The latest release of the Federal Reserve’s Senior Loan Officer survey back in January revealed a decidedly mixed picture of the state of commercial lending. While it is true that most executives surveyed reported stronger business demand for credit, almost 70% of respondents said that credit spreads were continuing to narrow. This was the 16th consecutive quarter in which a net majority of respondents reported eroding spreads. On the performance side of we can see this reflected in US banks’ quarterly net interest income which have been falling since on a year-over-year basis since January 2011.
The main culprit for these thinning margins and falling income is the historic low interest rate environment in the United States, which itself is the result of the unprecedented expansionary monetary policy adopted by the Fed in the wake of the financial crisis. After having set the short-term Federal Funds rate at near zero, the Fed embarked on three rounds of quantitative easing, i.e. buying assets with newly created money, to directly lower the yields on long-term interest rate. Since 2009, the Fed’s balance sheet ballooned from around $500 billion to nearly $4 trillion, more than one third of which is composed of mortgage-backed securities.
And yet all of this may soon change. With the US economy entering into a more robust phase of recovery, the Fed under Janet Yellen put out a more hawkish than expected statement regarding interest rate. While the minutes from the Fed’s March meeting reaffirmed fixing short-term rates at near zero at least until the end of 2014, they did announce additional tapering to the monthly asset purchases under the QE program. As a result, long term interest rates are already rising. The yield on 5-year Treasury notes has risen by 98 BP in April 2014 compared with the same period last year. For the 10 year bond, the figure is 87 BP (see chart). For banks, who tend to borrow in short term markets and lend long, the steepening of the IR curve will provide a good opportunity to increase margins at a time when demand is robust. In fact, margins may already be happening. CEB’s analysis of the FDIC’s data for the last quarter of 2013 revealed a 1.3% in net interest income compared to the same period in 2012. Although this would be a small change, it would represent the first time in almost 3 years that net interest income has risen.
Next month CEB TowerGroup will be publishing new research that provides more detailed analysis on how rising interest rates affect bank performance. If you are interested in a preview of this research or would like to discuss more, please contact us.