A Steeper Yield Curve May Not Matter

The problem with public prognostications, especially by economists, is that some jerk memorializes the predictions and then waits a couple of years to remind everyone that the crystal ball must have been on the blink. In January 2006, the Mortgage Bankers Association's three-year economic forecast contained some bold predictions about the housing markets in 2006, 2007 and 2008, many of which failed to anticipate the subprime mortgage meltdown and the ensuing credit crunch. The MBA wasn't alone. A lot of bright people peered over the horizon and missed that cruise missile hugging the ground and coming in fast and low under the radar.

Whatever else they missed, the MBA economists correctly called continued problems with the flat (or even inverted) yield curve. That's been a thorn in the side of community banks for several years now. With the aggressive rate cutting by the Federal Reserve, many thought that the problem might have resolved itself by now, but that's not been the case. Not yet, at least.

There was consensus at this week's Pennsylvania Bankers Association's convention about the Federal Reserve Board's numerous short-term interest-rate cuts: They have yet to provide much relief.

"The overall reduction of short-term rates hurt everyone," said one of the attendees, Berwyn-based Meridian Bank CEO Chris Annas, following the gathering in Broadmoor, Colo. "Everyone I've talked to has said the same thing."

[A side note: If I were to be required to attend the Pennsylvania Bankers Association's annual convention, there's no place I'd rather do it than at The Broadmoor in Colorado Springs, Colorado. Many nights were spent there overindulging and many subsequent days were spent there playing golf with a hangover during annual bar association conventions and banking and thrift industry trade meetings. It was heell, but someone had to do it. The late 1970s and early 1980s were, after all, the era of Michael Milken, Gordon Gecko, and the relatively unsupervised expense account.]

As I read this article, it seemed odd to me at first blush that the cutting of short term rates and the steepening the yield curve, which was one of the side effects that community bankers had hoped would occur, did not more quickly improve yield spreads for community banks. The problem is one of timing.

Annas said the cost of deposits has yet to be adjusted to interest-rate cuts that were designed to steepen the yield curve -- the difference between short-term and long-term interest rates -- and make it cheaper for banks to borrow. A steeper yield curve allows banks to increase lending or attempt to make money through investments. That has been difficult over the past two years as the yield curve was either inverted or flat -- meaning short-term and long-term rates converged.

Bankers say the flat yield curve made it much more difficult to make money off of loans and deposits. The condition had an adverse effect on net interest margin -- the difference between interest income and interest expenses, which is usually shown as a percentage of average earning assets.

With bankers feeling the weight of the credit crunch since last summer, the rate cuts were designed as a short-term fix. But bankers say the effects will not be felt until the second half of the year, when they can adjust the pricing of their certificates of deposit to the new lending rates.

"It should help the margins, especially with the securities portfolio," said analyst Andy Stapp of B Riley in Haverford. "With the Fed cutting interest rates, banks have not been able to match yet in terms of deposit costs."

If that's correct, then the benefits should start flowing to the bottom line at the latest by the first quarter of next year. Of course, to take advantage of a sharp yield curve, where you borrow short and lend long, you've got to be able to lend. If the economy's in the tank and consumers and small-to-medium businesses (a community bank's bread and butter) aren't borrowing, then the effect of the steeper yield curve may be muted, although as analyst Andy Stapp notes above, banks can buy securities and take advantage of the curve. However, as Chris Annas observes, there's a risk to that.

"If I were to go out and get a three-year loan at 3.5 percent and invest in a 10-year security at 5.5 percent, I could make some money," Annas said. "Banks have been doing that for years. But what happens if the rates go up [on the loan] and the margin disappears. You can take advantage of it but you have to be careful."

The article correctly observes that banks have been dealing with the flat or inverted yield curve by decreasing their reliance on yield spread, and trying to build other revenue streams from such business lines as wealth management, insurance, and leasing. Some even tried mortgage banking, which often didn't work out as well as other lines. I have clients who can testify to that.

What the article does not also mention is that banks have tried to generate additional fee income from their traditional customer bases. In the last several years we've seen public outcries over overdraft and credit card fees and practices, as well as ATM withdrawal fees, and the common complaint from consumers (and businesses) that commercial banks seem to to hit up customers for every nickel and dime that can be squeezed out of them. Many of these complaints have generated actual regulatory crackdowns and proposed regulatory crackdowns, proposed state legislation, proposed federal legislation, and plenty of jawboning, from elected officials at the state and federal levels.

Notwithstanding the backlash, and regardless of what happens to the yield curve, I don't think banks are going to give up these sources of revenue, or allow them to be substantially impaired by legislation, without a monstrous fight. We'll see what the proposed FRB regulations look like by the time they're finally issued. At  present, with many pundits (and the regulators themselves, by word and by deed) indicating that they are nervous about more bank failures this year and next, I'm not certain that any such legislation (no matter how popular with consumers it might be) is going to pass this year, at least not at the federal level, or, if it passes, will survive a veto. I could be wrong, and it wouldn't be the first time, but I don't see it happening in an election year. Even if the more egregious credit card practices of banks are restricted, they will have plenty of ways left to grind out the fee income that they believe they need  to survive these difficult times.