Question

Trends in Real Estate Credit are considerable pressure has been placed on interest rate margins And greater emphasis on fee income. Explain this statement and enumerate its reasons.

Answer 1

Net interest margin (NIM) is a measurement comparing the net interest income a financial firm generates from credit products like loans and mortgages, with the outgoing interest it pays holders of savings accounts and certificates of deposit (CDs). Expressed as a percentage, the NIM is a profitability indicator that telegraphs the likelihood of a bank or investment firm thriving over the long haul. This metric helps prospective investors determine whether or not to invest in a given financial services firm. Simply put: a positive net interest margin suggests that an entity operates profitably, while a negative figure implies investment inefficiency. In the latter scenario, a firm may take corrective action by applying funds toward outstanding debt or shifting those assets towards more profitable investments.  Trends in NIMs vary across countries. Multiple factors may affect a financial institution's net interest margin--chief among them: supply and demand. Monetary policies set by central banks also heavily influence a bank's net interest margins because these edicts play a pivotal role in governing the demand for savings and credit. If interest rates rise, loans become costlier, thus making savings a more attractive option, which consequently decreases net interest margins. The overall movement of the average net interest margin has tracked the movement of the federal funds rate over time. Following the financial crisis of 2008, U.S. banks operated under decreasing net interest margins due to a falling rate that reached near-zero levels from 2008 to 2016. During this recession, the average net interest margin for banks in the U.S. shed nearly a quarter of its value before finally picking up again in 2015.

A large fraction of banks’ revenue comes from noninterest income, which includes items such as overdraft fees and ATM charges.

Overall noninterest income as a share of bank revenue is lower than before the 2007 - 09 crisis, in part because of the collapse in securitization. After the crisis, though, banks with a low net interest margin tended to rely more on noninterest income. It thus appears plausible that they were making up for lost interest income due to the low-interest-rate environment ushered in by the financial crisis. Banks may also be relying more on noninterest income since the crisis, once we concentrate on service charges and exclude the parts of noninterest income most affected by the collapse of the financial markets, such as securitization, trading, and real estate.

Interest rate risk refers primarily to the variation in net interest income caused by changes in interest rates. The fundamental issue is to determine how much a bank's interest income will rise or fall when rates change compared to how much interest expense rises or falls. The focus is on the volume of rate sensitive assets and liabilities that can be repriced when interest rates change. If the rate sensitivity of assets is matched with the rate sensitivity of liabilities and a bank has no off-balance sheet exposure, it exhibits little interest rate risk. If the rate sensitivity difference is large as a fraction of assets, a bank's risk can be substantial. Banks typically examine their funding GAP as a measure of interest rate risk. GAP is a balance sheet measure that equals the dollar difference between rate sensitive assets and rate sensitive liabilities within a set repricing interval, such as the next 90 days. The greater is the difference, regardless of whether rate sensitive assets exceed rate sensitive liabilities, or vice versa, the greater is the risk. Banks also are required to use asset liability models to simulate changes in interest rates and the effects on earnings and capital. Interest rate risk is also associated with changes in the market value of bank assets versus changes in the market value of bank liabilities when rates rise or fall. Interest rate changes cause prices of certain balance sheet items to change in the opposite direction. When rates rise, prices fall; and when rates fall, prices rise. Interest rate risk can be measured by comparing the change in asset values relative to liability values as a result of interest rate changes, to determine how much the market or economic value of equity rises or falls. High credit risk produces high loan charge-offs and reduced interest and principal payments received from loans and securities. ·High interest rate risk manifests itself through reduced net interest income. High liquidity risk creates problems as banks can replace lost deposits only by asset sales and/or paying a premium on borrowed funds. Capital risk is thus closely associated with asset quality and rate sensitivity mismatches. A bank with few risky assets needs less of an equity buffer to protect against losses, while a bank with many risky assets should operate with more equity. The same holds for banks with high or low interest rate risk. Measures of capital or solvency risk thus compare long-term debt and equity to total assets or to risk assets.

Credit conditions remain supportive for banks even if trade and geopolitical tensions are undermining confidence and economic momentum. – The Fed’s and ECB’s responses to counter the slowdown are positive for banks’ funding conditions but continue to call into question their business models given that interest margins will remain low for longer. The pressure on profitability is higher in Europe and Japan.

Fee incomes today have evolved as a strong and efficient revenue stream for banks. As banks today are faced with the task of growing profits in an environment where capital is most scarce and expensive due to tighter capital provisioning norms. Fee incomes started to gain significance with the advent of capital adequacy norms for banks. The norms required banks to provide capital on advances made by a bank depending on the risk assessment. Fee incomes today are a relatively easier way to grow revenues as the business does not involve any fund-based exposure like a loan or a cash advance. This allows banks to conserve capital and put them to better use where returns are higher. While fee-based products prove attractive as banks don’t have to worry about these going bad or turning up as NPAs on the balance sheet, banks may have to take a hit if guarantees given are invoked by the third party.