by Todd Taylor, CPA & CFA, Taylor Associates
From the end of 1992 to the beginning of 2018, net interest margins in the financial institutions industry have declined 100 basis points, with earning asset yields declining from 8.1% to 4.2%, and funding costs falling from 3.8% to 0.5%. This margin compression has been offset by either lower credit losses and/or lower net non-interest expense. So the question remains, where do margins go from here?
As the yield curve flattens, the focus shifts to earning asset yields and whether institutions will be able to pass along increases in the Prime Rate
What's In the Mix
It is interesting to point out that large institutions (80% of the loan market), have loan to asset ratios near historical lows while community institutions are moving back to pre-crisis levels as their ability to generate fee income has not kept pace with the large institutions.
The Fed has raised rates 175bps and is expected to increase them 125-150bps by year end 2020. The Fed's DOT plot indicates they intend to lower rates over the long-term, averaging 2.75%, so adding duration to your earning assets isn't necessarily a bad thing. The challenge comes in identifying assets that compensate you for the remaining rate increases, but also protect you in the event that short term rates don't increase. Most floating rate and amortizing assets don't fit this profile.
Prime Loans to Go
With quality loans hard to find in the expanding economy and institutions hungry for even more loans to meet budget, some institutions have relied on traditional indirect channels to drive loan production while others have ventured into non-traditional fintech platforms to boost lending. This new growth into out-of-market signature lending is further increasing credit risk.
We are definitely in uncharted territory, with massive amounts of stimulus being removed from the system, funding costs accelerating and earning asset yields struggling to come off their lows. If your institution is experiencing or is concerned about earning asset yield compression, feel free to contact Taylor Advisors to learn about how we strategize prosperity. A final word of advice: Stay disciplined when evaluating unproven lending practices just to meet budget. Don't forget what happened to all those stated income prime & sub-prime loans. When extending terms on assets, reserve them for the highest quality borrowers and incorporate a call protected barbell strategy in the investment portfolio to improve duration-weighted returns.