The banking industry nationwide is still adjusting strategies necessary for succeeding in a rising interest-rate environment. With population growth in Massachusetts stagnant and the economy recovering more slowly than in other parts of the country, however, Bay State banks also are facing unique challenges specific to the region.

The Federal Deposit Insurance Corp.’s recently released state profile for Massachusetts revealed growing pressure on banks to attract new deposits. Time deposits such as certificates of deposit are growing in volume but rates of return also are on the rise, narrowing profit margins for banks.

The report also revealed an increase in consumer loan charge-offs in Massachusetts.

Paul Driscoll, regional manager for the research and insurance division of the FDIC, said there was a rush by some financially distressed consumers to file before bankruptcy rules became more stringent. A new bankruptcy law tougher on debt write-offs went into effect on Oct. 17, 2005. According to Driscoll, many consumers saw a window of opportunity under the old law and just about anyone contemplating filing for bankruptcy did so before the new law took effect.

Starting in 2005, financial institutions in Massachusetts began seeing an increase in loan charge-offs involving personal loans, car loans and credit card balances. He said mortgages are not included in that category. The trend is continuing in 2006 with a consumer loan net charge-off rate of 0.92 percent in the first quarter, up from a five-year low point of 0.3 percent in the second and third quarters of 2004.

Although local banks are seeing an increase in the number of charge-offs, it is still only about half the national average rate, which was 1.8 percent in the first quarter this year, he said.

Although Driscoll would not speculate on how long the trend would continue, he did say it is likely that the rise in loan charge-offs is a direct result of the bankruptcy filing spike, which surpassed 9,000 filings in the Bay State in the fourth quarter of 2005 and fell to just over 1,000 filings in the first quarter of 2006.

“It’s just a blip in the radar,” he said.

However, Massachusetts banks have not seen such a sharp increase in consumer loan charge-offs in more than five years and the same spike did not occur in every state. Driscoll said Connecticut, which is usually in line with Massachusetts when it comes to banking trends, has not experienced a sharp increase in consumer loan charge-offs such has been the case in the Bay State. In Connecticut, loan charge-off statistics remained flat.

Bob Segal, chief executive officer of Danvers-based J. William Mantz Investment Advisors, said he believes the spike in Massachusetts bank loan charge-offs will level off later this year.

Joe Roller, president and chief operating officer for Cambridge Trust Co., said an increase in loan defaults is not something his bank is experiencing.

“It’s hard for me to call it an ongoing trend at this point,” said Roller.

However, Roller said more aggressive lending tactics are taking place nationwide, and by more institutions than just banks. Such tactics could lead to trouble down the road. He said if, in fact, increased charge-offs is part of a larger trend rather than just a direct result of the bankruptcy reform, the changes in how people lend money and who they are lending to could be playing a role in rising default rates.

“A lot of people are in debt. When they hit a bump in the road, people can only afford to pay so much,” said Gerard R. Lavoie, executive vice president of Dedham Institution for Savings. However, Lavoie said Dedham Institution for Savings has not seen an increase in consumer loan charge-offs.

Time Shift
Also noted by the FDIC is the continuing rise in time deposits such as CDs that began in 2004. As time-deposit activity grows, deposits in traditional bank accounts like savings and checking have declined.

“The increase in the rates paid on time deposits and the growing volume of these time deposits may pressure net interest margins going forward,” noted the FDIC’s report on Massachusetts. “One reason is that FDIC-insured institutions headquartered in the state tend to hold large concentrations of long-term assets, which will tend to slow the extent to which their yield on earning assets will be able to rise with market interest rates.”

According to the FDIC’s findings, at the end of March 2006, 36 percent of the total assets held by banks were mortgage-related and 29 percent of total assets were long-term deposits such as CDs.

“One way for banks to make money is to borrow short and lend long,” said Driscoll.

Driscoll said in 2004, as interest rates began to rise, banks began struggling to maintain healthy net interest margins and the problem has continued to the present.

“What it means is that the basic business of banking is getting harder. It’s harder to make money today,” he said. “There are a lot of banks in Massachusetts. It’s very competitive.”

Paying out high interest rates continues to be the trend in the commonwealth. Driscoll said banks especially need to do so in a state without population growth. He said attracting new customers means taking them away from a competitor.

Local bankers say they are seeing more short-term time deposits as consumers are drawn to the growing returns for letting a bank hold a chunk of their change for nine months or so.

Driscoll said the increase in CDs also has to be viewed with the status of the yield curve. He said the short end of the yield curve has gone up from 1 percent to 5.25 percent, and the long end rose from 4.5 percent to 5.5 percent since 2003. With the difference in interest rates paid by banks for short-term and long-term deposits narrowing, consumers are more often opting for shorter-length investments.

“The general trend we are seeing with interest rates is they are getting higher on both ends,” Driscoll said.

But it is the short-term CDs that banks are most often using as leverage to attract new customers.

“I think we are seeing [that] trend,” said Roller.

According to Roller, Cambridge Trust has been among the many area banks to see a greater number of customers inquiring about time deposits. He said as long as interest rates are rising, the rate of return on short-term CDs also will be increasing, even though banks would like to see customers invest their money for longer periods. “There is no reward for going out further,” he said.

“The real problem right now is that it creates a problem for funding [bank investments and loans]. It makes funding more expensive,” said Segal. “On the funding side [banks] are paying a lot on CDs to keep people from going out the door. That is squeezing margins.”

Segal said if the economy slows later this year the Federal Reserve should see a need to drop interest rates. Therefore, the interest paid on, and popularity of, short-term CDs might decrease.

However, industry experts note, short-term CD promotions are an attractive product for banks to market at present.

Boston-based Eastern Bank recently launched a new promotion for its nine-month CD with a 5.2 percent rate of return and its 15-month CD carrying 5.4 percent interest. Introducing these new rates in May, the bank already has seen “hundreds of millions of dollars” in new deposits generated, said Joe Bartolotta, spokesman for Eastern.

“For consumers, this is one of the benefits of a rising interest-rate environment,” he said. “It had been a while since we ran a CD special. It’s a sure-fire way to bring traffic in through your doors.”

“The challenge for banks is to take these CD customers and turn them into customers of core banking services,” Bartolotta said.

Lavoie said banks such as Dedham Institution for Savings enjoyed a high percentage of core accounts, such as checking and savings, from 2003 to 2005. However, there has been a substantial shift in the way many consumers chose to leave their money with a bank. He said higher interest rates are drawing customers to explore other accounts, with the most popular choice at present being short-term CDs. He said several banks are seeing a 50-50 split between the percentage of funds from traditional accounts and the funds wrapped up in time deposits. In some cases the shift is pretty dramatic, said Lavoie, adding that his bank has seen a 13 percent shift toward time deposits.

“You are looking at a shift of about $80 million,” Lavoie said. “It raises your funding costs.”

Although CDs can draw in new customers who are seeking out good rates, the flip side is banks are paying more for funding than they would if all those customers dropped the same amount of money into a savings account paying with a lower rate of return. Lavoie said consumers are aware that the CD deals are out there in the high interest-rate environment, and it is likely more customers will put more money into timed accounts.