When Citigroup boss Vikram Pandit and Ken Lewis at Bank of America said their banks were off to strong starts this year, many analysts said that was only to be expected. After all, their cost of funds is negligible. Add a reasonable risk premium to benchmark government bond interest rates, which are significantly higher than bank's average borrowing costs, and new loans should be comfortably profitable.
But the US Federal Reserve’s plan to purchase some $300bn of Treasury bonds has caused benchmark interest rates to plummet. Ten-year Treasury bond yields fell nearly half a percentage point on Wednesday after the announcement – the biggest drop in over 20 years. Two-year notes fell 0.2 points. That means less profit for banks from bread-and-butter lending – a business that regulators have been desperate to encourage.
Of course, if the Fed programme performs as anticipated and lower interest rates spur mortgage lending, for example, then banks’ fee income may make up the difference. Plus, the government’s need to finance its swelling deficits could easily push longer-term rates back up.
For banks – if not the economy as a whole – this greater difference between short and longer-term rates, known as a steeper yield curve, would be welcome. US banks’ net interest margins – their revenues from long-term lending minus the cost of their deposits and borrowings – weakened sharply in the fourth quarter last year, according to St. Louis Federal Reserve data.
That’s unusual – net interest margins usually increase in recessions. But in this case, a lot of the cheap loans, like revolving credits, were committed in the boom but only drawn by borrowers when the downturn accelerated.
To offset this, banks should want to make more loans with fatter margins. Government policies that could narrow them – even as an unintended consequence – should be approached with caution.
