a.mackinlay@euruni.edu
Session 6 - March 6, 2012
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. Banks and the Yield Curve****
[1] DEFINITION
. Frank J. Fabozzi. Fixed Income Mathematics. Anlytical & Statistical Techniques. Chicago: Probus, 1993, chapter 13.
The graphical depiction of the relationship between the yield on securities of the same credit risk and different maturity is called the yield curve. The yield curve is constructed with the maturity and observed yield of Treasury securities because Treasuries reflect the pure effect of maturity alone on yield, given that market participants do not perceive government securities to have any credit risk. When market participants refer to the “yield curve”, they usually mean the Treasury yield curve. This is also true in the bond markets of other countries (P. 218).
Exhibit 13-1 show four yield curves that have been observed in the US Treasury market (and occur in other major government bond markets). In the yield curve in panel a, the yield increases with maturity. This shape is commonly referred to as an upward sloping or normal yield curve. The yield curve on panel b is downward sloping or an inverted yield curve. In a humped yield curve, depicted in panel c of the exhibit, the yield curve initially is upward sloping, but after a certain maturity it becomes downward sloping. Finally, a flat yield curve is one where the yield is the same regardless of the maturity. A flat yield curve is shown in panel d. [COPY OF EXHIBIT 13-1 PROVIDED IN CLASS]
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[2] SOURCES OF INFORMATION
. US Department of the Treasury: Daily Treasury Yield Curve Rates.
. Bloomberg Yield Curves
QUESTIONS : (1) HOW WOULD YOU DEFINE THE SHAPE OF THE YIELD CURVE ON MARCH 12 2004, JANUARY 14 2006, FEBRUARY 27 2007, NOVEMBER 5 2008 AND MARCH 2012?; (2) HOW WOULD YOU CHARACTERIZE THE DIFFERENCE BETWEEN MAY 2004 AND MARCH 2012?]
[3] THE YIELD CURVE AND BANK EARNINGS
[3.1] Definition of Net Interest Margin (*)
Banks have a number of measures, different from those used to analyze industrial companies, that investors can use to evaluate performance. One of the most basic of these is the net interest margin. The net interest margin, also sometimes referred to as the net yield on interest-earning assets, is usually defined as net interest income, divided by average interest-earning assets. The margin is calculated for a period of time, a quarter or a year, and is expressed as a percentage.
NIM = NET INTEREST INCOME / INTEREST-EARNING ASSETS
Net interest income, the numerator of the equation, is the total interest income earned on a bank’s loans, investment securities, and short-term investments (like on interest-bearing deposits with other banks) during a period of time, minus the cost of (interest expense related to) the funds used to make loans and investments. The usual sources of interest-bearing funds include deposits and short- and long-term borrowings.
Average interest-earning assets, the denominator of the ratio, consists of an average of all of a bank’s assets that generate interest income during a specific time period. This excludes certain assets, like property and cash on deposit with the Federal Reserve Bank to meet reserve and clearing requirements, that don’t earn interest income.
Bank balance sheets are often described in terms of their relative responsiveness to changes in short-term interest rates. Banks whose interest-earning assets (loans and investments) tend to reprice more quickly when short-term interest rates change than their interest-bearing deposits and borrowed funds are said to be asset sensitive. They tend to do well when interest rates rise, but their margins are squeezed when short-term interest rates decline. Banks whose liabilities reprice more quickly than their assets are liability sensitive. They probably would have benefited from the decline in short-term interest rates over the 2008 to 2009 period.
(*) From Theresa Brophy: “The Net Interest Margin: What is it? What does it say?”, Value Line, August 2010.
[3.2] Federal Reserve Monetary Policy in the 2000s
. Three-month LIBOR rates: see. [QUESTION: WHAT IS GOING ON? IS THE FEDERAL RESERVE BUYING OR SELLING BONDS TO BANKS? WHY?]
. Raghuram J. Rajan. Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, 2010) [web page] [Introduction] [video]
[3.3] The impact of changes in the yield curve on bank earnings
. FDIC: What the Yield Curve Does (and Doesn’t) Tell Us
Historically, the yield curve spread, or the difference between short-term and long-term interest rates, has had some predictive power for the performance of the U.S. economy and banking industry. In the past, a narrowing, or flattening, of the spread has tended to foretell both slower economic growth and increased pressure on bank earnings. Furthermore, the yield curve generally has inverted—a condition where short-term rates exceed long-term rates—up to two years ahead of a recession. Based on this historical context, the flattening in the yield curve since mid-2004 has been on the minds of many economists and banking analysts.
