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FDIC Outlook
Managing Net Interest Margins Under a Shifting Yield Curve
FDIC-insured institutions have operated in normal (upward sloping), flat, and inverted yield curve environments since 2000. The shape of the yield curve influences investment and funding strategies as well as net interest margins (NIMs).1 With every decision, financial managers face a risk/return trade-off. To enhance earnings, managers may be tempted to "chase yields" by selecting traditionally higher yielding investments without considering the impact on longer-term risks, such as credit, market, and liquidity risks. Institutions face similar risks on the funding side. Banks have a variety of short-term funding alternatives available with which to fund growth in higher-yielding, longer-duration asset portfolios. However, banks not only face risk from duration mismatches between investment and funding alternatives; managers may try to manage NIMs using funding sources without fully understanding the risks involved. (See inset box, "The Yield Curve Defined," for a description of the yield curve and the risks it embodies.)
| The Yield Curve Defined |
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The term structure of interest rates refers to the relationship between interest rates and the time to maturity. The yield curve is a graph of the term structure. The yield curve typically is presented using Treasury securities to eliminate the impact of credit risk on the term structure. Interest rates generally go up with the time to maturity, and the yield curve normally is upward sloping. However, yield curves can be flat or inverted in unusual economic environments. The slope of the yield curve is measured by the yield spread, which is the difference between a short-term and long-term interest rate, such as a one-year and ten-year Treasury rate.
A variety of risks affect the level and slope of the yield curve. Liquidity risk is the possibility that an instrument cannot be obtained, closed out, or disposed of rapidly at, or very close to, its economic value. Market risk is the possibility that an instrument will lose value as a result of a change in the price of an underlying instrument, an index of financial instruments, changes in various interest rates, or other factors. The principal types of market risk are price risk, interest rate risk, and basis risk.
- Price risk is the possibility that an instrument's value will fluctuate and unfavorably affect a bank's income, capital, or market risk reduction strategy.
- Interest rate risk is the possibility that an instrument's value will fluctuate in response to current or expected market interest rate changes.
- Basis risk is the possibility that an instrument's value will fluctuate at a rate that differs from a related instrument (for example, three-month LIBOR and three-month Treasury bills).
Yield curve risk is a manifestation of interest rate risk. Specifically, it is the risk that changes in the shape of the yield curve (such as a nonparallel shift where short-term rates change relative to long-term rates) may affect an institution's financial condition (such as earnings, asset values, or nature of funding).a
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a Definitions appear in the FDIC Division of Supervision and Consumer Protection Capital Markets Handbook, January 1999.
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This article explores the performance of FDIC-insured institutions in the normal, flat, and inverted yield curve environments observed since 2000. It identifies strategies used by community banks (banks with less than $1 billion in assets) and large banks (banks with more than $1 billion in assets) to manage NIMs, as well as strategies that may have raised institutional risk profiles in the recent flat yield curve environment.
The Changing Yield Curve Since 2000
The yield spread between one-year Treasury bills and ten-year Treasury notes since 2000 has ranged from –40 to 320 basis points. Consequently, FDIC-insured institutions have operated in normal, flat, and inverted yield curve environments (see Chart 1). In 2000, yields on ten-year Treasuries lagged yields on one-year Treasuries, and the yield curve went from flat to inverted. In 2001, yield spreads increased and the yield curve steepened. From late 2001 to mid 2004, the spread between one-year and ten-year Treasuries exceeded 200 basis points, and institutions operated in a normal, upward-sloping yield curve environment. In the second half of 2004, yield spreads fell and the yield curve flattened. From early 2005 through mid 2006, one-year and ten-year Treasury yield spreads averaged less than 30 basis points, and institutions operated in a relatively flat yield curve environment.
CHART 1
How FDIC-Insured Institutions Fared in Each Yield Curve Environment
During the normal yield curve environment in effect from late 2001 to mid 2004, NIMs fluctuated at both community and large institutions. (See Chart 2 for an example of a normal upward-sloping yield curve.) However, the two types of institutions followed different strategies to enhance NIMs. Community institutions invested in longer-term securities and expanded their commercial real estate portfolios on the investment side, and they grew deposits and Federal Home Loan Bank (FHLB) advances on the funding side. Large institutions expanded their residential loan and home equity loan portfolios on the investment side as demand for commercial and industrial (C&I) loans continued to decline. On the funding side, large institutions saw rapid growth in interest-bearing deposits and other borrowings.
