In previous cyclical downturns, emerging from economic contractions has coincided with some of our best net interest margin (NIM) experiences. Time was on our side, and just making it to the “other side” of the cyclical downturn was the solution.
We might be forgiven for thinking that the aftermath of the current downturn will be much like before, but for very important structural reasons, it could be different this time, and not in a good way.
Time is not on our side now and simply waiting to emerge could be dangerous. The current interest rate environment could lead to an unprecedented regime of industry NIMs below 3 percent. There is a previously unseen menace in our midst, and it threatens our ability to create reasonable shareholder returns.
Nothing has to change in credit severity, and nothing has to change in the structure of rates, for this time to be unpleasantly different. In fact, absent positive change towards a steeper or higher yield curve, we will suffer from structural NIM compression slowly, quarter over quarter, as our assets reprice lower, while our funding remains effectively floored. This slow-motion NIM erosion may not set off any institutional alarm bells, in the way that a negative credit wave might, but it would bode very poorly for franchise valuations.
I am not predicting that the yield curve will remain low and flat, but I am saying we must prepare now in case that becomes the reality.
We expend zero energy in trying to predict interest rates because we don’t believe that we, nor you, nor anybody else can do so accurately. But we do believe that banking executives must spend a great deal of energy understanding their opportunities and vulnerabilities in response to the variety of things that can happen with interest rates. Scenario analysis is critical to diagnose your risk and your reward.
Once a financial institution discerns its current situation, it becomes possible to evaluate taking action by measuring the trades-offs in decisions that might be made. This can only be done through the employment of expansive analytical capabilities, based on core principles, to holistically consider all financial decisions – from loan and liability structures, to security and wholesale funding selection and capital structure – in an integrated and comprehensive fashion.
What ties these shareholder return drivers together are their various sensitivities to the interest rate environment.
In basic terms, the trouble lies in assets repricing lower, while liabilities are nearly effectively floored. You have probably noticed this is currently happening, and if the current rate environment becomes the new normal, it is going to get worse. High-quality loan yields tend to settle in around 250 basis points over five-year swaps. In the midst of the crisis, that spread is closer to 300-325 basis points.
After credit concerns subside, if we settle into this new normal rate regime, loans and other assets available will offer much less income than assets you can add today, let alone the shrinking quantity of legacy assets added prior to 2020.
Asset spreads today can fortify us against NIM decay should the low-and-flat future come to pass. But since we cannot predict the future, and cannot know for sure that we will actually face that situation, we cannot just blindly lock in duration and hope for the best. We can’t make decisions today without measuring the amount of regret we might feel if rates rise.
Actions taken in 2018 and 2019 under a disciplined decision-making framework, based on absolutely no prediction of today’s reality, prepared some institutions for much better outcomes than the rest of the industry. These actions put them at no greater risk had rates instead risen and steepened. But identifying and taking these actions required discipline, education, and a willingness to look at the balance sheet as an integrated whole.
Time may not be on our side, but thankfully, there is still time.