With the economy expanding, the probability for the Federal Reserve to raise short-term interest rates in the first half of 2015 rises. Upgraded credit quality will accompany a healthier economy. Higher interest rates in a favorable environment mean bank performance should improve. Commercial and real estate loan demand will especially increase.
The recent changes in bank fee regulation has lowered the income banks derive from account fees and overdraft penalties. Mobile devices boost customers’ ability to check transactions and balances further limiting fee-generated income. As a result, banks have greater reliance on their net interest margins (NIM) for income generation.
Banks make most their profit by using deposits such as CD’s and borrowings to make loans. The net interest income or NIM is the difference it pays on the deposits compared to the interest it charges on the loans. What part does CD and Money Market Interest Rates play in profitability at banks?
Short-term deposits including savings, interest-paying checking accounts and short-term CD’s are sensitive to changes in market rates. Long-term CD’s and loans are not interest-rate sensitive.
If the Federal Reserve’s action increase market rates, bank portfolio’s with a higher proportion of short-term loans are able to re-price their loans and lift their NIMs.
Although interest rates on Fed Funds and treasuries will increase, rates on bank deposits will not keep pace since banks are already flush with deposits, making raising rates to attract deposits unnecessary. Banks will raise rates slowly and slightly from very low bases. In fact, from January to September in 2014 the US average rate for 5 year CD’s rose 4 basis points, from 0.86% to 0.90%.
Money market rates were flat at .09% in 2014 and money market rates are likely to show a downward curve before increasing.
Loans however, will be priced proportional to market rates so spreads between loan rates and CD rates will get larger.
So far 2015 looks like it is on track for an increase in interest rates and a healthier economy. As businesses increase their account receivables, inventories and capital expansion expenditures, banks have opportunity to make higher rate loans of good quality without significantly raising the rates on their CD and money market deposits.
Of course, bankers know that maximizing NIM is more complex than matching low CD rates with higher rate loans. Please contact us to learn how our loan pricing system can improve your bank performance.