CHART 2
During the flat yield curve environment in effect from early 2005 through mid 2006, NIMs diverged at community institutions and large institutions, with large institutions experiencing greater NIM compression. (See Chart 3 for an example of a flat yield curve during this period.) To enhance NIMs, community institutions grew their commercial real estate portfolios and home equity lines on the investment side, and reported a rise in short-term FHLB advances on the funding side of the balance sheet. Large institutions had a rebound in C&I lending and strong commercial real estate loan growth on the investment side, and they continued to report record levels of interest-bearing deposits on the funding side. Community institutions experienced shrinkage in their securities portfolios, while large institutions saw a shift toward longer maturities in their portfolios.
CHART 3
In the inverted yield curve environment of 2000, community institutions experienced greater NIM compression than larger institutions. (See Chart 4 for an example of an inverted yield curve.) In response, community institutions shifted assets from longer-term securities to higher-yielding loans. Large institutions took advantage of loans that matured or repriced within 12 months at higher interest rates to maintain more stable NIMs. Both community and large institutions experienced higher funding costs, with depositors looking to lock in higher short-term interest rates.
CHART 4
The appendix contains a more detailed analysis of how large and community institutions performed in each yield curve environment, including the effects on NIMs, operating challenges, investments, funding allocations, and risk/return trade-offs.
Risk/Return Trade-offs When Operating in a Flat Yield Curve Environment
While it is important to understand the risk/return trade-offs of operating in a range of yield curve environments, FDIC-insured institutions have operated in a relatively flat yield curve environment from 2005 through mid 2006. In June 2004, the Federal Reserve began 17 straight quarter-point increases in the federal funds rate. Consequently, the short end of the U.S. Treasury curve (one-year T-bill) increased almost 350 basis points from 2004 to 2006, while the long end (ten-year T-note) shifted up only 100 basis points. The net effect has been a dramatic shift from a normal, upward-sloping yield curve to a flat yield curve.
The shape of the yield curve affects investment and funding decisions, and ultimately the performance of FDIC-insured institutions. In a flat yield curve environment with compressed NIMs, managers may be tempted to chase yields through investment or funding strategies that initially offer attractive yields, but most likely also carry higher credit, market, or liquidity risks. For example, investing in government-sponsored agency securities or FHLB notes, which appear to have very little risk, may in fact increase investors' exposure to changes in financial markets, interest rates, or the shape of the yield curve.
Investment and funding strategies should be considered in the context of an institution's overall strategic goals. The investment process should be based on an understanding of the nature and characteristics of a security, how the security may perform in different yield curve environments, and the overall risk/return profile of the security.2 On the funding side, managers should consider how an institution's funding is obtained, the risk/return trade-offs of alternative funding decisions, and the longer-term implications of liabilities repricing under alternative yield curve scenarios.
Structured Products and Yield Curve Risk
It is important for managers to understand the longer-term risk/return trade-offs on the investment side of the balance sheet when operating in a flat yield curve environment. This section uses two examples to illustrate the point. The first example uses an investment in U.S. Government Agency Collateralized Mortgage Obligation (CMO) securities, and the second example uses an investment in an FHLB note.
Example 1
In this example, an institution purchased U.S. Government Agency CMO securities in early 2005. These securities are considered to have virtually no credit risk because they are issued by a government-sponsored enterprise (GSE).3 When these securities were purchased, yields on GSE CMOs were attractive at about 350 basis points above the risk-free rate of return. However, the coupon on this CMO series is based on a complex floating rate formula that moves inversely with the one-month London Interbank Offered Rate (LIBOR).4 As short-term interest rates increased throughout 2005 and early 2006 and the yield curve flattened, the price of these CMOs began to fall and the coupon payments dropped to zero.
This example shows that risks can appear later as the interest rate and yield curve environment changes, particularly for financial instruments with complex structures. Although initial yields may appear attractive, the risk/return trade-off inherent in each investment should be evaluated under a variety of market and interest rate scenarios. Other investments may be susceptible to the same yield curve risk. For example, structured notes, such as dual-index floating-rate notes, stepped inverse notes, and range accrual notes, may also react unfavorably to yield curve shifts.5 (See inset box, "Structured Notes," for a description of these instruments.)
| Structured Notes |
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Structured notes are hybrid securities that combine standard fixed or variable rate instruments with derivative products, such as embedded call options, and interest rate caps and floors. Examples of structured notes are dual-index floating rate notes, single and multiple step-up notes, stepped inverse notes, and range notes (or accrual notes).
A dual-index structured note is a security whose coupon is tied to the spread between two market rate indices. It can be structured in any manner and is designed to allow the investor to take advantage of the spread between two indices. Common interest rate indices used include LIBOR (London Interbank Offer Rate) and CMT (Constant Maturity Treasury index). However, these notes can be tied to indices other than interest rates, such as foreign exchange rates, commodity prices, or stock indices.