The Yield Curve and Banks
Just as the yield curve is not a perfect indicator of future economic growth, it also does not provide perfect foresight as to how bank net interest margins (NIMs) and earnings will fluctuate. The traditional view of the banking business holds that banks pay interest on their deposits based upon shorter-term interest rates while making loans tied to longer-term interest rates. Thus, the difference between interest paid and received—the margin—should be influenced by the slope of the yield curve. There is some empirical support for this view.
Large banks tend to have higher concentrations of commercial and industrial (C&I) loans and credit card receivables. The C&I lending environment, especially for large loans exceeding $1 million, has been very competitive in recent years [LOTS OF COMPETITION = ASSETS YIELD LESS]. Not only do banks compete against other banks, but they also compete against capital markets, which have become a popular source of funding for corporations [CORPORATIONS CAN ISSUE BONDS DIRECTLY TO THE MARKET = LESS DEMAND FOR BANK LOANS]. In addition, many corporations have experienced increases in their cash balances in recent years, creating less incentive to reach out to banks for financing [CASH-RICH COMPANIES = LESS DEMAND FOR BANK LOANS]. This strong corporate cash position has weighed on C&I loan growth.
Since early 2004, funding costs at large banks have risen much faster relative to small banks. Large banks have a greater reliance on overnight and wholesale funding than smaller banks. These funds tend to reprice faster than longer-term deposits, such as certificates of deposit and money market accounts, when short-term interest rates rise. This situation has resulted in a classic margin squeeze for the largest banks as the yield curve has flattened.
[3.4] Exercise: The impact of changes in short-term interest rates on Net Interest Margin (NIM)
. LIBOR is at 0.75% at the starting point, at 1.75% in Scenario 1, at 3.75% in Scenario 2;
. Interest paid on Savings accounts does not change (0.5%);
. Interest paid on time deposits is repriced every three-months; assumption: the bank pays 50% of the increase in LIBOR;
. Interest paid on overnight loans from other banks is repriced daily; assumption: the bank pays 100% of the increase in LIBOR;
BANK A AND BANK B: BALANCE SHEETS
. Bank A’s Liabilities. Demand deposits $100 million @ zero interest; Savings accounts $100 million @ 0.50%; Time Deposits $100 million @ 2%; Bonds issued by the bank with fixed coupon $100 million @ 4%.
. Bank B’s Assets. Credit card loans $100 million @ fixed 12%; Adjustable Mortgages (ARMs) $100 million @ LIBOR + 300bps; Fixed-rate mortgages $600 million @ fixed 7%; Bonds with fixed coupon $300 million @ 4.5%.
. Bank B’s Liabilities. Demand deposits $100 million @ zero interest; Savings accounts $100 million @ 0.50%; Time Deposits $300 million @ 2%; Floating rate bonds issued by the bank $200 million @ LIBOR + 200 bps; Overnight loans from other banks $300 million @ LIBOR.
QUESTIONS. CALCULATE NET INTEREST MARGIN FOR BANK A AND BANK B AT STARTING POINT AND IN SCENARIOS 1 AND 2].
. Bank A at starting point; LIBOR = 0.75%.
Interest Income = 12.0 +3.75 + 7.00 + 1.25 + 4.5 = 28.5;
Cost of funding = 0.0 + 0.5 + 2.0 + 4.0 = 6.5;
Net Interest Income = 28.5 – 6.5 = 22
NIM = (28.5 – 6.5) / 500 = 4.4%
. Bank A in Scenario 1; LIBOR = 1.75%.
Interest Income = 12.0 + 4.75 + 7 + 2.25 + 4.5 = 30.5;
Cost of funding = 0.0 + 0.5 + 2.5 + 4 = 7.0;
Net Interest Income = 30.5 – 7.0 = 23.5
NIM = (30.5 – 7.0) / 500 = 4.7%
[Note: Time Deposits @ 2% + half the increase in LIBOR = 2% + 0.5% = 2.5%]
. Bank A in Scenario 2; LIBOR = 3.75%.
