The Fed, Banks, and Why Easy Money Can Make It Difficult for Lending

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In its April statement, the U.S. Federal Reserve clearly said it would continue to keep the federal funds rate near zero percent until labor markets improve and economic growth becomes sustainable. In the same month, Bank of America (NYSE:BAC) reported that its net interest margins shrank to its lowest in more than a decade in the first-quarter this year.

So, how are the two facts related?

The federal funds rate — or the rate at which banks borrow from the Federal Reserve on an overnight basis to manage its asset liability imbalances — has been near zero percent since the financial crisis. The reason the Fed continues to keep these key interest rates so low is to make sure high interest rates do not stifle businesses growth and investment that are key drivers of economic activity and job growth.

The interest rates charged by banks on loans and deposits are anchored to the federal funds rate. Banks make money on the difference between what it pays depositors and the interest it charges from borrowers. This difference is called the net interest margin (NIM), or broadly the net interest yield. When interest rates are lowered, NIMs tend to shrink since banks are capped from charging a very high interest rate. The interest rate targeted by the Fed serves as an indicative rate for the markets.

A yield curve, which is a combination of interest rates charged for assets with varying maturities (going from shortest to the longest), is important to how interest rates impact bank profits. A steep yield curve is what banks are looking for. Since deposits are of a short-term nature, its pricing is linked to the market price of short-term assets, like say the three month treasury bills. Loans are generally long-term, so its pricing is influenced by the yield on longer term assets. In what is called the time value of money, lenders must be rewarded for holding on to the risk of having lent for longer term. So a steep difference in the interest rates on short-term and long-term assets makes for a steep yield curve, which means more profit margins or NIMs for banks.

After the financial crisis — when economic growth tanked, inflation fell, and jobs were lost — it came upon the Fed to make sure economic growth was revived by way of providing stimulus. The stimulus was in the form of reducing the fed rate to near zero and buying back treasury bonds to infuse liquidity; that is, to make money cheaply available in the economy.

Keeping interest rates pinned near zero percent meant credit has been made available in the banking system at very low cost. This has encouraged firms to borrow funds for growing businesses and increase investments by reducing the cost of capital. Increased business investment helps stimulate growth in jobs.

The Fed has made it clear that the focus is now on a sustainable employment growth and it is looking beyond the headline numbers before making decisions on the interest rates. In its April meeting, the Fed scrapped the earlier unemployment target of 6.5 percent. The Fed has also said interest rates will remain low even after the asset purchase, or bond buy-back program, has been rolled back completely.

Lowering of interest rates in the U.S. after the financial crisis has taken some toll on the NIMs of banks. Net interest margins for Bank of America fell to its lowest in the first-quarter this year to 2.29 percent from around 3 percent in the first-quarter of 2010. So was the case with Citigroup (NYSE:C). The bank reported that NIMs were down at 2.90 percent as of the first-quarter of this year, from around 3.32 percent in the first-quarter of 2010.

According to the Federal Reserve Bank of Chicago, a 1 percent rise in short term interest rates is associated with 1.5 basis point rise in the margins of a small bank with assets under $100 million, and about 0.3 basis point rise for larger banks. But as the numbers above show, some banks have been impacted more than others. According to the reserve bank, NIMs declined from an average 3.8 percent around 2010 to 3.3 percent by the end of 2013.

Is a high interest rate good news?

Remember, a bank is also a trader! Banks hold bonds in trading portfolios, and depending on the size of these portfolios, various banks will be impacted differently when the interest rates finally start to rise. The rule of bond pricing is, when interest rates rise, bond prices will fall, and vice versa. So when the Fed raises rates, you are stuck with bonds that are now cheaper than what you bought them for. The trader may have to sell them for losses then. This would hit their trading profits.

When the Fed starts raising rates and squeezes liquidity out of the system — in other words, squeezes money supply — banks that have a large depositor base may struggle to pay more on the deposits. Higher interest rates are likely to increase its cost of borrowing. Bank of America’s deposits base stands at $1.13 trillion, according to its first-quarter earnings report.

A bigger worry and an indirect fallout of higher interest rates for banks at a time when economic growth is shaky and labor conditions are poor is an increase in loan delinquencies, as borrowers may find it difficult to pay a higher floating rate. This may force banks to keep aside more capital to provide for bad loans, thus denting its profitability. According to Fed data, delinquency rates are down to 3.33 percent as of January this year, a big improvement from 7.50 percent in January 2010.

If inflation remains contained at or around 2 percent and job numbers improve, which it has in this year, the Fed is likely to start back on some monetary tightening. In other words, it will reduce the money supply. As key rates increase, the outcome will be that banks sooner than later will be able to raise lending rates. At the same time, competitive pricing of deposits may put pressure on the margins of some banks, as desperate depositors will be looking for some returns on their savings.