Single step-up notes are bonds with one coupon increase (if not called) according to a predetermined coupon schedule. Typically, coupon payments are semiannual. Principal is repaid at par at maturity or, if callable, on the call date, as determined by the issuer. If the coupon has more than one adjustment period, the bond is a multiple step-up note. Multiple step-up notes generally have coupons that increase annually or semiannually until maturity. A stepped inverse note is a variant of the step-up note. It also contains a coupon formula that moves in the opposite direction of the referenced index (inverse moves in interest rate).
Range notes (or accrual notes) accrue interest periodically at a fixed or floating coupon rate tied to a specified index. Most range notes have two accrual rates that allow interest payments to vary according to the number of days the designated index falls within or outside an established range of interest rates. If the index remains within the designated range, interest will accrue at the coupon rate. During periods that the index is outside the designated range, interest will accrue at a lower rate. In some structures, the lower accrual rate may be zero.
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Example 2
This example is based on an FHLB note that matures in 2015 and has a floating-rate coupon of three-month LIBOR plus 200 basis points, contingent on LIBOR not exceeding a certain rate based on a complex formula. In the case of the 2006 accrual formula, if three-month LIBOR is less than or equal to 4.75 percent, then the investor receives the stated coupon rate (which is attractive, given the AAA rating). If three-month LIBOR exceeds 4.75 percent, then the investor receives a floor rate of 3 percent. Given that the three-month LIBOR rate was well above 5 percent at the end of third quarter 2006, the investor received the 3 percent floor instead of the more attractive floating-rate formula. Consequently, this investor held an underperforming, relatively low-yielding asset with an extended duration, high market risk, and poor liquidity in the secondary market.
Borrowings—Caveats in a Flat Yield Curve Environment
There has been growing use of FHLB advances on the funding side of bank balance sheets. FHLB advances are particularly relevant in the context of a changing yield curve environment. As short-term rates have risen over the past three years, so too have rates on FHLB advances. Chart 5 shows that fixed rate one-year advances began trending upward well in advance of the Federal Reserve's decision to raise the federal funds rate, rising from 1.5 percent in first quarter 2004 to 5.5 percent in June 2006.
CHART 5
FHLB convertible advances carry embedded options that may magnify their risk in a changing interest rate and yield curve environment.6 In a convertible advance, the FHLB has the option of (1) calling the advance and issuing a new floating-rate advance tied to market rates, or (2) raising the interest rate on the advance. In return for accepting this risk, financial institutions obtain slightly lower funding costs than would otherwise be available. If rates rise, then the FHLB could exercise its option and either convert the advance from a fixed-rate to a market-based floating rate or terminate the advance and reissue it at the prevailing higher interest rate. For a financial institution that uses this instrument, the higher rate on convertible advances may alter cash flows on the funding side of the balance sheet, and may increase interest rate risk and the cost of funds. This is why special risk disclaimers appear in FHLB product circulars.7
Conclusion
FDIC-insured institutions have operated in normal, flat, and inverted yield curve environments since 2000. The shape of the yield curve influences their investment and funding strategies, and how they manage NIMs. FDIC-insured institutions should continually evaluate the risk/return trade-offs of their investment and funding strategies in the context of the institution's overall risk management strategies. Strategies that are appropriate in one yield curve environment may not be suitable in another. Institutions that assume complex risks are required to identify, measure, monitor, and control the risks they assume. Ultimately, each institution is unique, and the investment and funding strategies must be appropriate for the circumstances and needs of the institution.
Albert Crego, Senior Financial Analyst
FDIC Division of Supervision and Consumer Protection
acrego@fdic.gov
Mary L. Garner, Senior Financial Analyst
FDIC Division of Insurance and Research
mgarner@fdic.gov
Appendix
This appendix contains a detailed analysis of how community banks (banks with less than $1 billion in assets) and large banks (banks with more than $1 billion in assets) performed in each yield curve environment. It addresses the impact of the yield curve on NIMs, operating challenges, investments, funding allocations, and risk/return trade-offs. Table 1 evaluates bank performance in the normal yield curve environment from late 2001 to mid 2004; Table 2 evaluates bank performance in the flat yield curve environment from 2005 to mid 2006; and Table 3 evaluates bank performance during the inverted yield curve of 2000.
TABLE 1
| In the Normal Yield Curve Environment from Late 2001 to Mid 2004, Community Banks Grew Securities Balances and Maturities to Enhance NIMs, While Larger Banks Focused on Consumer Loan Demand
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Community Banks
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Large Banks
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Net Interest Margins
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The average quarterly annualized NIM ranged from a high of 4.27 percent to slightly less than 4.00 percent.
