There has been a lot of discussion over the past few years about how low interest rates are limiting the profitability of banks. In a headline sense this might be true, but the data tells a different story. We examined a number of metrics related to the US banking industry from 2004 to today with an eye to banks profitability. What we found wasn’t surprising, banks like all companies find ways to adapt to a changing interest rate environment.
The following graph shows how interest income (orange) and interest expense (blue) have changed over the past ten years:
As expected the chart continues to slope downward the longer we are in a low rate environment. But surprisingly banks have stabilized their interest income over the past year, and especially over the past few quarters. In the third quarter of 2014 banks on average earned 4.16% on their portfolios and paid .48% for deposits.
The reason banks have been able to stay profitable is because they’ve continued to lower what they pay on deposits. The spread between portfolio yield and funding cost (net interest margin) has remained very steady. The following chart shows net interest margin over the same period:
While banks have bemoaned the 41% drop in interest rates the real story is that the average net interest margin only dropped 10% from 4.09% to 3.68%.
What does this mean going forward? The lower rate environment coupled with the financial crisis eliminated a lot of marginal banks with questionable lending or costly operating structures. The result is a banking system that has found a way to survive in a lower rate environment. Low rates didn’t destroy the banking system, and it’s unlikely that high rates will either, especially if rate increases are gradual.