By Paul Gores

Faced with low interest rates, an abundance of deposits, and a pandemic-induced slowdown in business lending, many Wisconsin banks are wrestling with net interest margin (NIM) compression. 

While NIM compression is a long-term trend in banking, the effect of the still-spreading novel coronavirus on the economy has heightened concern over net interest margin, which essentially is the difference between what banks pay for deposits and earn on loans and investments. 

At a time when many banks have plenty of money to lend, the appetite for borrowing by good businesses is diminished and there’s not a lot of room for banks to further trim how much they pay depositors. 

“Suddenly you’ve got less loan demand,” said Jim Reber, president and chief executive of ICBA Securities. “You’ve got less that you can charge on your loans. The investments that banks own have gone down in yield as well because the Fed has purchased somewhere around $3 trillion worth of investments in 2020. And then, finally, banks have just been flooded with liquidity.” 

While the cost of funds is down, yields on assets have retreated faster than on deposits, he said. 

“That’s just mashed all the room for any net interest margin,” Reber said. 

Marc Gall, vice president and asset/liability strategist at BOK Financial, put it this way: “The downward push is really just that we’re in a very low rate environment where everything is getting compressed.” 

Data from the Federal Deposit Insurance Corp. shows how NIM has narrowed for Wisconsin banks. 

In the first half of 2018, the net interest margin average at Wisconsin-based banks was 3.51%. In the first half of 2019 it was 3.49%, and fell to 3.31% in the first six months of this year. Nationally, in those same periods, the NIMs for banks were 3.36%, 3.40%, and 2.97%, respectively. 

With no end to the low rate environment on the horizon, bank consultants expect the net interest margin squeeze to persist. 

In fact, said Ryan Hayhurst, managing director of The Baker Group, data for this year’s third quarter shows it’s getting worse. 

“The third-quarter margin compression was significantly more than the first and second quarter, and it’s probably going to continue because now you don’t have the benefit of the PPP (Payroll Protection Program) fees coming in anymore,” Hayhurst said.  

Looking at banks with assets of less than $10 billion nationally, NIM went from 3.68% in first quarter this year to 3.60% in the second quarter, and then lost another 20 basis points in the third quarter, Hayhurst said. 

The net interest margin compression is worse for community banks that do little or no mortgage lending. Mortgage lending and refinancing have been bright spots in banking. 

“If you’ve got an active mortgage department, an active mortgage presence, you’ve been able to refinance a whole lot of loans this year,” Reber said. 

Hayhurst said NIM compression can be tougher on community banks than on larger institutions.  

“The community banks receive approximately 80% of their income from margin sources,” Hayhurst said. “And bigger banks, it’s closer to 60%. So the larger institutions get a lot more of their revenue from non-margin sources like fee income, trust department, insurance activity, brokerages, investment banking – those kinds of things. The bigger banks also have lower overhead expenses because of economies of scale.” 

As nice as it was to derive fee income from PPP loans when the economy drastically slowed at the start of the pandemic, the loans could contribute to some NIM compression as they are forgiven. 

A decent amount of PPP is still sitting in banks, and once it’s forgiven, the return on it goes from 1% as a loan to only 5 to 10 basis points as cash. 

PPP loans might also be used by a borrower to pay down other loans on the books that have higher interest rates, said Kent A. Musbach, senior vice president for the BOK Financial Institutions Group. 

“So that’s a bit of margin headwind, if you will,” Musbach said. 

What can banks do to minimize NIM compression? 

One thing is to closely look at rates being paid for deposits like CDs, and cut them further. 

According to Reber, at this point, depositors aren’t expecting their money will earn very much anyway. 

Reber said banks have learned “they can be pretty aggressive on cutting their deposit costs because the depositors have very low expectations for any return.” 

“A lot of individuals, a lot of small business, have been able to refinance debt. They know they’re paying less on whatever they’ve borrowed from their bank, and they therefore reason, ‘Well, the bank is going to have to pay me less,’” Reber said. 

Gall said although cutting rates won’t have much of an impact over the last couple months of this year, it sets the stage for 2021. 

“It’s really going to have a whole impact when you have 12 months of that lower cost,” Gall said. “It’s really trying to get yourself at a good starting point for the next year. And that’s why banks have to really take a hard look at every account.” 

Said Hayhurst: “Because deposits have surged, I don’t believe most community banks are going to lose deposit relationships by cutting their deposit costs. Banks only have so many levers they can pull to fight margin compression.” 

In addition to reducing deposit expense, banks must make sure they deploy their assets as effectively as possible to combat NIM compression, consultants said. 

“Action step No. 1 is do something with the cash other than just have it sit at 10 basis points,” said Gall. 

Right now, many banks are sitting on a lot of cash. 

“Banks are holding that cash for a couple of reasons,” Hayhurst said. “One is the uncertainty – they saw a surge of deposits this year – and some of them are uncertain about if those deposits are going to surge back out. I don’t believe that they are. But there is a level of uncertainty there, so they’re holding cash for that reason.” 

Hayhurst continued: “Two, they don’t like the yields they can get in say, the bond market. So they are holding that cash earning 10 basis points because they don’t like that they can only buy a bond at 1% and they remember when they could buy a bond at 2% or 2.5%” 

“But 8% of your assets earning just 10 basis points is destroying margin. So first and foremost they need to deploy those assets,” Hayhurst said. 

Reber said some banks are selectively investing longer term than they normally would. 

“That 12-year bond that yields 2% is a better than a 5-year bond that yields 75 basis points,” Reber said. 

Gall said, depending on its position, each bank may have a little different approach.  

“The easy answer is the investment portfolio,” Gall said. 

In addition, he said, banks that are doing mortgage originations may choose to hold some mortgages. A bank might also opt to become more aggressive in lending. 

“The problem with that is in an uncertain economy you don’t really want to be leaning into potentially bad credits at lower rates,” Gall said. “You kind of pick your spot. But if you’re saying, ‘I’m going to earn 10 basis points for what the Fed has indicated is going to be three years if not longer, that’s going to be a huge hindrance on margin if you don’t do something with it.” 

Gall said some banks have the philosophy that they always need to price at the low end in their market or they’ll lose the deal.  

“Try to get a little bit more out of those loans, whether it’s 5 basis points or 10 basis points or 3 or 7,” Gall said. “Again, every additional couple of basis points you can get is probably what’s going to help banks succeed for the long run. Even though it doesn’t seem like a lot, when you start aggregating $250 million of assets and you start squeezing out 5 extra basis points, it becomes real dollars.” 

Musbach and Gall said bankers could be better off to not focus so much on NIM. 

“Is it the margin percentage that’s important, or is it the absolute net income interest number?” Musbach said. 

Consultants said banks also must keep becoming more efficient. 

It appears low rates are going to linger, and margins will remain under pressure, they said. 

“The Fed’s own projections show that rates aren’t going to be moving until 2023,” said Reber. “Now, they can change their mind, but the last time they put the numbers on a piece of paper, it said 2023.” 

The situation shouldn’t be anywhere near as bad as during the Great Recession, however. 

“You’re not going to have these bank failures in the numbers we did back then,” Reber said. “It’s going to be an environment where banks are just going to have to muddle along with very modest earnings but pretty secure, pretty safe balance sheets until whatever normal is returns.” 

Paul Gores is a journalist who covered business news for the Milwaukee Journal Sentinel for 20 years. Have a story idea? Contact him at paul.gores57@gmail.com