Each depositor insured to at least $250,000 per insured bank

Background
After two years of the lowest federal funds rates since the late 1950s, short-term rates began to rise in June 2004 when the Federal Reserve's Federal Open Market Committee (FOMC) raised the federal funds target interest rate a quarter point to 1.25 percent. During the remainder of 2004 the federal funds target rate was raised four more times, closing the year at 2.25 percent. In contrast, 10-year Treasury notes fluctuated within a band of between 4.73 percent and 4.10 percent during the same six-month period, ending the year at 4.23 percent, which was slightly below year-end 2003 levels.² Taken in combination, the changes in short- and long-term interest rates during the year resulted in a modestly flatter yield curve by the end of 2004 (see Chart 1). The yield curve spread, defined as the difference between the yields on the 10-year Treasury bond and the 3-month Treasury bill, declined from a high of 368 basis points at May 2004 to 201 basis points by year-end 2004.³

Typically, a flattening yield curve tends to compress net interest margins (NIMs) for financial intermediaries. However, despite a moderately flatter yield curve, NIMs actually improved at the majority of the nation's community banks.⁴ During the first nine months of 2004, 52 percent of community banks reported margin improvement, up from 27 percent a year earlier.

The improvement in NIMs during the recent period of a flattening yield curve may be the result of a number of factors. First, this analysis is through third quarter 2004 and represents only one-quarter of increases in the federal funds rate; further, only one increase was effective for the entire period. (Generally, there is a lag between rising market rates and increases in funding costs for some institutions, so the effects of the rate hike may not yet be fully reflected in funding costs.) In addition, the rise in the federal funds rate has taken place gradually at what FOMC statements have termed "a measured pace," which means that the increases were relatively modest and widely anticipated by financial market participants. Further, despite recent flattening, the yield curve spread of 201 basis points at year-end 2004 remained relatively steep and above its 20-year average of 180 basis points. The yield curve may need to flatten more significantly before there is a pronounced negative effect on community bank NIMs.

Rate/Volume Analysis: The Basics
In an effort to assess the impact of interest rate changes on NII, RVA analyzes an institution's change in NII by separating it into three components: changes in yields and costs (rate variance), fluctuations in volume of earning assets and interest-bearing liabilities (volume variance), and residual interest income and expense arising from the combination of rate and volume changes (mix variance). Conceptually, RVA follows a performance attribution methodology by breaking down NII into its components and then measuring the contribution of each component during a given period. RVA can be applied to any two consecutive periods (see Table 1).

RVA is just one analytical tool to evaluate IRR in the banking system. Although RVA is an excellent tool for assessing how interest rate changes affect the components of NII, it is limited in its ability to forecast future results. These limitations arise from a reliance on historical data as well as the potential for change in a bank's asset and liability mix over time. Regardless of the results of RVA for a past period, either balance-sheet repositioning or changes in the level or direction of interest rates could alter the degree and direction of IRR risk in future periods. In addition, RVA is limited in its ability to handle off-balance-sheet items.

Results of Rate/Volume Analysis
As of September 30, 2004, a trailing four-quarter RVA on the nation's community banks indicates that the interest rate environment had a nearly equivalent influence on asset yields and liability costs. These data suggest that the IRR exposure of the average community bank during the past year was relatively limited. The average asset yield of community banks fell 44 basis points to 5.62 percent, while the interest-bearing liability cost fell by an almost equivalent amount, 45 basis points, to 1.84 percent. As a result, the net interest spread for community banks remained relatively stable at 3.79 percent during the period.⁵ Robust growth in earning assets, particularly in commercial, construction, and residential real estate loans, contributed to the increase in interest income (see Table 2).

Only a small subset—about 3.6 percent of the 6,904 institutions analyzed—displayed a high level of sensitivity to rate movements during the period (see Table 3).⁶ Of these institutions, approximately one-third reported a negative earnings reaction, whereas the earnings of the remaining "highly sensitive" institutionsreacted favorably to recent interest rate changes. Geographically, community banks in the FDIC's San Francisco and Dallas Regions reported the highest percentage of highly sensitive banks, and the Boston area reported the lowest percentage. Despite these differences, the percentage of highly sensitive institutions during this period was low—below 5 percent—in every FDIC region.⁷

Note: Sensitivity is defined as net rate variance exceeding 20 percent of the prior four quarters' net interest income. This variance reflects reaction to the specific interest rate environment for a particular period. Different banks will likely display high sensitivity during differing rate movements.

Source: Federal Deposit Insurance Corporation.

Ronald Sims II, CFA, Senior Financial Analyst

¹ IRR includes repricing risk, basis risk, yield curve risk, option risk, and price risk. For more information, see the Federal Deposit Insurance Corporation Manual of Examination Policies, http://www.fdic.gov/regulations/safety/manual/index.html.

² Based on monthly average data for the 10-year U.S. Treasury note.

³ Treasury yields represent monthly averages.

⁴ Community banks consist of all FDIC-insured institutions with assets of less than $1 billion and exclude credit card and other specialty institutions as well as de novo institutions.

⁵ The net interest spread is calculated slightly differently from NIM. The net interest spread equals [interest income divided by average earning assets] less [interest expense divided by average interest-bearing liabilities]. The NIM equals [interest income divided by average earning assets] less [interest expense divided by average earning assets].

⁶ For this analysis, interest-rate-sensitive banks are defined as those banks where the net rate variance exceeded 20 percent or more of prior period NII. See Table 1 for a definition of net rate variance.

⁷ Geographical variations reflect differences among individual institutions over this specific time period. Results will change during different interest rate periods.