uploads///Net Interest margins

Interest Rates Change: A Key Indicator for the Banking Sector

Rekha Khandelwal, CFA - Author
By

May 20 2015, Updated 9:07 a.m. ET

Net interest margin

The average net interest margin (or NIM) in the fourth quarter of 2014 for all FDIC- (Federal Deposit Insurance Corporation) insured institutions declined to 3.12% compared to 3.15% in 3Q14. NIM data for the first quarter of 2015 is yet to be released.

NIM is net interest income expressed as a percentage of total interest earning assets. It’s the single most followed metric used to assess a bank’s performance in terms of deployment of funds and their costs.

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Squeezed margins

Lower interest rates on a sustained basis have negatively impacted the performance of the US banking sector. Interest rates banks earn on loans have declined, but borrowing costs cannot fall below zero. So banks are not able to use much deposit pricing strategies to boost margins.

As a result, the relative value of lower cost deposits has decreased significantly, lowering margins for most US banks. As the above graph shows, average NIMs for all FDIC-insured institutions have been on a declining trend for four years.

Lower net interest margins have negatively affected big banks such as J.P. Morgan (JPM), Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC). Margins have also affected regional banks such as BB&T (BBT), Regions Financial (RF), KeyCorp (KEY), and SunTrust Banks (STI). They have consequently affected the Financial Select Sector SPDR ETF (XLF).

How a rate hike impacts performance

Interest income typically contributes more than 60% to a bank’s total operating income and plays a key role in a bank’s performance. In an increasing rate environment, interest income produced by floating-rate loans increases. Income from short-term securities held in banks’ portfolios also increases as banks shift these to higher rates.

Banks typically raise the interest they charge for loans faster than what they pay on deposits. This gives an immediate boost to the margins.

A rate rise might also indicate an improving economy, resulting in a higher demand for loans. It also usually means rising income levels and lower defaults on loans. This results in lower charge-offs and loss of reserves.

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