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Low interest rates this year have driven commercial lending and spurred new and refinanced mortgages.
But as long-term rates dropped before the Federal Reserve began making moves on short-term rates, the spread between what’s paid on deposits and earned on loans continued to flatten, hurting profits for many community banks.
Last week’s decision by the Federal Reserve to cut interest rates for the third time this year could add some steepness back to the yield curve and help reverse this trend.
“One of the things we have been preaching forever is that the worst case for banks is lower interest rates,” said Frank Farone, a managing director with Newburyport-based Darling Consulting Group.
Farone works with CEOs and CFOs at community banks and other financial institutions nationwide. He said banks have seen their yields on assets go down while customers have refinanced or taken out new mortgages at rates near historic lows.
“Meanwhile banks’ cost of funds continues to go upward,” Farone said. “And therein lies the squeeze.”
With some banks paying more than 2 percent on deposits and charging below 4 percent on loans, opportunities for profit have become scarce.
Low Margins, Higher Volumes
While community banks and credit unions felt pressure from the low interest rate environment, they didn’t lack for customers. Those same low rates sent many flocking to their doors.
Many lenders had forecast higher long-term rates for 2019 and did not expect the mortgage and refinancing activity that happened, said Caleb Cook, vice president of consumer lending at Digital Federal Credit Union. So far, 2019 has produced a “banner year” for DCU’s refi business, he said. While auto loans started the year off slow, Cook said, activity picked up once short-term rates dropped, turning what would have been a year of contraction in that line of business into a more neutral one.
“Lower rates give members more buying power,” Cook said. “Consumer confidence has returned as we move into holiday season.”
Federal Reserve Chairman Jerome Powell testifies to Congress in 2018. Last week, Powell and the Federal Open Markets Committee cut the federal funds rate by a quarter-point, to a range between 1.5 percent and 1.75 percent. Photo courtesy of the Federal Reserve
Lower interest rates have helped the Institution for Savings in Newburyport by reducing deposit costs, President and CEO Mike Jones said. But they also meant that it was difficult to offer attractive returns to savers. Still, rates are not as low as after the Great Recession, Jones said, and few customers have complained.
“In general, with how well the economy is doing, low unemployment and such low inflation, that certainly lessens the pain of interest rates being low,” Jones said. “There’s also the safety aspect of having money in a community bank or commercial bank.”
Along with refinancing mortgages and receiving better credit card rates, customers at Holyoke-based PeoplesBank have also been refinancing commercial loans, leading to fierce competition between banks, said Brian Canina, the bank’s executive vice president, CFO and treasurer. But the surge of refis does have consequences.
“It becomes challenging when you have lenders who work on refinancing rather than working with new customers, Canina said. “It’s not as bad as it was five or six years ago, but that’s what any bank would be challenged with.”
Prepare for Worst, Hope for Best
The Fed’s rate cut could help steepen the yield curve and ease pressure on banks, but for Farone, this offers only a temporary reprieve. As bankers now work on budgets, some are concerned about holding on to earnings.
Farone would like to see bankers put aside interest rate biases and philosophies, changing how they manage their balance sheets.
“There are still a lot of opportunities for community banks to build and grow market share,” Farone said. “They just need to be a little bit more nimble.”
Changes banks could make include revisiting policies, such as with flexibility with loan structures and lower capitalization ratios, Farone said. He added that banks should understand their own unique risks when managing the balance sheet.
Farone does not think the U.S. will adopt negative interest rates, which he considers a failed economic policy in other countries. But banks should continue to prepare for lower rates and then hope rates start to move higher.
“Banks have to continue to manage against the falling rate environment and, like any insurance policy, hope whatever insurance you buy today against falling interest rates doesn’t pay off,” Farone said. “That’s a tough pill to swallow given where we are on the rate cycle, but that’s unfortunately the way insurance works.”
Smaller Lenders Go Commercial
Diane McLauglin
Smaller banks and credit unions have had to make business changes including getting more involved in commercial lending, said Tom O’Connor, a partner with GT Reilly and Co., which offers audit and tax services to community banks and credit unions. He has seen smaller banks and credit unions make business changes, including getting more involved in commercial lending. While more risk is involved compared to home mortgages, these loans often yield a better return for banks and credit unions.
Declining profits from low interest rates have been one factor in pushing smaller banks toward mergers, O’Connor said, and he expects to see mergers continue.
Community banks need to consider the long-term effects of the interest rate environment as well. With more opportunities for profit, banks could invest in technology, a key for attracting new customers and keeping existing customers and their families.
“We’re in this period of wealth transition from Baby Boomers to their children, and a real concern is being attractive to the next generation of customers,” O’Conner said. “They want more technology, and they expect there to be the best technology.”
