Board of Governors of the Federal Reserve System

April 19, 2019

Changes in Monetary Policy and Banks' Net Interest Margins: A Comparison across Four Tightening Episodes

Jared Berry, Felicia Ionescu, Robert Kurtzman, and Rebecca Zarutskie

How do banks' net interest margins (NIMs), a key measure of bank profitability, change as the Federal Open Market Committee (FOMC) raises or lowers its policy rate?² This question is fundamental to banks' role in monetary policy transmission in a number of ways. How much and when banks pass through interest rate changes to borrowers affects how monetary policy alters borrowing and thus spending behavior. Similarly, the timing and extent of the pass-through of monetary policy rate changes to deposit rates affects savings behavior. Moreover, changes in bank profitability may affect bank risk-taking and stability, which in turn may have spillover effects on the real economy.³

In this note, we examine how U.S. banks' NIMs have varied over the most recent monetary policy tightening episode compared with the three previous monetary policy tightening episodes. We find that banks' NIMs have increased overall since the beginning of the most recent tightening episode, whereas, in the prior three tightening episodes, by the end of each, NIMs had declined overall. Moreover, holding constant the amount of increase in the target federal funds rate, we continue to find that banks' NIMs have increased significantly more in the most recent tightening episode relative to the past three episodes. The increase in NIMs during the current monetary policy tightening episode is due to both a slower increase in banks' interest expenses as a percent of their interest-bearing assets and a faster increase in banks' interest income as a percent of their interest-bearing assets relative to increases in the target federal funds rate. We discuss changes in the U.S. banking environment that can help explain the different behavior of banks' NIMs during the most recent monetary policy tightening episode, including an abundance of deposits in the banking system and as a share of banks' overall funding and compressed NIMs during the period spent at the zero lower bound.

How Have Banks' NIMs Varied with Changes in Monetary Policy?
Banks' interest income for a given level of interest-bearing assets should generally rise as the FOMC raises its policy rate, and as longer-term rates rise, because banks can pass on rate increases to borrowers through floating-rate loans and new fixed-rate loan originations. Similarly, banks' interest expenses should rise, or at least not fall, as banks may pass through higher interest rates to savers. However, the overall net effect of monetary policy rate increases on banks' NIMs is not ex-ante clear, as the relative interest rate pass-through sensitivities of banks' assets and liabilities depend on the competitive environment for deposits and loans, the composition and condition of banks' balance sheets and funding sources, and the behavior of market-based longer-term interest rates, along with other factors.

Figure 1 shows aggregate commercial bank NIMs over the past 30 years alongside the target federal funds rate and the spread between the 10-year Treasury yield and the 3-month Treasury yield, a measure of the slope of the yield curve. In aggregate, banks' NIMs, which have ranged between 3 and 4 1/2 percent, have been fairly stable over time relative to the target federal funds rate and the slope of the yield curve. Banks' NIMs have also generally been declining over the past several decades.⁴

Figure 1: Net Interest Margins at Commercial Banks, and Selected Rates and Spreads

The dashed boxes in figure 1 denote monetary policy tightening episodes, and the gray-shaded regions indicate recessions. During periods of monetary policy tightening, NIMs have tended to decline somewhat or remain flat, as the increase in short-term interest rates gradually increases banks' interest expenses and the generally flattening yield curve reduces the income of interest-bearing assets tied to longer rates.⁵ During recessions, banks' NIMs have tended to rise for a time when the monetary policy rate has declined, as banks' assets--loans and securities, some of which earn a fixed rate--have generally repriced downward more slowly than their liabilities, which mainly consist of deposits that banks are relatively quick to reprice downward in such environments.⁶

The relative insensitivity of NIMs to changes in the monetary policy rate can also be seen in figure 2, which plots aggregate bank NIMs as a function of the target federal funds rate during the four most recent monetary policy tightening episodes. In the first three tightening episodes, NIMs declined or remained flat. However, the leftmost purple line shows that NIMs have generally increased during the most recent monetary policy tightening episode, a finding that we further explore by decomposing the changes in banks' NIMs. In each successive tightening episode, the level of the NIMs is lower, reflecting the general decline in NIMs over the past several decades.

