think rates are going up,” he added, “you try to do variable rate loans and fixed rate deposits. If you think rates are going to go down, you would want to do fixed rate loans and variable rate deposits.”

How can banks make more money in a lower interest rate environment?

One significant source of additional earnings that comes with a low interest rate environment is fee income that’s generated by mortgage loans as consumers refinance at lower rates, Kimball said. 

Most of the mortgages are fixed-rate loans and most get sold off in the secondary market. But he said the banks sell them for a premium, so they’re making fee income on those transactions.

Mortgages typically are not something a bank funds itself, Daniels pointed out. So when people are refinancing, typically that’s a positive thing because as the banks sell off the mortgages, someone else is taking the rate risk.

While many banks sell their fixed rate mortgages to other financial services companies, they typically keep their variable rate mortgages.

The present interest rate environment can be beneficial or not so beneficial all depending upon how the bank is positioned, said Jon Swets, senior vice president and CFO of Macatawa Bank.

How an individual bank is structured is really important in this connection, he said. Some banks will do very well if interest rates rise, he said, and some will do very badly if interest rates rise.

If the expectation is that rates will eventually go up, Swets said it may not make sense to be recording a lot of fixed rate loans on the books right now, because they’ll be locked in at those very low rates and that will hurt the bank somewhere down the road. 

“The banks that will do well in a rising rate environment will have more variable rate loans than variable rate deposits,” he said. “Rates on the assets on the loans will increase; more assets will increase in terms of their interest income than will deposits in terms of their interest expense, so the net interest income will go up as rates rise for institutions that have more variable assets than variable liabilities.”

The opposite also is true. Institutions that have very few variable rate assets but a lot of variable rate deposits, he said, will get hurt pretty badly with their net interest income as rates rise.

“It’s all very institution-specific,” Swets said. “The institutions that likely will do better are ones that are generally more heavily oriented towards commercial lending because commercial lending is generally done on a variable-rate basis.”

So commercial banks, vs. thrifts or S&Ls, oftentimes will do better as rates rise. As Swets pointed out, thrifts tend to be more focused on mortgage lending and will have more fixed-rate mortgages on their books, so won’t do as well in a rising rate environment but will do better in a decreasing rate environment.

“If you were a bank that a year ago bet a lot of money that interest rates were going to rise, you haven’t done as well as those banks that projected interest rates were going to fall.”

There are many factors that affect interest rates and different rates are often used as benchmarks concerning general interest rate movements; i.e., the federal fund rate, the prime rate and the LIBOR (London InterBank Offered Rate).

Typically, commercial loans are tied to prime or LIBOR rates, whereas mortgage rates are typically tied to treasury rates.

Movements in the fed funds rate normally give a very good indication of the general shape and movement of the yield curve, but Moran said it’s not necessarily an end-all, be-all with regard to the overall interest rate environment.

The Federal Open Market Committee decided Sept. 24 to keep its target for the federal funds rate unchanged at 1.75 percent.

Some people want to see rate cuts in the hope that it might continue to fuel a recovery and others are hoping to see rates get bumped a bit because margins are under a lot of pressure.

“The interest rate scenario is very dynamic,” Daniels said. “The Fed changes one rate that banks can borrow from the Fed at, but the market usually anticipates up or down what’s going to happen.”

A significant move up or down in interest rates could have the exact opposite impact on two banks that by all appearances operate under fundamentally the same business model, said Capitol Bancorp’s Moran.

“It may just be a function of their asset-liability mix as well as the duration of those assets and liabilities.” 

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