Net Interest Margins Face Headwinds

Overall, Community Banks have shown resilience and have for the most part withstood the impact of the economic slow-down and the low interest-rate environment brought by the recent COVID-19 pandemic.

This extreme and unpredictable event ushered and contributed to the Fed intervention in the economy, events that led to the unprecedented drop in interest rates of the recent months, major factors driving the experienced drastic reduction in interest income that has followed it.

The general economic slow-down and the rock-bottom interest rates the economy is currently experiencing, have been a major challenge for Community Banks, financial institutions that differently from larger US banks, derive most of their profits from lending, as the current economic conditions have made it difficult for these institutions to earn an adequate spread on loans they make.

Community Banks, a major source of loans in the economy, make money from the difference between what they pay to depositors and what they earn from the loans they make. It is not, therefore, a surprise that the current low interest rate environment fueled by the coronavirus pandemic has made it difficult for Community Banks to achieve sustainable Net Interest Income (NII), their largest source of revenue, given the current challenging conditions the economy is going through.

The weak lending opportunities fueled by the economic uncertainty induced by the pandemic,  has drastically curtailed the demand for loans while at the same time banks have experienced a  25% increase in deposits (4Q20 over 3Q20) as nervous consumers and companies look for a safe place to stash or park their cash.

Under the current low interest rate environment, Community Banks with large mortgage and loan exposures will continue to face significant  net interest margin pressure due to several factors:

1). As consumers and businesses continue to replace and refinance fixed-rate loans, net interest margin (“NIM”) will likely continue to feel downward pressures as maturing fixed-rate loans get replaced or refinanced by lower-yielding loans.

2). Community Banks are particularly susceptible to the impact of the low interest rate environment. As major holders of residential mortgages, which consist mostly of fixed-rate residential instruments with 10-30 years maturity, replacing or refinancing these loans has a direct negative impact on net interest margins (NIM) at these institutions.

3). Loan growth is likely to remain at low levels due to weak commercial demand and the fact that many Paycheck Protection Program (PPP) loans will get forgiven.

The COVID-19 related uncertainties have adversely impacted the economy with wide service disruptions, increasing the unemployment rate at high levels not seen since the last recession and making difficult for home owners  to keep up with their mortgage obligations.

Although the Federal Government has reacted quickly to help mitigate the adverse impact of the COVID-19 pandemic on borrowers with the enactment of the Corona Virus Aid, Relief and Economic Security (CARES) Act, which provides relief options for federally backed loans, which nearly 70% of homeowners have, the mortgage industry and Community Banks in particular are likely to continue to experience new high levels of economic stress and face new headwinds, after years of relative market calm.