Figure 2: Target Federal Funds Rate and Net Interest Margins

What Is Different about the Current Monetary Policy Tightening Episode?
We decompose changes in banks' NIMs over each of the four monetary policy tightening episodes to shed light on what underlies the different behavior of NIMs in the current episode. NIMs are defined as the ratio of net interest income (NII) divided by interest-bearing assets (IBA), where net interest income is in turn defined as the difference between interest income (II) and interest expense (IE). NIMs can also be defined as the difference between the interest income divided by interest-bearing assets (II/IBA) and interest expense divided by interest-bearing assets (IE/IBA):

In table 1, we show how interest income relative to interest-bearing assets (II/IBA) and interest expense relative to interest-bearing assets (IE/IBA) change with the target federal funds rate (FFR) through each of the four tightening episodes.⁷ Column (1) shows the cumulative change in the target federal funds rate (FFR) over each tightening episode, and column (2) shows the cumulative change in NIMs over the episode. Column (3) divides the cumulative change in NIMs by the cumulative change in the target federal funds rate (FFR) to show how NIMs have changed with each 1 basis point change in the target federal funds rate. NIMs increased by about 0.2 basis point for each 1 basis point increase in the target federal funds rate in the current tightening episode, in contrast to the previous episodes, in which NIMs decreased overall.⁸ While the target federal funds rate has risen by a total of 225 basis points to date in the most recent episode, we calculate changes in NIMs relative to a 200 basis points rise in the target federal funds rate because the final 25 basis point increase in the target federal funds rate was announced following the December 2018 FOMC meeting and our data end in 2018:Q4.

Table 1: NIMs Decomposition Relative to the Federal Funds Rate

Columns (4) and (5) in table 1 show how the components of NIMs change with each 1 basis point change in the federal funds rate. Changes in NIMs are the sum of changes in interest income over interest-bearing assets (II/IBA) and changes in interest expenses over interest-bearing assets (IE/IBA). These additional columns show that interest expenses as a share of interest-bearing assets have increased with the federal funds rate at a slower pace than in previous episodes, while interest income as a share of interest-bearing assets has increased with the federal funds rate at a faster pace.

One possible reason for the slower increase to date in interest expenses relative to interest-bearing assets is that the degree of monetary policy tightening--viewed in terms of the magnitude of the policy rate increase--in the current episode has not yet reached the point at which competition for bank deposits and other bank funding has sufficiently intensified. To examine this possibility, we condition on the degree of the increase in the monetary policy rate; our conditional analysis can also capture, more generally, differences across the four episodes due to the degree of monetary policy tightening in each episode. Specifically, in table 2, we calculate and decompose changes in NIMs during the previous episodes after the first 175 basis points of increases in the federal funds rate. In the 2004-06 episode, NIMs decrease by a larger amount with each 1 basis point change in the federal funds rate if we focus on the first 175 basis points of increases in the policy rate. The 1999-2000 episode only had 175 basis points of rate increases, so the results for that episode do not change. In the 1994-95 episode, NIMs decrease by a lesser amount after conditioning on the first 175 basis points of tightening, going from a negative 0.04 basis point change with each 1 basis point increase in the federal funds rate to a negative 0.01 basis point relative change.

Table 2: NIMs Decomposition Relative to the Federal Funds Rate after First 175 Basis Points of Increases

The decomposition in column (5) of table 2 reveals that the drag on NIMs from interest expenses is lower in the current monetary policy tightening episode than in the three previous episodes even after conditioning on the first 175 basis points of rate increases. Likewise, the decomposition in column (4) of table 2 indicates that the increase in interest income from the first 175 basis points of rate increases is greater in the most recent tightening episode compared with the prior episodes

Changes in the banking environment since the Great Recession have likely affected banks' loan and deposit rate setting behavior and contributed to the increase in NIMs as the FOMC has raised the target federal funds rate in the most recent tightening episode. First, the extended period at the zero lower bound of the target federal funds rate has served to reduced banks' NIMs as deposit rates hit zero and interest rates on loans continued to fall (Covas, Rezende, and Vojtech, 2015). As the FOMC has gradually raised short-term interest rates, banks have likely been more reluctant to raise deposit rates, even compared with past episodes, in order to recoup their lost profitability. Second, following large-scale asset purchases by the Federal Reserve, the banking system has had a large amount of liquidity in the form of both reserves and deposit funding, and a greater share of banks' funding is now in the form of deposits.⁹ Moreover, new liquidity regulations encouraged banks to hold greater shares of their balance sheets in liquid assets. As a result of abundant levels of reserves and deposits, banks may not have felt the need to compete as intensively as in the past for deposits as short-term interest rates have risen. Given the greater share of deposits in banks' funding during the most recent tightening episode, even if deposit rates rose at a similar pace as in prior monetary policy tightening episodes we would expect the drag on NIMs from these higher deposit rates to be less since other types of bank funding tend to have their rates adjust even more quickly in response to rising short-term interest rates. Finally, the greater shares of banks' portfolios held in liquid assets, which are tied to shorter-term rates, has facilitated faster upward adjustment of interest income stemming from tightening monetary policy.

