The big squeeze: As interest rates lower, so do banks’ profit margins

By Bryan Gentry

Published: May 11, 2008

Select Bank’s founders last July had no idea they were opening the bank just before interest rates would take a sudden, sustained dive.

The Federal Reserve hadn’t cut interest rates since 2003. In the first half of ’07, the central bank held its key interest rate steady at 5.25 percent.

But in September, two months after the Forest-based bank opened, the Fed started trimming interest rates.

Seven cuts later, the Fed’s key rate stands at 2 percent.

Mike Thomas, president of Select Bank, said he didn’t expect such dramatic cuts, which can squeeze banks’ profit margins.

But he said the challenging environment also creates opportunities. “You just have to manage for the opportunity.”

While interest rates are low, for example, Select Bank is growing its loan portfolio— the lower rates make loans more attractive to potential customers. In the first quarter, the bank’s loans grew from $15 million to $26 million.

Leaders at two other community banks based in Region 2000 said they also are finding ways to manage the lower interest rates.

Although Bank of the James and First National Bank of Altavista also are managing to increase their interest income — their main revenue source — it’s being sustained by more loans.

Since the drop in the Fed’s prime rate is linked to a corresponding drop in the interest banks charge for many loans, the banks actually are earning less interest per dollar loaned out.Banks usually lower or raise the interest rate they charge along with the Fed’s interest rate.

“That’s the whole reason the Fed cuts … to save consumers and small businesses money on their interest,” said Bank of the James president Bob Chapman.

The decrease of interest income per dollar really starts squeezing profits when the interest banks pay to depositors doesn’t go down right away.

With certain deposits, such as Certificate of Deposit accounts, the bank promises a steady interest rate up to an expiration date that could be two or more years in the future.The bank has to wait for that expiration date before resetting the interest rate.

Rob Gilliam, president of First National Bank of Altavista, said, “That can take anywhere from five days to five years.”

Chapman said that lower interest on loans and higher interest on existing deposits eats at a bank’s net interest margin — the percentage of interest income left over after the bank pays on deposits.

Both First National and Bank of the James saw a decrease in net interest margin during this year, costing each bank more than $160,000.

First National Bank of Altavista had $2.47 million of net interest income in the first quarter. But if the net interest margin had not dropped, the bank could have seen $164,600 more income in the first quarter.

Bank of the James had $2.56 million of net interest income in the first quarter. That number could have been nearly $168,000 higher if the net interest margin hadn’t changed.

To help counteract the drop in interest rates, Bank of the James reduced the interest it offers on new CD accounts.

Todd Scruggs, the bank’s vice president, said the rates for nine- and 12-month CDs dropped two percentage points. They were about 4.5 percent and are now about 2.5 percent.

But when the Fed cut its interest rate again on April 30, Scruggs and Chapman said the bank wouldn’t necessarily drop its CD rates again.

“We can absorb, to a certain extent, some of the interest rate cut,” Scruggs said.

“You sort of hit a floor there,” Chapman said. “You don’t want to cut your rates so low that you can’t be competitive in the marketplace.”

Gilliam said it’s hard to keep deposits and attract new ones when interest rates drop to today’s low levels. But First National Bank of Altavista continues to have many requests for loans, he said.

“The net result for that is we’re experiencing funding challenges,” he said. “We’re having trouble generating the level of deposits to fund the loans.”

To encourage deposits, the bank created a “Ka-Ching!” checking account. It pays 5.01 percent interest if the account holder uses direct deposit, completes 12 debit card transactions per month, and subscribes to receive statements electronically.

Gilliam said those requirements help reduce the bank’s hands-on processing and postage costs.

So far, he’s pleased with the deposits the interest rate has attracted.

It’s unclear how long banks will have to deal with the low-interest environment.

Thomas said some bond traders expect the Fed could start bringing interest rates up again by the end of the year due to inflation worries.

Gilliam, who serves on the board of directors for the Federal Reserve Bank of Richmond, isn’t betting on that.

“It’s going to take a while for things to level out and turn and go in the other direction.”