Interest Income = 12.0 + 6.75 + 7 + 4.25 + 4.5) = 34.5;
Cost of funding = 0.0 + 0.5 + 3.5 + 4.0 = 8.0;
Net Interest Income = 34.5 – 8.0 = 26.5
NIM = (34.5 – 8.0) / 500 = 5.3%
[Note: Time Deposits @ 2% + half the increase in LIBOR = 2% + 1.5% = 3.5%]
Interest Income = 12.0 + 3.75 + 42.00 + 13.5 = 71.25;
Cost of funding = 0.0 + 0.5 + 6.0 + 5.5 + 2.25 = 14.25;
Net Interest Income = 71.25 – 14.25 = 57.0
NIM = (71.25 – 14.25) / 1100 = 5.2%
. Bank B in Scenario 1; LIBOR = 1.75%.
Interest Income = 12.0 + 4.75 + 42 + 13.5 = 72.25;
Cost of funding = 0.0 + 0.5 + 7.5 + 7.5 + 5.25 = 20.75;
Net Interest Income = 72.25 – 20.75 = 51.50
NIM = (72.25 – 20.75) / 1100 = 4.7%
[Note: Time Deposits @ 2% + half the increase in LIBOR = 2% + 0.5% = 2.5%]
. Bank B in Scenario 2; LIBOR = 3.75%.
Interest Income = 12.0 + 6.75 + 42 + 13.5 = 74.25;
Cost of funding = 0.0 + 0.5 + 10.5 + 11.5 + 11.25 = 33.75;
Net Interest Income = 74.25 – 33.75 = 40.5
NIM = (74.25 – 33.75) / 500 = 3.7%
[Note: Time Deposits @ 2% + half the increase in LIBOR = 2% + 1.5% = 3.5%]
QUESTIONS & DEBATE
Identify fixed rate assets and liabilitiesIdentify floating rate assets and liabilities
Which bank is more affected by an interest rate increase?
Which bank is ‘asset sensitive’, which bank is ‘liability sensitive’?
Could we expect that the larger the interest rate increase, the larger the impact on NIM in Bank B?
What strategy can Bank B implement to diminish interest rate sensitiveness? From the FDIC article: “On top of an increased reliance on fee and other non-interest income, banks have additional means to reduce the impact of yield curve changes on profits. For example, many banks, especially the large ones, have been able to hedge their interest rate exposure by using derivatives.”
What would happen to NIM in Bank A and Bank B in case of an interest rate decline?
What is the purpose of Banco Santander’s campaign offering LED TV 26 inches for customers that bring their payroll to the bank?
Why would certain central banks (Bank of Canada and Sweden’s Riksbank) always endeavor to avoid drastic changes in the shape of the yield curve? Can they accomplish that a goal? How?
The FDIC paper: “Large banks have a greater reliance on overnight and wholesale funding than smaller banks. These funds tend to reprice faster than longer-term deposits, such as certificates of deposit and money market accounts, when short-term interest rates rise”. Does this apply to Bank A or Bank B?
Apply the NIM framework to the 2007-2008 financial crisis, where banks and investment banks financed massive long-term mortgage assets of questionable quality with mostly overnight loans.
A comment by Larry Fink: “European banks have preferred to borrow only short-term money because the interest rates tended to be cheaper. But that has exposed them to the risk that when they try to roll over their debts, the markets may balk” (Financial Times, November 26, 2010). What do you think?
UBS E-News for Banks, January 2012. Executive Summary. The performance of the global banking sector was one of the poorest in recorded history. In 2011, global banks’ performance was down 21.0% in absolute terms and 14.6% lower on a relative basis. Only in 2008, at the height of the global financial crisis, did the sector perform more poorly (see Chart 1). In our opinion, the poor performance – both absolute and relative – can be attributed to a combination of rising macroeconomic uncertainties, spill-over risks and contagion fears arising out of the European sovereign crisis, and persistent regulatory risks, notably at the national level. Increased risk aversion, arising from market concerns over the global economic outlook and notably Europe’s sovereign crisis has also undermined client activity levels and trading volumes, and, together with prevailing low interest rates and flattish yield curves, has weighed on revenues and earnings. [QUESTION: PLEASE EXPLAIN THIS LAST POINT]
[4] REVIEWING THE EVIDENCE
. Federal Reserve Bank of New York: The Yield Curve as a Leading Indicator. [The New York Fed estimates the probability of a US recession according to the shape of the yield curve. How would you rate that probability, given the shape of the yield curve?]
. Rolfe Winkler: “Yield curve can’t drive profits if banks won’t lend”, Reuters, January 11, 2010. [NICE CHART: NET INTEREST MARGIN AND THE SHAPE OF THE YIELD CURVE]
. US Banks: Nonperforming Total Loans;
. US Banks: Net Interest Margin for all U.S. Banks (USNIM)
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