Expanding Net Interest Margin

Andrew Paolillo Icon
Andrew Paolillo

High cash levels and low wholesale rates have dampened the value of deposit funding. Longer tenors of the yield curve have recently started to drift higher. Restructuring advances can lower cost of funds and reduce interest-rate risk without adding liquidity.

Excess Liquidity

In any other year, the phenomenal deposit growth that banks and credit unions have experienced in 2020 would have been unequivocally positive. However, the historically low level of interest rates, as well as the uncertain operating environment, have presented challenges in prudently and profitably deploying that excess liquidity. 

To put this into perspective, we looked at cash as a percentage of total assets for FHLBank Boston depository members as of the end of 2019 and compared it to the end of the third quarter of 2020. Whether setting the bar for excess cash at above 5% or above 10%, a significantly higher percentage of members are carrying more liquidity now than they were just three quarters ago:

(AS OF 12/31/19)
CASH > 10%
(AS OF 12/31/19) 
CASH > 5%
(AS OF 9/30/20)
CASH > 10%
(AS OF 9/30/20) 
Banks27 %11 %68 %32 %
Credit Unions47 %15 %75 %45 %

Tighter Spreads

This build-up of cash has been occurring as the relative value of wholesale funding has improved considerably due to the low level of interest rates. 

The chart below compares the rate on the 12-month Classic Advance with the median cost of savings and money market deposits for FHLBank Boston bank members. In 2019, deposit funding was supremely valuable, as the cost was 130 to 240 basis points less than the readily available wholesale option. With rates now lower across the board, that spread has been significantly reduced, with just a 10-basis point differential.

 “An advance restructure involves taking an existing and eligible advance and modifying it to a lower rate by extending the term of the advance.”

Intermediate Yield Curve Volatility

While the Federal Reserve has been consistent with their guidance that short-term rates will not be rising anytime soon, the intermediate and longer tenors of the yield curve have been trending higher recently. Whether this is attributable to encouraging vaccine developments, hints of inflation, or a skewed risk/reward profile, Treasury rates at five and 10 years have moved off the lows of the third quarter as outlined in the graph below. For most depositories, exposure to that part of the curve often comes from fixed-rate residential mortgages. Fortunately for members, mortgages have performed extremely well over the last few months, as spread tightening from historically wide levels has mitigated the impact of rising Treasury yields.

Margin vs. Interest-Rate Risk vs. Liquidity

How can members relieve margin pressure and take advantage of low rates without adding incremental liquidity? One way to accomplish this is through an advance restructure. An advance restructure involves taking an existing and eligible advance and modifying it to a lower rate by extending the term of the advance. The member can address multiple challenges at once by (a) reducing cost of funds, (b) mitigating exposure to rising intermediate rates, and (c) not adding any additional funding to the balance sheet.

Let’s look at an example of how an advance restructure works. Consider a scenario where a member had a current advance with a 2.05% coupon and nine months to maturity. If the member prepays this advance, the fee would be approximately 1.50% of the balance. However, by restructuring this advance to a three-year maturity, the member would avoid incurring any prepayment fees and could reduce the rate on the advance to 1.10%, a savings of 95 basis points.

The ability to obtain margin relief while being income statement neutral may appeal to many members, as asset yields continue to be pressured and further deposit repricing opportunities become limited. The median net interest margin (NIM) for FHLBank Boston depository members has contracted sharply when comparing the third quarter of 2020 to the fourth quarter of 2019. The majority of members — 79% of banks and 81% of credit unions — have seen margin decline during this period.

Banks3.213.0279 %
Credit Unions3.473.1781 %

Credit unions may be able to derive considerable benefit from advance restructures. The National Credit Union Administration (NCUA)’s approach to their Net Economic Value (NEV) Supervisory Test assigns standardized values to non-maturity shares. This has the impact of applying a shorter duration to deposits, which implies more exposure to interest-rate risk. Extending liabilities through an advance restructure would aid in mitigating that risk, while also improving net interest margin without adding to liquidity.

Another benefit of an advance restructure is that it allows members to expand the universe of assets to consider as they seek to normalize cash levels. Many members prefer to concentrate investment purchases on the front-end of the curve, where right now there is not much yield to be had in excess of what is being earned on cash balances. 

Let’s revisit the example of a member with an existing 2.05% advance with nine months to maturity. By restructuring the advance out to five years at a new rate of 1.20% and investing in a four-year asset at a 1% yield, the impact to margin and funding gap is noteworthy. Going from cash to the 4-year investment improves yield by 0.90%, but also lengthens assets by 4 years. However, the restructure counteracts that asset extension by increasing liability life by 4.25 years, while also lowering interest expense by 0.85%. Margin is improved through both more asset yield and lower liability costs, while net sensitivity to rising intermediate rates declines slightly.


RateAvg. Life
Before RestructuringCash0.10 %0
After RestructuringInvestment1.00 %4
0.90 %4


RateAvg. Life
Before RestructuringOld Advance2.05 %0.75
After RestructuringRestructured Advance1.20 %5
-0.85 %4.25

Before Restructuring-1.95%-0.75
After Restructuring-0.20%-1

In a time where investment yields are at extremely low levels, advance restructuring can help improve the margin and interest-rate risk impact of deploying excess liquidity.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.

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