Low interest rates this year have driven commercial lending and spurred new and refinanced mortgages.

But as long-term rates dropped before the Federal Reserve began making moves on short-term rates, the spread between what’s paid on deposits and earned on loans continued to shrink, affecting profits for many community banks.

Wednesday’s decision by the Federal Reserve to cut interest rates for the third time this year could help reverse that trend.

“One of the things we have been preaching forever is that the worst case for banks is lower interest rates,” said Frank Farone, a managing director with Massachusetts-based national financial industry consultants Darling Consulting Group.

Banks have seen the yield on assets go down while customers have refinanced or taken out new mortgages at rates near historic lows, he said.

“Meanwhile banks’ cost of funds continues to go upward,” Farone said. “And therein lies the squeeze.”

Yield Squeeze

With some banks paying more than 2 percent on deposits and charging below 4 percent on loans, opportunities for profit have become scarce.

The Fed’s rate cut could help steepen the yield curve and ease pressure on banks, but for Farone, this offers only a temporary reprieve. As bankers now work on budgets, some are concerned about holding on to earnings.

Farone would like to see bankers put aside interest rate biases and philosophies, changing how they manage the balance sheet.

“There are still a lot of opportunities for community banks to build and grow market share,” Farone said. “They just need to be a little bit more nimble.”

Changes banks could make include revisiting policies, such as with flexibility with loan structures and lower capitalization ratios, Farone said. He added that banks should understand their own unique risks when managing the balance sheet.

Farone does not think the U.S. will adopt negative interest rates, which he considers a failed economic policy in other countries. But banks should continue to prepare for lower rates and then hope rates start to move higher.

“Banks have to continue to manage against the falling rate environment and, like any insurance policy, hope whatever insurance you buy today against falling interest rates doesn’t pay off,” Farone said. “That’s a tough pill to swallow given where we are on the rate cycle, but that’s unfortunately the way insurance works.”

Smaller Lenders Go Commercial

Smaller banks and credit unions have had to make business changes including getting more involved in commercial lending, said Tom O’Connor, a partner with GT Reilly and Co., which offers audit and tax services to community banks and credit unions. He has seen smaller banks and credit unions make business changes, including getting more involved in commercial lending. While more risk is involved compared to home mortgages, these loans often yield a better return for banks and credit unions.

Declining profits from low interest rates have been one factor in pushing smaller banks toward mergers, O’Connor said, and he expects to see mergers continue.

Community banks need to consider the long-term effects of the interest rate environment as well. With more opportunities for profit, banks could invest in technology, a key for attracting new customers and keeping existing customers and their families.

“We’re in this period of wealth transition from Baby Boomers to their children, and a real concern is being attractive to the next generation of customers,” O’Conner said. “They want more technology, and they expect there to be the best technology.”

While community banks have felt the effects of the low-interest rate environment, customers have benefited.

Along with refinancing mortgages and receiving better credit card rates, customers at PeoplesBank, a Holyoke, Massachusetts-based bank with several branches in Connecticut, have also been refinancing commercial loans, leading to fierce competition between banks, said Brian Canina, the bank’s executive vice president, CFO and treasurer.

But the surge of refinancing does have consequences.

“It becomes challenging when you have lenders who work on refinancing rather than working with new customers, Canina said. “It’s not as bad as it was five or six years ago, but that’s what any bank would be challenged with.”