Combating Net Interest Margin Pressures
March 2015 - Financial executives will potentially see several long-anticipated regulatory and market events converge in 2015. Absent a major shock to the economy, the Federal Reserve will continue “easing off the accelerator” of its Quantitative Easing (QE) stimulus program and may allow its bond portfolio to shrink following an increase in short-term interest rates. Consensus among economists is that the Federal Reserve will raise the federal funds rate in 2015, although the outlook for the timing of a rate change is increasingly uncertain because of weakness in the global economy. In addition, as of January 1, 2015, large financial institutions must begin complying with Basel III liquidity coverage ratio (LCR) requirements.
If rates rise as expected, the confluence of these events may create heightened competition for retail deposits and greater pressures on financial institutions’ net interest margins. While there is no magic bullet for managing these challenges, there are several ways FHLBank Atlanta can help its shareholders position themselves to manage these risks and continue to generate strong financial results.
Pressure Point 1: LCR Compliance
The LCR requires financial institutions to hold enough high quality liquid assets on hand to cover potential losses during a 30-day stressed scenario. The final implementation period is staggered based on institution size. Smaller institutions have a longer period to comply and face less stringent requirements than the largest institutions. The following table summarizes the basics of the LCR requirement.
|Institution Type||Timeline||High Quality Liquidity Assets*|
> $250 billion in assets
Begin complying: Jan. 1, 2015
Reach full compliance:
Level 1: Generally cash, U.S. Treasuries, other securities with unconditional government guarantee
Level 2A: Securities issues by GSEs (15% haircut)
> $50 billion - $250 billion in assets
|Begin complying: Jan. 1, 2016||Level 2B: Certain corporate debt and equity securities (50% haircut)|
Level 1 must account for at least 60% of high quality liquid assets. Level 1A and 2B together cannot exceed 40% of high quality liquid assets. Level 2B alone cannot exceed 15% of high quality liquid assets.
*Does not represent a comprehensive list of accepted asset types.
LCR has resulted in larger banks investing in more Level 1 assets than in prior years. The FDIC reports that bank holdings of U.S. Treasuries increased 26 percent in the third quarter 2014 vs. the second quarter, reaching the highest percentage of bank assets in the last 100 years. Since Level 1 assets generally yield less than other assets, efforts to comply with LCR may reduce net interest margins.
Pressure Point 2: The Fight for Retail Deposits
Financial analysts and industry executives predict a “fight for deposits” as QE funds drain from the financial system and interest rates eventually rise. Competition will be heightened by the LCR requirements as some banks aggressively court retail deposits since they receive more favorable treatment under the regulation. Pricing changes to attract retail deposits may further compress net interest margins as institutions attempt to minimize deposit outflows.
Funding Options to Protect Net Interest Margins
FHLBank Atlanta offers numerous advance products that can help shareholders more effectively manage liquidity requirements and deposit outflows while protecting net interest margins in the current environment.
In different ways, each of the following structures can help shareholders
• compete more effectively for loan business without sacrificing margins;
• fund Level 1 asset investments to meet LCR requirements; and
• supplement retail deposits with wholesale funding and protect net interest margins.
One of the Bank’s newest advance structures, the Callable Fixed Rate Credit Floater advance, offers shareholders term funding at short-term interest rates with the flexibility to cancel the advance on certain dates with no prepayment fee. The advance’s interest rate floats based on the Bank’s short-term Fixed Rate Credit interest rate and resets periodically, typically every three, six, nine, or 12 months. Shareholders can choose the advance term and rate reset period and can exercise the option to call the advance on any rate reset date.
This structure provides numerous benefits:
• First, shareholders can use the advance to fund longer-term investments and loans and, at the same time, benefit from the pricing mismatch of the long-term asset and floating short-term rate of the liability. This discrepancy can help boost margins.
• Second, the call option gives shareholders maximum flexibility to manage the balance sheet if short-term rates become unfavorable.
• A third, ancillary, benefit is that, depending on a shareholder’s FDIC risk category, the long-term nature of the advance may be more favorable to an institution than a comparable short-term alternative.
Two other useful structures that have been popular over the last few years are the Forward Starting advance and Floating-to-Fixed advance. Forward Starting advances enable shareholders to secure a known fixed interest rate for future funding. In the current environment, the Forward Starting advance would be particularly effective for managing anticipated deposit runoff and protecting net interest margins as competition for deposits potentially heats up later in 2015. It can also be used to secure funding costs today on future loan business. Nearly any FHLBank Atlanta structured advance can be forward starting.
The Floating-to-Fixed advance offers stable liquidity and the ability to keep current funding costs low while securing fixed-rate protection for the future. The advance’s interest rate floats based on an index, usually three-month Libor, for a specified period and then changes to a fixed rate at a predetermined date for the remainder of the term. The Floating-to-Fixed advance allows shareholders to preserve net interest margins both now while rates remain low and in the future, via the fixed-rate term of the advance, when rates may be higher.
Preparation is key to managing the potential challenges ahead in 2015. FHLBank Atlanta can work with shareholders to analyze and mitigate their exposures to risk associated with LCR, the end of QE, and a potential rate increase in the coming months. For more information, contact your relationship manager at 1.800.536.9650.
“PNC predicts a 'fight for deposits.'” SNLFinancial , December 10, 2014.
“LCR compliance in sight, but could lead to 'fight' for deposits.” SNLFinancial , December 16, 2014.
The Federal Home Loan Bank of Atlanta is not a registered investment advisor. Nothing herein is an offer to sell or a solicitation of an offer to buy any securities or derivative products. You should consult your own legal, financial, and accounting advisors before entering into any transaction.