Higher rates have not brought higher net interest margins

The 21st Century has seen two parallel financial trends - an extended period of low interest rates and net interest margin compression. Would margins return to historic levels once interest rates rose? After 18 months in an elevated interest rate environment, the answer appears to be a resounding no. 

Net interest margin, the difference between what a financial institution earns in interest vs what it pays, is a critical metric in fractional reserve banking. The larger the gap the more money you earn. Increased competition and other factors can cause the spread to shrink. One hypothesis is that as interest rates rise, so to will the spread. After all, an environment with 7% mortgages has more wiggle room than when they are at 2%.

However, data does not appear to be bearing this out. Of the five banks shown, four are reporting net interest margins lower than their average pre-inflation rates. Only EQ Bank has managed to increase its NIM in the last two years, continuing a trend that started back in 2018.

Will the situation change as more mortgages renew? What impact does this have on financial institution strategies?

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Life at the margins

Net interest margin has been on an extended decline. For example, RBC recorded a NIM of 2.97% in 1990. This dropped to 1.87% in 2000 and just 1.51% in Q4 of this year. RBC's NIM has trended down over this time, regardless of the Bank of Canada's rate decisions. CIBC has converged with RBC over the last decade, and all of the Big 5 are in essentially the same spot. at 1.5% margin, a bank will record just $15M of interest revenue on every $1B in their loan portfolio. 

Smaller financial institutions have a bit more leeway. National Bank and EQ Bank are both in the 2% range, while credit unions can vary widely depending on local market conditions and growth strategies.

We've now spent almost two years in a higher-rate environment. If financial institutions were hoping this would ease the pressure on net interest margin, that has not been the case. From 2014-2021 CIBC's average NIM was 1.85%, while today it is 1.44%. National bank went from 2.22% to 2.14%.

It is possible that duration will have an impact. EQ Bank tends to sell shorter-duration mortgages and more uninsured mortgages vs the big banks. Their margin has improved from 1.68% to 2.00%. As loans reset at the higher rates there is an opportunity to increase the spread. However, EQ's trend started back in 2017 - well before recent rate hikes.

Beyond NIM

NIM spreads can increase due to different product mixes (e.g., unsecured vs secured lending), capital strategies (e.g., relying on retained earnings vs. broker deposits vs. GICs) and other factors. These must of course be accompanied by appropriate risk management strategies.

Duration mismatch is another important factor. As Silicon Valley Bank showed, a long duration of lending mixed with short-term borrowing can prove fatal. Sound treasury management during a period of rate instability is critical. 

Financial institutions must also look to build resilience via revenue diversification. Developing sources of non-interest revenue is more important than ever.

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