The Net Interest Squeeze
What it means for banks, borrowers, and savers
One key metric in banking is Net Interest Margin (NIM), which is the spread between what a bank earns in interest by lending money out and what it pays in interest to keep or attract deposits. For example, if a bank lends money out at 7.0% and pays 4.0% on its deposits, the NIM is 3.0%. The higher the NIM, the more profitable for the bank. Ideally banks would like to lend at, say, 7.0% and pay nearly nothing for deposits, which would generate a pretty robust NIM, but banks are subject to the market forces of supply and demand. If you’re a bank that is not paying much to your depositors right now, you are not going to have many deposits to lend because they will flow elsewhere.
Interestingly enough, NIMs have been on a fairly steady decline since the 1990s. As shown in the chart below, the average U.S. bank NIM peaked in 1994 at 4.91% before declining to below 3.0% in recent years. There are a lot of bank CEOs today who would drool for a NIM that started with a 4 let alone one that was pushing 5!
The NIM squeeze especially over the past 12-18 months has had major implications for borrowers and bank customers, not to mention bank investors. It is an interesting question to ponder about why NIMs have declined so significantly. I think one primary reason is that despite an overarching trend towards consolidation in the banking industry, many aspects of the banking world have actually become more open and more competitive over the past 30 years. What happened from 1994 onward? A technology boom. When people could start searching online for the most attractive interest rates on both loans and deposits, they were no longer beholden to whatever the local bank on the corner was offering, which likely was a key reason why NIMs started declining. Competition and transparency are good! (at least for the consumer).
The average nationwide NIM during the fourth quarter of 2023 was 2.94%. Typically speaking, the larger the bank in terms of asset size, the lower the NIM. This is likely because those banks have a certain amount of leverage due to their size and also have more robust alternate revenue lines than just loans so they are not as dependent on NIM for earnings in the way that smaller community banks might be. The righthand column below shows the NIMs for each swath of banks based on asset size (I think the Perc label is for “percent”).
The key reason for the NIM squeeze today is that the price of deposits has gone up so much in the last 12-18 months. Banks need to pay for deposits now in ways they did not for much of the 2010s and early 2020s. Interest rates on loans have gone up too, of course, so you might think that it is all a wash. But, when interest rates on loans go up, it dampens demand for loans, but when interest rates for deposit accounts go up, it boosts demands for deposits; the pressures become like opposite levers. The problem for banks is that there are so many fewer loans today than in 2020 and so much more in the accounts of depositors demanding higher yields. All the pressure and activity is on the deposits side of the ledger for banks.
Interest rates have been largely driven by the Fed, but just about one year ago from the time of this writing, the failure of several high-profile banks including Silicon Valley Bank created sudden pressures on deposits because of the acute liquidity fears among banks around the country. Banks large and small (but especially the small ones) boosted deposit rates almost immediately to draw in as many deposits as possible to bolster the balance sheet in the face of potential deposit slippage (or good old-fashion bank runs in the extreme case). This deposit rate boost happened almost exactly at the same time that loan volume was declining. This put a lot of pressure on both sides of the NIM equation.
What Does It Mean for Borrowers?
Higher rates on deposits are good news for savers, but the high rate environment has proven to be more challenging, to say the lease, for borrowers. If banks seek to achieve that industry-standard 3.0% NIM, but they are paying 4.0-5.0% for deposits, that puts interest the interest rate on loans around 7.0-8.0%. Banks are not going to price loans at 5.0% these days if they are paying 4.0% for deposits, for example, because the 1.0% NIM in this example is just not worth it. On that point, banks are more choosey right now. So the challenge for borrowers facing high interest rates is first and foremost a question of math, but it is also a question of bank appetite. Banks are simply saying no to a lot of deals right now, preferring to guard their deposit base and lend more sparingly until things get back to normal. In fact, according to the most recent Senior Loan Officer Opinion Survey (SLOOS), a full 50% of small bank senior lenders said that concerns about their bank’s liquidity position was either somewhat or very important reasons why their banks were tightening their lending standards.
Keep in mind, too, the other way that banks obtain deposits to lend out. Ideally banks are lending out their own deposits they have collected from customers. Some of those deposits are in fairly high yield CDs and money market accounts, but some are (even more attractively from the bank’s perspective) in normal checking and savings accounts, which might still have negligible interest rates on them even with all the upward pressures on rates in the past two years. But once a bank starts to run out of these deposits to lend, they can go to the Federal Reserve and borrower additional funds to lend out at the Federal Funds Rate, which right now is 5.33%. You can understand why interst rates on loans have gotten so high if banks are borrowing from the Fed: to get that 3.0% NIM, a loan has to be priced at 8.33%.