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The average quarterly annualized NIM for first quarter 2002 was 4.04 percent, but it declined to less than 3.70 percent by the second half of 2003.
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Operating Challenges
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The U.S. economy was rebounding from a mild recession, so institutions were trying to attract higher-yielding assets. Portfolios of commercial real estate loans grew, particularly nonfarm, nonresidential properties.
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Interest rates were low, and the demand for residential mortgage loans and home equity lines of credit was strong. At the same time, the demand for C&I loans fell, and total C&I loans outstanding dropped below $800 billion for the first time since mid 1998.
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Investments
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Securities portfolios grew, reaching a peak of $331 billion in first quarter 2004. Institutions increased exposure to securities with maturities between 5 and 15 years to achieve higher, longer-term yields.
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Investments in longer-maturity securities grew, with maturity and repricing dates in excess of five years.
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Funding
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FHLB advances, non-interest-bearing deposits, and interest-bearing deposits all grew.
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Interest-bearing deposits grew to a new record, reaching more than $3 trillion in first quarter 2003. Other borrowings grew as well, particularly those with maturities of less than one year.
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Risk/Return Trade-off
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Institutions were taking advantage of longer-term interest rates by investing in securities with longer maturities and repricing dates. Institutions were using nondeposit funding sources, including FHLB advances, to fund growth. By shifting to longer-term securities, yields were higher, but market and interest rate risks increased.
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C&I loan demand was weak, but demand in the residential real estate market was growing. With excess funds, management relied on a risk/return strategy of investing in longer-term securities to increase yields, fund residential loan demand, and grow deposits.
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Community banks are FDIC-insured institutions with total assets less than $1 billion.
Large banks are FDIC-insured institutions with total assets greater than $1 billion.
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TABLE 2
| In the Flat Yield Curve Environment from 2005 to Mid 2006, Community Banks Managed Interest Expenses to Offset Lower Interest Income, While Large Banks Had Significant NIM Compression Partly as a Result of Higher Funding Costs |
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Community Banks
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Large Banks
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Net Interest Margins
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During this time of a relatively flat yield curve, smaller institution NIMs averaged 4.11 percent.
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The story was NIM compression. The quarterly annualized NIM dropped to 3.36 percent by first quarter 2006, the lowest since year-end 1990.
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Operating Challenges
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Commercial real estate lending was very strong, particularly in the areas of construction and development and nonfarm, nonresidential properties. Home equity lines of credit were expanding, while consumer lending volumes continued to decline.
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Commercial real estate loans grew, particularly construction and development loans, one-to-four family residential mortgages, and home equity lines of credit. C&I loan growth also rebounded, topping $1 trillion, a new record.
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Investments
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Securities volumes began to drop, notably in securities with longer maturity and repricing dates, as institutions realized they could obtain similar yields with shorter-term securities.
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Securities growth was moderate during this time, but maturity and repricing allocations changed dramatically. Larger FDIC-insured institutions reported a significant drop in mortgage pass-through securities backed by one-to-four family residential properties with maturity or repricing dates of 3 to 15 years. However, securities with maturities and repricing dates greater than 15 years increased markedly.
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Funding
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The volume of FHLB advances less than one year grew, while longer-term advances declined and federal funds purchased and securities sold under agreements to repurchase (repos) remained at about the same level. Other longer-term borrowings increased. Interest-bearing deposits also surged, with depositors taking advantage of higher short-term interest rates.
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Interest-bearing deposits peaked at $4 trillion at year-end 2005. Money market deposits and time deposits in excess of $100,000 with a maturity of less than one year accounted for the majority of growth. Repos grew approximately one-third from year-end 2001 to late 2005.
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Risk/Return Trade-off
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Smaller institutions focused on construction lending and short-term securities to take advantage of higher short-term interest rates. Smaller institution funding costs remained lower than those of larger institutions, reducing some margin pressure.
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For larger institutions, the risk/return trade-off shifted to longer-term securities with maturities or repricing dates over 15 years in an effort to hold longer-duration assets. As rates on interest-bearing deposits and short-term liabilities continued to rise, compressing NIMs, large banks focused on real estate lending to achieve higher yields and to grow shorter-term assets.
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Community banks are FDIC-insured institutions with total assets less than $1 billion.
Large banks are FDIC-insured institutions with total assets greater than $1 billion.
