A.M. Best Special Report: Loan Margin Pressures Collide With Rising Credit Costs.

OLDWICK, N.J. -- The lending business of banks has been under pressure from thinning margins combined with rising credit costs, still another sign confirming the turning point of the U.S. banking industry cycle that A.M. Best Co. believes began in early to mid 2006. Prior to 2007, the sometimes flat, sometimes inverted yield curve had been an obvious factor in overall margin pressures experienced by U.S. banks. Though a recent shift toward a more traditional yield curve eventually should provide relief to the industry, for now, pressures remain on margins. Regulatory bank filings and earnings releases through the first quarter of 2007 indicate that the relationship of loan spreads to funding costs and loan provisioning has deteriorated to the point where it is threatening to get out of balance.

Generally, loan margin compression seems to affect large banks more than small banks. The underlying factors of scarce sources of earnings, heightened price competition among lenders and the excess supply of loan funds, however, all confront the majority of banks to some degree. In this research report, A.M. Best takes a closer look at the components of the industry's net interest margin (NIM)--defined as interest income minus interest expense, divided by earning assets--with a particular focus on loan margin compression and rising credit costs.

The NIM for the industry declined gradually for some time, especially for the larger banks, where NIM dropped sharply and steadily from a 10-year peak of 4.04% in 2002, through the third quarter of 2006 at 3.33%, with a dramatic further drop in the fourth quarter to 3.20%. Preliminary data for March 2007 indicate that margins for the industry overall are down from the same quarter in 2006--though improved from the last quarter of 2006--caused by strong increases in funding costs set against only very modest increases in loan yields.

As of the first quarter of 2007, it appears that the NIM of smaller banks was declining at an intensifying pace, but larger institutions engineered an improvement in NIM. Smaller banks reported a NIM of 4.04% for the fourth quarter of 2006, which declined to 3.91% for the first quarter of 2007; larger banks reported a NIM of 3.20% in the fourth quarter, with an improvement to 3.32% in the first quarter.

The behavior of interest margins of larger banks relative to smaller banks ran more or less in tandem in the past. Those margins began to diverge, however, in 2002, with a widening gap seen between NIM for large and small institutions into 2006. Recently, NIM for smaller institutions typically ran about 50 basis points higher than for larger institutions. Interestingly, however, the gap that began to widen in 2002 apparently began to narrow in the first quarter of 2007.

For the first time since 2002, larger institutions in the first quarter of 2007 actually improved their NIM, while NIM at smaller institutions declined. The widening gap between smaller and larger institutions from 2002 through 2006 was partly because structural changes in the industry have had a disparate impact on large versus small banks, as have changes in the way each group responds to fluctuations in the overall interest-rate environment.

The net effect of a confluence of factors--impacting the NIM as well as asset quality--has been pressure on lending operations from all sides. It will be interesting to see how much impact one factor--the recent normalization of the yield curve--will have on NIMs within the banking industry.

Loans historically have been the mainstay of commercial banks, and especially for community banks. If recent trends pressuring lending do not reverse, banks will be forced to navigate some tricky waters, having to choose when to walk away from some transactions. As is always the case, the more disciplined banks will fare better in the long run. The individual circumstances and the approach of each bank are important factors considered by A.M. Best in evaluating an individual bank's strength in this or any stage of the industry cycle.

This special report is available electronically from the A.M. Best Company Web site at www.ambest.com/banks.

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Founded in 1899, A.M. Best Company is a full-service credit rating organization dedicated to serving the financial services industries, including the banking and insurance sectors. For more information, visit www.ambest.com.