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Chicago Fed's Evans on community banks in the 'lower for longer' environment

Charles Evans, president and CEO of the Federal Reserve Bankof Chicago, said that if the "lower for longer" interest ratescenario persists, community banks "are going to have to adjust to a newnormal."

Evans discussed what the lower-for-longer interest ratescenario means for financial institutions' profitability at the CommunityBanking in the 21st Century Research and Policy Conference, jointly hosted bythe Federal Reserve Bank of St. Louis and the Conference of State BankSupervisors on Sept. 28. He implored banks to prudently invite and handle riskas they grapple with ways to remain profitable.

"I feel we will likely be in a low interest rateenvironment for some time," he said, later adding: "This environmenthas been and will continue to be a challenging one for community bankingperformance. … It is important for banks, particularly community banks, tocarefully plan for the lower-for-longer rate environment and to think hardabout its impact on both current and long-term earnings."

Evans said that banks are no stranger to adjusting theirbusiness models and prices to reflect interest rate sensitivity, in part bychanging the rate paid on deposits and designing and enforcing interest ratefloors on floating rate loans. Through those and other adjustments, the mediannet interest margin for community banks has moved down only about 40 basispoints between mid-2007 and late 2015, even as the target federal funds ratehas declined 500 basis points over the same period. And there appears to be noend in sight: Evans said many analysts now believe that both short-term moneyrates and longer-term interest rates will be lower in the long run than theyhad expected in previous years. Further compounding the situation is the factthat deposit pricing seems to have reached the "lower bound" end ofthe range during 2015, Evans said, and banks will now need to shift their focusto the asset side of the balance sheet.

He implored banks to be thoughtful about interest rate riskand to adhere to "sound business practices" throughout thislower-for-longer interest rate environment. He said that he has seen bankersextend loan terms, and that the weighted average maturity of community bankloans has outpaced loans originated by bigger banks, according to Chicago Fedstaff calculations comparing call report data from banks with less than $10billion in assets and banks with more than $10 billion in assets. Althoughmatching short-term liabilities with longer-term assets has always been the"bedrock" of community banking profitability, this approach bringsinto focus the "inherent" interest rate risk exposure that bankswrestle with.

Additionally, community banks have coped with low interestrates by deploying "alternative strategies" such as new businesslines, fee-based products and services, and loosening credit underwriting. Hesaid these ventures can be done prudently but also risk reaching for yield in a"perilous fashion."

He said banks can be careful and thoughtful about how tonavigate the low interest rate environment by managing risk even as they inviteit. They need to carefully weigh their risk tolerances and test their depositsensitivity in a potentially changing rate environment. Banks still need tomodel for interest rate risk even as rates remain persistently low and shouldcontinue to simulate firm earnings and equity performance under various rateenvironments. He specifically highlighted the importance of testing andunderstanding what interest rate risk a bank's deposits pose, given that foryears, banks have been awash with cheap liquidity, but prices have bottomed out.