Preparing to Be There for Your Community

The fallout
from COVID-19 will likely take some time to stabilize. The personal and social
costs are already significant, and neither is independent of economic and
business disruptions.

Especially impacted
are the businesses on Main Streets everywhere that are served by community banks.
Community banks will be essential to any recovery, so it is important that they
take steps now to ensure they’re positioned to make a difference.

The Challenge Of A “New Normal”
Financial markets were in “price discovery” mode this spring, but that phase is unlikely to last for long. If Treasury rates rise from their current levels, banks are likely to do well with their traditional models. But if they remain low, and spreads eventually stabilize to 2019 levels, nearly every institution will encounter pressure that could undermine their efforts to be a catalyst for Main Street’s recovery.

Bank Director’s recent piece “Uncharted Territory” warned that the experience of past financial crises could mislead bankers into complacency. Last time, dramatic reductions in funding costs boosted net interest margins, which helped banks offset dramatically higher loan losses. The difference today is that funding costs are already very low – leaving little room for similar reductions.

Consider
asset yields. Even without significant credit charge-offs, community bank
profitability could face headwinds. Community banks entered 2020 with plenty of
fuel to support their thriving Main Streets. Their balance sheets had been established
for a Treasury rate environment that was 100 basis points higher than today’s. If
rates settle here for the next couple of years and existing assets get replaced
at “new normal” levels, yields
will fall and net interest margins, or NIMs, could take a hit.

Banks could have trouble “being there” for their communities.

Where do the current assets on banks’ balance sheets come
from? They were added in 2018, 2019 and the first quarter of 2020. If we assume a fixed rate loan portfolio yields somewhere
around 300 basis points over the 5-year swap rate at closing (which averaged about
1.75% over 2019), and floating rates loans yield somewhere around 50 basis points
over prime day to day, we can estimate banks’ first quarter loan yields at
perhaps 4.75% fixed-rate and 5.25% prime-based.

Prime-based
yields have already dropped for the second quarter and beyond: They are now
earning 3.75%. Fixed-rate loans continue to earn something like 4.75%, for now.

Banks that can quickly reduce funding costs might, in fact, see a short-term bump in net interest margins. If they can stave off provision expenses, this might even translate into a bump in profitability. But it will not last.

If Treasury
rates remain at these historic lows and spreads normalize to 2019 levels,
current balance sheets will decay. Adjustments today, before this happens, are
the only real defense.

Banks’
fixed rate loans will mature or refinance at much lower rates – around 3.50%,
according to our assumptions. Eventually, banks that enjoyed a 3.50% NIM in
2019 will be looking at sustained NIMs closer to 2.50%, even after accounting
for reduced funding costs, if they take no corrective steps today. It will be
difficult for these banks to “be there” for Main Street, especially if
provision expenses begin to emerge.

Every
community bank should immediately assess its NIM decay path. How long will it
take to get to the bottom? This knowledge will help scale and motivate
immediate corrective actions.

For most banks, this is probably a downslope of 18 to 30 months. For some, it will happen much more rapidly. The data required may be in asset and liability management reports. Note that if your bank is using year-end reports, the intervening rate moves mean that the data in the “100 basis points shock” scenario from that report would represent the current rates unchanged “baseline.” Reports that do not run income simulations for four or more years will also likely miss the full NIM contraction, which must be analyzed to incorporate full asset turnover and beyond.

Times are
hectic for community banks, but in many cases commissioning a stand-alone
analysis, above and beyond standard asset-liability compliance requirements, is
warranted.

Then What?
The purpose of analyzing a bank’s NIM timeline is not to determine when to start taking action, but to correctly size and scope the immediate action. All the levers on the balance sheet- assets, liabilities, maybe even derivatives – must be coordinated to defend long-term NIM and the bank’s ability to assist in Main Street’s recovery.

The Small Business Administration’s Paycheck Protection Program lending is fully aligned with the community bank mission, but it is short term. Banks must also plan for sustainable net interest income for three, four and five years into the future, and that planning and execution should take place now. The devised NIM defense strategy should be subjected to the same NIM decay analysis applied to the current balance sheet; if it’s insufficient, executives should consider even more significant adjustments for immediate action.

The economic environment is out of bankers’ control. Their responses are not, but these require action in advance. Banks can – and should – conduct a disciplined, diagnostic analysis of their NIM decay path and then correct it. This interest rate environment could be with us for some time to come.