Lower Net Interest Margin: What Does It Mean to Financial Institutions?

Ashley Garrison: Hello, and welcome to this week’s episode of Lending Made Easy. It’s gonna be a fun topic, net interest margin.

It’s going all over the place because of the Fed is raising the rates here. But the question for bankers is how are they looking to control this squeeze on net interest margin?

For those of you new to this show, we’ve got two resident banking experts and gurus here. Brian Peckinpaugh and David Catalano.

So I’ll throw this question to David first. Let’s talk a little bit about what is net interest margin? What does it mean to financial institutions and why is it such a hot topic right now?

David Catalano: Net interest margin is essentially the life blood of any bank and particular commercial banks that we work with all the time.

They’re making a spread between their cost of funds, which is typically an FDIC insured deposit and what they charge their commercial customers to borrow money and that is the net interest margin.

When that compresses there’s less money to be spent within the bank. So, what you wanna do is you want to enhance that margin, but at the same time, you can also take a look at how you’re operating as a bank. How efficient are you at creating net interest margin? And in, in particular community banks?

Let’s say $3 billion and under. The majority of those banks are making their money from commercial lending. That is a very that’s a huge opportunity for optimization. There’s no question about it—both on the employees side (where they’re processing all of the commercial loan requests) and then on the client service side.

There’s a huge opportunity there, but really the underlying compression here is interesting. If you look at the 10 year yield and you subtract the two year yield from it, you get 34 basis points today. So that’s a compression of our yield curve.

Yield curve compression doesn’t mean a recession’s coming, but we’ve never had a recession without a compression in the yield curve.

So really what banks need to be looking at is what’s going on in their underlying credits. If we think about on May 4, we had the small business jobs, really it’s the ADP job release, but the small business segment had the third largest drop ever shredding 120,000 jobs in that small business sector.

The next day we had the JOLTS data come out and we see 4.5 million people quitting the job force 900,000 of those being in the retail type restaurant space. There’s a dramatic change going on in the underlying labor and small businesses are having problems both on higher input costs and rising labor costs. They’re getting whacked.

From a banking perspective, I would be on the alert for what’s happening in my portfolio today. What could happen here as we move into a slowing economy with a rapidly rising costs input costs for the many of these businesses, they can’t pass that onto the consumer. They’re having hard times with labor.

Government subsidies both to the consumer and to really just federal spending are dramatically reduced. This is an interesting environment. We got rising rates into a slowing economy and that doesn’t bode well. 

Ashley Garrison: Bryan, your thoughts?

Bryan Peckinpaugh: No, it sure doesn’t bode well.

Let’s not go all do and gloom, though. It’s certainly some challenging days ahead. It’ll be interesting to see what the recent rate raise does in the coming months. But, I think, you hit on something in there, David, as you were talking about what do the banks need to be focusing on the efficiency behind their lending processes. 

Where the compression that has been out there the the very tight margins on the lending business, it means you gotta go find more with what you got, right? If I can’t drive a higher interest margin. How do I just get more of it? 

That’s where I think we’ve seen a lot of interesting things, especially coming out of the technology change in lending with the online PPP and forgiveness programs that banks and credit unions are really starting to think about how do I tap into markets that maybe I haven’t had before? 

Is that online loan channels is that freeing up my RM’s, taking work off their plate? What have you seen in, in banks you’ve been talking to as to what maybe technology solutions they’re evaluating that could, as we like to talk about, build capacity into their process?

David Catalano: I think the biggest movement I see, and in particular that bank size say $10 billion and under, is really optimizing the commercial lending process.

Where they’re making their regular C&I loans or CRE loans, the full underwriting making that process much more efficient where you don’t have duplicate data entry multiple times, 10 times through that process.

You can actually create, think about a circle or a loop with all the different components on that loop, underwriting, origination, underwriting, documenting, funding, servicing, reporting, all of that. 

You enter data once and use it over and over and over. That’s an efficient digital process. You can get that today. That is an absolute way to boost your efficiency. It’s fairly easy to be able to create 20% more capacity within a department or a bank who’s moving to a digital lending solution.

