Can banks Do Anything As Margins Continue To Erode?

Banks continue to struggle with their margins as rates hover close to bottom for longer than most ever thought possible. The Fed funds rate is still at 1%, and most of us, who thought this condition could not persist, are left helplessly watching our margins shrink. This is particularly true for banks with a strong commercial long base, because the yield on variable, prime-based loans continues to decline while deposit prices have reached rock-bottom. One can’t pay below zero on a deposit account

Some banks have found ways to provide relief to the pressured margin without changing their business mix. In another article, I discussed some possible business changes that could ease the margin. In this article, I’d like to cover options within the financial department’s realm.

Many banks have long term debt on their balance sheet, ranging from Trust Preferred to other long term debt instruments. Oftentimes, the rates on the debt, while extremely attractive in the long run, is a heavy burden to carry in today’s rate environment. For example, issuing debt at 5% or even 4% is a coup in the long run, but in this environment, when one can borrow shorter term funds at 1% plus, 4% is very expensive.

The burden of such debt is particularly painful for banks whose balance sheets are comprised in large part of variable rate loans. Prime-based loans are extremely attractive under almost all scenarios. The rate is even better than LIBOR based loans, while variable and therefore less sensitive to interest rate movements. It is the very attraction about the rate that is its downfall in the unique rate environment within which we operate. Consequently, asset-sensitive banks are hurting.

Many such banks have been reluctant to use derivatives to 'freeze' their spreads in the past. Derivatives have been at the root of some banks’ demise, they are not always easily understood and they can get quite pricy. Many solid community banks refuse to add them to their balance sheet, even as rates persisted in these extremely low levels, because they have weathered the storm effectively in the past. However, for those community banks who feel that they can no longer sit on the sidelines and watch their margins evaporate and stay at these extraordinarily low levels, there are some debt restructuring options that might be attractive and without significant risk.

Consider this example: an asset sensitive bank with over 60% variable rat commercial loans has also a meaningful Trust Preferred issue on the books. The rate on the debt is much higher than the rate paid today on variable rate debt. Why not swap the fixed rate debt into a variable rate one? The advantages are clear: the bank will lower its debt service burden significantly at a time when its margin is abnormally low. In other words, lower the debt expense during the period when the bank can least afford to pay such interest because of its own earnings pressure.

The risk is also clear: when rates go up, the price of the best will rise and will likely be higher than the original coupon. Is the bank mortgaging its future to dress up short term earnings? Is it subjecting itself to higher payments in the future unwisely? This is a question that every bank needs to answer for their individual situation, but I’ve been several institutions where the answer was: It’s the right thing to do right now. Lowering interest expense when you are less capable of servicing it, and facing higher payments in the future, when you can afford it as margins normalize, is not an unreasonable approach to financial and margin management.

There are other such examples of debt restructuring and interest rate risk management that your investment banker will be glad to share with you. It does seem that the time might have come for more banks to consider the benefits (and risks) of financial engineering without necessarily involving the entire balance sheet in the activity. An isolated transaction to lower debt costs or even to capture built-in profit for years to come is a legitimate management tool available to all banks, and some may be well served to consider it at this point in the date cycle.