Saber Capital: Interest Rate Fears And The Dreaded Yield Curve

In the first business segment, the problem with rates going lower is that banks can’t reprice their deposits as fast as their assets. This “asset sensitivity” means that banks earn more net interest income as rates rise, and less as rates fall. If rates stabilize, margins eventually stabilize, but if rates are fluctuating, margins will fluctuate as well.

A bank’s net interest margin (NIM) is an industry metric that reflects this profit margin. NIM is simply the net interest income that a bank earns on its assets. It’s sort of a gross margin of a bank, where the interest collected is revenue and the interest paid is the “cost of goods sold”. Add the non-interest income and subtract all the operating expenses and reserves for bad loans, and you have a bank’s profit.

Here is a chart of the net interest margin of the US banking system going back to the early 1980’s:

net interest income

Profit margins hit record lows back in 2015, just before the Fed began raising rates. The worry is now that rates will head back lower, and therefore profit margins will return to those all-time lows.

I’ll mention two simple thoughts as a possible counterpoint to the low rate fears.

First, banks earned record profits the same year their NIMs hit all time lows. Just like Walmart is one of the most profitable businesses in the Fortune 500 with razor thin margins, banks can earn lots of money with lower interest spreads if they make it up in the volume of total deposits they take and lend out or invest. Just as greater revenue can support lower margins at Costco, a higher amount of assets in the banking system can mitigate or offset the decline in net interest margins.

Second, the growth in assets in the banking system is about as predictable as anything in business. Money supply grows just about each and every year, and with it, so do bank assets, deposits, and net interest income. Basically, as people acquire more money (i.e. the economy grows), the banking system holds more money, and over time, earns more profits.

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