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TABLE 3
| During the Inverted Yield Curve of 2000, Community Banks Experienced Greater NIM Pressure as Funding Costs Increased Faster Than Yields on Assets, and Large Banks Were Better Able to Manage Assets and Liabilities Repricing at Short-Term Rates |
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Community Banks
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Large Banks
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Net Interest Margins
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Community banks had a relatively stable quarterly annualized NIM of 4.30 percent for the first nine months of 2000. By first quarter 2001, NIM dropped considerably to 4.07 percent.
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Large banks had a relatively stable NIM, dropping only 11 basis points from 3.72 percent in first quarter 2000 to 3.61 percent a year later.
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Operating Challenges
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Institutions shifted from consumer lending and securities to commercial real estate loans to increase their share of traditionally higher-yielding assets. Institutions were trying to increase NIMs.
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The more stable NIM reflected how larger institutions implemented different asset and liability management strategies to deal with different yield curve environments.a On the asset side, large institutions reported 61 percent of loans, excluding closed-end one-to-four family loans, repriced or matured within 12 months. This allowed large institutions to reprice assets faster and at higher rates than smaller institutions.
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Investments
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The volume of total securities declined almost 11 percent during the year ending first quarter 2001. U. S. government, agency, and other securities with repricing dates greater than three years reported a marked decline as yields on longer-term securities lagged those of shorter-term securities.
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The volume of debt securities remained relatively stable, but securities reallocation occurred. Securities with repricing dates of less than one year increased. The volume of mortgage pass-through securities backed by one-to-four family residential properties with maturities greater than 15 years grew rapidly at the beginning of 2001.
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Funding
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The volume of interest-bearing deposits grew, while non-interest-bearing accounts remained relatively stable as depositors searched for short-term higher yields.
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Brokered deposits and money market deposits grew rapidly because of attractive short-term yields.
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Risk/Return Trade-off
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Funding costs were rising more rapidly than yields on interest earning assets, squeezing NIMs. Institutions increased exposure to commercial real estate loans to hold higher-yielding assets and reduced securities exposure, which offered lower yields. Interest-bearing deposits were growing, resulting in higher funding costs.
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Larger institutions managed higher interest expenses by holding shorter-term assets that repriced upward. They shortened asset durations and attracted higher-cost funds through brokered deposits.
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Community banks are FDIC-insured institutions with total assets less than $1 billion.
Large banks are FDIC-insured institutions with total assets greater than $1 billion.
a John M. Anderlik and Richard D. Cofer, "Does Net Interest Margin Matter to Banks?" FDIC Outlook, Second Quarter 2004.
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1 Other factors—including credit shocks, interest rate shocks, term shocks, asset quality, and balance sheet composition—can affect NIM performance. See Gerald Hanweck and Lisa Ryu, "The Sensitivity of Bank Net Interest Margins to Credit, Interest Rate, and Term Structure Shocks," FDIC Working Paper, September 3, 2004.
2 The Office of the Comptroller of Currency (OCC) issued guidance in 2002 entitled "Unsafe and Unsound Portfolio Practices for National Banks." The OCC bulletin discussed the ramifications of poor investment selection on future earnings and capital. Further, it emphasized the importance of maintaining prudent credit risk, interest rate risk, and liquidity risk management practices to control risk in the investment portfolio. In April 1998, the Federal Financial Institutions Examination Council (FFIEC) issued a document adopting a new "Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities" (1998 Statement). The 1998 Statement provides guidance on sound practices for managing the risks of investment activities, with a particular emphasis on market risk (primarily interest rate risk) and can be accessed at
www.fdic.gov/news/news/financial/1998/fil9845.html.
3 GSEs are chartered by Congress to serve a public policy purpose (such as housing and availability of credit). GSEs are rated AAA by the Nationally Recognized Statistical Rating Organization (NRSRO)—the highest credit grade and lowest risk of default. The capital markets view GSEs as having the implied backing of the U.S. government during times of financial stress.
4 In this example, interest rates were increasing rapidly, so yields on these inverse-floating securities decreased.
5 The FDIC has issued several Financial Institution Letters (FILs) addressing structured notes: "Structured Note Holdings Reported at FDIC-Supervised Banking Institutions" FIL-59-2004 issued May 18, 2004, and "Examination Treatment for Certain Types of Credit-Linked Notes" FIL-88-2000 issued December 13, 2000.
6 The FDIC Division of Supervision and Consumer Protection Memorandum dated August 22, 2000, entitled "Federal Home Loan Bank Advances" addresses the risk/return trade-offs of using FHLB advances.
7 Member Products and Services Guide, p. 52, Federal Home Loan Bank of Atlanta
http://www.fhlbatl.com/misc/MPSG/MPSG_2006.pdf#page=1.
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