NEW YORK (TheStreet) -- Community banks anxious for a boost from a Federal Reserve rate hike should be prepared to wait. And then wait some more.
The initial interest-rate increase, which Fed Chair Janet Yellen indicated will be this fall, is a small first step. Raising rates to historical norms will take many years, and especially in the early stages, banks will have to juggle to find the right balance between the interest rates they charge borrowers and the rates they pay to depositors.
The process will require time and experimentation, Christopher McGratty, an analyst with Keefe, Bruyette & Woods, said in an interview. Furthermore, the initial rate increase is likely to be as little 0.25%, which won't make tremendous differences in profitability right away, he said. "Initially, when rates start going up there will be some tweaking at banks to get their feet under them," he said.
Unlike larger peers with several lines of business, community banks primarily deal only with loans and deposits in local markets. And because of that, they have been uniquely hurt by low rates. First, their margins were compressed because they couldn't charge high interest on their loans. Second, the conditions of the financial crisis, which necessitated the Fed's rate drop, meant that there weren't many eligible borrowers. In short, the banks lost on interest revenue as well as volume.
"The majority of community banks are very spread dependent. If you look at the variables of how they make money, net interest margin is by far the most important," McGratty said. The figure, often referred to by its acronym, NIM, gauges the difference between interest income from borrowers and interest payments to depositors.
Bradley Rust, CFO of German-American Bancorp, a southern Indiana bank that holds $2.3 billion in assets, concurred with McGratty's assessment.
"Obviously as a banking company, NIM is our single largest source of earnings," Rust said in a presentation on Tuesday, and increasing it in a low-rate environment has been the bank's "single largest challenge."
How the banks manage their deposit business, one of two factors in calculating net interest, may prove to be difficult after the first rate hike as they adjust their mix of interest-bearing and non-interest bearing deposit accounts.
"We know at a time of rising interest rates, this composition of funding may put short-term pressure on our cost of funds," Rust said. "But, over time, whether we're in a rising or falling interest-rate environment, we believe this funding will allow us to maximize net interest income."
With rates near zero, households and businesses have become accustomed to earning little to no money on their deposits. As rates creep up, banks may feel pressure to offer attractive deposit rates to entice new clients -- especially since advances in money-transfer technology have made the pain of switching banks less cumbersome.
"Everyone's interpretation of how well they're positioned is different," McGratty said. "They all disclose how they think their balance sheet will move, but it's all based on assumptions and we've never experienced rates as low as we have for as long as we have. One of the things that is impossible to decipher is what is going to happen to deposits."
Even so, McGratty says some of these concerns might be overblown as it will take several rate-hikes for interest earned on deposits to be meaningful to investors. "Are people really going to rate-shop over 25 basis points?" he asked.
In the interim, there will be plenty of opportunity for investors, even though McGratty cautions that some of the benefits are already priced into banking stocks. A 74% increase on KBW's index of 24 banks since the end of 2008 still trails gains by some of the largest banks, such as JPMorgan and Wells Fargo.
"Banks who will be successful will be the banks that can strategically deploy capital," McGratty said. By his measure, some of the regions that were hit the hardest by the financial crisis -- such as California, Florida, and Michigan -- have also rebounded the most significantly. Of Michigan's recovery, he adds that the trajectory has been "like a hockey stick."
Perhaps an appropriate measure for the Red Wing state?