Living With Narrow Net Interest Margins

How to deal with life in a low-rate environment.

February 16, 2012

In the past, most credit unions could generate sufficient net interest to cover operating expenses. For most of us, this is no longer true.

During the past few decades, net interest margin (NIM) has been on a steady downward progression. Careful management of NIM, however, is still extremely important to the long-term success of a credit union.

NIM typically is expressed as a ratio: total interest income (from all loans and investments) less total interest expense (cost of funds from all deposits and borrowings) divided by average assets, and annualized if necessary. Historically, credit unions used this calculation as a tool to manage profitability.

With the Federal Reserve Board’s recently stated commitment to maintain low rates until 2013, NIM will continue to face downward pressure.

The reasons are many:

  • As credit union loan and investment portfolios reprice (for example, a loan pays off and is replaced with a new loan at a lower rate), the overall yield on those portfolios continues to fall;
  • Since the onset of the recession, we’ve already been in a very low rate environment, so there’s little room to decrease deposit rates (controlling our cost of funds) at a pace similar to the drop in loan and investment rates.

In addition to low Treasury rates pushing down loan rates, fierce competition for loans also is driving rates down further in many markets.

While the Fed plans to spur economic activity by lowering rates, many credit unions face decreased loan demand regardless of rate. Thus, lower demand for loans and increased competition for those loans likely will keep rates low.

To deal with the challenges, here are some strategies to help credit unions improve NIM:

  • Re-examine how much credit risk your credit union is willing to accept. Recent losses in real estate lending (based primarily on the devaluation of home prices, combined with job losses) have caused some credit unions to tighten credit on all loan types, with more stringent underwriting criteria. This likely was a result of recent pres-sures on overall profitability due to increased charge-offs and higher provisions for loan loss expense.

If priced appropriately, however, originating loans with additional credit risk can bolster NIM. Of course, always carefully consider this approach before proceeding. Give careful attention to pricing versus additional risk (credit spread). And develop a full business plan to justify the actions to the credit union’s asset/liability committee and to regulators.

  • Reassess loan profitability by loan type. Perhaps a shift in product mix could potentially improve overall margin. My credit union has noticed one bright spot in the overall economic morass: Used-car lending is looking stronger. This is also a more profitable book of business than other loans, so continued efforts in this area could increase NIM.

And products like credit cards and personal lines of credit can improve NIM—by growing these loans relative to the overall portfolio. This also might help mitigate concentration risk.

  • Consider taking on additional interest-rate risk. While interest-rate risk has been a major focus of the regulators, your credit union’s balance sheet structure might allow it to add duration to either the loan or the investment portfolio—adding income without taking on excessive risk.

Some credit unions pay a financial price by not taking on enough duration in their investment portfolios. This is especially true today: Loan demand is low and more credit unions have a higher percentage of their assets in investments.

Through liquidity analysis and effective cash flow management, many credit unions can increase investment portfolio yields by buying slightly longer-term investments. Interest rates are expected to stay low, so adding duration to the investment portfolio is very defensible.

It’s an opportune time to review and discuss your credit union’s plan for managing NIM.

DAVID D’ANNUNZIO is senior vice president/chief financial officer at Heritage Trust Federal Credit Union, Summerville, S.C., and chair of the CUNA CFO Council. Contact him at 843-832-2680.