To provide insight into these changes to banks' balance sheets, we further decompose the changes in interest income relative to interest-bearing assets by asset types since the start of the current monetary tightening episode, as well as the changes in interest expense relative to interest-bearing assets by liability type. Figure 3 illustrates this decomposition, with the vertical bars representing the cumulative contributions of each asset and liability type to total changes in NIMs. The green-shaded portion of the bars indicates that loans have been the biggest positive contributors to NIMs, especially loan types such as commercial and industrial loans, which tend to have floating interest rates that adjust upward more quickly with changes in the federal funds rate than do other types of longer-term fixed rate loans such as home purchase mortgages. Figure 3 also shows that securities and excess reserves--the blue and yellow portions of the bars, respectively--have contributed positively to the cumulative change in NIMs but by far less than the contributions from loans.

Figure 3: NIMs Cumulative Change Decomposition, 2015:Q4‒2018:Q4

Furthermore, figure 3 reveals that the liabilities exerting the most downward pressure on NIMs to date have been deposits, the largest source of funding for most banks, but that the downward pressure has been less than the improvement to NIMs coming from loan interest income.

Conclusion
Given the importance of the role of banks in the transmission of monetary policy, we examined how banks' NIMs have varied over the current monetary policy tightening episode compared with the three previous monetary policy tightening episodes. We find that in contrast to the previous three episodes in the United States, banks' NIMs have increased in the current episode. The increase in NIMs does not seem to be due to the current point in the tightening episode, but rather to changes in the banking environment following an extended period at the zero lower bound and abundant amounts of deposits and liquid assets in the banking system.

If short-term interest rates were to rise further and the Federal Reserve to further reduce the size of its balance sheet with the amount of reserves in the banking system also declining, banks may eventually begin to compete more aggressively for core deposits resulting in higher interest expenses. Additionally, interest income from securities tied to short-term rates may also decline. In such a scenario, we may witness a more rapid increase in interest expenses relative to interest income as a share of interest-bearing assets, and the behavior of commercial bank NIMs in response to increases in the monetary policy rate may begin to resemble behavior witnessed in past monetary policy tightening episodes.

Appendix: Calculating and Decomposing Changes in Banks' NIMs during Monetary Policy Tightening Episodes
To examine changes in banks' NIMs, we use merger-adjusted Call Report data, which are reported on a quarterly basis.¹⁰ To calculate aggregate NIMs, we pool assets and liabilities of commercial banking units for a given top holder and weight each observation by its total amount of interest-bearing assets at the top holder level.

We study the past four monetary policy tightening episodes because we have reliable, merger-adjusted income statement data for all elements of our decomposition for the past four episodes. In our analysis, the first quarter before an increase in the target federal funds rate (the reference quarter) is always defined as the closest quarter-end to the first increase. Consequently, the February 4, 1994, rate hike has a reference quarter of 1993:Q4, while the remaining episodes all have a reference quarter during the first rate increase: 1999:Q2, 2004:Q2, and 2015:Q4. We always choose the quarter after the last rate increase in a given tightening episode as the final quarter. Thus, the final quarters for the first three episodes are 1995:Q2, 2000:Q3, and 2006:Q3. We use data until 2018:Q4 for the most recent tightening episode.

To reduce the likelihood that changes in NIMs may pick up seasonal differences in NIMs based on the starting and ending points of each tightening episode, we examine the change in NIMs at the end of the tightening episode relative to the four-quarter trailing average of NIMs at the beginning of the episode. If we set the reference level of NIMs as the level in the quarter at the beginning of the episode instead of the four-quarter trailing average level, the 1993:Q4-1995:Q2 tightening cycle witnessed a 0.01 basis point increase in NIM for each 1 basis point increase in the target federal funds rate, in comparison with the negative 0.04 basis point relative change in NIMs shown using the trailing average method. Similarly, the 1993:Q4-1995:Q2 episode shows a larger relative increase after the first 175 basis points of increases--0.10 basis point for each 1 basis point increase in the federal funds rate. These differences are the product of NIMs falling in 1993:Q4 right before the first rate hike after being relatively flat from 1993:Q1-1993:Q3. The results are quantitatively and qualitatively similar in the other three episodes no matter how the reference level of NIMs is calculated.

We follow the methodology described in Covas, Rezende, and Vojtech (2015) when decomposing changes in banks' NIMs into contributions from different asset and liability types.

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