Net interest margin
In the first quarter of 2015, the average net interest margin, or NIM, among all institutions insured by the FDIC (Federal Deposit Insurance Corporation) declined to 3.02%, down from 3.16% a year earlier.
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 the deployment of funds and their associated costs.
Sustained low interest rates have negatively affected the performance of the US banking sector. Interest rates that banks earn on loans have declined, yet borrowing costs can’t fall below zero. Still, banks aren’t able to use deposit pricing strategies to boost margins to any significant degree.
As a result, the relative value of lower-cost deposits has decreased significantly, lowering the margins at 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). Lower margins have also affected regional banks such as BB&T (BBT), Regions Financial (RF), KeyCorp (KEY), and SunTrust Banks (STI).
The banking sector makes up 37% of the Financial Select Sector SPDR Fund (XLF).
How a rate hike affects performance
Interest income typically contributes more than 60% of a bank’s total operating income and plays a key role in a bank’s performance. In a rising rate environment, interest income produced by floating-rate loans increases. Income from short-term securities held in a bank’s portfolios also increases as it shifts these to higher rates.
When rates rise, banks typically increase the interest they charge for loans faster than what they pay on deposits. This gives an immediate boost to their margins.
A rate hike might also indicate an improving economy, giving rise to greater demand for loans. This would also usually mean rising income levels and a lower default rate on loans, resulting in fewer charge-offs and lower reserves.