It is not a surprise that many community financial institutions are highly net interest income dependent. When the largest earning asset, loans, is not seeing a lift in new production yields following a 100 basis point increase in Prime, it has many bank and credit union executives concerned and wondering why. We discuss several of the reasons here.
A flatter yield curve is partially to blame. We use the Fed Funds Target Rate as a proxy for short-term rates and wholesale funding costs, and the 5 Yr Treasury as a price point for many earning assets, i.e., fixed rate commercial loans. In 2015, prior to the first Fed Funds increase, the average spread, or slope between the Fed Funds Target Rate and the 5 Yr Treasury was 1.28%. Today, this spread, or slope, is 0.68%.
Tightening credit spreads are another component of sticky loan yields. In 2015, 5-7 Yr fixed CRE loans priced around 4.00-4.50% in competitive markets. Today, we see loan pricing only marginally higher, in a 4.25-4.75% range for the same terms. However, the 5 Yr Treasury is up 40 bps and Prime is up 100 bps over the same period. This spread compression is a result of financial institutions competing for earning assets to replace portfolio cash flow and grow footings quickly at the expense of other risks.
Traditional earning asset growth is a viable strategy being pursued by many institutions to combat margin compression and improve earnings. However, executive management needs to continuously evaluate and monitor the institution’s balance sheet risk positions, i.e., credit, capital, liquidity and interest rate risk, to balance the risk reward trade-off of the strategy. With overall loans yields already low, financial institutions have little room for error in their credit decision process. This is especially true today when charge-off rates are reaching historical lows and the repeating nature of business cycles begs the question of not IF, but WHEN, will we see credit losses increase and how will this impact capital, balance sheets, and regulatory examinations. (We wrote an E-brief on this topic titled “Understanding the Relationship of Credit Cycles and Interest Rates” in October of 2016.)
With spreads between funding and earning asset yields narrowing for community financial institutions and the economy in the expansionary phase of the credit cycle, it is especially important to remain disciplined with loan pricing. Management should utilize loan pricing tools to appropriately price credit and market risks, and evaluate competitor pricing to help maintain that discipline. It is also important to regularly assess the institution’s strategic direction in the loan portfolio. Here are some questions that should be frequently coming up during ALCO and Loan Committee meetings:
“Are we being compensated enough for the risk?”
“Should we begin reducing our loan concentrations in higher risk sectors?”
“How does a risk-adjusted return of a 5-7 Yr CRE loan compare to that of other earning assets, i.e., high quality municipal bonds?”
“Do we have the appropriate earning asset mix for our balance sheet?”
These types of discussions and the resulting decisions/strategies could be the difference between falling asleep at the wheel and making the right move at the right time.