A.M. Best Banking Special Report: Net Interest Margins Remained Stable in the Third Quarter of 2005.

OLDWICK, N.J. -- Beginning in 2006, A.M. Best Co. initiated analysis and coverage of the U.S. banking industry. To this end, a new series of regular research papers and analytical methodologies will be published. This article is part of a regular series of special reports and highlights the trends of the U.S. banking industry.

In spite of rising short-term interest rates, the net interest margin for the U.S. banking industry in the third quarter of 2005 was relatively stable when compared with the prior quarter, dropping by only 1 basis point from 3.51% at June 30, 2005, to 3.50% as of Sept. 30, 2005. Although margins have been under increasing pressure from a combination of rising short-term interest rates and a relatively flat yield curve, the industry has been able to maintain its margins through shifts in the asset composition of the balance sheet and by trying to lock in lower-cost sources of funding.

As a result of rising short-term rates, the industry's total interest expense in the third quarter of 2005 was 67% higher than in the third quarter of 2004 at $55.2 billion, while total interest income was 24% higher at $136.1 billion. Even with the significant percentage increase in the overall cost of funds, the net interest margin has experienced only modest shrinkage. The limited shrinkage is largely due to the gradual, but noticeable shift in the industry's asset composition in an effort to boost asset yields.

The shift, which intensified after the Federal Reserve began raising short-term rates in June 2004, continued into the third quarter as cash and securities, as a percentage of total assets, dropped from 22.0% as of June 30, 2005, to 21.6% as of Sept. 30, 2005, while total loans rose from 61.1% to 61.4% of total assets. The shift toward higher-yielding loans, in particular commercial real estate and construction loans, helped push earning asset yields to 5.62% at Sept. 30, 2005, an increase of 12 basis points from June 30, 2005. In the quarter ended Sept. 9, 2005, the cost of funds rose by 13 basis points, reaching 2.12%.

The net interest margin for small banks (less than $100 million in total assets) stood at 4.25% at Sept. 30, 2005, an increase of 3 basis points from June 30, 2005. Net interest margins for large banks (more than $100 million in total assets), which generally have trended downward since Dec. 31, 2003, rose by 1 basis point to 3.49%. Larger institutions generally are more reliant on wholesale funding sources than their smaller counterparts are, and as a result, their margins are more sensitive to changes in market interest rates.

In the short term, bank margins are likely to remain under pressure, given the 75-basis-point increase in the federal funds rate since Sept. 30, 2005, and the continued potential for future rate increases. The future direction of short-term rates is clouded by the uncertainty presented by the installation of Ben Bernanke as the new chairman of the Board of Governors of the Federal Reserve in February 2006. Analyst opinion is divided as to whether the new chairman will feel compelled to demonstrate his inflation-fighting capabilities, or whether the January 2006 rate hike will be the last in this most recent series of rate increases.

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