March 17, 2022
The Federal Reserve recently took a major step toward curbing inflation by raising the effective federal funds rate by 25 basis points. Here’s a look at what this means for community banks and local communities.
The Federal Open Market Committee’s interest rate increase is expected to be one in a series of rate hikes throughout the year.
The hikes target rising inflation, which has reached levels not seen since the early 1980s due to a resurgence in post-pandemic economic activity, continued stress on global supply chains, and 2020-2021 fiscal and monetary accommodation intended to address labor market instability.
In other words, as the pendulum of economic priorities has swung back from sustaining growth to preventing unsustainable growth, the Fed is working to address inflation using all available resources in its toolkit, including multiple interest rate hikes.
Generally, rate hikes are advantageous for community banks. Research suggests that community banks focus their asset base on higher-yielding loans that reprice faster than deposit rates when interest rates rise. Meanwhile, large banks are more likely to focus on tradeable assets, including securities and other debt instruments, that make them less sensitive to interest rate changes.
As shown in Figure 1, the net interest margins of community banks under $1 billion in assets are often higher than those of larger banks during the course of a tightening cycle, averaging between 10 to 20 basis points. Similarly, net loans and leases constitute 60 percent of total assets at the average bank under $1 billion in assets, but just 50 percent at the average bank over $50 billion in assets. So based on the composition of their total assets, community banks have more to gain from a tightening cycle.
Figure 1: Quarterly Change in the Federal Funds Rate and Net Interest Margins (NIMs) by Bank Peer Group (sources: FDIC, Federal Reserve, ICBA)
This tightening cycle and the ongoing recovery are expected to moderate some of the economic consequences of the pandemic over the long-term, but excess liquidity accumulated over the past two years will remain a short-term industry challenge for net interest margins.
As Figure 2 shows, weak borrower demand accompanied by Paycheck Protection Program forgiveness and early paydowns to other credits stifled loan growth throughout late 2020 and 2021. Meanwhile, deposits surged due to a drawdown in corporate credit lines, increased personal savings, and record levels of fiscal spending.
These pandemic-specific imbalances are expected to moderate throughout the ongoing recovery, with the current tightening cycle likely to inhibit deposit growth while improved economic conditions engender increased lending. This normalization should provide an opportunity for community banks to improve efficiency, reduce operating costs, and ultimately advance the recovery in their local communities.
Figure 2: Quarterly Change in Net Loans and Leases to Deposits Ratios (LDRs) by Bank Peer Group (sources: FDIC, ICBA)
Community banks will also have to cope with yield curve risk stemming from market pessimism related to the current monetary policy shift.
When interest rates are tightened quickly, the yield curve flattens on the expectation of lower growth owing to a sudden reduction in credit, while a more gradual pace enables the yield curve to steepen by allowing a buildup of inflationary pressures.
As per Figure 3, the Fed has initiated its first rate hike at a point of rapid convergence in the yield curve, driven by fear that higher prices for oil and raw materials due to the ongoing Russo-Ukrainian War will accelerate the persistence of inflation, requiring a quick, aggressive tightening cycle.
Community banks can position themselves to weather this volatility by focusing their portfolios on shorter-duration bonds and higher-yielding sectors with low correlation to government bonds, both of which offer some insulation from a flattening yield curve while providing opportunities for growth if long-term rates resume their ascension.
Figure 3: Monthly Change in the Market Yield of 10-Year and 2-Year Treasuries (sources: US Department of the Treasury, ICBA)
The new cycle of rate hikes is designed to establish a post-pandemic equilibrium between maximum employment and price stability. While community banks may benefit from a tightening cycle, they must remain watchful over their portfolios throughout the transition, particularly if credit spreads widen in anticipation of a global recession.
While the challenges of high inflation are far different from those of high unemployment only two years ago, community banks maintain robust financial capabilities to shepherd their customers and communities through another major turn in the economic cycle.