What Comes Next
Interest rates will soon drop, although it will not be this month as had been hoped for previously; a strong labor market, robust consumer sentiment, and stubbornly high inflation have delayed the anticipated rate cuts. When rates do drop, however, it should ease some of the NIM pressure. Interest rates on loans are sure to come down a bit, but so too will deposit rates.
Competition for deposit dollars among banks is fierce. Sure, there are plenty of depositors at any bank who will never leave. Maybe they are just very loyal or the thought of changing banks or opening up new accounts feels too complicated or overwhelming. But for others, especially younger consumers with fewer ties to a traditional brick-and-mortar bank, it’s just too easy to log in and compare deposit rates between not only different banks but also the Vanguards, Fidelitys, and SoFis of the world not to mention more traditional vanilla investments like Treasury Bills and corporate bonds. I wrote last week about the pressures traditional banking will face in the years ahead because of AI. But the pressures of FinTech and what non-brick-and-mortar financial institutions can offer for terms on deposits and loans are pretty major as well and present real challenges to traditional banks.
Ironically, banking (especially community banking) has historically been perceived as a sleepy industry: collect local deposits, lend them out, make money on the margin and earn some additional revenues from other bank services. But the world has changed, and so too has banking in this uncertain rate environment and with so many changes to the competitive landscape.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com.
Weekly Round Up
Here are a few things that caught my eye this week.
Some additional color on today’s topic via S&P Global Marketplace:
Banks continue to prize liquidity and securities balances continued to shrink, while loans grew at a slower pace in the third quarter. In the third quarter, total loans rose 0.4% from the linked quarter, after growing 0.7% on a sequential basis in the second quarter. Modest loan growth and pressure on deposits caused the industry's loan-to-deposit ratio to rise further, increasing to 66.5% from just shy of 66% in the prior quarter
Mark Rubinstein wrote this past week in his Substack newsletter Net Interest that the Nikkei 225, which is the Japanese blue-chip stock market index, only just recently matched its 1989 high (!!!). The multi-decade swoon shows how long it can take for a stock market to recover following a drop, although Japanese stocks are unique on a global scale in part because so few Japanese people invest in them. He writes:
Equities account for just 11% of household financial assets in Japan, compared with 39% in the US and 21% in Europe. Investment funds add another 4% but in the US that number is 12% and in Europe it is 10%. In contrast, Japanese households hold over half their assets in cash – fine when consumer prices are falling, expensive when they are not.
A new government program has been set up that allows Japanese people to invest up to $120,000 over their lifetime tax-free, which may be boosting inflows to stocks. Read more here.
No larger message or conclusion here, but it’s interesting that the Dakotas have the highest fertility rates in the country right now. The chart below shows birth rates per 1,000 women age 15-44 in 2021 per CDC data. The lowest fertility rates? All of the New England states and Oregon followed by various other states in the northeast and northwest.
The national average credit score recently decreased from 718 to 717. The drop was notable because it was the first such decrease in over a decade. More via CNBC: “As of October, the average credit card utilization was 35%, up from 33% a year earlier, and just over 18% of borrowers had a more than 30-day past-due missed payment against their credit accounts, up from 16.5% the year before.” Read more here.
In Augusta, Maine, this week, I was served lunch by a robot waiter. It was pretty wild. I can still remember the first text message I ever got. It was from a college friend who was home on break in the winter of 2002. I also now remember the first time I was served a meal by a robot. Click below to see the short video:
One Good Long Read
I appreciate the positive comments people have been sending me about enjoying the One Good Long Read feature that I’ve been doing the past few weeks. I think if you are the type of person who likes to read my articles in general, you are also the type of person who likes who likes to read other forms of longford journalism.
In 1986, a man in Maine went into the woods. He didn’t come out until 2013, and only then because he was caught stealing from a camp storeroom and put in jail. His name was Christopher Thomas Knight, and he was The North Pond Hermit. Living in Maine, I remember the story of when he was found. The story was so ubiquitous you couldn’t avoid it. But this article was the first time I heard much about his life before the woods, or after. You can read the thoughtful and entertaining article by Michael Finkel of GQ here.
Have a great week, everybody!
Most informative Ben. Do you have any data on Australian banks. An international comparison might be interesting.
Perhaps the decline in NIM may be in part due to the adoption of technology that enables a bank to operate more cheaply and efficiently, perhaps less activity in the tellers booth, the closure of branches that is rampant in Australia.
Another question: Would it attract borrowers if US banks offered 30 year mortgages at an invariable interest rate. Would that be seen as not feasible. I am aware of the role of Fanny Mae and Freddie Mac. I'm interested in the possibility of doing this in Australia where changing rates play havoc with the budgets of borrowers, and in particular those on the edge of not meeting their obligations when interest rates are low.