Two years ago, I noted that the steep yield curve produced by the Fed’s policy accommodation would give way to a flatter and more treacherous yield curve environment as a weak recovery continued. The Fed would see the weak recovery as a reason to keep rates at zero percent and, thus, cause interest rate expectations to decline. With rates stuck at the zero bound that would mean less interest income for banks and lower profits.
I wrote that “I am starting to take the view that the Fed is reducing net interest margins. Back in 2008 and 2009, US banks benefited from low rates as their net interest margins were huge. For the first quarter of this year, JPMorgan Chase even had a negative net borrowing rate of interest while it made 324 basis points in net margin. They were effectively paid to borrow, leading to a more than 3% interest rate spread on loans. That’s a great story. Can it last, though?
“The short answer is no. As the long end of the yield curve comes in due to either QE or what I have been calling permanent zero (PZ), as zero rates become a permanent state of affairs, interest margins have compressed. Rates will compress even more the longer rates stay at zero percent because the expected future rates will start to come down…”
This is what has begun to happen. But it has affected too big to fail banks differently than it has affected smaller regional banks. The Wall Street Journal advises us that:
the Fed’s move is turning out to be as much bane as blessing for banks, whose dependence on lending income has grown following a regulatory overhaul and public backlash against fees.
“The longer the Fed stays down at these levels the more it will hurt banks,” said Scott Lied, the chief financial officer of ENB Financial Corp., an Ephrata, Pa., institution that has eight branches and 225 employees. “It’s painful.”
Over time, subdued bank profits are likely to accelerate a shakeout that has halved the number of insured institutions over the past two decades, by increasing the pressure on smaller banks to bulk up to take advantage of new technologies and of loosened restrictions on interstate branches.
Hudson City Bancorp, a Paramus, N.J., lender whose profits have been hammered by falling income on its large mortgage portfolio and which agreed in August to sell itself, said in a recent filing that the Fed’s moves “had an adverse effect” on the company, which has $43.6 billion in assets.
The spread between banks’ deposit and lending rates has narrowed in part because of low Fed-influenced rates and slack demand for loans amid soft economic growth.
Net interest margin fell during the third quarter at 79% of all banks tracked by investment bank Keefe, Bruyette & Woods. The average margin for the industry’s largest banks, at 3.12%, is the lowest since the second quarter of 2009 and has been dropping since the third quarter of 2011, according to data tracker SNL Financial.
Meanwhile, the likes of JPMorgan Chase and Wells Fargo are boosting earnings by collecting fees from mortgage refinance deals. So the Fed’s policy is favoring the interests of big banks and letting smaller banks take it on the chin. My prediction is that low net interest margins will be a bank killer in the next downturn with a higher than normal level of bank insolvencies as a unintended consequence of easy money. Plus ca change.