Trends in Community Banks' Net Interest Margins

Gary S. Corner , Andrew P. Meyer

Net interest margins are clearly under pressure at community banks, but this trend is not new. It is a product of a highly competitive banking industry and a direct result of today’s lower lending levels and abundant balance sheet liquidity.

The net interest margin (NIM) is the difference between interest income and interest expense. (Both are expressed as a percentage of average earning assets.) As shown in Figures 1 to 4, interest income and interest expense fluctuated considerably through the business cycle, but the long-term trend indicates that asset yields are falling faster than deposit and other funding costs.

NIM Trends

As shown in Figure 1 below, the NIM for U.S. banks under $1 billion in assets fell 117 basis points since 1995 (from 4.89 percent to 3.72 percent). Figure 2 shows that in the Eighth District, the NIM experienced a similar decline, falling 74 basis points (from 4.49 percent to 3.75 percent). District margins were historically weaker than national averages because lending levels were generally lower. Based on the numbers above, small community banks in the District reported an average NIM that was 40 basis points below their national counterparts in 1995. However, by June 2013, District and national measures of small community bank NIM converged to a difference of only 3 basis points, with small District banks slightly edging out other small U.S. banks. In Figure 3, we see that large community banks (between $1 billion and $10 billion in assets) experienced a similar downward trajectory.



U.S. Banks Under $1 Billion

Figure 1

SOURCE: Reports of Condition and Income for U.S. Commercial Banks


Eighth District Banks Under $1 Billion

Figure 2

SOURCE: Reports of Condition and Income for U.S. Commercial Banks


U.S. Banks $1 Billion to $10 Billion

Figure 3



Eighth District Banks $1 Billion to $10 Billion

Figure 4

SOURCE: Reports of Condition and Income for U.S. Commercial Banks

It is interesting to note that, generally, smaller banks more effectively reduced funding costs and maintained NIM during the financial crisis than larger banks. As expected, reliance on institutional or wholesale funding during this period proved less sound than reliance on retail funding.

Until recently, bankers have driven down their deposit costs nearly lockstep with the fall of their asset yields, as depicted in Figures 1 to 4. Banks with higher, more stable loan volume are in a generally better earnings position, along with those that have aggressively reduced funding costs.

Loans to Total Assets

Lending in small community banks (with less than $1 billion in assets) spiked leading up to and into the financial crisis, reaching more than 70 percent of the banks’ total assets by 2008. (See Figure 5.) Since then, lending has retrenched and currently stands at around 62 percent of total assets. Contributing factors are weak loan demand, tightened loan standards and a surge in deposits that loan demand could not absorb. As a result, excess liquidity is held in securities and cash balances. Leading up to the financial crisis, large community banks nationwide (between $1 billion and $10 billion in assets) experienced similar gains in lending, but they have been able to retain a slightly greater amount of that lending, as loans currently represent around 64 percent of total assets. (See Figure 6.)



Loan-to-Asset Ratio, Banks Under $1 Billion

Figure 5

SOURCE: Reports of Condition and Income for U.S. Commercial Banks


Loan-to-Asset Ratio, Banks $1 Billion to $10 Billion

Figure 6

SOURCE: Reports of Condition and Income for U.S. Commercial Banks

NIM Risk Factors

To maintain margins, banks may need to continue to focus on their deposit costs while waiting for their loan demand to strengthen. Alternatively, chasing asset yields that significantly extend balance sheet duration today may prove painful down the road. As shown in Figures 1 and 3, the average interest expense for banks under $1 billion in assets is 57 basis points; for banks between $1 billion and $10 billion in assets, it is only 48 basis points. Perhaps there is room to further reduce deposit costs, as bank customers today tend to be somewhat indifferent to deposit rates.

When the rate environment turns, will bankers have done enough to protect themselves? In addition to higher funding costs, deposits that surged into the banking system may move back out as depositors find more attractive yields elsewhere. Perhaps, just as loan demand improves, a portion of deposit funding may dissipate. Depending on the nimbleness of their balance sheets, many banks are at risk of experiencing further NIM compression for a period of time. Consequently, decisions relative to today’s earnings pressures must be balanced with overall risk-management considerations.


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