When I say solution, I mean from core extract all the way to boarding. Right back to core.

It’s very much possible. That will take costs out of processing that will improve commercial customers experiences. There, there’s just no question about that.

Bryan Peckinpaugh: Yeah, and that’s key, right? It’s the experience aspect and it’s not just the customer experience. It’s the FI employee experience, right?

David Catalano: Exactly.

Bryan Peckinpaugh: If I have a good experience, I’m gonna give a good experience to the clients of my institution. You hit on it, David, that it’s now a reality, having that fully integrated LOS that comes, information out of the core into an origination system into doc then straight back through a boarding process.

For those that haven’t explored that avenue it’s, maybe well past time to do so, but, but there’s also institutions that have technology in place that have solutions that need to be enhanced to take advantage of the current market.

The one thing I would recommend and maybe even caution against is, too often it comes down to feature function, right? It’s I want an online application and I want OCR for my spreading. They come and they talk to us about how do I do these feature function ideas.

It’s also the time to step back and say, what does that mean to my experience? What am I looking to solve for? So in those two examples, first one being the what’s behind the question is I need to evaluate this online presence. How am I engaging in a pure digital Arena with clients and prospects and what do I need to consider? How does that fit with my brand, as a bank, with how I want to lend money, grow deposits, et cetera, not just, I wanna put an online loan application out there.

With the latter, that’s where you get into I’m trying to free up time. I’m trying to build capacity by automating the world of financial analysis, but there’s a lot that goes into that as far as the risk behind it.

Do I really wanna trust that to technology, to spread financials for me, or are my analysts providing value to the process as they interpret the files I’m given and put that into the appropriate buckets in, in my spreading application.

It really is stepping back to say, what does that experience need to be to drive value throughout the process?

That, again, in turn I can bring to my customer and prospect base to try to drive more volume, to capitalize on larger amount of net interest margin, because it is difficult to increase just the margin itself, right? Hopefully with it going up half a basis point that or 50 basis points, sorry that it’ll materially impact the industry.

David Catalano: Yeah. I mean, we’re definitely seeing changes in the underlying economy. And I started this whole podcast off with some macroeconomic observations.

If you think back to why CECL a was put into place, it was very much to get bankers thinking in a macroeconomic way, instead of looking at historical losses, which aren’t gonna predict the future, look more as to what’s going on in the current environment.

When I look out at the environment, it’s a perfect time to be thinking like a CECL person, as opposed to an allowance person. When you think about managing your portfolio, one of the best ways I can think of as is to think about that is to look at behavior changes?

Who pays as agreed and is also all of a sudden not paying as agreed? Who deposits money every month out of their business and slowly those deposits are diminishing or maybe they’re stopping? Look for behavior changes at the account level.

See if you can get some triggers off those to get early indications of any credit deterioration or any need on the client’s part with respect to whatever outstanding credit they have, whether it’s a line of credit or term loan, but all of those accounts the behavior of those accounts are absolutely telling you something.

The question is, do you have technology in place to tell you one, they’re telling you something and two to take action on it?

Can you create an assign a task to somebody in the event one of your large deposit accounts stops depositing money or moves, or removes a transaction account?

There’s just ways in which you can monitor behavior to determine the health of the underlying asset, whether it’s a deposit or loan account then take an action from that. Now is a really good time to be thinking about that, given the macroeconomic environment that we’re in.

Bryan Peckinpaugh: Yeah, absolutely.

It brings even more technology into the picture, lots of these quote unquote digital concepts so maybe a topic for further conversation in the future about what does this world look like with even more technology and how do we ensure we don’t lose kind of a, a human touch to it?

David Catalano: Absolutely.

Ashley Garrison: So guys, one of the things that I’ll end on here is I heard efficiency. That’s like the name of the game. For a bank to compete, to deal with this squeeze on net interest margin, it really comes down to looking at your process. Is it efficient? Is it working for you if you wanna stay in the business of banking?

Thanks everyone for joining us and tune in next time for Lending Made Easy.